Doomsday Investors betting on market crash
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Eh, the article makes it out to be more of a directional bet this is. Here's IMO the most pertinent bit:
For an individual investor, put options are probably the best analogy - if you have $16,533 in a S&P500 mutual fund (this being about the price of a 100-share block of the SPY exchange traded fund), then you could buy a deeply-out-of-the money put option on the underlying ETF fund. To protect against a 20% drop, you'd want a strike price of around $135 or so. This would give you the right, but not the obligation, to sell 100 shares of the SPY ETF at $135 a share on or before a specified point in the future. Why would you want to do that, with a current price of $165? You wouldn't, really, and you most likely never will. But if you buy the option to do so now, it's cheap (for example, a put with a December 20th, 2014 expiration date and a strike price of $135 can be bought for $6.32 a share, or a 100-share contract of $632 plus commission. That's a very long option contract - an Aug 17th '13 contract is a bit more typical, and is $0.31 a share). If suddenly something happens and the economy crashes, and the SPY ETF suddenly drops down to $115 or so (a loss of 30%, tame compared to '2008 but a "black swan" event by most definitions and not a likely occurance) then the option to sell 100 shares of the SPY ETF at $135 a share is suddenly tremendously valuable - in fact, worth $20 a share or $2,000 all in for something that you bought for $600. What this does is effectively cap your losses - your ETF investment losses will be offset by gains on the option, so no matter how far the market crashes, your portfolio won't decline below $13,500, and your loss would be capped at about $3,600 - the $600 option premium plus about a $3,000 depreciation from today's price to the strike price.
That's sort of how a "tail risk" fund functions in a broader portfolio - people very rarely invest in them because they expect the market to dive. Rather, the idea is that it's a good diversification move because the payoff should be negatively correlated with the rest of your portfolio.
Also, I love options. Clearly. :lol: asymmetrical payoffs kick ass, imo.
It's a form of diversification, hedging your portfolio against a very unlikely negative outcome. 99% of your portfolio will perform well in a strong market and poorly in a down market, so you offset this and effectively narrow the range of possible outcomes by making a very small bet that is most likely going to be a loss, but will post big profits if the rest of your portfolio does badly.
For an individual investor, put options are probably the best analogy - if you have $16,533 in a S&P500 mutual fund (this being about the price of a 100-share block of the SPY exchange traded fund), then you could buy a deeply-out-of-the money put option on the underlying ETF fund. To protect against a 20% drop, you'd want a strike price of around $135 or so. This would give you the right, but not the obligation, to sell 100 shares of the SPY ETF at $135 a share on or before a specified point in the future. Why would you want to do that, with a current price of $165? You wouldn't, really, and you most likely never will. But if you buy the option to do so now, it's cheap (for example, a put with a December 20th, 2014 expiration date and a strike price of $135 can be bought for $6.32 a share, or a 100-share contract of $632 plus commission. That's a very long option contract - an Aug 17th '13 contract is a bit more typical, and is $0.31 a share). If suddenly something happens and the economy crashes, and the SPY ETF suddenly drops down to $115 or so (a loss of 30%, tame compared to '2008 but a "black swan" event by most definitions and not a likely occurance) then the option to sell 100 shares of the SPY ETF at $135 a share is suddenly tremendously valuable - in fact, worth $20 a share or $2,000 all in for something that you bought for $600. What this does is effectively cap your losses - your ETF investment losses will be offset by gains on the option, so no matter how far the market crashes, your portfolio won't decline below $13,500, and your loss would be capped at about $3,600 - the $600 option premium plus about a $3,000 depreciation from today's price to the strike price.
That's sort of how a "tail risk" fund functions in a broader portfolio - people very rarely invest in them because they expect the market to dive. Rather, the idea is that it's a good diversification move because the payoff should be negatively correlated with the rest of your portfolio.
Also, I love options. Clearly. :lol: asymmetrical payoffs kick ass, imo.
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I wouldn't get terribly worried just yet. :yesway:
The idea is it's nice to have a small amount of an investment that will do very well when the rest of your portfolio does very poorly because it reduces the risk of your overall portfolio. :yesway:
Everything after that sentence is an explanation about what guys like you or I who don't have a couple million to invest in can do to apply similar concepts to our portfolios.
The idea is it's nice to have a small amount of an investment that will do very well when the rest of your portfolio does very poorly because it reduces the risk of your overall portfolio. :yesway:
Everything after that sentence is an explanation about what guys like you or I who don't have a couple million to invest in can do to apply similar concepts to our portfolios.
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Just out of curiosity, what would be the advantage of that over a covered call?
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Different "costs" of protection. A covered call (selling a call option for some prive above the current price of the underlying security, while holding the underlying security in the same quantity as represented by the option, i.e. 100 shares with a single option contract) gives you cash up front in return for giving up potential upside. It's an income generation strategy and in essence "enhances" the return of your position for most likely outcomes, but if the security price moves sharply up, your shares will get called and your gain is capped at the difference between the current market value and the strike price, plus the option premium you earned. It offers some downside protection in terms of the initial premium (which can be thought of as "absorbing" a downward movement of up to the amount of the premium) but it won't protect you against a catastrophic drop.
A protective put (the reverse of a covered call - buying a put option while holding the underlying security) gives you the reverse payoff - compared to just holding the security, your upside is reduced by the premium you pay for the option, so right off the bat your most likely outcome is going to be a loss equal to the option premium. However, while a covered call offers limited downside protection (from the premium, earned as income) in return for capping your upside, a protective put offers only limited upside reduction, but puts a floor on your downside by giving you a guaranteed selling price if the security falls. It's essentially equivalent to an "insurance" contract on your position that pays off if losses exceed a certain threshold (worth noting - there's no reason you couldn't do this with an "in-the-money" put, which in the example above would be like buying a put with a $170 strike price when the underlying is trading at $165. It will be a more expensive contract, however, representing the fact that when you purchase it it already has an "intrinsic value" equal to 170-165 = $5/share).
Which is more appropriate depends on, IMO, 1.) what sort of a hedge you're after (a bit of a cushion against losses vs. total protection), and 2.) what you're volatility exceptions relative to the market are (as option prices are related to volatility - higher volatility equals a higher price, all else equal). If you think the market will be less volatile than expected, then a covered call might make sense because you'd be selling an option priced higher based on a volatility assumption you think is too high. If you think the market is underestimating volatility during your holding period, then options would be priced "cheaper" than your belief, and selling a call would therefore be less attractive than buying a put.
Disclaimer - how the strategies work I'm comfortable speaking to, but the CFA program is a "generalist" program so the only expectation is that I understand how options price and how various strategies are put together. That's a roundabout way of saying that the paragraph above on which is more attractive is based on my reasoning rather than anything I've read, and therefore should be treated with more suspicion than the description of how the payoffs differ. Also, typical industry disclaimer, none of this should be taken as investment advice, investments have risk including that of loss of principle, etc etc.
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By the way, before you do that I'd spend some time thinking about your risk tolerance and what you want from a retirement investment account - plenty of professional investors DON'T do anything like this (my firm doesn't), and depending on your appetite this may not make sense for you.
Do you live in a state that requires car insurance? If not, do you have insurance anyway? When selecting health insurance plans do you tend to look for the smallest monthly premium or the most coverage, or somewhere in between? do you value avoiding large losses more than making an equivalent gain? Or, asked a different way, which is more important to you, maximizing return for a given level of risk or minimizing expected losses? Which would give you the most regret, missing out on a large gain or taking part in a large loss?
A strategy utilizing protective puts will tend to underperform in most market environments and will only outperform in relatively bad periods, where you will still see losses but not nearly as bad as an unhedged strategy. A strategy utilizing covered calls will tend to outperform in most normal market environments, but will not offer much protection in periods of large losses, and will underperform in periods of large gains.
Another alternative is a collar - selling a covered call and using the proceeds to buy a protective put. In some ways this is a "costless" strategy in that if you choose your strike prices right they can offset so you have no up-front cost associated with the strategy, but there's an opportunity cost in that using a collar guarantees your return will fall inside a given channel over the life of the option, and if the market were to move aggressively up then you've given up a lot of potential gains (the reverse is true on a sudden fall).
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