The Search for Alpha
The search for alpha necessarily entails performing in excess of the overall market performance index of a similar market. An alpha of 1 is achieved when a portfolio investment outperforms the indicative average market performance by 1%.
Competition in the market place is part of its inherent character; the very precept of the capitalistic philosophy lies in the free pursuit of financial independence within various markets lending themselves to investment and risk. The particular features and idiosyncrasies of a market will dictate the risk it demands and the return that it may provide however, as with any astute investment, it pays to dedicate resources to extensive analysis before committing to risk. In modern markets technology is an indispensible resource for investment analysis and risk assessment.
Options markets do indeed provide opportunities to add value to investments with an aim to outperform the industry benchmarks through supplementary returns. Apart from individual strategies such as the covered call, that have been historically proven to provide an investment with an Alpha in excess of 1, the very anomalies that exist between historical and implied volatility, those that arise as an incident of the pricing model needing to be reasonably adapted to market forces, and those that provide opportunities for complex combinations of derivatives, will all provide success in return if an objective, consistent and mathematical approach is applied.
One limitation of the pricing model is that it assumes that variables remain constant until expiry of the option and reversal of the risk. This of course can rarely be further from the truth, and so on any given day value may be seen in overpriced and underpriced options, which are all too willingly to offer an attractive return to those that learn to recognize them. To characterize these opportunities as ‘value’, a relative comparison needs to be made; it is the epitome of value judgments.
To this end it is suggested that option models be adapted to market conditions as far as possible. In a pragmatic sense, this will mean skewing volatility in order to accommodate a likely change in volatility subsequent to a move in the underlying, to accommodate the presence of specific interest in the market place, or to simply revise ones view of volatility in respect of broader market influences.
In effect, these modifications to the model are reshaping the bell curve and adjusting the gradients of probability, to ensure that the statistical benchmark used in relative comparison will only assume value is present when it is beyond all reasonable doubt; when risk and return are within reasonable proximity. If these opportunities present themselves, it is then that an investment is made and risk is adopted. When value is derived from a stringently adapted pricing model, and is also the motivation for every trade, profitability and return is merely a matter of time.
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