The concept of risk-adjusted returns is crucial for investors because it allows for evaluating investment returns relative to the risk taken to achieve that return. I’ll review how to look at risk for individual stocks and the overall market. And then I’ll provide a hedge for the overall market. Common sense suggests that rational investors would demand higher rates of return to take on greater risk. Assuming investors have some estimate for both the rate of return they expect over time and a method to measure the risk associated with an investment, they may compare the risk-adjusted returns between different investments, even if they have various levels of risk. Of course, estimating an investment’s future returns is a nontrivial exercise, as is estimating future risk; both have proven to be rabbit holes deep enough to fill entire libraries with books on the topic. However, for our purposes, it’s only necessary to illustrate the point using two different stocks, each with comparable total rates of return over the past 52 weeks but very different peak-to-trough drawdowns and standard deviation (“volatility” in options trader parlance). Standard deviation, beta, and other measures that rely on historical data are examples of what can happen but are not necessarily predictive of what will happen. Two stocks, two very different risk profiles The first of the two companies is the electric utility PPL Corp (PPL) . The stock price is up 28% over the past 52 weeks, and the total return, net of dividends, is greater than 31%. The second is semiconductor company Teradyne Inc (TER) , up 26% over the same period. Between Teradyne’s slightly lower price appreciation and smaller dividend, its total return underperformed PPL by 3% over the past year, but it is close enough for our exercise. Both have had respectable 1-year total returns. However, they took very different paths to get there. Notice that the volatility of Teradyne was much more significant, and the drawdowns over the past year were far worse. Teradyne experienced five peak-to-trough drawdowns of 10% or more, Only once did PPL experience a peak-to-trough drawdown more significant than 10% (about 12% in Sep/Oct 2023). The most recent peak-to-trough drawdown for Teradyne exceeded 30%. Incidentally, PPL has a dividend yield of over 3%: higher total returns, less than half the volatility, plus income in the form of quarterly dividends. All else equal, investors should prefer lower volatility. If these results indicated risk and returns going forward, investors would prefer PPL to Teradyne. Complicating things is that volatility itself is not constant. Stocks tend to be more volatile around catalysts such as earnings than between those events. Overall, stock markets experience volatility regimes. Some periods are characterized by very low volatility; during other periods, particularly market corrections and bear markets, volatility can spike sharply. Broader market risk A one-year history for only two individual stocks is not statistically meaningful. Still, these two securities’ very different risk/reward characteristics might prompt investors to ask themselves: Is the market efficiently priced for risk? Do riskier stocks yield better returns over time than less risky stocks? What about a riskier stock market? Will an investor who purchases stocks during periods of elevated volatility be appropriately rewarded with higher rates of return? Looking at data broken into four “regimes” for the S & P 500 going back to December 1927, 30-day realized volatility was not a meaningful indicator of short-term outperformance or underperformance looking ahead thirty to ninety days. Those four regimes were all periods above the median (depicted in orange), above the mean (depicted in green), and above the 80th percentile (shown in light blue). The results suggest that jumping into equities during elevated volatility does not necessarily reward investors for the extra risk they’re taking. 12-, 18-, and 24-month returns were significantly lower than the average. As I write this, the S & P is within 3% of all-time highs. While valuation multiples are not terrific market timing tools, they provide some context. Trailing 12 month price-to-earnings in blue, and forward estimated price-to-earnings in orange… However, the Cboe Volatility index (VIX) is now above 20, meaning 30-day options premiums are above average. The trade One way to play a market one believes may have limited upside when options prices are high is by selling an upside call spread. This strategy may be employed on single stocks or a broad market proxy such as an ETF. In this case, we’ll use the SPDR S & P 500 ETF (SPY) . Trade: Sell SPY $555 Oct. 4 call Buy $570 $570 Oct. 4 call The example I’m providing here in SPY is a bet that the market does not break out to new all-time highs within the next 30 days. DISCLOSURES: (None) All opinions expressed by the CNBC Pro contributors are solely their opinions and do not reflect the opinions of CNBC, NBC UNIVERSAL, their parent company or affiliates, and may have been previously disseminated by them on television, radio, internet or another medium. THE ABOVE CONTENT IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY . THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSITUTE FINANCIAL, INVESTMENT, TAX OR LEGAL ADVICE OR A RECOMMENDATION TO BUY ANY SECURITY OR OTHER FINANCIAL ASSET. THE CONTENT IS GENERAL IN NATURE AND DOES NOT REFLECT ANY INDIVIDUAL’S UNIQUE PERSONAL CIRCUMSTANCES. THE ABOVE CONTENT MIGHT NOT BE SUITABLE FOR YOUR PARTICULAR CIRCUMSTANCES. BEFORE MAKING ANY FINANCIAL DECISIONS, YOU SHOULD STRONGLY CONSIDER SEEKING ADVICE FROM YOUR OWN FINANCIAL OR INVESTMENT ADVISOR. Click here for the full disclaimer.
#options #trade #pays #fails #highs #month
