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Making small bets against bubbles for big return
Old 01-08-2010, 10:48 AM   #1
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Making small bets against bubbles for big return

Sorry for the spam-like title!

Does anyone take a very small percentage of their portfolio and use it to strategically make small bets that a bubble will collapse? Or I suppose you could take a similar bet that there is an inverse bubble (ie an asset has over corrected on the down side).

I think this strategy was basically what Taleb was using and described in his book (which I have yet to read). Essentially making bets on the fat tails of the curve.

Here is what I'm describing with example values.

Say you have 500,000 in your portfolio. Taking 1%, or 5,000 each year and putting it on some way out of the money puts or calls on a bubble asset or assets. The percentage could be less or a little more depending on your risk appetite. Trimming 0.5-1% off of the return of maybe 7-10% a year isn't a huge sacrifice to occasionally get a big winner (either by the option going into the money or by the option itself increasing in value significantly).

Assets I thought about "shorting the bubble" on before: oil and china right before their respective crashes. Didn't act on any of it. May not have made any money if I would have since so much is dependent on timing (ie luck). Currently I'm eying gold as a candidate for one of these wild bets.

For example the GLD Jan 2011 and Jan 2012 70 puts were roughly $0.85 and $2.25 earlier today (underlying trading around 110-111 at the time). A big movement on GLD downwards could make these inflate big time. And you have 1-2 years before these options can expire worthless.

I know the basics of options - price declines over time due to decay; price moves up/down along with volatility/risk in the market. You could still lose money on these way out of money options even with a big market movement in the underlying asset in your favor.

And to some extent, you have to time these transactions. When something is particularly bubbly and/or vix is low and options are cheaper, maybe you are willing to make larger bets (ie buy what is cheap). During highly volatile times or where nothing appears particularly bubbly, you don't buy or buy little.

There just seems to be so many times when you look at something, smell a fish, and want to put your money where your mouth is, but I don't want to do anything too crazy and place a significant portion of the portfolio at risk.

Anyone doing something like this and care to share how it's going, tips, tricks, caveats?
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Old 01-08-2010, 11:10 AM   #2
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I shorted internet stocks during that bubble. I was right about them being severely overvalued. Unfortunately they went to ridiculously overvalued and I was killed by margin calls and had to cover before I was proven right.

Never again will I play a bubble.

Although I won't have to pay capital gains taxes for the next decade or so.
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Old 01-08-2010, 11:53 AM   #3
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I shorted internet stocks during that bubble. I was right about them being severely overvalued. Unfortunately they went to ridiculously overvalued and I was killed by margin calls and had to cover before I was proven right.
I would be scared to short naked, since the sky is the limit in terms of losses and the intervening margin calls would wipe me out.

But small amounts on options where the risk of loss is limited to the cost of the options purchased would have a limit on the loss. 100% of the amount invested, but if this only represents 1% of your portfolio, then the total portfolio loss is limited.

I realize that one big problem is getting the timing right. You could go chasing after a bubble hoping it pops for years.
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Old 01-08-2010, 12:35 PM   #4
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I do this sort of thing on a regular basis. However, I never do it with a simple outsized long or short, instead always using something like an option that has a very clear max loss. I also usually limit this sort of thing to a small proportion of my portfolio.

At the moment, I am long a large pile of warrants issued by a SPAC. If they do a deal, the warrants will be worth multiples of what I paid for them. If not, the warrants are worthless.
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Old 01-08-2010, 12:35 PM   #5
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Bubbles can last a long time, so derivatives are too risky for me.

I'm of the buy-and-hold mindset, but over the last year I've reluctantly decided it makes sense to tilt my stock/bond ratio a bit according to market valuations, but never outside a range I wouldn't be comfortable to stay in for 5+ years. My goal is not to maximize gains, but to minimize the chance of running out of money. To my surprise, I believe there is enough evidence to justify this approach, although it is certainly not mainstream and probably not suited to most.
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Old 01-08-2010, 12:47 PM   #6
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Since I am in the accumulation stage, I am comfy making small, swing-for-the-fences bets.
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Old 01-08-2010, 03:26 PM   #7
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Originally Posted by brewer12345 View Post
Since I am in the accumulation stage, I am comfy making small, swing-for-the-fences bets.
I think this is a really good idea, but it is emotionally difficult. All kinds of social science research suggests that people evaluate bets from a frequency of success standpoint, not from a mathematical expectation standpoint. A bunch of options that were bought at a favorable price but expire worthless tend to convince us that all these bets are stupid.

Plus the idea is not extremely simple, and people like extremely simple guidelines in their investing.

Ha
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Old 01-08-2010, 05:25 PM   #8
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Originally Posted by haha View Post
I think this is a really good idea, but it is emotionally difficult. All kinds of social science research suggests that people evaluate bets from a frequency of success standpoint, not from a mathematical expectation standpoint. A bunch of options that were bought at a favorable price but expire worthless tend to convince us that all these bets are stupid.

Plus the idea is not extremely simple, and people like extremely simple guidelines in their investing.

Ha
Life is all about choices, I guess. In the case of my warrants, if I lose I am out 2% of my net worth. If I win I am probably up 10%. I looked closely at the situation and believe the chances of winning are good, so I like the odds.
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Old 01-08-2010, 06:11 PM   #9
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I watched several people attempt to do this. They were always too early - often 2 years two early. And these are people who just sold the asset class figuring it couldn't go higher or a drop was imminent - not folks who went short. I can't imagine the pain of going short REITs 2 years before they finally peaked!

Anyway - not me!

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Old 01-08-2010, 08:32 PM   #10
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Just want to make clear I'm not thinking of shorting something. Too risky. Could lose multiples of the amount shorted.

I'm talking about buying way OTM puts on a bubble asset. Asset price drops below strike price, you make money. Way below strike price and you make a killing. Asset price drops significantly but not below the strike price, and you make money if it does so before time decay makes your option worth less than you paid.

The idea here is like Brewer is saying. Not a lot, maybe 1%, 2%. You lose, it all goes bye bye and you are out 2% of your net worth. You strike it big, and you make 10%. My thinking is if I do this and am right 1 out of 3 times, and make a huge return on the one time I'm right, I'll come out money ahead. The odds on one single event are not good, but the payoff is significant enough to more than compensate for the risk of failure.

Basically I'm in the same boat - young enough and still accumulating so swinging for the fences is still ok. Losing a percent a year isn't going to kill me.
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Old 01-08-2010, 08:43 PM   #11
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For retirees, the potentially attractive variants is to buy out of the money puts pn equity indices. You give up a little money for an instrument that would pay off hugely inthe case of an equity market collapse. Its hard to imagine that this would not be attractive to a lot of people still licking their wounds from the downdraft.
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Old 01-08-2010, 10:49 PM   #12
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Originally Posted by FUEGO View Post
The odds on one single event are not good, but the payoff is significant enough to more than compensate for the risk of failure.
Wouldn't you be surprised to find that risk isn't fairly priced in a market so nearly perfect as equity options? Ubiquitous availability of information pertaining to valuations, fairly low frictional costs, very few bars to entry.

I think if it were easy, folks would be devoting all day to it and making huge sums. And they'd be very wealthy, and everyone would soon be doing it.

"Where are the clients' yachts?"
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Old 01-09-2010, 12:05 AM   #13
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Wouldn't you be surprised to find that risk isn't fairly priced in a market so nearly perfect as equity options? Ubiquitous availability of information pertaining to valuations, fairly low frictional costs, very few bars to entry.

I think if it were easy, folks would be devoting all day to it and making huge sums. And they'd be very wealthy, and everyone would soon be doing it.

"Where are the clients' yachts?"
See my post above. And besides, a huge group of market participants believe in the efficient market.

Ha
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Old 01-09-2010, 02:02 AM   #14
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It's better odds than playing the lottery or going to the casino but, as Keynes is reputed to have said,"markets can remain irrational for longer than you can remain solvent". You would need to have a very strong belief that the market was not only pricing the investment irrationally but that a correction was immenient.
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Old 01-09-2010, 07:47 AM   #15
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It's better odds than playing the lottery or going to the casino but, as Keynes is reputed to have said,"markets can remain irrational for longer than you can remain solvent". You would need to have a very strong belief that the market was not only pricing the investment irrationally but that a correction was immenient.
I see obvious mispricing of assets on a regular basis in out so-called efficient market.
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Old 01-09-2010, 08:05 AM   #16
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Just want to make clear I'm not thinking of shorting something. Too risky. Could lose multiples of the amount shorted.
Spouse's uncle, a long-term successful stockpicker, ER'd in the late 1980s. He started shorting the NASDAQ in 1996 when it was clearly, by any rational measure, overvalued.

He returned to the workforce in 1999 as a teacher in East LA. He managed to ER again a couple years ago.

Quote:
Originally Posted by FUEGO View Post
I'm talking about buying way OTM puts on a bubble asset.
I think the challenge to this "investment" is twofold:
1. Being willing to put in the work to identify a bubble. Sure, it's easy to set triggers for various indices, but once you start digging into the asset you find yourself thinking that it's not too overvalued after all. Especially if it's fueled by cheap govt funding which could go on for years.
2. Being willing to accept years of pouring money down a rathole with the foreknowledge that you're going to lose at least 8 out of 10 before the payoff arrives. It takes the kind of mental discipline that can cheerfully light cigars with $100 bills. Even Taleb says that his best personal investing payoff was a once-in-a-lifetime deal.

I find it much less work, and much more rewarding, to seek undervalued asset classes.
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