It's holiday time, the VIX is subdued and everybody is looking forward to next year and the returns for the next decade. Institutional investors are buying tonnes of put options to hedge their positions against the next downturn, despite growing optimism about the current melt-up.
Here's my current view on the market and why I expect delta-neutral option selling strategies to bode well for smart investors.
Future Equity Returns Will Be Inferior To What We've Enjoyed Over The Past Years
With the S&P-500 climbing higher nearly every day and investor sentiment reaching euphoric readings, everyone naively believes in the same future returns like the ones we've enjoyed over the past decade. Valuation multiples are getting stretched, corporate debt levels are rising while QE4 and buybacks (which have a positive recurring effect on future EPS) have been very supportive for equity returns for quite some time now. The inevitable question becomes: how long can this bullish sentiment last and what's the impact of a stellar decade with unprecedented returns on your future performance? Stocks and bonds, the two most common asset classes, have been through cycles of inferior Sharpe Ratios especially. I wouldn't be too surprised if we were to see a long-lasting period of noticeably lower Sharpe Ratios for stocks courtesy of their rich valuation levels. An expected annualized return of maximum 5% for US equities falls short of the 12% we've seen over the past years.
Higher P/E = Lower Future Returns
The higher the P/E ratio, the lower your starting yield. Seems so logical, but it actually makes very little sense in a world where ETFs become even more popular, thereby pushing the richest multiples to even higher levels (Apple, Microsoft, and the FANG Gang in general). Increasing P/E ratios aren't necessarily bad as long as they are accompanied by earnings growth and that is precisely what most companies lack due to weak industry data, trade tensions and below-average capital expenditures. Although a period of overvaluation can linger for a while (along with a low VIX), it's very likely to put a damper on future returns. A message I read all the time: Just follow the market and you'll be fine. I doubt whether this kind of lazy approach is going to take you where you want to be (over the past decade, passive investing has been the Holy Grail, that's for sure) in terms of risk-adjusted and absolute returns. The greedier dumb/passively invested money is today, the worse its performance is going to be.
Selling Options With A High Probability Of Profit Will Thrive
That's why delta-neutral option selling strategies with low-volatility stocks are very likely to thrive over the next decade because we don't have to care about valuation multiples being stretched. We just need to set a specific win area wherein we collect a decent amount of time value regardless of market sentiment. That's a whole different mindset: we know what returns we can expect and aren't greedy when the market rallies. We focus on the best risk-adjusted returns instead.
Put Skew = Looking For More Room To The Downside
Put skew is now elevated meaning we get more bang for our buck on the put side relative to the call side. And honestly, I currently do care more about downside risk than a continuation of the massive rally, so being a little more conservative on the put strikes is going to bear fruit during the next correction.
Another 10% rally from today's levels would lead to exuberance if it's not backed by a solid catalyst (i.e. earnings growth or remarkably improving manufacturing data).
Our objective is simple: generating the highest risk-adjusted returns, i.e. achieving the best possible outcome with the least amount of volatility. For the sake of context, I've set a specific number: 6.5% annualized volatility while generating a nice monthly return of, on average, 2%. On a compounded basis, that would bring you to lofty double-digit returns. Our goal is not to beat the market on a short-term basis, which is self-explanatory as our delta-neutral strategy doesn't benefit from a melt-up. You can track our results which we update regularly on a monthly basis. https://www.optiongenerator.com/track-record
Combining the best of both worlds allows us to generate returns far exceeding those of traditional investing while being less volatile.