Hello,
welcome back to Papers with Backtest podcast.
Today,
we dive into another Algo trading research paper.
Great.
What have we got today?
The study we're unpacking is called Active Collar Strategy,
and it's actually an update to a previous look at collar strategies applied to the QQQ
ETF. Ah,
OK.
Collars on the QQQ.
I remember the original.
So this one takes it further.
It does.
This updated research extends their analysis from March 1999 all the way through September 2010.
even including some out-of-sample data up to that point.
That's a really interesting timeframe.
You've got the dot-com bubble bursting in there,
a decent bull run,
and then the 2008 credit crisis.
Exactly.
And as the authors point out,
that 08 crisis really,
you know,
renewed interest in protective strategies like these equity callers.
People were definitely looking for ways to manage downside.
Makes sense.
So maybe we should quickly recap what a caller actually is.
Good idea.
So imagine you hold shares of the QQQ.
A basic caller involves buying a put option.
Think of it like insurance.
It gives you the right to sell at a certain price if things go south.
It protects your downside.
Right.
And at the same time,
you sell a call option.
This gives someone else the right to buy your shares if the price goes up to a certain level.
Which generates some income,
helps pay for the put maybe,
but it also caps your potential gains.
Precisely.
Your returns get kind of bracketed,
limited on both the upside and the downside.
And this paper looks at two main flavors of this,
passive and active.
Yeah.
So the passive approach is where you just set fixed rules for picking the options,
you know,
how far out of the money,
when they expire,
and you just stick to them.
Set it and forget it,
basically.
Pretty much.
And then the active strategy is where those rules actually change.
They adapt based on market conditions.
Okay.
And that's where it gets interesting.
What conditions are they looking at?
This is the core of it.
They tested using signals like momentum,
market volatility,
think the VIX.
and even some macroeconomic data like unemployment trends.
Ah,
so trying to be smarter about when to tighten the protection or when to allow for more upside?
Exactly.
The big question for you listening is,
does this active approach actually work better?
Does adapting the collar based on these signals improve performance compared to the simple passive rules?
Or it's just holding the QQQ.
That's what the back tests explore.
All right,
let's get into the passive ones first then.
As you said,
fixed rules for option selection,
moneyness,
and expiration.
Right.
They looked at a few combinations,
different starting points for how far out of the money the puts and calls were,
ranging from ATM at the money up to 5%
OTM.
And different lengths for the puts.
Yeah,
they tested one,
three,
and six-month puts,
but always paired them with a one-month call.
Keeps the upside cap resetting more frequently,
I suppose.
Makes sense.
And they focused on one particular setup as a kind of benchmark?
They did.
A lot of the comparison revolves around a passive strategy,
using a one-month call and a longer six-month put.
With the put starting 2%
out of the money.
Okay.
2%
OTM put,
six-month expiry,
one-month call.
Got it.
So how did that specific passive caller do over the whole period,
April 99 to September 2010,
compared to just holding QQQ?
Well,
the difference was pretty stark,
actually.
If you just held QQQ,
you basically broke even,
maybe a tiny loss of 0.3%
annualized,
but with a lot of volatility,
almost 30%.
Oof.
Yeah,
that was a rough decade overall for QQQ.
But the 2%
OTM passive collar,
it showed a 9.6%
annualized gain.
And crucially,
the volatility was way lower,
only about
10.7%. Wow,
okay.
Better returns and much smoother ride.
What about the worst case scenario,
the maximum drawdown?
That's where the protection really shows up.
The max drawdown for QQQ was a brutal negative 81.1%.
It's devastating.
Yeah,
I remember that.
For the passive collar,
though,
it was only negative 17.6%.
A huge,
huge difference in capital preservation.
That alone is a pretty compelling argument for the collar,
especially during that period.
Definitely.
Yeah.
Let's break down those periods a bit.
What about the tech bubble bursting,
say,
99 to late 02?
Okay,
yeah,
that was prime time for QQQP,
and it lost about 23.3%
annualized during that stretch,
with volatility over 40%,
just wild swings.
And the passive collar?
This is incredible.
The 2%
OTM passive collar actually made money.
It had an annualized return of 21.6%,
positive,
with volatility around 13,
14%.
So it turned a massive loss into a significant gain just by capping the upside and protecting the downside.
Effectively,
yes.
And that drawdown number during the tech bust,
Q2Q hit that netable 81%.
But the caller's worst drawdown in that period was only netable 7.5%.
Minus 7.5%.
That's amazing protection.
It really highlights the buffering effect during a crash.
Okay.
But callers aren't always great,
right?
The paper mentioned an unfavorable period,
October 2002 to September 2007.
What happened then?
Right.
That was mostly a strong,
steady bull market recovery phase.
QQQ did really well,
about 20.4%
annualized return.
And the caller.
It lagged because the market was mostly going up.
That call option you sold kept capping your gains.
The passive 2%
OTM caller only made about 5.2%
annualized then.
So lower volatility,
but you missed out on a lot of the rally.
Exactly.
That's the tradeoff.
You pay for that insurance,
and when there are no accidents,
you feel the cost of the premium,
so to speak.
Makes sense.
Then came the next storm,
the credit crisis,
late 07 to September 2010.
How did it play out there?
Similar story to the tech...
bust,
just maybe less extreme,
QQQ lost about 1%
annualized.
Not catastrophic,
but still negative.
And the collar.
The passive collar was positive again.
It returned 3.8%
annualized with less than half the volatility of QQQ.
So again,
it provided that cushion during market turmoil.
Okay.
So passive works for protection,
maybe enhances returns overall in volatile times,
but can lag in strong bull markets.
Now the active strategies,
they tried to improve on this.
That was the goal.
Instead of fixed rules,
the active callers adjusted the option choices based on three main types of signals,
momentum,
volatility and macro factors.
Trying to be more dynamic.
Let's break those down.
How did the momentum signal work?
They use pretty standard simple moving average or SMA crossovers on the NASDAQ 100 index,
the NDFs,
things like the one day crossing the 50 day or the five day crossing the 150,
different time frames.
OK,
short term versus longer term trends.
And what did those signals do to the caller?
Generally,
a...
buy signal,
faster average,
crossing above slower,
would lead them to widen the collar.
So they'd choose a put that was further out of the money and a pull that was also further out of the money.
Giving it more room to run on the upside,
maybe less immediate protection.
Right.
And a sell signal would do the opposite.
It would tighten the collar,
bring the put strike closer,
bring the call streak closer for more immediate protection,
but less upside potential.
Okay.
That makes sense.
Adapting to the trend.
What about the volatility signal based on the VIX?
Yep.
Based on the VIX,
they looked at where the VIX was relative to its own moving average,
like 50-day,
150-day,
etc.
So is volatility high or low compared to usual?
Exactly.
If the VIX was really high,
like more than one standard deviation above its average indicating high anxiety or fear,
they'd actually write fewer call options.
Maybe only 0.75 calls per QQQ share instead of the usual one.
Interesting.
Why fewer calls when fear is high?
The thinking,
I believe,
is that high VIX often precedes
sharp market reversals,
including potential bounces.
So writing fewer calls leaves a bit more potential upside open if the market snaps back quickly.
Conversely,
in low anxiety periods,
they might write more calls,
maybe 1.25 per share.
Adjusting the ratio.
And the third signal was macroeconomic.
Yeah,
this combined two things.
The trend in initial unemployment claims using moving average crossovers again,
like one week versus 10 week,
and the official NBER
business cycle status,
whether we're in expansion or contraction.
How did that influence the caller?
It depended on the cycle.
For example,
during an expansion,
if unemployment claims started rising a bad sign,
they'd widen the collar,
move the put and call further OTM.
But during a contraction,
rising claims might actually lead them to tighten the collar.
The idea is the market might react differently depending on the overall economic backdrop.
That's quite sophisticated layering those signals.
So on roll dates monthly for calls,
six monthly for the puts in the main strategy.
they'd calculate these signals and use formulas to pick the options.
That's right.
The formulas directly use the signal values to determine the percentage OTM for the call and the put,
and also that call writing ratio based on the mixed signal.
For instance,
positive momentum and positive macro signals might both add to how far OTM the call strike was set.
Got it.
So the million dollar question,
did this active approach actually work?
better over the full 1999-2010 period?
It seems like it did.
The active strategies,
particularly the one using the shorter term momentum and macro signals,
generally outperformed both the QQQ itself and the benchmark passive caller.
By how much?
The best one,
the short-term active strategy,
delivered about 12.5%
annualized return with volatility just over 11%.
So higher return than the passive caller,
slightly higher vol,
but better risk-adjusted performance overall.
Measures like the Stutzer index and Leland's alpha were higher.
Better bang for your buck,
risk-wise.
Pretty much.
And how did Active do in those specific periods,
like the tech bubble?
It significantly outperformed the passive caller during the tech bubble.
Better returns,
better risk metrics.
And the unfavorable period,
the bull run,
did Active help at the lag?
It seemed to mitigate it somewhat.
The active strategies still lag the QQQ during that strong uptrend,
but less so than the passive one.
They didn't sacrifice quite as much upside.
And the credit crisis.
Active outperformed passive again,
and both obviously crushed the QQQ during that downturn.
It really suggests that adapting the collar structure based on these signals added value,
especially in volatile times.
And they even had a little bit of out-of-sample data.
Yeah,
a short period from June 2009 to September 10th.
after the main study period.
And in that window,
the active callers also outperformed the passive ones.
It's not definitive proof,
but it's encouraging.
Interesting.
They also mentioned applying this to a mutual fund where you can't directly buy options on the fund itself.
Right.
They showed how you could adapt it.
Say you have a small cap mutual fund,
you could calculate its rolling beta relative to the QQQ,
look at the relative price levels,
and then scale the QQQ caller position accordingly.
So you'd use QQQ options as a proxy hedge.
Exactly.
You'd have to rebalance the size of the QQQ caller daily to maintain the right hedge ratio as the fund's price and its beta changed.
And did it work,
applying active and passive callers this way?
They said the results were broadly similar to when they applied the callers directly to the QQQ,
so it suggests the approach can be adapted.
Okay,
so wrapping this up,
what are the main takeaways for someone thinking about callers?
Well,
first,
even simple passive callers showed real value in reducing risk,
especially big drawdowns.
And they actually proved returns over that whole volatile period compared to just holding QQQ.
Definitely valuable during market stress.
But the really compelling part is the active strategy.
By adapting the caller rules based on momentum,
volatility and macro signals,
they demonstrated the potential to outperform the passive approach,
both in and out of sample in this study.
So being dynamic seems to pay off.
It appears so.
But of course,
a key thing to remember is that the effectiveness of any caller strategy really depends on the market environment.
They shine in choppy or falling markets,
but can be a drag in strong,
steady uptrends.
That trade-off is always there.
Absolutely.
And finally,
the research suggests these strategies aren't just limited to assets with direct options.
They can potentially be adapted using correlated index options,
like they showed with the mutual fund example.
Great summary.
Lots to think about there regarding dynamic risk management.
For sure.
Thank you for tuning in to Papers with Backtests podcast.
We hope today's deep dive gave you useful insights into the world of active and passive collar strategies.
Join us next time as we break down more research.
And for more papers and backtests,
find us at https.paperswithbacktests.com.
Happy trading!