Market timing and short-term portfolio selection based on state price density

Abstract

Market timing models aim to anticipate short-term market movements according to a given source of information. Such information could be extracted from an analysis of history or a forecast of the future. In fact, the financial markets are driven mainly by the expectations of market investors and by exogenous sources. An explicit way for market investors to make clear their expectations about a certain asset is to define the implied volatility of the options that are written on that asset. Moreover, the literature proposed tools that generate the state price density of the underlying by observing the implied volatility of the options. The combination of the implied volatilities and the state price density can give deep insight into investors’ expectations about the short-term movements of the underlying and, thus, can represent a reliable source of information to perform a market timing strategy or to select a portfolio for a risk-neutral investor with a short-term horizon. To avoid adjusting the procedure for dividend-paying assets, we develop our approach considering market price indexes. This approach constitutes a completely new technique to establish both a market timing strategy and a ranking among the considered indexes. In the empirical analysis, we considered both the market timing problem for a single index and the portfolio selection problem when multiple indexes are available.