Global equity markets may have underestimated the economic effects of a potential COVID-19 pandemic because the only historical parallel to it is the 1918 flu pandemic (which is likely worse than COVID-19 due to a higher fatality rate) and stock markets didn’t drop that much. But maybe traders haven’t taken into account (and I just realized this) that there was war-time censorship in effect which strongly downplayed the pandemic and kept workers going to factories, which is a big disanalogy between the two cases, so markets could drop a lot more this time around. The upshot is that maybe it’s not too late to short the markets.
How can a private individual with a few thousand dollars to invest effectively trade on the idea that equity markets underestimate this? Might this be a way to make money for rationalists?
I bought some S&P 500 put options (SPXW Apr 17 2020 3000 Put (PM) to be specific) a couple of weeks ago. They were 40% underwater at some point because the market kept going up (which confused me a lot), but is up 125% as of today. (Note that it’s very easy to lose 100% of your investment when trading options. In my case, all I’d have to do is not sell the options until April 17 and S&P 500 hasn’t dropped to 3000 by then.) I had to open a brokerage account (most have no minimum I think) then apply to trade options then wait a day to be approved. You can also sell stocks short. You can also bet against foreign markets and specific stocks this way.
The above is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.
The option I bought is up 700% since I bought them, implying that as of 2/10/2020 the market thought there was less than 1⁄8 chance things would be as bad as they are today. At least for me this puts a final nail in the coffin of EMH.
Added on Mar 24: Just in case this thread goes viral at some point, to prevent a potential backlash against me or LW (due to being perceived as caring more about making money than saving lives), let me note that on Feb 8 I thought of and collected a number of ideas for preventing or mitigating the pandemic that I foresaw and subsequently sent them to several people working in pandemic preparedness, and followed up with several other ideas as I came across them.
Someone made a profitable trade ergo markets aren’t efficient?
This is why I said “at least for me”. You’d be right to discount the evidence and he would be right to discount the evidence even more, because of more room for selection bias.
ETA: Hmm, intuitively this makes sense but I’m not sure how it squares up with Aumann Agreement. Maybe someone can try to work out the actual math?
The position is now up 1000%. I find myself unsure what to do at this point. (Aside from taking some profit out) should I close out the position, and if so put the money into what?
Also, I find myself vexed with thoughts like “if only I had made this other trade, I could have made even more profits” or “if only I had put even more money into the bet …” How do professional or amatuer traders deal with this?
An update on this trade in case anyone is interested. The position is now up 1500%. I also have another position which is up 2300% (it’s a deeper out-of-the-money put, which I realized would be an even better idea after seeing a Facebook post by Danielle Fong). For proper calibration I should mention that a significant part of these returns is due to chance rather than skill:
VIX (a measure of stock market volatility priced into options) was unreasonably low when I bought the puts (apparently because traders got used to central banks rescuing the stock market on every downturn), meaning the put options were underpriced in part due to that, but I didn’t know this.
Russia decided not to cooperate with Saudi Arabia in lowering oil production, in order to hurt the US shale oil industry. This is not something I could have reasonably predicted.
I also didn’t predict that the CDC would bungle their testing kits, and the FDA would delay independent testing by others so much, thus making containment nearly impossible in the US.
Another reason for attributing part of the gains (from betting on the coronavirus market crash) to luck, from Rob Henderson’s newsletter which BTW I highly recommend:
The geneticist Razib Khan has said that the reason the U.S. took so long to respond to the virus is that Americans do not consider China to be a real place. For people in the U.S., “Wuhan is a different planet, mentally.” From my view, it didn’t seem “real” to Americans (or Brits) until Italy happened.
Not only have I lived in China, my father was born in Wuhan and I’ve visited there multiple times.
It feels like your background should be attributed differently than things like the Saudi-Russian spat, or the artificially deflated VIX. In Zvi’s terminology this is an Unknown Known; it isn’t as though you weren’t updating based on it. It was merely an unarticulated component of the prior.
Have you sold those put options by now? Looks like the Fed and Treasury 6 trillion stimulation package boosted the market a lot. I had similar put position which dropped significantly during the past 2 days of Market rally. Do you think it is still good to hold the put options?
I did sell some of the puts, but not enough of them and not near enough to the bottom to not leave regrets. I definitely underestimated how fast and strong the monetary and fiscal responses were, and paid too much attention to epidemiological discussions relative to developments on those policy fronts. (The general lesson here seems to be that governments can learn to react fast on something they have direct experience with, e.g., Asian countries with SARS, the US with the 2008 financial crisis.) I sold 1⁄3 of remaining puts this morning at a big loss (relative to paper profits at the market bottom) and am holding the rest since it seems like the market has priced in the policy response but is being too optimistic about the epidemiology. The main reason I sold this morning is that the Fed might just “print” as much money as needed to keep the market at its current level, no matter how bad the real economy gets.
One explanation is that the deeper out-of-the-money put (which remains out-of-the-money) benefits from both a fall in the underlying security and an increase in VIX. The shallower out-of-the-money put (which became in-the-money as a result of the market drop) benefits from the former, but not so much from the latter. Maybe another way to explain it is that the deeper out-of-the-money put was more mispriced to begin with.
Not 100% on this but I suspect the in the money puts start to be dominated by the inherent value so you have to pay for that in the money portion of the option price. The out of the money put is pure volatility.
Epistemic status: I am not a financial advisor. Please double-check anything I say before taking me seriously. But I do have a little experience trading options. I am also not telling you what to do, just suggesting some (heh) options to consider.
Your “system 1” does not know how to trade (unless you are very experienced, and maybe not even then). Traders who know what they are doing make contingency plans in advance to avoid dangerous irrational/emotional trading. They have a trading system with rules to get them in and out. Whatever you do, don’t decide it on a whim. But doing nothing is also a choice.
Options are derivatives, which makes their pricing more complex than the underlying stock. Options have intrinsic value, which is what they’re worth if exercised immediately, and the rest is extrinsic value, which is their perceived potential to have more intrinsic value before they expire. Options with no intrinsic value are called out of the money. Extrinsic value is affected by time remaining and the implied volatility (IV), or the market-estimated future variance of the underlying. When the market has a big selloff like this, IV increases, which inflates the extrinsic value of options. And indeed, IV is elevated well above normal now. High IV conditions like this do not tend to last long (perhaps a month). When IV reverts to the mean, the option’s extrinsic value will be deflated. You should not be trading options with no awareness of IV conditions.
If you are no longer confident in your forecast, it may be prudent to take some money off the table. You can sell your option at a profit and then put the money in a different position that you like better. Perhaps a different strike or expiration date, or something else entirely.
A “safe haven” investment is one that traders tend to buy when the stock market is falling. For example, TLT (a long-term treasury bond ETF), has shot up due to the current market crisis, but it is also a suitable investment vehicle in its own right, with buy-and-hold seeing positive returns in the long term, so it can hold value even after the market turns around. But being a bond fund with lower volatility, its returns are likewise lower.
On the other hand, if you are more confident in your forecast and want to double down, you could close one of your puts and use some of the profits from your put to buy two puts at a lower strike. (Maybe out of the money for their Gamma*). If your forecast is correct, and the market continues to fall rapidly, you’ll gain profit even faster, but if you’re wrong and the market turns around, they may expire worthless. Keep in mind that these puts are more expensive than normal due to high IV, even considering the current underlying price. If the market regains confidence, they’ll deflate in value, even before the market turns around. Options with less extrinsic value are less affected by IV. (IV sensitivity is known as Vega.)
If you have a margin account, you could take advantage of the high IV conditions by selling call spreads. You would sell the call with a Delta* of ~.3 and simultaneously buy another call one strike higher up to cap your losses if you’re wrong (this also reduces the margin required). This will be for a net credit. If the market continues to fall, you can let the whole spread expire worthless and keep the credit, or buy it back early for less than the credit (maybe for half) and then reposition. If you’re not terribly wrong and the market goes sideways or even slightly up, you can still buy these back for less than you paid for them due to deflating extrinsic as expiration nears and IV falls (due to market stabilization). If you are wrong and the spread goes under, your max loss is limited to your original margin (the difference between strikes, less the initial credit).
[*Delta is a measure of sensitivity to the price of the underlying. It’s also a rough estimate of the probability that the option will have any intrinsic value at expiration. Gamma is the rate of change of Delta. Together with Theta (time sensitivity) and Vega, these are known as The Greeks, and should be available from your broker along with the option quotes.]
Thanks, this is a really helpful intro to options. One thing you didn’t address which makes me hesitant to do any more options trading is the ask-bid spread, which can easily be 10% or more for some of the options I’m looking at. I don’t know how to tell when the ask-bid spread makes strategies such as “sell 1 put and buy 2 puts at lower strike” not worth doing (because potential profit is eaten up by transaction costs).
Also, picking the strike price and expiration date is also a mystery to me. I did it by intuition and it seems have worked out well enough, but was probably far from optimal.
They have a trading system with rules to get them in and out.
I don’t see how a trading system can incorporate new complex and often ambiguous evidence in real time. I definitely take your point about emotional trading being dangerous though.
Maybe out of the money for their Gamma
What does this mean?
Is there a book you can recommend for a more complete education about options? Maybe I can quickly flip through it to help me figure out what to do.
the ask-bid spread, which can easily be 10% or more
Options are much less liquid than the underlying, since the market is divided among so many strikes and dates. If the spread is less than 10% of the ask price, that’s actually considered pretty good for an option. You can also look at open interest (the number of open contracts) and volume (the number traded today) for each contract to help judge liquidity (this information should also be available from the broker.) Typically strike prices closer to the underlying price are more liquid. Also, the monthly (third-Friday) contracts tend to be more liquid than the Weeklys. (Weeklys weren’t available before, so monthly contracts are something of a Schelling point. They also open sooner.)
Do not trade options with market orders. Use limit orders and make an offer at about the midpoint between bid and ask. The market maker will usually need some time to get around to your order. You’ll usually get a fill within 15 minutes. If not, you may have to adjust your price a little before someone is willing to take the other side of the deal. A little patience can save a lot of money.
I don’t know how to tell when the ask-bid spread makes strategies such as “sell 1 put and buy 2 puts at lower strike” not worth doing (because potential profit is eaten up by transaction costs).
I meant close one of the profitable puts you already own, and then use the money to buy two more. (Incidentally, the spread you are describing is called a backspread, which is also worth considering when you expect a big move, as the short option can offset some of the problematic Greeks of the long ones.) Maybe you can vary the ratios. It depends on what’s available. I don’t know how many puts you have, but how aggressive you should be depends on your forecast, account size, and risk tolerance.
I don’t know your transaction costs either, but commissions have gotten pretty reasonable these days. This can vary widely among brokers. TD Ameritrade, for example, charges only $0.65 per contract and lets you close contracts under $0.05 for free. Tastyworks charges $1.00 per contract, but always lets you close for free. They also cap their commissions at $10 per leg (which can add up if you trade at high enough volume). Firstrade charges $0. That is not a typo. (There are still some regulatory fees that add up to less that a cent.) If your commissions are much higher than these, maybe you need a new broker.
I don’t see how a trading system can incorporate new complex and often ambiguous evidence in real time. I definitely take your point about emotional trading being dangerous though.
Systematic trading is not the same thing as algorithmic trading. They’re related, but algorithmic trading is taken to the extreme where a computer can do all the work. Normal systematic trading can have a human element, and you can provide the “forecast” component (instead of technical signals or something), and the rules tell you what to do based on your current forecast.
You need to have an exit already planned when you get in. Not just how to deal with a win, but also how to handle a loss, or you may be tempted to take profits too early, or be in denial and ride a loss too far. The adage is “cut your losses short and let your profits run”. Emotional trading tends to do the opposite and lose money. (BTW, the rule is the opposite for short option spreads.)
Carver’s Systematic Trading is a good introduction to the concept. This one I have read.
Gamma is the rate of change of Delta. It’s how curved your P&L graph is. Gamma opposes Theta. If you want more Deltas (like owning shares) and you expect a big move, Gammas are a way to get them cheaply, because they turn in to Deltas. (Of course, Deltas are negative for long puts.)
Is there a book you can recommend for a more complete education about options? Maybe I can quickly flip through it to help me figure out what to do.
Options are complex, but maybe not that complex. Option pricing models do use differential equations, but everybody uses computers for that. Trading options is not beyond the reach on anyone who passed a calculus class, but I’m still not sure if you can pick it up that quickly.
I did not learn all of this from a textbook. I know there are books that cover this. Hull’s Options, Futures and Other Derivatives is the introductory textbook I hear recommended, but I have not read it myself (you might want to skip the futures chapters.) There may be shorter introductions. I think Tastyworks was supposed to have a good intro somewhere.
Also, picking the strike price and expiration date is also a mystery to me.
Use the Greeks! Watch them and adjust them to your needs. They trade off against each other, but a spread can have the sum or difference of them. Keep in mind that extrinsic value is perceived potential and the Greeks make a lot more sense. The strikes nearest the underlying price have the most extrinsic and liquidity. Those deeper in the money have more Delta. Each Delta is like owning a share (puts have negative Deltas). Those further out of the money have more Gamma for the price. These relationships are nonlinear, because the underlying price variance is assumed to have a normal distribution (which is close enough to true most of the time).
Theta is not constant. It gets stronger the closer you get to expiration. Think about future variance as a bell curve spreading out from the current price like <. There’s much less time to vary left near the tip of the curve. For this reason, when holding a long option position, you probably want 60-90 days so you’re not exposed to too much Theta. But that also means more Vega, due to the higher extrinsic value.
On one hand, people in the mainstream still seem too optimistic to me. Like, apparently,
Cases of the new coronavirus disease are rising quickly outside China, and the odds of the outbreak turning into a pandemic have now doubled — from 20% to 40%, according to a report from Moody’s Analytics.
This seems super optimistic to me. I don’t see why people are still forecasting majority probability that it will be contained. On the other hand, I’ve been convinced to be more optimistic than the 15-20% prediction of disaster I had the other day.
I did a more detailed dive into the evidence for a case fatality rate in the 2-3% range and I know think that it’s very likely lower. Still, at 0.5% − 1% it would be much more severe than an average flu season and the market might take it seriously simply due to the shock factor. There is also the potential for an effective anti-viral being developed by the end of the year, which makes me a bit more hopeful.
I am not well calibrated about whether the ~12% market drop is appropriate given the evidence above.
I find myself unsure what to do at this point. (Aside from taking some profit out) should I close out the position, and if so put the money into what?
I bought some $APT (US-based mask manufacturer) in mid-January.
Sold off most of it this week as it 8x’d. I put most of the earnings into other coronavirus-relevant names: $AIM, $INO, $COCP, $MRNA, $TRIB. Also considering $GILD but haven’t bought any yet ($MRNA and $GILD aren’t really corona pure-plays because they’re large-ish biotech companies with multiple product lines).
I’ll revisit these allocations when the market opens on Monday. I don’t have a good sense of how smart this is… there’s a lot of hype in this sector and I haven’t carefully diligenced any of these picks, they’re just names that seem to be doing something real and haven’t had a crazy run-up yet.
I also pulled back a lot of my portfolio into cash.
One way of framing the EMH is to say that in normal circumstances, it’s hard to beat the market. But we are in a highly abnormal circumstance—same with Bitcoin. One could imagine that even if the EMH false in its strong form, you have to wait years before seeing each new opportunity. This makes the market nearly unexploitable.
One could imagine that even if the EMH false in its strong form, you have to wait years before seeing each new opportunity. This makes the market nearly unexploitable.
I’m not sure I understand your point. Investing in an index fund lets you double your money every 5 to 10 years. If every 10 years there’s an opportunity to quickly 5x your money or more (on top of the normal market growth), how does it make sense to call that “nearly unexploitable”?
Hmm, true, but if you took that argument to its logical extreme the existence of a single grand opportunity implies the market is exploitable. I mean technically, yeah, but when I talk about EMH I mostly mean that $20 bills don’t show up every week.
Eh, I’m not so sure. If I noticed that every Wednesday the S&P went up 1%, and then fell 1% the next day, that would allow me to regularly beat it, no? Unless we are defining “abnormal” in a way that makes reference to the market.
If the market is genuinely this beatable, it seems important for the rationalist/EA/forecaster cluster to take advantage of future such opportunities in an organized way, even if it just means someone setting up a Facebook group or something.
(edit: I think the evidence, while impressive, is a little weaker than it seems on first glance, because my impression from Metaculus is the probability of the virus becoming widespread has gotten higher in recent days for reasons that look unrelated to your point about what the economic implications of a widespread virus would be.)
my impression from Metaculus is the probability of the virus becoming widespread has gotten higher in recent days for reasons that look unrelated to your point about what the economic implications of a widespread virus would be.
Do you care to share those reasons? I’ve also been following Metaculus and my impression has been a slow progression of updates as the outbreak has gotten bigger, rather than a big update. However, the stock market looks like it did a big update.
I don’t know what the reasons are off the top of my head. I’m not saying the probability rise caused most of the stock market fall, just that it has to be taken into account as a nonzero part of why Wei won his 1 in 8 bet.
It seems like your opinion has changed a lot since our conversation 7 months ago, when you wrote:
(I personally bought some individual stocks when I was younger for reasons similar to ones you list, but they mostly underperformed the market so I stopped.)
I rolled a lot of the puts into later expirations, which have become almost worthless. I did cash out or convert into long positions some of them, and made about 10x my initial bet as a result. (In other words I lost about 80% of my paper profits.) It seems like I have a tendency to get out of my bets too late (same thing happened with Bitcoin), which I’ll have to keep in mind in the future. BTW I wrote about some of my other investments/bets recently at https://ea.greaterwrong.com/posts/g4oGNGwAoDwyMAJSB/how-much-leverage-should-altruists-use/comment/RBXqgYshRhCJsCvWG, in case you’re interested.
I don’t understand options well and would like to make some small options trades to drive my learning, but from what I see on my broker (Fidelity), all puts for something like $SPX cost several thousand at minimum.
I feel that I should also point out that long options are a risky play. They do eventually expire, and may expire worthless. You have to get the timing right as well as the direction, and deflating volatility could mean they lose most of their value sooner than you expect. You could lose your entire investment. If you want to experiment, either do a “paper” trade (simulate and track it, but don’t actually do it), or make sure it’s money you can afford to lose on a very small percentage of your account. 5% of the account is considered big for a single trade, even for experienced option traders who know what they are doing, and I basically never go that high on a long position. I’d recommend you keep it to 1% or less.
You can try puts on SPY instead. It’s an ETF that tracks the same index: the S&P 500, but the share price is 1/10th, so the options are proportionally cheaper as well. There’s also the XSP mini options, but I think SPY still has better liquidity.
Also, if you have the right kind of account, you can try spreads, buying one option and selling another to help pay for it.
You could also consider a call option on an inverse index ETF, like SH, which is designed to rise when SPX falls. Its share price is even lower than SPY, currently about 1/100th of SPX or under $30/share. Most options on this will cost hundreds or less per contract, not thousands.
Selling short is not what someone with a few thousand should be doing. The puts on the other hand allow you to set your loses when you enter the position.
You can buy stock in companies like Zoom and Slack that enable remote work. I did this about a month ago and their stocks have gone up about 30% since then.
You could buy an inverse ETF, like SH for a short-term bearish forecast. An advantage of inverse ETFs over options is that they do not require you to apply for margin account or option trading privileges.
[Epistemic status: I am not a financial advisor! Double check anything I say. For educational purposes only. This is information to consider, not a recommendation to buy anything in particular. I have no idea where the market bottom is. Maybe we’re already there.]
SH closely tracks the daily −1x performance of the S&P 500, but may not be aligned that well over long periods. There are a number of other inverse ETFs you might consider, including −2x (SDS) and −3x (SPXU) leveraged ones (which have even worse alignment over long periods, especially during high-volatility periods, such as right now), as well as ETFs tracking the inverse of other indexes. For longer periods consider “safe haven” investments like TLT.
Global equity markets may have underestimated the economic effects of a potential COVID-19 pandemic because the only historical parallel to it is the 1918 flu pandemic (which is likely worse than COVID-19 due to a higher fatality rate) and stock markets didn’t drop that much. But maybe traders haven’t taken into account (and I just realized this) that there was war-time censorship in effect which strongly downplayed the pandemic and kept workers going to factories, which is a big disanalogy between the two cases, so markets could drop a lot more this time around. The upshot is that maybe it’s not too late to short the markets.
How can a private individual with a few thousand dollars to invest effectively trade on the idea that equity markets underestimate this? Might this be a way to make money for rationalists?
I bought some S&P 500 put options (SPXW Apr 17 2020 3000 Put (PM) to be specific) a couple of weeks ago. They were 40% underwater at some point because the market kept going up (which confused me a lot), but is up 125% as of today. (Note that it’s very easy to lose 100% of your investment when trading options. In my case, all I’d have to do is not sell the options until April 17 and S&P 500 hasn’t dropped to 3000 by then.) I had to open a brokerage account (most have no minimum I think) then apply to trade options then wait a day to be approved. You can also sell stocks short. You can also bet against foreign markets and specific stocks this way.
The above is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.
The option I bought is up 700% since I bought them, implying that as of 2/10/2020 the market thought there was less than 1⁄8 chance things would be as bad as they are today. At least for me this puts a final nail in the coffin of EMH.
Added on Mar 24: Just in case this thread goes viral at some point, to prevent a potential backlash against me or LW (due to being perceived as caring more about making money than saving lives), let me note that on Feb 8 I thought of and collected a number of ideas for preventing or mitigating the pandemic that I foresaw and subsequently sent them to several people working in pandemic preparedness, and followed up with several other ideas as I came across them.
Thank you for sharing this info. My faith is now shaken.
From someone replying to you on Twitter:
This is why I said “at least for me”. You’d be right to discount the evidence and he would be right to discount the evidence even more, because of more room for selection bias.
ETA: Hmm, intuitively this makes sense but I’m not sure how it squares up with Aumann Agreement. Maybe someone can try to work out the actual math?
Would pre-registration fix the issue?
I always thought the EMH was obviously invalid due to it’s connection with the P=NP issue (which is to say the EMH iff P=NP).
The position is now up 1000%. I find myself unsure what to do at this point. (Aside from taking some profit out) should I close out the position, and if so put the money into what?
Also, I find myself vexed with thoughts like “if only I had made this other trade, I could have made even more profits” or “if only I had put even more money into the bet …” How do professional or amatuer traders deal with this?
An update on this trade in case anyone is interested. The position is now up 1500%. I also have another position which is up 2300% (it’s a deeper out-of-the-money put, which I realized would be an even better idea after seeing a Facebook post by Danielle Fong). For proper calibration I should mention that a significant part of these returns is due to chance rather than skill:
VIX (a measure of stock market volatility priced into options) was unreasonably low when I bought the puts (apparently because traders got used to central banks rescuing the stock market on every downturn), meaning the put options were underpriced in part due to that, but I didn’t know this.
Russia decided not to cooperate with Saudi Arabia in lowering oil production, in order to hurt the US shale oil industry. This is not something I could have reasonably predicted.
I also didn’t predict that the CDC would bungle their testing kits, and the FDA would delay independent testing by others so much, thus making containment nearly impossible in the US.
Another reason for attributing part of the gains (from betting on the coronavirus market crash) to luck, from Rob Henderson’s newsletter which BTW I highly recommend:
Not only have I lived in China, my father was born in Wuhan and I’ve visited there multiple times.
It feels like your background should be attributed differently than things like the Saudi-Russian spat, or the artificially deflated VIX. In Zvi’s terminology this is an Unknown Known; it isn’t as though you weren’t updating based on it. It was merely an unarticulated component of the prior.
After today’s crash, what are you at now?
Up 2600% and 5200%. ETA: Now back down to 2300% and 4200%.
Have you sold those put options by now? Looks like the Fed and Treasury 6 trillion stimulation package boosted the market a lot. I had similar put position which dropped significantly during the past 2 days of Market rally. Do you think it is still good to hold the put options?
I did sell some of the puts, but not enough of them and not near enough to the bottom to not leave regrets. I definitely underestimated how fast and strong the monetary and fiscal responses were, and paid too much attention to epidemiological discussions relative to developments on those policy fronts. (The general lesson here seems to be that governments can learn to react fast on something they have direct experience with, e.g., Asian countries with SARS, the US with the 2008 financial crisis.) I sold 1⁄3 of remaining puts this morning at a big loss (relative to paper profits at the market bottom) and am holding the rest since it seems like the market has priced in the policy response but is being too optimistic about the epidemiology. The main reason I sold this morning is that the Fed might just “print” as much money as needed to keep the market at its current level, no matter how bad the real economy gets.
Why are deeper out-of-the-money puts better here? Have been scratching my head at this one for a while, but haven’t been able to figure it out.
One explanation is that the deeper out-of-the-money put (which remains out-of-the-money) benefits from both a fall in the underlying security and an increase in VIX. The shallower out-of-the-money put (which became in-the-money as a result of the market drop) benefits from the former, but not so much from the latter. Maybe another way to explain it is that the deeper out-of-the-money put was more mispriced to begin with.
For a given dollar notiional investment, you are buying more vega with deeper OTM puts (or just more contracts).
Basically the same as why getting things correct on 10 20-to-1 bets pays more than getting a 1-to-1 (even odds) bet.
Not 100% on this but I suspect the in the money puts start to be dominated by the inherent value so you have to pay for that in the money portion of the option price. The out of the money put is pure volatility.
Epistemic status: I am not a financial advisor. Please double-check anything I say before taking me seriously. But I do have a little experience trading options. I am also not telling you what to do, just suggesting some (heh) options to consider.
Your “system 1” does not know how to trade (unless you are very experienced, and maybe not even then). Traders who know what they are doing make contingency plans in advance to avoid dangerous irrational/emotional trading. They have a trading system with rules to get them in and out. Whatever you do, don’t decide it on a whim. But doing nothing is also a choice.
Options are derivatives, which makes their pricing more complex than the underlying stock. Options have intrinsic value, which is what they’re worth if exercised immediately, and the rest is extrinsic value, which is their perceived potential to have more intrinsic value before they expire. Options with no intrinsic value are called out of the money. Extrinsic value is affected by time remaining and the implied volatility (IV), or the market-estimated future variance of the underlying. When the market has a big selloff like this, IV increases, which inflates the extrinsic value of options. And indeed, IV is elevated well above normal now. High IV conditions like this do not tend to last long (perhaps a month). When IV reverts to the mean, the option’s extrinsic value will be deflated. You should not be trading options with no awareness of IV conditions.
If you are no longer confident in your forecast, it may be prudent to take some money off the table. You can sell your option at a profit and then put the money in a different position that you like better. Perhaps a different strike or expiration date, or something else entirely.
A “safe haven” investment is one that traders tend to buy when the stock market is falling. For example, TLT (a long-term treasury bond ETF), has shot up due to the current market crisis, but it is also a suitable investment vehicle in its own right, with buy-and-hold seeing positive returns in the long term, so it can hold value even after the market turns around. But being a bond fund with lower volatility, its returns are likewise lower.
On the other hand, if you are more confident in your forecast and want to double down, you could close one of your puts and use some of the profits from your put to buy two puts at a lower strike. (Maybe out of the money for their Gamma*). If your forecast is correct, and the market continues to fall rapidly, you’ll gain profit even faster, but if you’re wrong and the market turns around, they may expire worthless. Keep in mind that these puts are more expensive than normal due to high IV, even considering the current underlying price. If the market regains confidence, they’ll deflate in value, even before the market turns around. Options with less extrinsic value are less affected by IV. (IV sensitivity is known as Vega.)
If you have a margin account, you could take advantage of the high IV conditions by selling call spreads. You would sell the call with a Delta* of ~.3 and simultaneously buy another call one strike higher up to cap your losses if you’re wrong (this also reduces the margin required). This will be for a net credit. If the market continues to fall, you can let the whole spread expire worthless and keep the credit, or buy it back early for less than the credit (maybe for half) and then reposition. If you’re not terribly wrong and the market goes sideways or even slightly up, you can still buy these back for less than you paid for them due to deflating extrinsic as expiration nears and IV falls (due to market stabilization). If you are wrong and the spread goes under, your max loss is limited to your original margin (the difference between strikes, less the initial credit).
[*Delta is a measure of sensitivity to the price of the underlying. It’s also a rough estimate of the probability that the option will have any intrinsic value at expiration. Gamma is the rate of change of Delta. Together with Theta (time sensitivity) and Vega, these are known as The Greeks, and should be available from your broker along with the option quotes.]
Thanks, this is a really helpful intro to options. One thing you didn’t address which makes me hesitant to do any more options trading is the ask-bid spread, which can easily be 10% or more for some of the options I’m looking at. I don’t know how to tell when the ask-bid spread makes strategies such as “sell 1 put and buy 2 puts at lower strike” not worth doing (because potential profit is eaten up by transaction costs).
Also, picking the strike price and expiration date is also a mystery to me. I did it by intuition and it seems have worked out well enough, but was probably far from optimal.
I don’t see how a trading system can incorporate new complex and often ambiguous evidence in real time. I definitely take your point about emotional trading being dangerous though.
What does this mean?
Is there a book you can recommend for a more complete education about options? Maybe I can quickly flip through it to help me figure out what to do.
Options are much less liquid than the underlying, since the market is divided among so many strikes and dates. If the spread is less than 10% of the ask price, that’s actually considered pretty good for an option. You can also look at open interest (the number of open contracts) and volume (the number traded today) for each contract to help judge liquidity (this information should also be available from the broker.) Typically strike prices closer to the underlying price are more liquid. Also, the monthly (third-Friday) contracts tend to be more liquid than the Weeklys. (Weeklys weren’t available before, so monthly contracts are something of a Schelling point. They also open sooner.)
Do not trade options with market orders. Use limit orders and make an offer at about the midpoint between bid and ask. The market maker will usually need some time to get around to your order. You’ll usually get a fill within 15 minutes. If not, you may have to adjust your price a little before someone is willing to take the other side of the deal. A little patience can save a lot of money.
I meant close one of the profitable puts you already own, and then use the money to buy two more. (Incidentally, the spread you are describing is called a backspread, which is also worth considering when you expect a big move, as the short option can offset some of the problematic Greeks of the long ones.) Maybe you can vary the ratios. It depends on what’s available. I don’t know how many puts you have, but how aggressive you should be depends on your forecast, account size, and risk tolerance.
I don’t know your transaction costs either, but commissions have gotten pretty reasonable these days. This can vary widely among brokers. TD Ameritrade, for example, charges only $0.65 per contract and lets you close contracts under $0.05 for free. Tastyworks charges $1.00 per contract, but always lets you close for free. They also cap their commissions at $10 per leg (which can add up if you trade at high enough volume). Firstrade charges $0. That is not a typo. (There are still some regulatory fees that add up to less that a cent.) If your commissions are much higher than these, maybe you need a new broker.
Systematic trading is not the same thing as algorithmic trading. They’re related, but algorithmic trading is taken to the extreme where a computer can do all the work. Normal systematic trading can have a human element, and you can provide the “forecast” component (instead of technical signals or something), and the rules tell you what to do based on your current forecast.
You need to have an exit already planned when you get in. Not just how to deal with a win, but also how to handle a loss, or you may be tempted to take profits too early, or be in denial and ride a loss too far. The adage is “cut your losses short and let your profits run”. Emotional trading tends to do the opposite and lose money. (BTW, the rule is the opposite for short option spreads.)
Carver’s Systematic Trading is a good introduction to the concept. This one I have read.
Gamma is the rate of change of Delta. It’s how curved your P&L graph is. Gamma opposes Theta. If you want more Deltas (like owning shares) and you expect a big move, Gammas are a way to get them cheaply, because they turn in to Deltas. (Of course, Deltas are negative for long puts.)
Options are complex, but maybe not that complex. Option pricing models do use differential equations, but everybody uses computers for that. Trading options is not beyond the reach on anyone who passed a calculus class, but I’m still not sure if you can pick it up that quickly.
I did not learn all of this from a textbook. I know there are books that cover this. Hull’s Options, Futures and Other Derivatives is the introductory textbook I hear recommended, but I have not read it myself (you might want to skip the futures chapters.) There may be shorter introductions. I think Tastyworks was supposed to have a good intro somewhere.
Use the Greeks! Watch them and adjust them to your needs. They trade off against each other, but a spread can have the sum or difference of them. Keep in mind that extrinsic value is perceived potential and the Greeks make a lot more sense. The strikes nearest the underlying price have the most extrinsic and liquidity. Those deeper in the money have more Delta. Each Delta is like owning a share (puts have negative Deltas). Those further out of the money have more Gamma for the price. These relationships are nonlinear, because the underlying price variance is assumed to have a normal distribution (which is close enough to true most of the time).
Theta is not constant. It gets stronger the closer you get to expiration. Think about future variance as a bell curve spreading out from the current price like <. There’s much less time to vary left near the tip of the curve. For this reason, when holding a long option position, you probably want 60-90 days so you’re not exposed to too much Theta. But that also means more Vega, due to the higher extrinsic value.
On one hand, people in the mainstream still seem too optimistic to me. Like, apparently,
This seems super optimistic to me. I don’t see why people are still forecasting majority probability that it will be contained. On the other hand, I’ve been convinced to be more optimistic than the 15-20% prediction of disaster I had the other day.
I did a more detailed dive into the evidence for a case fatality rate in the 2-3% range and I know think that it’s very likely lower. Still, at 0.5% − 1% it would be much more severe than an average flu season and the market might take it seriously simply due to the shock factor. There is also the potential for an effective anti-viral being developed by the end of the year, which makes me a bit more hopeful.
I am not well calibrated about whether the ~12% market drop is appropriate given the evidence above.
I bought some $APT (US-based mask manufacturer) in mid-January.
Sold off most of it this week as it 8x’d. I put most of the earnings into other coronavirus-relevant names: $AIM, $INO, $COCP, $MRNA, $TRIB. Also considering $GILD but haven’t bought any yet ($MRNA and $GILD aren’t really corona pure-plays because they’re large-ish biotech companies with multiple product lines).
I’ll revisit these allocations when the market opens on Monday. I don’t have a good sense of how smart this is… there’s a lot of hype in this sector and I haven’t carefully diligenced any of these picks, they’re just names that seem to be doing something real and haven’t had a crazy run-up yet.
I also pulled back a lot of my portfolio into cash.
Habituation, meditation, and/or alcohol.
One way of framing the EMH is to say that in normal circumstances, it’s hard to beat the market. But we are in a highly abnormal circumstance—same with Bitcoin. One could imagine that even if the EMH false in its strong form, you have to wait years before seeing each new opportunity. This makes the market nearly unexploitable.
the absolutely important part that people seem to miss with a basic 101 understanding of EMH is “hard” in no way means “impossible”
People do hard things all the time! It takes work and time and IQ and learning from experience but they do it.
I’m not sure I understand your point. Investing in an index fund lets you double your money every 5 to 10 years. If every 10 years there’s an opportunity to quickly 5x your money or more (on top of the normal market growth), how does it make sense to call that “nearly unexploitable”?
Hmm, true, but if you took that argument to its logical extreme the existence of a single grand opportunity implies the market is exploitable. I mean technically, yeah, but when I talk about EMH I mostly mean that $20 bills don’t show up every week.
That’s a tautology: Anytime I can beat the market is a highly abnormal time. You can only beat the market in a highly abnormal time.
Eh, I’m not so sure. If I noticed that every Wednesday the S&P went up 1%, and then fell 1% the next day, that would allow me to regularly beat it, no? Unless we are defining “abnormal” in a way that makes reference to the market.
If the market is genuinely this beatable, it seems important for the rationalist/EA/forecaster cluster to take advantage of future such opportunities in an organized way, even if it just means someone setting up a Facebook group or something.
(edit: I think the evidence, while impressive, is a little weaker than it seems on first glance, because my impression from Metaculus is the probability of the virus becoming widespread has gotten higher in recent days for reasons that look unrelated to your point about what the economic implications of a widespread virus would be.)
Do you care to share those reasons? I’ve also been following Metaculus and my impression has been a slow progression of updates as the outbreak has gotten bigger, rather than a big update. However, the stock market looks like it did a big update.
I don’t know what the reasons are off the top of my head. I’m not saying the probability rise caused most of the stock market fall, just that it has to be taken into account as a nonzero part of why Wei won his 1 in 8 bet.
The easy way is for Wei_Dai to take your money, invest it as he would his, and take 10% of the increase.
It seems like your opinion has changed a lot since our conversation 7 months ago, when you wrote:
Now that April 17 has passed, how much did you end up making on this bet?
I rolled a lot of the puts into later expirations, which have become almost worthless. I did cash out or convert into long positions some of them, and made about 10x my initial bet as a result. (In other words I lost about 80% of my paper profits.) It seems like I have a tendency to get out of my bets too late (same thing happened with Bitcoin), which I’ll have to keep in mind in the future. BTW I wrote about some of my other investments/bets recently at https://ea.greaterwrong.com/posts/g4oGNGwAoDwyMAJSB/how-much-leverage-should-altruists-use/comment/RBXqgYshRhCJsCvWG, in case you’re interested.
Do you know of a way to buy puts with <$1000?
I don’t understand options well and would like to make some small options trades to drive my learning, but from what I see on my broker (Fidelity), all puts for something like $SPX cost several thousand at minimum.
I feel that I should also point out that long options are a risky play. They do eventually expire, and may expire worthless. You have to get the timing right as well as the direction, and deflating volatility could mean they lose most of their value sooner than you expect. You could lose your entire investment. If you want to experiment, either do a “paper” trade (simulate and track it, but don’t actually do it), or make sure it’s money you can afford to lose on a very small percentage of your account. 5% of the account is considered big for a single trade, even for experienced option traders who know what they are doing, and I basically never go that high on a long position. I’d recommend you keep it to 1% or less.
You can try puts on
SPYinstead. It’s an ETF that tracks the same index: the S&P 500, but the share price is 1/10th, so the options are proportionally cheaper as well. There’s also theXSPmini options, but I thinkSPYstill has better liquidity.Also, if you have the right kind of account, you can try spreads, buying one option and selling another to help pay for it.
You could also consider a call option on an inverse index ETF, like
SH, which is designed to rise whenSPXfalls. Its share price is even lower thanSPY, currently about 1/100th ofSPXor under $30/share. Most options on this will cost hundreds or less per contract, not thousands.Thank you – super helpful.
Selling short is not what someone with a few thousand should be doing. The puts on the other hand allow you to set your loses when you enter the position.
You can buy stock in companies like Zoom and Slack that enable remote work. I did this about a month ago and their stocks have gone up about 30% since then.
You could buy an inverse ETF, like SH for a short-term bearish forecast. An advantage of inverse ETFs over options is that they do not require you to apply for margin account or option trading privileges.
[Epistemic status: I am not a financial advisor! Double check anything I say. For educational purposes only. This is information to consider, not a recommendation to buy anything in particular. I have no idea where the market bottom is. Maybe we’re already there.]
SH closely tracks the daily −1x performance of the S&P 500, but may not be aligned that well over long periods. There are a number of other inverse ETFs you might consider, including −2x (SDS) and −3x (SPXU) leveraged ones (which have even worse alignment over long periods, especially during high-volatility periods, such as right now), as well as ETFs tracking the inverse of other indexes. For longer periods consider “safe haven” investments like TLT.