Is There A Role For Options Insurance In Equity Portfolios?

[yakers]

Recent article in The Economist magazine ‘Buttonwood’ column on disagreement between Taleb and Cliff Asness about options as investments. Taleb thinks options are a good idea and Asness holds that options are insurance and thus a drag on performance over time.
Certainly some make money on options but as someone with a simple portfolio (mostly index funds and VG W/W, just a few ‘old’ stocks) I’m not sure if options are a good thing for me to try to understand. Really interesting article, the Economist ultimately doesn’t agree with either of them saying: “It can make sense to use them when they are relatively cheap.”
Now, what is cheap? Anything a layman can understand and use?

 

[Sunset]

I use options a bit.
Be careful with them as they use different terminology than stocks, for example when I sell 2 call options on SPY for $1.50. It really means I'm selling the option for 200 shares, and get $1.50 x 200 = $300 premium.

Here is where I find them most useful:

I'm thinking of selling a stock, I can sell a Covered Call on it, getting a premium paid to me, and if the stock goes up in price to meet the strike price it gets called away (sold). If the price does not go up enough, I get to sell a Call again on it.
Of course if the price shoots way up, I miss that appreciation in price.
Nothing is free.

 

[OldShooter]

... Now, what is cheap? Anything a layman can understand and use?

I doubt it. I am a real Taleb fan and have read his books multiple times. I an currently on my umpteenth trip through "Fooled By Randomness." He does not discuss options or option strategy very directly but my understanding is that he buys options that will pay off big in the case of a many-sigma market move. He expects the options to expire worthless most of the time, but waits for the big winner that covers all the losses and then some. I assume this is the hedge he is advocating.

Again, he does not address this directly, but I think it only works if the options he buys are underpriced. If they are always efficiently priced, then I think his net has to be close to zero.

This layman has no way to know whether an option is underpriced or not. From my very limited understanding of Black-Scholes, I think it would not help with a Taleb strategy because by definition Taleb is buying things that are off the charts. So no joy there either.


FWIW here is a link to the Economist article: https://www.economist.com/finance-a...le-for-options-insurance-in-equity-portfolios It may be behind a paywall though. As a subscriber I can get it but YMMV.

 

[pb4uski]

I'm looking at long term (Dec 2022) LEAP calls on SPY that are delta 0.7 (roughly 15% ITM). They are a little expensive right now but if/when prices normalize I think they may be an attractive alternative to direct investment in equities. Similar upside but with limited downside risk.

I also own a little SWAN, which is an ETF that is 90% Treasuries and 10% SPY call options (5% 12 month SPY calls bought at 0.7 delta bought every 6 months).

 

[OldShooter]

I'm looking at long term (Dec 2022) LEAP calls on SPY that are delta 0.7 (roughly 15% ITM). They are a little expensive right now but if/when prices normalize I think they may be an attractive alternative to direct investment in equities. Similar upside but with limited downside risk. ...

If the options are efficiently priced, though, then probabilistically the buyer will lose as much as he wins, no? So then it's a wash except for costs? I guess any one buyer will never know because his sample size is so small.

... I also own a little SWAN, which is an ETF that is 90% Treasuries and 10% SPY call options (5% 12 month SPY calls bought at 0.7 delta bought every 6 months).

Taleb's "barbell" strategy from "Antifragile." Interesting.

 

[FIRE'd@51]

If the options are efficiently priced, though, then probabilistically the buyer will lose as much as he wins, no?

Not necessarily. One can still make a lot of money buying overpriced call options if the underlying stock or index goes up. IOW, if someone is a good stock picker or market timer, the alpha he generates from his stock-forecasting ability could be significantly greater than the negative alpha generated by overpaying for an option.

I would agree with your assertion if the option buyer (or seller) were implementing a delta-neutral strategy.

 

[OldShooter]

"delta-neutral" ?? Teach me.

 

[FIRE'd@51]

"delta-neutral" ?? Teach me.

Delta-neutral means the option plus a hedging portfolio is independent of the price of the underlying, i.e., the combination of the two has a net delta of zero. This is the only way to isolate and capture the mis-pricing of an option.

 

[bmcgonig]

I'm looking at long term (Dec 2022) LEAP calls on SPY that are delta 0.7 (roughly 15% ITM). They are a little expensive right now but if/when prices normalize I think they may be an attractive alternative to direct investment in equities. Similar upside but with limited downside risk.

I also own a little SWAN, which is an ETF that is 90% Treasuries and 10% SPY call options (5% 12 month SPY calls bought at 0.7 delta bought every 6 months).

Pb

I've been looking at swan and trying to see how it can bite me in the ass. What comes to be is a real bear market like 73/74 e.g., down two years in a row. The options would expire worthless possibly twice for a permanent loss of 20%? That would also seem to be the case if the market just went down 10% each of the two years. Your normal portfolio would have a chance to recover with time but the swan would have a permanent loss.

If interest rates were rising at the same time your treasures would also lose. They seem to buy a ladder of treasuries 7-10yr duration.

Does that make sense or am I missing something?

 

[Sunset]

I'm looking at long term (Dec 2022) LEAP calls on SPY that are delta 0.7 (roughly 15% ITM). They are a little expensive right now but if/when prices normalize I think they may be an attractive alternative to direct investment in equities. Similar upside but with limited downside risk.

I also own a little SWAN, which is an ETF that is 90% Treasuries and 10% SPY call options (5% 12 month SPY calls bought at 0.7 delta bought every 6 months).

One annoying thing about Leaps on SPY is missing out on the dividend for the 1.5 yrs.

 

[FIRE'd@51]

One annoying thing about Leaps on SPY is missing out on the dividend for the 1.5 yrs.

Presumably, the fact that you're not getting the dividend is factored into the LEAP price.

You could always just hold the SPY and buy the 0.3 delta one-year puts every six months. This would give you the same return pattern as the SWAN, and you wouldn't have to pay the 0.5% expense ratio. This is the way I would do it if I were looking for that return pattern.

 

[Closet_Gamer]

Interesting thread. I recently started experimenting with options a bit. To the outside observer it probably looks like monkey poking a fire ant nest with a stick. Amusing but unlikely to end well.

Anyone interested in a participating in a sustained options thread in the same mode as the preferred stock thread that's been around forever?

Interesting and highly technical topic.

 

[pb4uski]

Pb

I've been looking at swan and trying to see how it can bite me in the ass. What comes to be is a real bear market like 73/74 e.g., down two years in a row. The options would expire worthless possibly twice for a permanent loss of 20%? That would also seem to be the case if the market just went down 10% each of the two years. Your normal portfolio would have a chance to recover with time but the swan would have a permanent loss.

If interest rates were rising at the same time your treasures would also lose. They seem to buy a ladder of treasuries 7-10yr duration.

Does that make sense or am I missing something?

I think you need to compare it to what a conventional AA portfolio would do under the same scenario rather than flat.

In the 694 days between 11 January 1973 and 6 December 1974, the*New York Stock Exchange's*Dow Jones Industrial Average*benchmark suffered the seventh-worst*bear market*in its history, losing over 45% of its value.

Seems like the 20% loss would be less than 60% of a 45% loss.

SWAN's loss wouldn't be permanent because when the normal portfolio would recover the options in SWAN would be profitable and offset the earlier losses.

 

[pb4uski]

Interesting thread. I recently started experimenting with options a bit. To the outside observer it probably looks like monkey poking a fire ant nest with a stick. Amusing but unlikely to end well. [emoji23]

Anyone interested in a participating in a sustained options thread in the same mode as the preferred stock thread that's been around forever?

Interesting and highly technical topic.

Yes.

 

[Dawg52]

Interesting thread. I recently started experimenting with options a bit. To the outside observer it probably looks like monkey poking a fire ant nest with a stick. Amusing but unlikely to end well.

Anyone interested in a participating in a sustained options thread in the same mode as the preferred stock thread that's been around forever?

Interesting and highly technical topic.

I probably fall into the monkey camp but it would be an interesting topic and I might learn something. Heaven forbid.....

 

[Months.in.Wyoming]

Interesting thread. I recently started experimenting with options a bit. To the outside observer it probably looks like monkey poking a fire ant nest with a stick. Amusing but unlikely to end well.

Anyone interested in a participating in a sustained options thread in the same mode as the preferred stock thread that's been around forever?

Interesting and highly technical topic.

Yes... I have an options passive income strategy (still working out details at the edges) but I plan to use it (eventually in a Roth) to provide all my income while letting the majority of the nest egg grow for as long as I'm here... Idea is to generally sell Put options that are near term (with 5 weeks out) on companies with fortress balance sheets that I'd like to own anyway at slightly out of money strikes. And just live off the premium. If I get put to, then I'll maybe have to do a traditional withdrawal until I'm back to strike (or higher) and sell and return to put writing. Anyone else doing this? I have been and am tracking all trades - I sleep well at night as these are all cash covered and with companies I'd like to own (even though that isn't my goal).

 

[Montecfo]

I used options pretty heavily at times during accumulation phase as a way to limit risk or control a higher equity position with a limited number of dollars.

After years of not using them, I recently began buying puts on SPY as a bit of downside insurance. I'm only going out about a month at present to keep it cheap.

Seems better than selling stocks at a time when markets remain strong, though I have been doing some selling into strength also.

 

[Retireby45ish]

I'm looking at long term (Dec 2022) LEAP calls on SPY that are delta 0.7 (roughly 15% ITM). They are a little expensive right now but if/when prices normalize I think they may be an attractive alternative to direct investment in equities. Similar upside but with limited downside risk.

I also own a little SWAN, which is an ETF that is 90% Treasuries and 10% SPY call options (5% 12 month SPY calls bought at 0.7 delta bought every 6 months).

pb4uski - happy to provide insight since your posts on all other topics are always so informative. Thanks for teaching me and others so much over last few months.

Buying ITM calls is leveraging your cash. Upside is great but you can lose it all if SPY finished below that strike. So def downside risk! It’s a leveraged long. You are also paying for the option in the form of some premium to do this (tough to explain in a few sentences). And yes, the Dividend discount is imbedded in these options already so you aren’t missing out on this.

General notes:

I’m relatively (few months) new to the board and learning lots but options are the one thing I know. Been working with them professionally for almost 2 decades.

Few things from reading thread.

Options are tricky...insanely complex really. Be careful that you understand them before you play with them.

They are great for passive investors to use simply as insurance or call writing (covered). These two strategies are pretty simple on the surface.

Options are well priced but can serve a purpose for you if you understand them. Otherwise there is no edge. There is no mispricing. You are playing against very sophisticated firms who specialize in these. They are repriced on the millisecond level with news and market info digested by complex algorithms. The papers you read make it sound like you can find a miss priced option. You can’t.

You can buy small lotto tickets and wait for the big win as someone said. But zero edge (in fact negative due to fees and wide spreads). Same with all other strategies.

Again I’d stick to The puts or calls strategies above after you have read up on them. But they’ll be perfectly priced every second of the day. As someone said above, nothing is free. But they are the only two things I’d advise doing as a non professional.


Happy to answer any questions on this topic if anyone has specifics or wants to start a thread.

 

[Sunset]

If a person buys deep ITM Leaps, I've felt this is a fairly safe, move.
I would not mind if folks point out my poor thinking

Example: Spy is currently $316.83
A leap strike price of $160 is about $158/sh (where I'm looking and its not real time).
So the premium is only $2 (seems too cheap to me, but would be missing out on about $11 of dividends).

What could happen in the nearly 2 years:

1. Stock goes way up -> make a nice leveraged profit.
2. Stock stays flat -> miss out on divs
3. Stock goes down $50 -> I lose some money when exercise option, the more it goes down the more I lose to a point.
4. Stock goes down below strike prices of $160, I don't lose as much compared to person who held the stock, I don't exercise the option.

I do wonder if being a (+) person and thinking in 2 years the market will be higher, if it would be better to buy a $320 Strike price for $30/sh as for roughly the same money as the deep ITM leap I could buy 5 options at a cost of $150/sh.

 

[CoolChange]

Similar Thoughts

Yes... I have an options passive income strategy (still working out details at the edges) but I plan to use it (eventually in a Roth) to provide all my income while letting the majority of the nest egg grow for as long as I'm here... Idea is to generally sell Put options that are near term (with 5 weeks out) on companies with fortress balance sheets that I'd like to own anyway at slightly out of money strikes. And just live off the premium. If I get put to, then I'll maybe have to do a traditional withdrawal until I'm back to strike (or higher) and sell and return to put writing. Anyone else doing this? I have been and am tracking all trades - I sleep well at night as these are all cash covered and with companies I'd like to own (even though that isn't my goal).

I have been considering something similar but have yet to do any real work modeling, back testing, etc.

My thinking is along the lines of selling puts on things (likely all or mostly indexed ETF's) that I want to own at a lower entry point anyway.



Some of the many things I still need to work out:

1. Pricing the puts
2. Cash covered only or using margin for more flexibility
3. Tax implications

 

[OldShooter]

... options are the one thing I know. Been working with them professionally for almost 2 decades. ... You can buy small lotto tickets and wait for the big win as someone said. But zero edge (in fact negative due to fees and wide spreads). Same with all other strategies. ...

First, thank you for showing up and posting. True expertise sometimes dampens the excitement here, but IMO that is a good thing.

A question: Nassim Taleb is a little evasive on his option strategies, but his general idea seems to be to continuously buy options that are far out of the money and, as you say, wait for the big win. I have always felt (and have posted the comment) that for that strategy to work, the options must be underpriced. I think you are agreeing with this and further saying that even those "far out" options are going to be efficiently priced. So ... no cigar. Comment?

 

[Retireby45ish]

First, thank you for showing up and posting. True expertise sometimes dampens the excitement here, but IMO that is a good thing.

A question: Nassim Taleb is a little evasive on his option strategies, but his general idea seems to be to continuously buy options that are far out of the money and, as you say, wait for the big win. I have always felt (and have posted the comment) that for that strategy to work, the options must be underpriced. I think you are agreeing with this and further saying that even those "far out" options are going to be efficiently priced. So ... no cigar. Comment?

Glad to be of help.

Technically, those options are actually slightly OVERPRICED. because they are akin to lottery tickets people shy away from selling them. They work until some 5 standard deviation event happens once a decade or two and you lose the farm. Everyone knows this so they are slightly worth more than they should be. But if you make, say, $10 every month but then stand to lose $100k once every decade, is it worth it? No. Even if they are overpriced and I collect $12 instead of $10? nope,not for me.

Google optionsellers.com : someone created a fund to sell these options...raised money from people who saw these steady returns and didn't understand what they were betting on. But one day he lost every penny of investor money plus the investors got letters asking for EXTRA money to cover the losses.

No such thing as free money!

If you sell these covered then it's fine. But the upside is slim.

 

[Retireby45ish]

If a person buys deep ITM Leaps, I've felt this is a fairly safe, move.
I would not mind if folks point out my poor thinking

Example: Spy is currently $316.83
A leap strike price of $160 is about $158/sh (where I'm looking and its not real time).
So the premium is only $2 (seems too cheap to me, but would be missing out on about $11 of dividends).

What could happen in the nearly 2 years:

1. Stock goes way up -> make a nice leveraged profit.
2. Stock stays flat -> miss out on divs
3. Stock goes down $50 -> I lose some money when exercise option, the more it goes down the more I lose to a point.
4. Stock goes down below strike prices of $160, I don't lose as much compared to person who held the stock, I don't exercise the option.

I do wonder if being a (+) person and thinking in 2 years the market will be higher, if it would be better to buy a $320 Strike price for $30/sh as for roughly the same money as the deep ITM leap I could buy 5 options at a cost of $150/sh.

Buying ITM options is a leveraged play on the underlying asset. IF it goes up you'll win big, if down you lose big.

For example, if it goes down $50 you lose 31% (50/158) on the ITM call. If you owned the stock you only lose about 14% (50/360).
If the stock goes down from 316 to 160 you lose 100% of your investment vs if you own the stock you'd only lose 44%. Pretty big difference. And you can't just wait to see if it rebounds. That money is gone and you have to find more to play again. Not sure what you meant by "I lose to a point"...because that point is 100% of your investment. yikes!

on the Divs, those are priced into the option price already. Everyone estimates the projected div stream and discounts the call by that amt (it's priced on the forward value of the stock or ETF).

 

[Retireby45ish]

Yes... I have an options passive income strategy (still working out details at the edges) but I plan to use it (eventually in a Roth) to provide all my income while letting the majority of the nest egg grow for as long as I'm here... Idea is to generally sell Put options that are near term (with 5 weeks out) on companies with fortress balance sheets that I'd like to own anyway at slightly out of money strikes. And just live off the premium. If I get put to, then I'll maybe have to do a traditional withdrawal until I'm back to strike (or higher) and sell and return to put writing. Anyone else doing this? I have been and am tracking all trades - I sleep well at night as these are all cash covered and with companies I'd like to own (even though that isn't my goal).

This is another viable strategy. Just realize that the options are fairly priced...but if you have a lot of cash sitting around it's probably going to get you a decent little return since you know you're happy to buy them if they go below the strike price (put to). Probably way better than a traditional MM or CD return, but I haven't done any formal analysis on it.

In general, people tend to write covered calls instead if they already own the underlying. I've read some papers that say that if you do this you can gain about a 2% yield over a long time horizon. You'll certainly cap upside potential over a given time-frame.

 

[pb4uski]

If a person buys deep ITM Leaps, I've felt this is a fairly safe, move.
I would not mind if folks point out my poor thinking

Example: Spy is currently $316.83
A leap strike price of $160 is about $158/sh (where I'm looking and its not real time).
So the premium is only $2 (seems too cheap to me, but would be missing out on about $11 of dividends).

What could happen in the nearly 2 years:

1. Stock goes way up -> make a nice leveraged profit.
2. Stock stays flat -> miss out on divs
3. Stock goes down $50 -> I lose some money when exercise option, the more it goes down the more I lose to a point.
4. Stock goes down below strike prices of $160, I don't lose as much compared to person who held the stock, I don't exercise the option.

I do wonder if being a (+) person and thinking in 2 years the market will be higher, if it would be better to buy a $320 Strike price for $30/sh as for roughly the same money as the deep ITM leap I could buy 5 options at a cost of $150/sh.

Buying ITM options is a leveraged play on the underlying asset. IF it goes up you'll win big, if down you lose big.

For example, if it goes down $50 you lose 31% (50/158) on the ITM call. If you owned the stock you only lose about 14% (50/360).
If the stock goes down from 316 to 160 you lose 100% of your investment vs if you own the stock you'd only lose 44%. Pretty big difference. And you can't just wait to see if it rebounds. That money is gone and you have to find more to play again. Not sure what you meant by "I lose to a point"...because that point is 100% of your investment. yikes!

on the Divs, those are priced into the option price already. Everyone estimates the projected div stream and discounts the call by that amt (it's priced on the forward value of the stock or ETF).

I guess the % isn't as important to me as the $ amounts. So to extend Sunsets's example, let's say that I buy 10 contracts rather than invest $316,830 in the SPY and my investment in the LEAPs is $158,000.

If index rises to 450, 1000 shares of SPY are worth $450,000 and a $133,170 gain where at expiry the LEAPs are worth $290,000 and a gain of $132,000.

If index is flat then 1000 shares of SPY are worth $316,830 and $0 gain where at expiry the LEAPs are worth $156,830 and loss of $1,170.

If index is 266.83 then 1000 shares of SPY are worth $266,830 and a loss of $50,000 where at expiry the LEAPs are worth $106,830 and a loss of $51,170.

So in that scenario it seems to me that you are getting roughly the same investment gain as directly investing in the SPY but with your downside limited to $158,000 loss at worst.

Now all of that said, I was thinking of LEAPs that were more like 15% or so in-the-money vs 50% in-the-money.