Investing in stock market indices via option spreads beats buffet?

[ironchef]

If you want to claim to "beat Buffet" you need to show that you achieved a higher return with a lower risk, not simply that you had higher returns. Any jackass can throw together an options "strategy" that will give a higher return than Buffet, that's absolutely meaningless. I'd recommend the OP read up on the concept of risk adjusted return and then get back to us.

If I compare two investments, e.g., two stocks, how do I calculate the respective risks of the stocks? Someone here (and Buffett) told us that volatility is not risk. If I cannot assess the "riskiness" how can I calculate risk adjusted returns? Perhaps an example would be comparing the returns of DIA vs RUT, RUT has higher volatility but also higher mean so short term it might have higher swings but over any 30 year time horizon, starting from 1960, it always out performed DIA. For someone with a long time horizon is RUT riskier than DIA?

Please help me out. Thanks.

 

[Trading Education Buyer]

risk = total maximum drawdown (I am using trading systems type of comparisons)
compare with s and p , nasdaq , dow
?

I would assume you get maximum one or two losses

just a few hints here

 

[Sig]

If I compare two investments, e.g., two stocks, how do I calculate the respective risks of the stocks? Someone here (and Buffett) told us that volatility is not risk. If I cannot assess the "riskiness" how can I calculate risk adjusted returns? Perhaps an example would be comparing the returns of DIA vs RUT, RUT has higher volatility but also higher mean so short term it might have higher swings but over any 30 year time horizon, starting from 1960, it always out performed DIA. For someone with a long time horizon is RUT riskier than DIA?

Please help me out. Thanks.

A quick dive into the Sharpe Ratio (https://en.wikipedia.org/wiki/Sharpe_ratio) would probably help answer many of your questions. I'd also highly recommend one of the many free MOOC finance 101 courses, you can take one them from some of the best universities and their best professors and you can't beat the price. It would take several pages to go over it here and it still wouldn't do it justice. Sorry, I know that sounds like a non-answer one typically gives when they don't have an answer, but it's just not an easily reducible concept and involves some at least mid-level prob/stats (or at least I don't have the skills to make it an easily reducible concept).

 

[ironchef]

A quick dive into the Sharpe Ratio (https://en.wikipedia.org/wiki/Sharpe_ratio) would probably help answer many of your questions. I'd also highly recommend one of the many free MOOC finance 101 courses, you can take one them from some of the best universities and their best professors and you can't beat the price. It would take several pages to go over it here and it still wouldn't do it justice, it's just not an easily reducible concept and involves some at least mid-level prob/stats.

Thanks. I did take a few MOOC finance classes to learn some fundamentals of finance, e.g. risk adjust returns... but is having difficulty understanding the relationship between risk and volatility.

In layperson's words, how do I calculate the risk of a stock/company and comparing it to another one if volatility is not it?

 

[Sig]

Thanks. I did take a few MOOC finance classes to learn some fundamentals of finance, e.g. risk adjust returns... but is having difficulty understanding the relationship between risk and volatility.

In layperson's words, how do I calculate the risk of a stock/company and comparing it to another one if volatility is not it?

So total layperson's explanation to the OP, let's say I offered you option A, which was a U.S. treasury yielding 5% and option B, which was an options strategy yielding 5% that consisted of selling naked OTM puts. It's obvious that the nearly risk-free Treasury return is not the same as the put option return, even though in percentage terms they are the identical. A risk-neutral investor would always choose A. Now lets say A yields 5% but B yields 7%. We can't know for sure without doing the math, but intuitively you'd probably say A will still provide you a higher expected value. At some point, maybe when B yields 55%?, A and B have the same expected value and a risk neutral investor will be indifferent between them.
There are reams of literature on determining where that point of indifference lies, and lots of smart people disagree an exactly how that's best determined, but they don't disagree on the fundamental premise that A and B can't be measured on their return alone. The Sharpe Ratio is one such measure, the formula is

, so you're comparing they idiosyncratic risk of a particular security to an index. It is based on the concept of variance and the fact that the variance of two independent variables together is less than the variance of either alone. Because securities aren't completely independent, we try to tease out how much of a securities movement is based on idiosyncratic risk and how much is based on systemic risk, i.e. the movement of an index. You generally wouldn't compare one index to another using this, unless the one index was a subset of the other.

 

[ironchef]

So total layperson's explanation to the OP, let's say I offered you option A, which was a U.S. treasury yielding 5% and option B, which was an options strategy yielding 5% that consisted of selling naked OTM puts. It's obvious that the nearly risk-free Treasury return is not the same as the put option return, even though in percentage terms they are the identical. A risk-neutral investor would always choose A. Now lets say A yields 5% but B yields 7%. We can't know for sure without doing the math, but intuitively you'd probably say A will still provide you a higher expected value. At some point, maybe when B yields 55%?, A and B have the same expected value and a risk neutral investor will be indifferent between them.
There are reams of literature on determining where that point of indifference lies, and lots of smart people disagree an exactly how that's best determined, but they don't disagree on the fundamental premise that A and B can't be measured on their return alone. The Sharpe Ratio is one such measure, the formula is

, so you're comparing they idiosyncratic risk of a particular security to an index. It is based on the concept of variance and the fact that the variance of two independent variables together is less than the variance of either alone. Because securities aren't completely independent, we try to tease out how much of a securities movement is based on idiosyncratic risk and how much is based on systemic risk, i.e. the movement of an index. You generally wouldn't compare one index to another using this, unless the one index was a subset of the other.

Thanks for the reply.

Still, what I am struggling with is the definition of risk. In the Sharpe Ratio, risk is defined by volatility (related to standard deviations of the underlying) but in real businesses, two businesses with the same standard deviation for a specified period might not be similarly risky (to me defined as the probability of long term successes). When I am trying to decide which to invest, are there any financial parameters that I can look at to differentiate the riskiness of the two in addition to volatility? I read Buffett's annual reports and in them he often said risk was different from volatility but never explained how to calculate risk.

Appreciate you taking the time to answer my posts.

 

[Sig]

Thanks for the reply.

Still, what I am struggling with is the definition of risk. In the Sharpe Ratio, risk is defined by volatility (related to standard deviations of the underlying) but in real businesses, two businesses with the same standard deviation for a specified period might not be similarly risky (to me defined as the probability of long term successes). When I am trying to decide which to invest, are there any financial parameters that I can look at to differentiate the riskiness of the two in addition to volatility? I read Buffett's annual reports and in them he often said risk was different from volatility but never explained how to calculate risk.

Appreciate you taking the time to answer my posts.

I think you've moved from the area of established thought to one where lots of smart people have different opinions. Variance/volatility is the quick solution but it has lots of known issues, there are various other approaches that quickly get complicated and have their own issues. The variance is essentially what the market is saying the "risk" is. If you think the market is wrong, which I think is what Buffett is essentially doing in his investment approach, I think you'd choose your own number based on your thesis and use that. This allows you to still use the established formulas while taking into account that you have a different view of the security than the market. That's my approach, but again there are lots of people lots smarter than me with a bunch of other approaches that could be a better fit for what you're doing. As long as you avoid the trap the OP fell into with the thread title, I think you're well on your way to at least approaching the issue the right way.

 

[ironchef]

I think you've moved from the area of established thought to one where lots of smart people have different opinions. Variance/volatility is the quick solution but it has lots of known issues, there are various other approaches that quickly get complicated and have their own issues. The variance is essentially what the market is saying the "risk" is. If you think the market is wrong, which I think is what Buffett is essentially doing in his investment approach, I think you'd choose your own number based on your thesis and use that. This allows you to still use the established formulas while taking into account that you have a different view of the security than the market. That's my approach, but again there are lots of people lots smarter than me with a bunch of other approaches that could be a better fit for what you're doing. As long as you avoid the trap the OP fell into with the thread title, I think you're well on your way to at least approaching the issue the right way.

Thank you. I don't have a formal financial training so your responses are extremely helpful. After a couple of years trading options, in 2014 I finally realized I had to get off the beaten paths of listed popular option strategies to be profitable or else I was the one providing the profits to others.

Regards,

 

[Martinghoul]

Thanks for the reply.

Still, what I am struggling with is the definition of risk. In the Sharpe Ratio, risk is defined by volatility (related to standard deviations of the underlying) but in real businesses, two businesses with the same standard deviation for a specified period might not be similarly risky (to me defined as the probability of long term successes). When I am trying to decide which to invest, are there any financial parameters that I can look at to differentiate the riskiness of the two in addition to volatility? I read Buffett's annual reports and in them he often said risk was different from volatility but never explained how to calculate risk.

Appreciate you taking the time to answer my posts.

Think of it this way (I think that's what Sig said as well). Risk, as you point out, is hard to measure. One person's opportunity is another person's threat. So you can think of volatility as an estimate of true underlying risk of an asset. Is it a perfect estimate? Certainly not. Is it, on balance and in most cases, the best estimate we can get? Probably yes. Is it also quite practical, since it's relatively easily observable by all investors/mkt participants? Definitely yes.

 

[ironchef]

Think of it this way (I think that's what Sig said as well). Risk, as you point out, is hard to measure. One person's opportunity is another person's threat. So you can think of volatility as an estimate of true underlying risk of an asset. Is it a perfect estimate? Certainly not. Is it, on balance and in most cases, the best estimate we can get? Probably yes. Is it also quite practical, since it's relatively easily observable by all investors/mkt participants? Definitely yes.

Thanks. Make sense. So I should look at volatility as a major component of risk and perhaps add a few other factors.

My question for you sir is: Are there any technical indicators that can supplement volatility to get a better risk management. For example, if I sell a call option that has a high volatility (indicate riskiness) I should sell it when technical indicator signifies a resistance/peak?

Regards,