It may surprise subscribers to learn that Value Line Options has been ranking options for nearly three decades (we were mostly a print product before 1996) and that we have 29 ½ years of quarterly returns. We make these results available in our template, Trakrec.Xls. One particularly useful feature of Trakrec.Xls is its ability to suggest optimal portfolio allocations for options, stocks, bonds and cash, as we will demonstrate in this report.
29 ½ Years of Quarterly Returns
You will find Trakrec.Xls in our Excel Software Weekly Option Performance directory. The template contains the quarterly returns for the basic option strategies from the beginning of 1980 through Q2 2009. These results are derived from the weekly performance of our option ranks as reviewed in our quarterly option rank performance reports and as presented in our Ranksfile.Xls file. (See “June 2009 Option Rank Performance,” Ot090702.Pdf and “A Review of Our Performance Data,” Ot070122.Pdf in our Reports Archive.)
In Trakrec.Xls, we try to make our performance more representative of how an investor might have fared following our option ranks. Based on the assumption that option ranks can slip a notch after a position is initiated and still be held, we include the performance of rank 2 options as well as rank 1s for call and put buying and for covered call writing. Similarly, we include rank 4 as well as rank 5 options for call writing and put writing. (For purchases and covered calls, we give a 66% weight to rank 1s and a 33% weight to rank 2s. For writes, we give a 66% weight to rank 5s and a 33% weight to rank 4s.) In addition, to reflect transaction costs, we narrow the gains and widen the losses of call and put buying and writing by 5% each quarter.
Trakrec.Xls also contains the quarterly returns on other basic asset classes: stocks (the S&P 500 total return), bonds (the Lehman AGI Index) and interest-bearing cash. The inclusion of these asset class returns helps investors determine which option strategies go best with the rest of their portfolio. In Figure 1 (see FigureGraphs.Pdf attached), we show rows 1 through 23 of Trakrec.Xls. Rows 21 through 133 contain the actual quarterly returns and the cells that perform the necessary calculations. Users enter various portfolio allocations in the cells in row 20 (e.g. cell B20 for Put Buying; cell C20 for Put Writing, etc.). Note that the weights for the entire portfolio should always add up to 100%. For this reason, we have put a formula in cell L19 that calculates a residual weighting for interest-bearing cash.
You can change this default formula if you want.
In cells A2 through F14, we summarize the results for the various allocations. In column B, we show the performance of the entire 29 ½ year period. We also show three sub periods: (1) Q1 1980 through Q4 1990 (Column C), (2) Q1 1991 through the latest quarter (Q2 2009) (Column D) and (3) Q1 2000 through the latest quarter (Column E).
Using Solver
We have set the template up so subscribers can use Microsoft’s Excel Solver to find optimal portfolio allocations. (See Figure 2 below for an example of the Solver dialogue box.) You can activate Solver by clicking on Tools and then Solver in Excel. You can set your desired level of volatility by changing the number in B16. Solver is particularly helpful for investors who want to know which option strategies are best, given the composition of the rest of their portfolio.
In our example in Figures 1 and 2, we have set Solver to get the maximum return, with a volatility constraint of 20% for the past 18 ½ years (beginning 1991 through Q2 2009) assuming that 25% of the portfolio is held in the S&P 500 (cell I20) and 25% in bonds (cell J20).
The option strategies we are considering adding to the portfolio are put buying, call buying, and covered call writing. (To select these strategies, separate the cell references with commas). Solver computed the following “optimal” weights; 7.6% put buy, 6.2% call buy, 36.1% covered calls and zero percent interest-bearing cash (with 25.0% in the S&P 500 and 10.0% in bonds).
These weights produced a 37.2% annual return over the target period (cell D4), with an annual standard deviation of only 20%. On a risk-adjusted basis, this performance was very positive, with a Relative Sharpe Ratio* of 5.09.
Our Graphs
To help investors visualize the performance of our strategy allocations, we provide two graphs in this template. Graph 1 (attached) shows the performance of the abovementioned portfolio optimized for the past 17 ¼ years. This graph also shows the performance of the S&P 500 and a Relative Performance line of the optioned portfolio versus that index. Whenever this relative performance line dips, the options portfolio has underperformed the stock market. For most of the quarters in this example, this indicator has risen, indicating that the portfolio had beaten the market over these periods.
Graph 2 (also attached), is an “X/Y” type graph, in which the S&P 500 returns are on the horizontal (or “X”) axis and the portfolio returns are plotted along the vertical (or “Y”) axis. If the portfolio is above the diagonal line, then it has outperformed the S&P 500 over the period. Also, we show how closely the portfolio tracks the stock market by also plotting out the Beta Line derived from regression analysis (in the form of: Portfolio = Constant (Alpha) + Beta x S&P 500). Finally, we have also added a polynomial regression fit of the portfolio to the market. This shows that the portfolio has tended to perform well when there has been a large move in either direction.
Replicating our Results
Can one replicate the results in Trakrec.Xls? Bear in mind that returns are based on the week-to- week mid-point (bid/ask) performance of all options in the various ranks. Even though these returns have been adjusted to reflect transaction costs, these costs can still be highly unpredictable. That said we still believe that the results derived from Trakrec.Xls indicate the type of returns that can be achieved by following our option and covered call ranks in a judicious manner.
Prepared by Lawrence D. Cavanagh
Footnote: *The Sharpe Ratio is a standard measure of risk-adjusted return. You calculate the Sharpe Ratio by subtracting the risk-free rate from the rate of return on investment and dividing this result by the standard deviation of the investment. The Relative Sharpe ratio is this return divided by the Sharpe ratio of the S&P 500 for the same period.