Market Timing with Option-Implied Distributions: A Forward-Looking Approach

Alexandros Kostakis, Nikolaos Panigirtzoglou () and George Skiadopoulos
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Nikolaos Panigirtzoglou: Department of Economics, University of London, London E1 4NS, United Kingdom

Management Science, 2011, vol. 57, issue 7, 1231-1249

Abstract: We address the empirical implementation of the static asset allocation problem by developing a forward-looking approach that uses information from market option prices. To this end, we extract constant maturity S&P 500 implied distributions and transform them to the corresponding risk-adjusted ones. Then we form optimal portfolios consisting of a risky and a risk-free asset and evaluate their out-of-sample performance. We find that the use of risk-adjusted implied distributions times the market and makes the investor better off than if she uses historical returns' distributions to calculate her optimal strategy. The results hold under a number of evaluation metrics and utility functions and carry through even when transaction costs are taken into account. Not surprisingly, the reported market timing ability deteriorated during the recent subprime crisis. An extension of the approach to a dynamic asset allocation setting is also presented. This paper was accepted by Wei Xiong, finance.

Keywords: asset allocation; option-implied distributions; market timing; performance evaluation; portfolio choice; risk aversion (search for similar items in EconPapers)
Date: 2011
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Citations: View citations in EconPapers (64)

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Persistent link: https://EconPapers.repec.org/RePEc:inm:ormnsc:v:57:y:2011:i:7:p:1231-1249

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