Blog - Investing Notes

July 18, 2008 - Test Strategy Premium/Effect Sizes to Date

Our Test Strategy attempts to exploit the value premium, the size effect, the turn-of-the-month effect and the volatility premium embedded in index options. The strategy has outperformed buy-and-hold, achieving a small gain during a mostly declining market over the past 16 months. How has each premium/effect contributed to strategy performance? Using strategy account and benchmark data over the period 3/16/07 through 7/11/08, we find that:

We calculate the four premiums/effects as average (arithmetic mean) impacts on monthly returns as follows:

• The value premium is the difference between returns for the iShares Russell 2000 Value Index - (IWN) small-capitalization value exchange-traded fund (ETF) used to execute the strategy and returns for the broader related iShares Russell 2000 Index - (IWM) small-capitalization ETF.
• The size effect is the difference between returns for IWM and returns for the S&P 500-mimicking SPY.
• The turn-of-the-month (TOTM) effect, based on the way the strategy uses it, is the difference between returns for the ten trading days centered on the turn of the month and returns for the entire month (from options expiration date to options expiration date).
• The volatility premium is the difference between actual strategy returns and the preceding three premium/effects.

The following chart summarizes the sizes of the four premiums/returns as monthly averages over the 16-month test period. The value premium, size effect and turn-of-the-month effect are all negative. The volatility premium is very positive.

A possible conclusion is that it would be better just to focus on the volatility premium. However, sample size is too small for reliable inference, and the sizes of the four premiums/effects may be interrelated. For example, the volatility premium may have been smaller for SPY than for IWN over the test period.

In summary, a very positive volatility premium has more than offset a negative value premium, negative size effect and negative turn-of-the-month effect for our test strategy over the past 16 months.

For additional information, see Strategy Test.