option strategist option based portfolio management

This material does not constitute investment advice and sho uld not be viewed asa current or past recommendation or a solicitation of an offe r to buy or sell anysecurities or to adopt any investment strategy.

Q.M.S Advisorstel: 078 922 08 77

e-mail: info@qmsadv.comwebsite: www.qmsadv.com

Equity Derivatives Solutions – S&P 500 Index October 2012

Option StrategistOption Based Portfolio Management

Q.M.S Advisors | tel: +41 (0)78 922 08 77 | e-mail: info@qmsadv.com | website: www.qmsadv.comPage 1

� Equity markets are likely to keep on experiencing periodic, broad-based and dramatic

selloffs going forward.

� Adopting an Options Based Portfolio Management approach to investing (OBPM) in

the chaotic, multi-modal market environment we entered since 2008 is particularly

pertinent.

� Risk can be an abstract concept until it materializes. In 2008 and early 2009, risk

materialized as never before and brought awareness to alternative portfolio

management strategies, such as OBPM.

� Options are particularly adapted to manage portfolio risks. They can be used to

augment income, enhance return potential and limit portfolio risk. As such, they

have never been more viable investment tools, especially within an asset allocation

and portfolio construct.

� In a historical portfolio context, the statistical properties of several OBPM in our

analysis compare very favorably to traditional long only exposures.

Enhancing Long-Term Portfolio Performance while Mitigating Equity Drawdown RisksGOAL

Option Based Portfolio Management Tail-risk Hedging and Income in a Multimodal World

� Option-based strategies:

The strategies we examine are based on indices created and monitored by the Chicago

Board Options Exchange (CBOE):

�The CBOE S&P 500 BuyWrite Index – BXM

�The CBOE S&P 500 2% Out-of the Money (OTM) BuyWrite Index – BXY

�The CBOE S&P 500 PutWrite Index – PUT

�The CBOE S&P 500 95-110 Collar Index – CLL

Each of these indices has over twenty years of daily return data and follow a consistent

methodology for re-establishing or rolling the option hedge upon or just prior to

expiration.

� We also cover three additional Option Based Portfolio Management strategies that

merit consideration by investors, but for which there is not as much return

information. It is important to note that these OBPM strategies are purely systematic,

and that they maintain a strict and fully invested profile, holding both the long

position in the index and the option position(s) at all times.

� Our approach is that of a portfolio manager, and not a trader, as these are all passive

strategies. However, it is possible to pursue active approaches as well.

� Numerous Supporting Studies

� Over the past several years, multiple studies of OBPMS have been published—both

by independent consulting firms and industry organizations. While the studies are

careful not to openly endorse the strategies, the data regarding the average return

and low standard deviation of returns speak for themselves. Q.M.S Advisors recently

conducted its own return and risk analysis and the results continue to hold up very

well compared to both long-only equity strategies and fixed income strategies.

� From an Efficient Frontier perspective, OBPM dominate other asset classes and

strategies over the time period considered.

� Prudence, Theory and Practice

� In the current environment, investors need exposure to risk assets to meet their

required returns, to collect income or to reduce or limit risk. All of the strategies we

consider provide one or more of the aforementioned characteristics.

� Over the time period we considered, exposure to OBPM strategies brought both

solid returns and risk reduction characteristics to a well diversified portfolio. Reliable

return enhancing and/or risk reducing strategies that can be implemented in a cost-

efficient manner should be considered at the Strategic Asset Allocation level.

� Strategic Asset Allocation and Investability

� Q.M.S Advisors’ view is that reliable portfolio management approaches rest upon

sound Investment Policy Statement (IPS) and Strategic Asset Allocation foundations.

� This is also what makes ad hoc option overlays or trading so tactically challenging. Without

being formally addressed in the IPS, adding option positions informally introduces serious

timing issues as well as potentially serious disruption to the formal asset allocation.

� Q.M.S Advisors’ believes that when OBPM strategies are formally examined and

considered, investors can and should make permanent allocations to them because

of their superlative long term risk and return characteristics.

� Academic research supports the stylized fact that implied volatility has been and most

likely will remain higher than realized volatility over the long run.

� Historically, OBPM strategies have dominated the efficient frontier.

� OBPMS are highly investable. Option and futures trades are executed on deep,

transparent, reliable, efficient and extremely liquid markets. Unlike Hedge Fund

strategies, OBPMS offer full transparency as to the investment methodology and

associated payoff characteristics . They are also available in vehicles that offer daily

or even continuous liquidity.

Source: Bloomberg, QMS Advisors

Whether considered on a standalone or total portfolio basis, OBPM offered compelling statistical propertiesRATIONALE

Based on audited historical data from 01.01.1989 to 28.09.2012

Libor 3-Month USD

S&P 500 TR Index

CBOE S&P 500 BuyWrite Index

CBOE S&P 500 2% OTM BuyWrite

CBOE S&P 500 PutWrite Index

CBOE S&P 500 95-110 Collar Index

Historical Returns 2.8% 7.4% 8.2% 9.1% 9.7% 5.5%Historical Volatility 0.1% 18.2% 12.8% 14.5% 11.9% 11.4%Historical Skewness 0.03 -0.26 -0.73 -0.59 -0.76 -0.07Historical Kurtosis 2.21 12.01 25.25 17.44 31.09 5.83Tracking Error 0.0% 8.4% 6.2% 9.5% 9.5%Sharpe Ratio 0.00 0.25 0.42 0.43 0.57 0.24Maximum Drawdown -59.6% -43.5% -48.6% -40.2% -39.6%Up Market Capture 100% 53% 75% 44% 64%Down Market Capture 100% 79% 89% 71% 86%Correlation to the S&P 500 TR Index 0.01 0.91 0.95 0.88 0.89Average Beta to the S&P 500 TR Index 0.00 0.64 0.76 0.58 0.56

Beta '+/-' to the S&P 500 TR IndexY = 0.64X -0.07 |X|

+0.0006Y = 0.76X -0.05 |X|

+0.0005Y = 0.58X -0.07 |X|

+0.0007Y = 0.56X +0.02 |X|

-0.0001R2 0.84 0.91 0.78 0.80Convexity -0.065 -0.053 -0.067 0.022

Historical Efficient Frontier

8% 10% 12% 14% 16% 18% 20%

Historical Volatility (in % p.a.)

Libor 3-Month USD S&P 500 TR Index CBOE S&P 500 BuyWrite IndexCBOE S&P 500 PutWrite Index CBOE S&P 500 2% OTM BuyWrite Index CBOE S&P 500 95-110 Collar Index

Based on Audited Historical Data from Jan. 1st 1989 to Sep. 28th 2012

Relative Performance

1000Ja

S&P 500 TR Index CBOE S&P 500 BuyWrite IndexCBOE S&P 500 2% OTM BuyWrite Index CBOE S&P 500 PutWrite IndexCBOE S&P 500 95-110 Collar Index

-1% 0% 1% 2% 3% 4% 5%

Proba. Dist. F(). S&P 500 TR IndexProba. Dist. F(). CBOE S&P 500 BuyWrite IndexCumul. Dist. F(). S&P 500 TR IndexCumul. Dist. F(). CBOE S&P 500 BuyWrite Index

-1% 0% 1% 2% 3% 4% 5%

Proba. Dist. F(). S&P 500 TR IndexProba. Dist. F(). CBOE S&P 500 2% OTM BuyWrite IndexCumul. Dist. F(). S&P 500 TR IndexCumul. Dist. F(). CBOE S&P 500 2% OTM BuyWrite Index

-1% 0% 1% 2% 3% 4% 5%

bility

t. Fun

Proba. Dist. F(). S&P 500 TR IndexProba. Dist. F(). CBOE S&P 500 PutWrite IndexCumul. Dist. F(). S&P 500 TR IndexCumul. Dist. F(). CBOE S&P 500 PutWrite Index

-1% 0% 1% 2% 3% 4% 5%

Proba. Dist. F(). S&P 500 TR IndexProba. Dist. F(). CBOE S&P 500 95-110 Collar IndexCumul. Dist. F(). S&P 500 TR IndexCumul. Dist. F(). CBOE S&P 500 95-110 Collar Index

Maximum Drawdowns

S&P 500 TR Index CBOE S&P 500 BuyWrite IndexCBOE S&P 500 2% OTM BuyWrite Index CBOE S&P 500 PutWrite IndexCBOE S&P 500 95-110 Collar Index

� Source of excess returns and sustainability

� There are three sources of return inherent to the OBPM strategies we presented.

� Two of the return streams are commonly earned by investors, namely the Treasury bill

return and the downside returns to the S&P 500 stock market index. Given that these two

market exposures are widely held and understood, we traditional beta exposures.

� In addition to the traditional beta exposures, investors in OBPM strategies earn

returns from an exotic beta source: equity market volatility.

� The source of the excess returns to this strategy comes from the tendency of index options

to trade at prices above their fair value. As the demand for index options is high, and the

natural number of options sellers is low, the buyers of options tend to pay a premium for

the ability to insure against falling stock prices. In options lingo, the implied volatility tends

to trade at a higher level than the realized volatility.

� Sellers of index options, over long periods of time, earn this risk premium of the excess of

implied volatility over realized volatility as compensation for selling volatility. Notice, in our

next slide, that realized volatility rarely exceeds implied volatility over a 1-month period.

We believe that investors in OBPM strategies will continue to earn the volatility risk

premium, as buyers of index put options seem to be willing to pay for insurance, while

sellers of index put options continue to demand a risk premium to provide this insurance

coverage.

30 Days Historical VS Implied Volatilities

100%Ja

Volatility Differental RHS (in % p.a.) S&P500: 30 Days Implicit Volatility in % p.a. X=100%

S&P500: Historical 30 Days Volatility in % p.a.

� Option Based Portfolio Management strategies are valuable tools in the

investment toolbox. They can provide income, attractive risk adjusted returns

and the potential for a cushion during market downturns.

� From Q.M.S Advisors vantage point, we see growing conviction in the marketplace

for moderating long term return expectations. Combine this view with a low interest

rate environment and the result is an increasing number of investors searching for

higher levels of portfolio income and protection against short term volatility. One

way investors are achieving these goals is by implementing indexed or active call

overwriting programs against long portfolios. In this paper, our objective is to review

basic strategy characteristics, risk/reward profiles and key overwriting strategy

design factors.

� Naturally these elements should be viewed against the backdrop of overall portfolio

objectives, current volatility regime and expectations for future volatility in order to

optimize the strategy.

� Option Based Portfolio Management are valuable tools in the investment

toolbox. They can provide income, attractive risk adjusted returns and the

potential for a cushion during market downturns.

� Total Growth. Total growth since 1989 were 9.7% p.a. for the PUT Index, 8.2%

p.a. for the BXM Index, 9.1% p.a. for the BXY Index, 7.4% for the S&P 500® Total

Return Index, and 5.5% for the CLL Index.

� Lower Volatility. The PUT, BXM, BXY and CLL indices all had volatility that were

significantly lower than the volatility of the S&P 500 TR Index.

� Left-tail Risk. Over the past 23 years, the maximum drawdown for the S&P 500

TR Index was a decline of 59.6 percent, compared to less than 50% for all other

indices (from -48.6% for the BXY to -39.6% for the CLL).

� Risk-adjusted Returns. One measure of risk-adjusted returns, the Sharpe Ratio,

was 0.57 for the PUT Index, 0.43 for BXY, 0.42 for BXM, 0.25 for S&P 500 TR, and

0.30 for CLL Index. Please note that all the indexes had negative skewness.

� Monthly Premium Income. The average for the gross monthly premiums

collected by the BXM Index was 1.7 percent and were usually richly priced.

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