Tag Archives: portfolio-strategy

Summary US equities look wobbly. Buying downside protection is in vogue. Skew is high. Let’s put it to use. Put on your contrarian boots Market participants are wired to cheer for bull markets. Anyone even marginally attached to the finance industry knows what I mean. Every trading floor has a guy with his hair on fire. He is screaming about an imminent collapse in the stock market. He spends his days reading David Stockman’s blog and cruising Zerohedge. Sometimes he mumbles things about an electromagnetic pulse. The marketing department spends at least three hours of every day thinking up ways to get him fired. Nobody likes that guy. Not even me. (Despite my affinity for Mr. Stockman. And let’s be honest, who doesn’t like themselves some good Zerohedge?) Anyway, markets are structurally wired to be long only. Bears have been earning themselves a bad rap since 2009. Here is a fun trick that you can use to avoid ridicule while showing your bearish side. Just call it “Portfolio Protection” One reasonable way to play the trick is to buy put options. Sometimes people ask me to teach them things about options. I start by warning them about the dangers of being a goldfish. It is my adaptation of the 10th Man’s explanation for why efficient market theory is nonsense . Goldfish have crappy memories. They probably don’t spend much time thinking about the future either. When the goldfish gets to the future, it doesn’t think about how it got there. The goldfish is just living in the moment. Think about that if you are using charts like this to analyze an options trade. This is what I call a “goldfish chart.” It is a slice of what the goldfish’s wallet might look like when the option expires. On expiration date, you could ask the goldfish how it got there. It’ll shrug and say something like, “I don’t care.” Don’t be a goldfish I mean, you are probably not a goldfish. You spend a fair amount of your time thinking about your portfolio. You probably care about what your profit and loss will be tomorrow. You certainly care what it will look like when you retire. You pretty much continuously care about your portfolio performance. Goldfish charts narrow your focus onto some arbitrary date called “expiration.” That’s dumb. Much to do about skew While going through the morning routine here, I came across this little gem entitled “Who’s the Bear Driving Up the Price of U.S. Stock Options? Banks” All it really says is that the implied volatility curve is highly skewed. But that sounds like rocket science. So, the author did a really nice job breaking it down. If you want to buy a put to protect against losses in the Standard & Poor’s 500 Index, often you’ll pay twice as much as you would for a bullish call betting on gains. Get it? There are a lot of market participants with their hair on fire. They are bidding up high prices on out of the money put options. Portfolio protection is getting expensive. Let’s create a synthetic security! Sounds like fun, right? There is some magic math we could do to create something that looks a lot like buying a put option on the S&P 500 (NYSEARCA: SPY ). [Long Put] = [Short Put] + [Long Call] + [Short Stock] Let’s not think about it too much. Just take my word for it. To a goldfish, the combination of things on the right of the equals sign (the “Synthetic Put”) looks a lot like the thing on the left of the equals sign (just a normal put). Remember when that guy at Bloomberg said that buying puts cost twice as much as buying calls? Take another look at that synthetic put. [Short Put] + [Long Call] + [Short Stock] The goldfish wants to buy a put. But puts are expensive. So instead, the goldfish sells an expensive put and buys a cheap call. Short some stock and… Voilà! That my friends is magic math. How a magic goldfish might short the stock market Let’s do some magic goldfish math. We would like to buy an SPY put with a 204 strike and a March expiration. The market is asking $7.90 for that at the moment. Here is the goldfish chart again. We could just buy the overpriced put for $7.90, but that’s dumb. Let’s build a better mousetrap. We sell a 173 strike SPY put for $1.30. Then we buy two 210 call options for $4.58 each. Adding those things up we have paid $7.86 in net. Then we short 200 shares. Here is what the synthetic looks like compared to the at the money put. That is magic charting! At about the same price we are getting much more protection. How can this be? I have a couple of theories. Maybe three theories. One is that the market is structurally wired to trade long only. The typical market participant doesn’t have a margin account with permissions to go out selling put options and shorting stocks. But the banks do. Why don’t the banks jump in and arbitrage this? I have a theory for that too… First, this is not really “arbitrage.” The synthetic is very short skew. That doesn’t matter much to a goldfish, but it matters a lot to a hedge fund, or a bank, or someone like them. It should matter to you too! You’re not a goldfish. Second, if you are a bank, you are probably going to have a hard time explaining to Mr. Dodd or Mr. Frank what you are doing. Try telling a politician you want to add downside protection by selling a put and buying a call. It sounds a little bit like bullish speculation. The politician is not going to be interested in your magic math. The trade Anyone considering buying portfolio protection should be looking at a synthetic put. Skew is high. It could go higher. There are some other risks. Like, the market is not giving me an early Christmas present. Still, it feels like I would be sufficiently compensated for going short skew. Maybe you will feel like that too. But don’t go out creating synthetic securities just because a stupid chart looks attractive. Don’t be a goldfish.