Market Uncertainty, Volatility & Options Valuations

Over the past twenty months, my partner and I have observed a wide range of options performance.

For some time, we have tracked, for each month's portfolio, the same duration and out-of-the-money S&P calls and puts, as well as either actual or theoretically-managed put and call portfolios.

Typically, in a healthy equity market, either the puts are positive and the calls are negative, or vice versa. This has been the case for most of the period during which we have invested in options, rather than the underlying equities.

Because of this sign difference, and the tendency of the positive side, in volatile market conditions, to outperform the negative one, a straddled option portfolio produces returns which a simple equity portfolio strategy cannot. The latter has to be net long or short to have any potential to earn a non-zero return.

However, to our surprise and disappointment, there seems to be a market condition in which both calls and puts sink in value. And the accompanying chart of our November 2008 portfolios demonstrates this.

Both the S&P calls and puts, and our option portfolios of calls and puts, are negative.

What, we asked ourselves, could cause this condition? It seems theoretically impossible that investors would value both calls and puts negatively at the same time for the same equities.

The calls are negative, we reason, because macroeconomic and business conditions are so dismal- now, and looking forward for the duration of the options.

Why, then, are the puts also negative?

Here we believe we see the cost of heavy-handed, unpredictable government intervention.

Back in late March, we saw rising puts suddenly fall after the Bear Stearns rescue. It became clear to investors that the Fed and Treasury would not let money be made by betting on a falling market. The resulting two month period of April and May were good for calls. Then sentiment overwhelmed government intervention, and puts took off once more, as volatility increased to unhealthy levels.

The current mix of badly-designed, pork-laden government programs, including TARP-2, renamed, the spending in the "stimulus" bill, TALF, the looming auto sector bailout, and suspected industry-changing provisions of the stimulus bill, all seem to be leaving investors unsure of where falling business fortunes might be unexpectedly propped up, irrationally, by some government program or cash injection.

With uncertainty regarding governmental actions so high, we reason investors are wary of what would otherwise be reasonable bets on the imminent fall in value of many equities.

Thus, we see a rare event- both puts and calls of the same equities posting a temporary negative return. Since this is an inherently unstable position, we expect that puts will rise in value in the next few months. It seems unlikely that government's unpredictable meddling can last for very long before bringing bad consequences, e.g., inflation, rising interest rates, continuing poor economic results from delayed, not eliminated recessionary forces.

Current Market Signals

Things sure have changed in the equity markets since March.

Back in the final weeks of that month, as the Fed opened the discount window to investment banks and assisted in the retention of trades on the books of the failing Bear Stearns, my partner and I saw signals that the worst of the equity and options markets for long positions was over. The Fed, as my partner put it, was not going to allow money to be made on the short side anymore.

At that time, the risk was to the financial services sector and, it was believed, the credit markets in general.

We carefully monitored our new signaling/risk management tools and bought calls in April and May. By June, we again bought calls, but with a sense that maybe we should have straddled.

We were right.

In just two months' time, we sold call options with returns of over 150%, and roughly 50% on the April portfolios. May's options were less profitable, but still returned positive results, with one call exercised for a very significant return.

Now our signals look very similar to those of both December and March. Our S&P-based volatility measure has risen significantly to levels near that of mid-March, while the S&P returns in trailing months has been dropping.

Without divulging our specific proprietary measures, this combination is a lethal one for equities.

What has stunned my partner and me is that we don't really think there has been much in the way of new, fresh, bad economic news. But the business media and political machines of both parties seem to be dwelling on the worst economic and sentiment measures they can find.

Housing is compared to the Great Depression, as is joblessness, though both are wrong.

Energy producers are maligned, as are derivatives markets investors who provide liquidity and price discovery services to energy futures markets.

Now, they are labelled 'profiteers' and 'speculators.' Talk of windfall profit taxes and stiffer regulation or prohibition of 'speculation' is rampant among our King Canutes in Congress.

In fact, I don't think economic measures have declined as precipitously as the S&P and its futures have. Perhaps the one new development is more awareness of higher, if not crippling, inflation, and a potential rise in the Fed rate sometime in the next few months.

But these two factors alone seem to be offsetting the less-than-catastrophic business and economic news occurring recently.

Back in April, I thought we had a good 4-5 months of call options portfolios before we had to worry about weakening markets.

Instead, in only six weeks, we're somewhere between neutral and short in our evolving outlook for equity allocations in the next month.

That's Not Possible

This morning, after playing squash, my business partner and I were discussing recent equity and options markets performances.

My website, linked to this blog, provides weekly performance information on the equity portfolio strategy which I run. A chart of monthly gross returns for this year, to date, appears nearby.

As of last Friday, 21 December, the portfolio has realized a 35% return, versus the S&P500's 4.7%, yielding a performance margin for my portfolio of 30.3 percentage points.

When my partner's son related this to some clients of his in one of Deutsche Bank's trading operations, I am told they simply refused to believe this.

Maybe they viewed the rest of the performance information, including the prior year performances of the portfolio's approach, dating back to 1990. Maybe not.

I'm not totally surprised at their reaction, though. I've heard it so often before.

Those who can't do, evidently, simply deny. Especially when the approach differs so radically from that of the critic.

In contrast to institutional traders, we invest in equities for six-month durations. Our options positions are bought and held up to a six-month duration, with sales occurring at return levels established via proprietary options performance research.

It must be difficult, indeed, for institutional equities and derivatives traders to imagine making our returns on simple, unhedged equity and options positions over such timeframes.

If the equity portfolio performance was unbelievable, imagine how my partner's son's clients would have reacted, had they seen our performance data on our options implementation of the same equity strategy. The nearby table is taken from last Friday's closing performance, covering the six active portfolios.

Prior to these six, our May options portfolio had a 41.5% gross return, and June's was 77.6%.

While there are a variety of methods for weighting and annualizing the various monthly portfolio returns, the overall return for this year, to date, for uniform monthly investments, is in the neighborhood of 70%.

Since call options have downside loss protection, relative to holding equities, and allow for inherent leverage of as much as 20x, they provide much higher returns than the equity approach, while using the same selection process and weightings.

Three of the current options portfolios' daily performance charts are included nearby- December, November and September.

The blue curves represent the performance of the options as purchased, without any management. The red curve depicts the performance of a similarly dated and priced, relative to the money, S&P500 call option. No value exists past November, since Yahoo discontinued free index options tracking near the end of that month. The green curve represents the actual performance of our portfolios resulting from sales of call options at pre-determined points throughout the portfolios' durations.

As good as our equity returns have been this year, our options returns have been even better.

By applying the results of proprietary research into the performance of large-cap equities over time, our portfolios, both equities and options, tend to consistently produce superior returns, relative to the S&P500 and its related options instruments.

Not every month's portfolio achieves the same high returns. But, on balance, already, they've delivered stunningly good performances in one of the most challenging and volatile seven month periods in the equity markets in the last five years.

It's been an above-average year for our equity portfolio in terms of the level of outperformance of the S&P500, though not in the mere occurrence of this outperformance.

Our options portfolios, which have been live since May of this year, have met our expectations, considering market conditions.

Are these levels of performance possible? We believe so, because we have experienced them in live investing, including equity portfolios as far back as 1997.

Originally, I began this blog as a way of expressing opinions and analysis about current business topics from the viewpoint of our equity strategy. My partner felt that having a body of written observations and analysis which reflected my proprietary research findings would make it easier to attract equity investments to our portfolio management efforts.

As such, the success of our equity strategy gives us cause to feel that our perspectives on investing and business management are validated.

Others may not believe our live investment results, because they simply cannot imagine strategies which, while simple, rest on quantitative expressions of powerful insights into equity and options performances. More often than not, I think, criticism stems from envy, lack of comprehension, and lack of creativity on the part of the critics. It's easier to simply dismiss what you can't understand, or didn't think of first, than to accept it.

Fortunately, though, in the institutional investment field, most managers will stick with their own underperforming approaches, rather than accept that another approach yields superior returns. And, since our options approach provides return levels which reduce our need for other customers, we don't need to waste a lot of time convincing people that what we do works.

Instead, we now simply treat it as a proprietary approach for proprietary capital.

Nassim Taleb's Hedge Fund Strategy and Return to The Business

Last month, in this post, I wrote about how Nassim Taleb's writing on options, distributional statistics, and investor misperceptions about risk, influenced my partner and I to move to an options expression of my long-running, consistently superior equity portfolio strategy.

That modification has been doing very well, as I wrote recently, here.

In last Friday's Wall Street Journal, one of its writers discussed Taleb's return to hedge fund management- actually, advisory- after several years away from the business. I hadn't even realized he left!

The firm, Universa Investments of Santa Monica, CA, expects to raise $1B for deployment in Taleb-inspired strategies.

I found the Journal article very reassuring. In it, Taleb's approach is described in more detail than prior articles I have read. It reinforced my feeling that his is a very inconsistent strategy. That is, he is constantly buying puts, losing a little money routinely, in hopes of profiting from the really big market meltdowns. This is what I more or less sensed from my prior reading about Taleb's hedge funds.

In the Journal piece on Friday, however, Taleb's performance is discussed. His last fund earned a 60% return in 2000, then lost money in 2001 and 2002, with only low single-digit gains for the next two years. He closed the fund on the heels of such mediocre performance, during years when conventional hedge funds rack up much higher gains.

Ironically, Taleb's thinking regarding the risks associated with buying call or put options, rather than the underlying equities, made a lot of sense to my partner and I, and we have developed a very effective variant of our equity strategy as a result. However, whereas our returns are already showing signs of tracking with our consistent basic equity returns, they are, of course, many times higher, because of the natural leverage inherent in the use of options.

Thus, Taleb's approach, and, probably, that of the new fund using his ideas, tends to be erratic, and depend upon high volatility to earn large returns.

Our approach is just the opposite. We strive for consistent, reliable gains in any type of market, and try to become less sensitive to volatility.

I can't help but feel that, for investors who do not wish to be forced to time the market, or fund investments, ours is the more attractive approach to earning consistently superior returns in equities or options.

Portfolio Performances and Selections

Thursday was trading day for my equity strategy. As such, I didn't have time to write a thoughtful post on a relevant business topic.

Today, I want to discuss our stunning first-half performance. From early January, when I purchased the portfolio for the first half of this year, to mid-yesterday, it earned 21.35% vs. the S&P500's 10.43% for the same period. That's a margin of outperformance of nearly 11 percentage points, which is the long-term average of the strategy's margin over the index, net of fees.

Terex, Occidental Petroleum, and ATI, the former very heavily weighted, and the latter a major holding, returned 58%, 39% and 32% respectively. Network Appliance, with a smallish weight, was the worst-performing holding, at -26%, while Boston Properties and PCG were the only other negative performers, with returns of -3% and -1%, respectively, for the period.

Overall, the January, 2007 portfolio was substantially weighted in energy, finance, and commercial property holdings, with some commodity- and construction-oriented holdings as well.

Our new selections appear in the nearby table (please click to see a larger version).

Perhaps most notable is the increase in equities associated with technology, energy, and construction and components manufacturing. Aligent, Apple, Avaya, Autodesk, Adobe and Memc Electronic represent the technology sector, with a total weight of roughly 35%.

Noble Energy, Edison International, National Varco, Smith International and Williams Cos. account for nearly 16% of the portfolio.

ATI, Precision Castparts, Eaton, Ingersoll Rand, and Goodyear Tire compose roughly 13% of the portfolio's weighting.

A collection of healthcare-related issues (Cigna, Express Scripts), commodities (Freeport-McMoran), retail apparel (VFC, ANF, Nordstrom) and financial (TR Price) companies make up the rest of the portfolio.

Meanwhile, our adaption of the equity portfolio strategy into call options portfolios is working as predicted. Currently, the May portfolio's value, as invested, has a total return in excess of 100%, while the June options portfolio has a total return over 80%, after only one month. Our initial expectations are for monthly options returns of at least 100%, on average, during periods of positive expectations for market performance. July marks the third month in which we will have a live options portfolio controlling an initial $1MM of equity positions according to the selection process' weights.

Hedge Fund Leverage Risks

Today's Wall Street Journal carried a piece on the back page of the Money & Investing Section, describing the state of credit derivative hedge fund investments.

According to the article, over $300B is currently invested in these funds, on a leveraged basis, 6-1, for roughly $1.8T of controlled assets. One of the eye-opening pieces of arithmetic the authors did was to point out that a credit derivative fund with only 4x leverage, experiencing a decline of just 5% in the value of its portfolio, would be required to liquidate as much as 25% of its total assets to meet a 20% margin requirement. Multiply this by many hedge funds engaged in similar investing, with similar exposures, and you understand a fundamental underpinning of my partner's and my own options strategy.

We have a static options strategy in place which works automatically, without any recourse to a change in positions, in the event of severe market declines.

During a lunch meeting today with some associates in the financial sector, to explain in more detail our recent options-based implementation of our equity portfolio strategy, we discussed precisely this aspect of risk management. Ranging in ages from the 60s through 40s, we had enough cumulative and historical experience in the markets to all agree on one thing- the time at which you need to deploy a dynamic risk management strategy is precisely when it will be unable to be deployed, due to unforeseen market conditions involving illiquidity. This illiquidity could take the form of a failure for markets to be made in the instruments in question, or their quotes and prices to be impractical to take, due to an overall shortage of liquidity at affordable prices.

Thus, reading this recent piece on the implicit current risk of rapid and dysfunctional declines in prices and liquidity in the credit derivative markets, I am pleased that we are putting in place a 'no moving parts' risk management approach which relies on the simple attribute of a call or put option to allow for, but not necessitate, a trade, in order to limit downside risk to value.

Implementing an Equity Strategy Through Options: More On Nassim Taleb

My recent post on the review of Nassim Taleb's book, "The Black Swan," has led to some insights which have radically transformed the alternatives for implementing our equity portfolio strategy.

In that prior post, I discussed Taleb's concerns regarding the inappropriate use of statistical distributions for various financial event forecasting and/or simulation.

Following on that book review, in a circuitous fashion, my partner and I were given a fairly lengthy article about Taleb, which appeared in the New Yorker magazine several years ago.

In that piece, buried toward the end, amidst considerable qualitative reasoning by Taleb on the subject of 'once in a lifetime' events, were a few jewels of investment insight. One was, a la Taleb's book, to eschew the use of normal distributions when assessing the likelihood of extreme market events, such as outsized negative or positive returns. The other was his avoidance of any equities, in favor of only purchasing puts or calls.

After considerable reflection, and the integration of the very timely comments of Professor Stephen Ross, discussed in this post, I realized that, strictly from a catastrophic event perspective, there is no scenario in which holding equities would be preferable to holding out-of-the-money call options on the same portfolio.

The only limiting factor to implementing an equity strategy in this fashion is one familiar to those who frequent casinos. Can we be fairly certain that our portfolios of call options will rise in value, above the cost of the premium, which is lost (unlike the investment in the underlying equity) each period, sufficiently frequently to avoid going bankrupt from a run of mediocre or negative portfolio performances?

After more reflection and some fairly involved quantitative Monte Carlo simulations, my partner and I have found the answer to be, "yes."

Further, once we determined that the risk of this bankruptcy is acceptable, we turned to a fairly simple, but incredibly effective strategy familiar to any casino player- banking your winnings. That is, we developed a simple approach to sweeping the positive returns back into the investment base, and making the size of each investment portfolio dependent upon various multiples of the original investment having been 'banked.' Thus, within a few periods of investing in the equity strategy via call options, we are playing with house, or the market's, money. This rapidly builds over time. The greatest risk for the strategy, as expressed through options, is a losing streak during the first 18 months. After that, the probabilities are that virtually any dry period can be weathered without losing the entire investment.

Along with the safety of implementing our equity strategy via call and put options, we realized two other transforming aspects of the new approach. By using options, rather than equities, we are able to reduce the investment required for holding a given dollar-value portfolio by roughly a factor of 20. And by more frequently investing in the strategy, using each month's selections, rather than simply running two, six-month duration equity portfolios each year, we were able to increase the expected returns by a roughly a factor of 6.

Together, the effect of using less-capital-intensive options, more frequently, have allowed us to increase the expected returns of the original equity portfolio strategy by something in the neighborhood of more than 100-fold, on a gross basis. And this assumes delta neutrality for long-dated, out-of-the-money options. In reality, our assumptions are very conservative with respect to the expected returns of such options, vis a vis those of their underlying equities. Since the original equity strategy had an expected annual return of roughly 20%, this yields a much more potent, yet safer, approach to exploiting the consistency of our large-cap equity selection process.

As a result of these recent new, and transformational, developments in our equity portfolio strategy, through the use of call and put options instead of underlying equities, we believe we will be able to forego the search for a large, institutional investor for the near term, and turn, instead, to our own capital, and that of selected high net worth individuals.