The Wrong Side of Risk
Part 4 of the Inefficient Markets sequence.
[Formerly entitled How to Pick the Wrong Side, which on reflection, I felt was too clickbaity. I am not your financial advisor! For educational purposes only. Read part 1 first.]
The Basic Idea of Insurance
You want protection from a risk. An insurer with deeper pockets offers to take that risk off your hands, for a price.
Make no mistake, the insurer is doing this for profit. You are indeed paying to spread the risk around, and your money will go to help the unfortunate. But the insurers take in much more premium than they pay out in claims. Is that fair or efficient? Are they exploiting you?
Money is not the same thing as utility. If there is something for sale that you want more than your money, you can pay for it with your money. Now you have less money. This happens all the time, and we capitalists don’t think it’s wrong. It’s just business.
The big market players are not simply maximizing returns. They’re investing other people’s money, and the other people want a tolerable level of volatility more than they want optimal Kelly bets. Their utility is not their money. They might need their money for something else later, at a time they find hard to predict. If a fund has a large drawdown, most investors will panic and bail.
Options
Insurance also exists for stocks. They’re called “put option contracts”. The fund manager pays a premium to the market for the right, but not the obligation (the option) to dump a certain amount of stock at an agreed-upon strike price, within a certain time frame. If the manager exercises that right, the insurer is then obligated to buy the shares at the strike even if that’s far above the current fair-market price.
Make no mistake, the insurer is doing this for profit. Why offer the contract at all, if the expected value is zero? The insurers take in much more premium than they pay out in claims. They don’t offer contracts that would be a bad deal for them. The higher the risk, the more expensive the contract. But the fund manager doesn’t have the choice. He has investors to satisfy, and they cannot tolerate too much risk.
So you see, over time, money flows from the investors to the insurers.
The options market is open to retail traders. You too can buy insurance. You too can be the insurer.
Which side is the better deal? What do you want?
Bonds
A bond is a kind of loan. Some entity, often a corporation, needs cash to run its business. Companies that borrow money can grow faster. Companies that don’t grow fast enough are often outcompeted by those that do. They can buy more equipment, hire more employees. And use those resources to make even more money.
But business is risky. Sometimes plans don’t pan out. Mistakes can be made. Competitors can do it better. Pandemics happen. (Among other surprises.)
The company may be unable to pay off its debts.
Bonds have a risk of default. To compensate investors, the company must pay a premium in the form of interest, or they wouldn’t get enough investors willing to take on their risk. The more risky the business, the more premium they have to offer to get investors.
The bond market (or at least part of it) is available to retail traders. You too can loan money to companies.
Would you rather earn interest or pay it? What if there’s a risk of default?
Currency
Fiat currency works like bonds do. And, in fact, loans increase the supply of money. To invest in a country’s bonds, you have to use that country’s currency. As with corporate bonds, a country with a higher risk of default must offer a premium in the form of higher interest to get foreign investment in its bonds.
Also as with bonds, the riskier currencies tend to be more volatile. And similarly, countries that default on their bonds will see less demand for their currency, which reduces its price.
Forex is available to retail investors. You too can earn higher interest rates offered by foreign countries.
Stocks
Companies issue stocks for much the same reason as bonds: to obtain the capital required to do their business.
Why are stocks worth anything?
Because people think they have value. That’s kind of a non-answer, but sometimes there isn’t much more to it than that. The markets are not always rational.
So why do people believe stocks have value? Ostensibly, it’s because stocks pay dividends. And because shares convey certain ownership rights in the company. In particular, companies may be bought out by other companies, who must buy the stock for the rights. Companies have also been known to buy back their own shares.
If you own stock, you too can collect the dividends, and you too can profit from a buyout, or even from the perceived potential for one.
But to get these benefits, you must take on the risk of owning the stock. And it is a risk. After all, stocks can drop in value.
The Third Law of Averting Ruin
Don’t Fight the Wave
Again and again, we see that the market systematically transfers wealth to those that are willing to take on risk, at the expense of those who are not.
You may feel like you want to be on the wrong side of this current. But avoiding the risky bets means forgoing (or paying) the risk premium.
The right side is uncomfortable.
Be willing to endure some risk and DON’T PANIC.
That doesn’t mean you can never take the other side. You can, tactically, or to limit your own risks, because we Don’t Bet the Farm. But your portfolio, as a whole, should be favored by the current. You will wipe out sometimes. But if you follow the Laws, you won’t be ruined. Surf the wave. Trade with the wind at your back.
Be the insurance company, even if you have to buy some reinsurance. Be the bank, even if you also borrow money for leverage.
You are allowed to be bearish at times, but it’s better to sell calls or buy anticorrelated bonds and continue to collect the risk premium, than to short the stocks and be on the hook for the dividends or buyouts.
Buy-and-Hold works, folks! It can work against you too. Sell the option. Buy the stock. Carry the currency. Collect the premium.
Market Misconceptions is up next.
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Recently I had the epiphany that an investor’s real budget constraint isn’t how much money they have (with portfolio margin you can get 6x or even 12x leverage) but how much risk-taking capacity they have. So another way of making what I think is your main point is that the market pays you to take (certain kinds of) risks, so don’t waste your risk-taking capacity by taking too little risk. But one should be smart and try to figure out where the market is paying the most per unit of risk.
Standard finance theory says the market should pay you the most for taking “market risk”, i.e., holding the total market portfolio. But the total market portfolio includes no options, because short and long options cancel each other out giving a sum of 0. So the only way that it makes sense for someone to hold an options position is if they differ from the average investor in some way, and figuring out how they differ should be the starting point for deciding what kind of options positions to hold, right?
In this case, it seems that you’re saying the average investor manages someone else’s money, which makes them want to buy puts. They have to pay extra for this because most assets are managed by investors like this, so there’s a lot of demand and little supply of puts. If you’re not like this, you can therefore make above-market risk-adjusted returns by selling puts to meet this demand. (I’m not totally sure this is true empirically, but wanted to spell out the reasoning I think you’re using more.)
Empirically, option implied volatility tends to exceed realized volatility for most stocks most of the time. This is plainly visible if you plot both implied and historical volatility on the same chart, and even more obvious if you use moving averages for each to smooth the noise. This is the well-known “option seller’s edge”, an effect that has been quite persistent historically.
And not just for puts, due to put-call parity, this applies to calls as well.
Empirically, a covered short strangle portfolio not only beat the index, it had performance comparable to a hedge fund.
Empirically, this strategy of selling a naked 30-day at-the-money
SPYoption (randomly a call or put) shows a positive expectancy, while the reverse strategy of buying the option shows the opposite. I’m not actually recommending you do this (because it’s easy to accidentally Bet the Farm by selling naked options), but it illustrates the edge.As for why this should happen, yeah, the market is risk-averse, so there’s a risk premium for taking that risk off their hands. How big that premium is depends not just on the amount of risk, but the demand for insurance and the competition between insurers. If there were too many competing insurers to supply the puts (or if they were too big), then the margins would be too thin (but not negative!) for retail traders to profit from. But that’s not what we see happening. I wouldn’t say differing from “the average investor” is what matters, but from the investors who control the most money.
I strongly downvoted this post and now came back to write a comment now to explain why. (I think it’s a good policy to explain all my strong downvotes.)
Your first post in the series was all over the place. It felt like trying to check off all the rationality boxes; something like “I fit in here, let me say some stuff”. Which is may be just my perception or may be you are just a wordy writer. Anyway, I just didn’t vote on that post, but I think it’s important for context here.
This post is about finance which is a pretty complicated topic. A lot of things that “just make sense” don’t actually work out the way you’d think. (Or have worked so recently but not historically.) So I think you have to be especially careful in describing and analyzing most types of financial strategies. This post (and previous posts in this sequence) does the opposite. It lists a bunch of ideas rapidly with minimal explanation or analysis. It feels like a flag waving for doing finance in a better and cooler way.
(However I did like Wei_Dai’s summary of your post and your response to it. I think those two comments alone could be expanded to fill a post, if not a whole sequence, if you want to do it “right”.)
Applause lights! (There, I checked off another one.)
I was worried about coming off that way in the first post, but these rationality memes really were a major influence in getting me to my conclusions. Are we a culture that talks big, but doesn’t deliver? By our own rules, if we’re not winning, we’re doing it wrong.
I admitted in the first post that I feel that I’m “barely starting to understand this stuff”. If you can prove a factual inaccuracy in my understanding, I want to update. Finding the gaps in my understanding is one of my main motivations for writing this sequence (“to cultivate my comprehension”).
Inferential gaps, man. I don’t expect that my whole audience understands finance as well as you do (if they did, I’d have jumped straight into data analysis). Rather than call it a flag, I would call it a foundation: I have to develop some minimal background to get to the part I really wanted to talk about, which is practical alpha trading. I.e. how do you go about finding an edge? Then how do you exploit it? Parts 2, 3 and 4 are mostly about how to not get hurt (too much) when doing this (part 5 will tie those together and segue into the practicals for part 6). If that’s insufficient, then I want to know so I don’t get hurt either.
I developed these posts quickly from my own notes and outlines from my study. Listing ideas rapidly with minimal analysis is exactly what I’ve been doing so far. If I went into as much detail as you seem to want, it would take too long to get through it all. This is a sequence, not a textbook. But I’m happy to discuss specifics in the comments.
Thanks for taking my criticism in stride. I do appreciate you writing and often it’s better to get something out there than not at all. And after all, that’s how we learn.
I wouldn’t say I understand finance particularly super well, which I think is part of what makes reading your post frustrating. It’s not aimed at a beginner because it’s not explaining the basics and isn’t focusing one one concrete concept at a time. It’s not building up on one idea. I guess it might be trying to show an overview, like flying over an area. But as it stands, I don’t have much to hang these concepts on, so they just slide right off. I guess I’ll wait until the future parts to see how it caches out.
I’m actually writing a post on finance as well right now. Hope to have it posted tomorrow. I’d be curious to hear your thoughts on it, and in particular on how it does the explaining part.
It’s hard to judge the level of my audience. If I were teaching this one-on-one, I’d be asking for feedback before saying this much. That’s harder to do on a blog. I noticed that it is possible to share drafts before publishing, but I don’t know who to share it with. Would you be interested in reviewing future drafts of posts in this sequence? It could help me get them up to a level that you wouldn’t downvote before I publish them.
I don’t feel it’s very productive to re-explain basic financial concepts that already have good explanations elsewhere. It would make the sequence too long without adding much value. Unfortunately, there’s so much low-quality information in this space from people trying to sell you get-rich-quick schemes that the good information can be hard to find. I could certainly try to add links in this post if you can tell me more specifically which parts need the exposition in your eyes.
Fwiw your posts are exactly appropriate to my level and are motivating me to go and learn more about some of these strategies.
Yeah, that’s actually a very good point. I just created this question: https://www.lesswrong.com/posts/EuEybxcSPEcoN8i6v/what-posts-on-finance-would-your-find-helpful-or-interesting
Btw, here’s my post: https://www.lesswrong.com/posts/Wfed7zfm6ZyBXsrrp/the-holy-grail-of-portfolio-management I ended up writing two, since I had to explain the portfolio management before getting to individual strategies. :)
I don’t think I can commit to reviewing drafts; I have a 3mo old baby which takes up a lot of my free time. But I hope you’re not feeling too discouraged! Just continue writing and reading, and I’m sure you’ll get better. (And FWIW I don’t think I’m a particularly good at writing or explaining either. I do much better 1:1 as well.)
I think what I’ll try to do, now that we’ve had this chat is to leave better comments on your future posts.
Doesn’t “sell calls” mean the same thing as “short the stocks”?
No, it really doesn’t. You can make money from an out-of-the-money short call even if the stock goes up, as long as it stays below your strike price. You can even make money if it exceeds your strike price and then falls back below before expiration (assuming you don’t get assigned early, which can happen if there’s a dividend that exceeds the time value of the option). And even if it expires a little above your strike, if you took in enough premium, you could still come out ahead on net after subtracting your loss from covering your assigned short position. You don’t have to be right about the market direction to make money. It’s enough to not be terribly wrong.
My main point here was that you collect the risk premium for selling the call, but you pay the premium for shorting the stock.
Oh so in this case you’re selling a call, but you can’t be said to be “shorting the stock” because you still benefit from a higher price?
Right. A call is an option contract. It’s a different instrument than the underlying shares of stock. You can be short a call option and not short shares. You’re still executing a bearish play on the stock, but you’re not shorting the stock.
If you get assigned on your call (unless it’s cash-settled), you will have to produce the shares to give to the contract holder. If you didn’t already have the shares, you will end up with a short position in the stock, which you will eventually have to cover by buying stock.
You can construct a synthetic short stock position using options, by selling a call, but you also have to buy a put at the same strike and expiry. This will behave very similarly to (typically) 100 short shares.