A couple of weeks ago, I was reading the story of the three little pigs to my daughters. And for some reason, I couldn't help but think about the untold story of the three little pigs who traded options. Yes, it's true; many people don't know this, but the three little pigs were actually given a large chunk of money from their mother, and each decided to trade wildly different options portfolios when they set out on their own.
- We look at three different portfolios to understand what volatility, portfolio performance, and stability really mean.
- Here, the Three Little Pigs story is an analogy for these three factors.
- Each of three pigs starts out with the capital of $100,000. Let’s see what happens to them over the course of ten years.
Option Buying Type Strategy: The Little Pig Who Built His House with Straw
- The little pig wanted to win big and be an aggressive trader.
- He had successful performance in some years and poor performance in others.
- He loses 19% in his first year, 15% the next year, 12% the next year. Many option buyers see the same performance streak.
- Why did the little pig have this wide disparity in performance? Why does this often happen to option buyers in this strategy?
- Answer: his portfolio was based on a lot of volatility.
Option Spread Type Strategy: The Little Pig Who Built His House with Sticks
- In this scenario, this little pig doesn’t have the time to invest in building a house made of bricks but doesn’t want to risk as much as the house made of straw.
- This little pig wants to make his returns 5% more narrow than the first little pig. For example, when the first little pig makes 21%, the second little pig makes 16%.
- This little pig’s strategy is to reduce the volatility of the first little pig’s portfolio.
Similarities and Differences Between the First Two Little Piggies’ Strategies
- Both pigs went through a losing streak, but the second little pig lost 5% less because of his less volatile risk strategy.
- However, the second little pig gave up increased earnings when things went in the right direction.
- This is a common, classic complaint of losing potential.
- The surprise: the little pig who built his house of sticks still earned more than the little pig who built his house of straw.
- The first pig (house of straw) ended with $138,097.
- The second pig (house of sticks) ended with $154,055.
- The interesting thing is that the average return for both of these portfolios was the same at 6.5%. So how did this happen?
- The difference between these portfolios is the volatility or the standard deviation.
- The first little piggy (house of straw) had a standard deviation of 27%.
- The second little piggy (house of sticks) had a standard deviation of 22%.
The Moral of The Story: Less Volatility = More Money Long Term
- The second portfolio (house of sticks) did not participate in all the upside potential, nor did he participate in all the downside draws.
- Still, the second little pig had the exact same average return.
- This portfolio ended up making more money in the long run.
- How did this happen? Because less volatility = more money long term.
Narrow Range: The Third Little Pig Who Built His House with Bricks
- The third little pig comes in with the same starting capital of $100,000.
- This little piggy is more cautious and does things on a much smaller scale.
- He takes just 10% off the model portfolio on either end. So, if the first little pig made 20%, the third little pig would make 10%.
- He is preserving capital first and foremost.
- His average return is the same as the other two pigs at 6.5%
- But because his volatility was lower, he ends up with a standard deviation of 17.3%.
- The third little piggy ends up with $166,587 (which is more than the other two little pigs).
- How did this happen when all three portfolios got the exact same return?
- Answer: the variance in the third little pig’s portfolio was so much smaller that his portfolio grew at a more consistent pace.
- This proves that you should be focusing on the volatility in your account, rather than your returns.
- Was the first little pig at a big disadvantage straight out the gate?
- What if we flip all the portfolios around at a total inverse? The pigs all still end up with the same average returns because the return distribution doesn’t matter.
- What matters is the volatility of your account. The bigger swings you go through, the less you will make.
- When you reduce the volatility of your account you create a portfolio that is more stable and able to compound smoother going further.
- You want a smooth equity chart.