The Missing Puzzle Piece: Clues From The Options Market

On the face of things, it didn’t appear that investors sold in May and went away. The S&P was up slightly over 1% but the concerns and turbulence of months past feels as strong as ever. Greece enters June with some make-or-break challenges to its national debt repayment. Nerves are high as China announced tighter restrictions on stock trading. Trading volume in May was one of the weakest of the year. Yet, in spite of all this, the Nasdaq hit an all-time high. Like many moments in history, the market lacks direction as plenty of existential issues weigh on investors. Instead of battling the daily tape, our analysts at Cassia are taking the high road, managing volatility, and prepping our portfolios for whatever the market has in store ahead.

May Performance Update
Cassia Diversified: Down -0.6% [more analytics]
Cassia Optimal Premia: Down -0.4% [more analytics]
Cassia Optimal Premia+: Up +0.4% [more analytics]

Portfolio Changes during May
Spotlight: Cassia Optimal Premia portfolio

Our Cassia Optimal Premia portfolio is designed with a 6% annualized volatility target and underperformed in May (-0.4% vs. +0.3% for a 40-60 stock-bond benchmark). In positioning the portfolio going forward, we’ve added more exposure to US High Yield Muni Bonds (almost +10% MoM and +22% YoY). The High Yield bond market has been much debated during May as DoubleLine Capital’s Jeffrey Gundlach sparred with Marty Fridson, another high yield specialist. Fridson published research recently that showed high yield outperforming investment grade bonds in a market characterized by rising interest rates.

Cassia research finds connection between option trading and future returns
At Cassia, we’re continuously analyzing data that can contribute to our goal of providing superior, long term, risk-adjusted returns for the 3 portfolios we manage. Our analysts have been plugging away on a data set of the options market over the past 10 years.

In the pursuit of finding the connection between the options market and the stock market, we painstakingly dissected this data for all major markets and controlled for liquidity. We also controlled for famous biases like the volatility smile.

One thing we learned is that the collective actions of options traders can be used to predict returns. Specifically, the term structure of the options implied volatility contains significant predictability of future returns.

Here’s a glimpse of what we found.

Days where the term structure (meaning how volatility is priced over time) is at its steepest (contango) tend to lead to higher returns over the next month. We also found that the inverse is also true (meaning, says when the term structure is flattest tend to lead to lower returns over the next month).

Term structure vs. Next month return (annualized)

All 6.20%
Lowest Quartile 0.80%
Highest Quartile 15.60%
Lowest Decile -12.50%
Highest Decile 14.50%

Join Cassia in bringing the latest predictive analytics to investment advisors and investors.This research points to a strong enough predictability that got us thinking about how this can help our clients. Keep your eyes open over the next couple of months as we roll-out more research we’ve uncovered that actively forecasts future returns by combining a variety of predictive factors by using machine learning techniques we’re pioneering. So if you’re still basing your investment decisions on the P/E ratio, you’re miles behind.

Build your practice on the backs of 3 Nobel prizes — Prospect Theory, MPT, and GARCH. 

See what GARCH can do for you.
See what GARCH can do for you.
Build your practice on the backs of 3 Nobel prizes — Prospect Theory, MPT, and GARCH.