I've discussed in the past the benefits to pairing a trading strategy with an allocation strategy. Since then I have made some mental strides in conceptualizing how to discuss the advantages and some adjustments that can be made.
What it comes down to in taking advantage of and capitalizing from an option strategy is whether or not the cost of options is cheap enough to profit. When implied volatility is low, it is a situation where historically average (and above average moves) in the right direction will make you a disproportional amount of money to the risk you take if you are wrong. However, when implied volatility gets higher, it requires a greater and greater move above and beyond average to have a strategy that does more than break even. Although you may be able to develop a skill enough to the point where you can capitalize over the long run in low volatility and high volatility situations, for the time when volatility is high it becomes less profitable and at times unprofitable. Although you can profit from an allocation strategy over the very long run just from prices normalizing through high and low volatility situations it is less profitable when volatility is low.
The idea of pairing each strategy is therefore about reducing the negative effect that downward volatility has on your portfolio so you are better capitalized to recover drawdowns. Typically a 20% drawdown requires a 25% gain just to break even and a 50% drawdown requires a 100% return so the more volatile, the most costly the strategy is, even if on the other side of it you can gain with greater risks.
The other side of it is actually having MORE money on a system that works in the current environment and then being able to smoothly transition.
But the strategy doesn't need to use options. You can pick stocks and still help rebalance and adjust the position whenever necessary without negatively impacting your allocation to a position. If you have a bunch of stocks with a target of 30% and a downside risk of 10%, you don't want to have to reduce your position to half that when the stock is up or down. Nor do you want your entire portfolio and allocation to stock increase by nearly 30%. If you have a winenr, you also want to be willing to let it run if it reacts positively and continues to work beyond your price target. If you have a portfolio that is consisting of the same stocks and it is up a bunch, your allocation would otherwise be overly aggressive at any given time in a normal strategy. With the allocation strategy pairing it, you can simply reduce your stocks index allocation and maintain paritiy with the rest of your portfolio. Additionally, doing so with a stock index that is typically positively correlated with individual stocks (even if that correlation is low) means that you will TEND to reduce the position of the stocks allocation when prices are high, and add to it low. This is the opposite from a trading strategy which must cut losses lower than the purchase price as not doing so would prevent you from having a disproportionally large upside gain to downside risk unless you were to invest very long term and allow for many hundred percent returns like Buffett with coca cola.
The strategy also need not stop there. One thing I recognize is that when volatility gets extreme it can be awhile before your options strategy is profitable again. In the meantime it might be wise to bennefit from both normalization of prices and declining volatility AND having a product with a basic edge. the XIV product for example bennefits from the vix futures constantly being in "contango" except when prices get really high (typically above 30). Once prices fall below there the XIV will also have gone up in price anyways, and the normalization of prices over time even without rebalancing results in the XIV going up as does the length of time it spends in contango. So if the product survives you can make a lot with the XIV. Note that when the VIX moves sideways over a long period of time the XIV and other products are up considerably. It has a structural edge and the return can be well in excess of 100% while the loss can only be 100% So part of the strategy should not just be allocating to a stock index and adding and subtracting shares but permanently owning an allocation of XIV that increases when the VIX gets above 20 and decreases when the VIX gets to it's lower range. This not only will make money over time, but will put more on it when your edge is larger and it will also raise cash when your edge of an option trading system is larger so that you have fuel to keep betting on your greatest edge.
Finally, having CASH is necessary at all times. You may need cash to add to an allocation strategy that dips below a certain amount, particularly if you don't have another allocation that has grown to large enough to sell to raise cash. You also need cash to provide capital to add options into your account and sustain losses. You need enough cash so that your position size doesn't need to get substantially smaller after a handful of losses and you need cash to reduce the volatility as options and leverage can create lots of it. However, it may be on average quite some time before you use ALL of the cash. Enter INCOME.
The idea behind income strategy is not only having a constant flow of capital to normalize return and provide a positive return, but also is in recycling the cash that you have. If you accumulate dividends at a fast enough rate you can naturally have some rebalancing occur so that no position gets too large for very long and no allocation gets too large. If you get income fast enough, you won't need to reduce position size after you have sustained losses in your portfolio because the gains from the income will offset it (and from the allocation rebalancing).
Also, the stock market as a whole can be beaten either with increased returns over average on the way up and the same risk, or by reduced returns on the moves down with the same returns. Pairing each strategy so that you have a particular balance will allow for increased returns on decreased risk. Buffett is capitalized to always have the ability to buy and capitalize off of lower markets. Over the long term, bear markets will not impact him as much as others. However it is possible that in bull markets he will only match the performance of the S&P. Nevertheless, overall he should be expected to outperform and the added capital of the insurance business should make Birkshire Hathaway a good very long term investment. Applying leverage yourself via 2x and 3x ETFs or calls on the market can provide leveraged upside and if you can reduce the allocation on the way up it in theory could neutralize the downside, but using calls as leverage can make the downside manageable to where if it exceeds market's expectation the cost and downside is still fixed.
A hedge can still normalize your return and make your return on risk positive if done correctly even if it is only a break even hedging strategy or slightly worse. If it allows you to increase leverage without increasing your drawdown and the gains are in excess of the cost of the strategy, you still can gain. But mostly hedging is to naturally adjust to a sudden change in the market as the allocations of calls will shrink and the value of the puts and hedges will grow when market engages in a correlated sell.
Finally, Dynamic allocation where you take some liberties to handicap the market and have some skill edge may increase the volatility and risk depending on how aggressively you do it, but it may be worth the effort. You can increase the cash/currency/bond position if you want to reduce the volatility of the strategy.
Also, in the long run, balancing out the volatility of each asset so that you reduce the downside risk can be done if going forward the standard deviations of return remain reflective of the future. You can use tools based upon this theory to attempt to balance out the return so that you have limited downside and high upside with minimal volatility, and then consider leveraging up the strategy to boost the returns, or leveraging it down to reduce the risk depending on your goals.
portfolio visulizer is a tool where you can maximize sharpe ratio and sortino ratios
I am not sold on the theory behind this as I think even 50 years is not enough time to really get a sense for what can happen to assets. From 1940 to 1980 you might conclude that there can be no 90% decline in stocks while the bonds also eventually are liquidated and lose lots of value but if you look at the 1929-1933 that is exactly what happened. Just because a strategy is robust over the last 50 years doesn't mean it will be going forward. I think you have to anticipate relationships to some degree. However, you can still see that international small cap and small cap value where relatively effective in the past at reducing some of the risks of treasuries. If you think those risks are greater than advertised, simply reduce the allocation of them and increase the allocation of that which normalizes and neutralizes it. Just be aware that that may present other risks and you have to offset those.
I think understanding the nature of how rotations of assets and the right balance of ownership can compliment each other constructively provides for an interesting opportunity in understanding the nature of the markets, and how the sum of a portfolio parts can be greater than the whole. But the concept of game theory is what would say to me "if everyone positioned such that owning this allocation was advantageous there would be an over ownership in treasuries, and eventually it would reach a point where the least amount of selling can cause the most amount of pressure downward on price and the yield can go higher". Japan tried manipulating a market for a very lengthy time and it didn't work, so I wouldn't necessarily believe that the fed will be able to handle it and keep bond yield low. Plus pension funds may find it increasingly difficult to maintain high returns without rotating into risk which may have political consequences and pressure for rates to go higher.
However, it is still useful to understand how treasuries provided income that normalized a lot of the downward risk of smallcaps and how international exposure mitigated some of the risk of domestic smallcap value. And gold also provided enough of a boost in the late 70s to mitigate the loss of confidence in treasuries and slowing growth of the stagflationary era. That knowledge could be used to even attempt to "game" certain market conditions by tweaking the allocations, and the value of income can also be introduced and considered.
Although it is a bit difficult to map out a dynamic strategy that ADJUSTS as conditions change and much easier to illustrate a baseline the thing I think in the future I do want to incorporate is
1)I want lots of income and exposure in the private equity and business development asset class (enter BDCL and asset management stocks like BX). 2)I want the XIV to be used to capitalize off of high volatility 3)I want the option buying strategies to shrink when the VIX gets higher and the position size of options to increase as the VIX gets lower and decrease, and ultimately be eliminated as the VIX gets higher. I want the number of positions to decrease as correlations go up and as the VIX goes higher as well. I want to own a larger portion of birkshire when markets are more vulnerable to under performance and decline, and I want to increase allocation of BDCL and BX and private asset management stocks and/or leveraged ETFs (and possibly XIV if it will occur on falling volatility) when I suspect markets will outperform. 4)When volatility is LOW I will reduce XIV and increase the SPY hedge to mitigate the potential damages XIV may cause if VIX keeps going higher. When VIX is high and going higher I will increase the XIV position as I reduce the allocation of the hedge. 5)I will attempt to handicap the market and normalize the volatility in allocation strategy a bit but not too aggressively. 6)Corporate bonds. I am really skiddish ito invest in treasury or government debt right now as everyone has followed the model of the US which is aim to finance their way out of a financial crisis and borrow money to starve off recession which may put them at risk for being able to sustain the borrowing ability just as any market security can become oversaturated, so too can the government become too large and require too many taxes to operate and become too invasive in collecting taxes to the point where the people no longer tolerate it and/or the bond holders no longer can support the risk and the taxes going higher no longer creates higher revenue as increased taxes will just increase the people and capital fleeing and going off the grid and moving countries and using offshore accounts. There has to be a tipping point.
The adjustments will not be easy but I am thinking about something like the following:
VIX around 10 and under XIV 2.00% SPY puts 9.00%
VIX under 13.5 XIV 8.00% SPY puts 5.00%
VIX around 15 (sliding scale) XIV 14.00% SPY puts 4.00% VIX above 17.5 XIV 20.00% SPY puts 3.50% VIX above 30 XIV 25.00% SPY puts 2.50%
The strategy will then adjust the allocation of the XIV/SPY put hedge accordingly. So it will look something like the following:
| VIX around 10 | ||
| XIV/SPY puts pair trade | 11.00% | long term outperform |
| BRK/B | 5.00% | long term outperform |
| IWM/SPY | 1.00% | long term outperform |
| commodities | 4.00% | commodities |
| bonds | 5.00% | bonds |
| currency | 7.00% | currency |
| 1-2wk | 5.00% | stock timing |
| 3-4wk | 11.00% | stock timing |
| 5-15wk | 6.00% | stock timing |
| 15-40 week | 6.00% | stock timing |
| 40+wk | 5.00% | stock timing |
| stock basket of 5 tops | 0.00% | stock picking allocation to sector |
| income | 2.00% | protection |
| cash | 18.00% | protection |
| hedge | 14.00% | protection |
| 100.00% | ||
| VIX around 12 | ||
| XIV/SPY puts pair trade | 12.00% | long term outperform |
| BRK/B | 3.00% | long term outperform |
| IWM/SPY | 2.00% | long term outperform |
| commodities | 5.00% | commodities |
| bonds | 5.00% | bonds |
| currency | 6.00% | currency |
| 1-2wk | 4.00% | stock timing |
| 3-4wk | 12.00% | stock timing |
| 5-15wk | 7.00% | stock timing |
| 15-40 week | 7.00% | stock timing |
| 40+wk | 5.00% | stock timing |
| stock basket of 5 tops | 0.00% | stock picking allocation to sector |
| income | 5.00% | protection |
| cash | 20.00% | protection |
| hedge | 7.00% | protection |
| 100.00% | ||
| VIX around 14 | ||
| XIV/SPY puts pair trade | 15.00% | long term outperform |
| BRK/B | 3.00% | long term outperform |
| IWM/SPY | 2.00% | long term outperform |
| commodities | 4.00% | commodities |
| bonds | 4.00% | bonds |
| currency | 5.00% | currency |
| 1-2wk | 3.00% | stock timing |
| 3-4wk | 10.00% | stock timing |
| 5-15wk | 5.00% | stock timing |
| 15-40 week | 5.00% | stock timing |
| 40+wk | 4.00% | stock timing |
| stock basket of 5 tops | 0.00% | stock picking allocation to sector |
| income | 10.00% | protection |
| cash | 25.00% | protection |
| hedge | 5.00% | protection |
| 100.00% | ||
| VIX around 16 | ||
| XIV/SPY puts pair trade | 20.00% | long term outperform |
| BRK/B | 3.00% | long term outperform |
| IWM/SPY | 2.00% | long term outperform |
| commodities | 4.00% | commodities |
| bonds | 4.00% | bonds |
| currency | 5.00% | currency |
| 1-2wk | 3.00% | stock timing |
| 3-4wk | 7.00% | stock timing |
| 5-15wk | 4.00% | stock timing |
| 15-40 week | 5.00% | stock timing |
| 40+wk | 4.00% | stock timing |
| stock basket of 5 tops | 5.00% | stock picking allocation to sector |
| income | 5.00% | protection |
| cash | 25.00% | protection |
| hedge | 4.00% | protection |
| 100.00% | ||
| VIX around 20 | ||
| XIV/SPY puts pair trade | 24.00% | long term outperform |
| BRK/B | 3.00% | long term outperform |
| IWM/SPY | 4.00% | long term outperform |
| commodities | 2.00% | commodities |
| bonds | 3.00% | bonds |
| currency | 4.00% | currency |
| 1-2wk | 1.00% | stock timing |
| 3-4wk | 2.00% | stock timing |
| 5-15wk | 3.00% | stock timing |
| 15-40 week | 4.00% | stock timing |
| 40+wk | 4.00% | stock timing |
| stock basket of 5 tops | 10.00% | stock picking allocation to sector |
| income | 5.00% | protection |
| cash | 28.00% | protection |
| hedge | 3.00% | protection |
| 100.00% | ||
| VIX around 30 | ||
| XIV/SPY puts pair trade | 27.00% | long term outperform |
| BRK/B | 2.00% | long term outperform |
| IWM/SPY | 4.00% | long term outperform |
| commodities | 2.00% | commodities |
| bonds | 3.00% | bonds |
| currency | 3.00% | currency |
| 1-2wk | 0.75% | stock timing |
| 3-4wk | 1.50% | stock timing |
| 5-15wk | 2.00% | stock timing |
| 15-40 week | 2.50% | stock timing |
| 40+wk | 3.50% | stock timing |
| stock basket of 5 tops | 12.25% | stock picking allocation to sector |
| income | 5.00% | protection |
| cash | 29.00% | protection |
| hedge | 2.50% | protection |
| 100.00% | ||
alternate strategy when vix gets above 16 something like:
| alternative | |
| XIV/SPY puts pair trade | 0.00% |
| BRK/B | 0.00% |
| IWM/SPY | 0.00% |
| commodities | 0.00% |
| bonds | 0.00% |
| currency | 2.00% |
| 1-2wk | 2.00% |
| 3-4wk | 2.00% |
| 5-15wk | 2.00% |
| 15-40 week | 2.00% |
| 40+wk | 2.00% |
| stock basket of 5 tops | 62.50% |
| income | 0.00% |
| cash | 20.00% |
| hedge | 5.00% |
| 100% | |
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