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

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, constant maturity S&P 500 implied distributions are extracted and subsequently transformed 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 compared with the case where 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. JEL Classification: C13, G10, G11, G13.