How to beat the market? The magic of volatility.
The dream of any investor is to show returns above the market average. As practice shows, even many professional market participants cannot do this. Let’s assume that you were such an insightful investor that you only selected clear winners in your portfolio. Big 4 — Amazon, Apple, Google and Facebook.
A chart of such a portfolio (blue line) compare to S&P 500 (red line)
It looks impressive, in reality you would get double the returns compared to the broad market (S&P 500). CAGR 26% vs 13%. But the drawdown would also be twice as large 45% vs 24%.
These are the results for the best stocks in the world. It’s evident that predicting the best-performing stocks in the future in advance is nearly impossible. The good news is that we have a simpler way to beat the market. What should we do? We need to select stocks with higher volatility than the market index. Next, we sell put options on these stocks and buy call options on the index. If the volatility of the selected stocks is twice as high as the index, then we can achieve a return of X2. It’s sufficient that they do not experience a decline; they don’t necessarily need to outperform the market. I must admit that this is a much simpler task than finding real winners. Many stocks have volatility that’s five or even ten times higher than the index. The main problem is that most highly volatile stocks are usually extremely risky, and many of them go bankrupt. This is especially true for stocks in the biotechnology sector. Such investing resembles a pure lottery.
So we need to look for strong and safe stocks with high volatility. I have years of experience in investing, and I have effective methods for finding such stocks.
As an example of the results we can achieve
The idea of this strategy is to sell put options with 2–3 months before expiration and 0.1–0.15 Delta(it’s very safe!) for few selected stocks AND to buy call options with 0.5 delta for SPY. We specifically exclude winners like Facebook, although Facebook’s volatility is ideal for this strategy. We use such average stocks as Miсron or Qualcomm. As a result, we get the same profitability as the broad market and the drawdown is 3 times smaller. If we need higher returns and we are ready to larger drawdowns, then we can simply sell put options with a higher delta.
Today a good example of such a stock is PayPal (ticker PYPL). It has nearly X3 IV compared to the S&P 500 (>50% vs 18%). The stock has been falling for two years and has already reached ridiculous levels. Downside risk is limited. We will be completely satisfied even if the stock remains at its current levels without growth.
I have working filters for screening stocks. I use a quantitative approach including machine learning. However the final word always goes to manual fundamental research. The last step is very time consuming. So if someone wants to join in on the fundamental research of selected stocks, welcome aboard !
