The Untold Story of the 3 Little Pigs that Traded Options

In this podcast I talk about why it's important we know the story of the three little pigs that traded options. I'll walk through each of the different portfolios the three little pigs used and how volatility and variance can impact long-term performance.
The Untold Story of the 3 Little Pigs that Traded Options
Kirk Du Plessis
Apr 19, 2019

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.

Overview:

  • 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.

Conclusion

  • 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.
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