This paper proposes an option selling overlay to improve portfolio rebalancing. Within a multi-asset class portfolio, portfolio weights deviate from targets as asset values fluctuate. Investors typically apply periodic rebalancing to bring portfolio weights back to their desired strategic levels.
However, between rebalances, investors are exposed to unintentional timing bets as weights deviate from targets. These timing bets introduce basis risk to their policy portfolio. The authors1 argue that a short option overlay can assist with hedging this unintentional exposure. They solve for the overlay construction that provides the desired rebalancing trade upon option expiration.
Backtesting an illustrative overlay, they find a significant reduction in the portfolio’s uncompensated timing exposure. Furthermore, by selling options, the overlay earns the volatility risk premium and thereby adds alpha to the portfolio. We think this is a very innovative way to improve upon a traditional multi-asset rebalancing process.
1 Israelov & Tummala, “An Alternative Option to Portfolio Rebalancing”, Journal of Derivatives, Vol. 25, No. 3, pp. 7-32, 2018.
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