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Covered Calls and Cash Secured Puts (Part 9)

Earlier in this blog series I posted a risk graph showing why CCs and CSPs are less risky than stock. In the last post, I reviewed backtesting results showing index CC returns ($BXM) to be roughly equivalent to the index itself with only 67% of the volatility.  This affirms my former illustration and can mean better returns for traders.

I will use downside volatility to explain why this is the case.  Volatility of returns is always something to monitor when understanding performance of a trading system.  Volatility is measured by standard deviation to determine how much returns deviate from their average.  Returns may deviate to the upside or downside but downside volatility is what makes me uncomfortable as a trader.  The more I lose, the more stress and discomfort I will experience.  If this becomes extreme then I will stop trading the system even if it means exiting at the worst time.  At least I can then begin to accept the magnitude of loss and not have to worry about future losses becoming even larger.

Lower standard deviation of returns means the system may be traded in larger size.  Suppose my loss tolerance is 20% of the total account.  For the sake of simplicity, I will say the S&P 500 lost 50% in the 2008-2009 financial crisis.  I therefore would not have wanted to invest more than 40% of my account in the S&P because the resultant loss would be 20% total.  Because the $BXM exhibits roughly 67% of the S&P volatility, the $BXM may have only lost 33.5% during the financial crisis.  I could therefore have invested 60% of my account in $BXM while remaining within tolerance limits.

Being able to invest more of my account equates to larger returns.  An 11.7% per year return equates to 4.68% on the whole account when investing 40% and 7.00% on the whole account when investing 60%.  These differences compound over time.  Over 25 years, $1 million becomes $3.138M in the S&P 500’s case vs. $5.427M in the $BXM’s case.

Comments (2)

[…] the last post, I discussed volatility of returns. This is a measure of risk and the lower the volatility, the […]

[…] outperformed (underperformed) the benchmark. Standard deviation is a measure of risk (as discussed here and here) along with max drawdown (MDD) (as discussed here). Risk-adjusted return is total return […]

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