Finding Alpha In Options Market Sentiment

An Anzani 10-cylinder radial aircraft engine (image via Wikimedia Commons). 

Switching To Four Cylinders 

Six months ago, we changed the way we selected our top names. We had already determined that we could find alpha by using hedging cost to analyze options market sentiment. Among our top ranked names, securities that could be hedged against >9% declines with optimal, or least-expensive, puts expiring in approximately 6 months tend to significantly outperform those that couldn't be hedged that way over the next 6 months. We'd been calling those "AHP" ("Also Hedgeable with Puts") for short. What we did starting on November 20th was drill down further, looking at the performance of securities that were also hedgeable against even smaller declines with optimal puts. 

Limited Data

One problem was we had limited data about securities hedgeable against declines of less than 6%, because those had rarely showed up among our top names under our old approach. So, in November, our security selection process was informed by the four calibration factors circled in red below.   

We had data on names that were hedgeable against >6%, >7%, >8%, and >9% declines with optimal puts expiring in approximately 6 months. As far as calibration factors were concerned, we had a four cylinder engine. 

New Data Starts To Pour In

Giving preference to securities hedgeable against >6% declines starting in November meant that we ended up with some names that were also hedgeable against even smaller declines. For example, all of our top 10 names on November 20th were hedgeable against >6% declines, but two of them, Anixter AXE and the SPDR Gold Trust ETF GLD were also hedgeable against >4% declines. 

On May 20th, 6-month performance data started pouring in from the new approach. The top performers from that top names cohort were the two hedgeable against >4% declines, GLD and AXE. 

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