Monthly Archives: April 2012
No, I’m not discussing political leadership changes in a foreign country due to intervention or a coup. The term “regime change” also applies to the stock market. The stock market goes through regime changes or shifts. What the term refers to is the state of the market in terms of its trend and volatility. The majority of the time, the market trends quietly upwards with low volatility. These periods of low volatility are interrupted by brief periods of rapidly falling prices and high volatility. Without delving into the underlying mathematics of the econometric models that calculate regime change, it can be summed up in simple terms to mean that about 85% of the time the market will trend higher with low volatility. We’ll call this “state one”. About 15% of the time the market will be in “state two” characterized by falling prices with high volatility. The trend is approximately three times as large in the negative direction when the market is in state two. Also, when the market is in state two, it tends to revert to state one quickly with 90% probability.
Ok, so what does this type of quantitative research mean to investors? What it means is that if you invest in the market you should expect most of the time to see your portfolio increasing in value with modest price swings, but also expect to have those quiet periods interrupted by brief periods of rapidly falling prices with larger price swings. Long term investors can use the periods of falling prices to add to market positions. Investors with a shorter time horizon, like those who are already retired can find the state two periods to be very unsettling. Investors can always consider using some sort of hedging mechanism if the volatility is causing too many sleepless nights. Index options can be used to hedge downside risk as can some of the new volatility and inverse ETFs.
What this can mean for option traders is that if we are in a period of high volatility, we can expect the market to eventually return to normal which means that the high volatility will eventually subside and we can expect to profit from strategies that involve selling options and collecting premium.
The concept of expected return is critical for options traders to understand. The expected return is known as the weighted average outcome. The math is really simple and can be shown as follows; say you were considering an investment that had a 25% chance of a 20% return, a 25% chance of a 10% return, a 25% chance of a 5% return and a 25% chance of a -5% return. The formula would look like this;
Expected Return = (0.25) (0.2) + (0.25) (0.1) + (0.25) (0.05) + (0.25) (-0.05) = 7.5%
As an options trader or if you use options to reduce risk and enhance return on your investment portfolio you need to get in the habit of using an option calculator and calculate the expected return on any position that you are considering. Options without an expected profit should not be used. Scan the market for strategies that have a positive expected return.
Say for example someone challenges you to a game of coin toss. You can pick heads or tails and you can play as long as you wish. If the payout was the same for either heads or tails say $1, there is no statistical advantage to the game and no reason to play. Now if you were the receive $2 when you won and only had to pay $1 when you lost, you’d have a huge statistical advantage and should play that game as much as you can.
Casino games are like the above example but the casino gets $1.05 when it wins and you get $.95 cents. When trading options, use an expected return calculator, find trades where the expected return is on your side and manage your risk always.