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Author: Dwdonhoff Big gold star, 5000 posts Top Favorite Fools Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 76406  
Subject: Re: Distributions of S&P500 returns Date: 3/31/2013 8:02 PM
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This is interesting in the statistical abstract. It could apply if the markets were actually "a random walk" and had no trends, or if outlier rallies (or drops) were just as likely as previous similar rallies (or drops.)

That's not the case, though. The majority of the major annual rallies occur after significant down trends... and this has a major reduction effect on the benefits of capturing "all the rally upside" above caps.

To give a very simple example,
If Trader A's position in a market drops 20%, we all know it requires a rally of 25% to reach the prior water level.

When Trader B's posiiton in the same market is traded with a 0 floor and 12 cap, Trader B lost nothing in the down year, and gained 12% in the following year (though "missing out" on the 13% above her cap.)

Trader A has to actually get a 37% return in order to merely 'catch up' to Trader B. Since the current rally gave them both 25%, Trader A is *STILL* down, despite capturing "ALL" the 25% windfall rally.

Of course, if Trader A gets several consecutive years of rallies greater than Trader B's caps, then Trader A may indeed supercede.

This is why a floor/cap hedge outperforms in volatile markets, and particularly excels when there are significant bearish periods. When there is a strong certainty of straight rally years greater than a particular cap, then going naked is better.

The simple question to ask is;
What is the rough probability of consecutive S&P rally years greater than 12%, without intermediary years below zero to wipe out the above-cap gains?

Everybody can make their own guess...
Mine is that the probability is low... or extremely low.

Dave Donhoff
Leverage Planner
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