Weekly Update 5/18/2018 The Iron Maiden Trade
by Zach Marsh on Jun 19, 2018
Calibrate Weekly Update
What Option Greeks Teach Us About Our Retirement Plans
You pick up a lot of interesting terminology by spending too many years trading options. The lingo can vary greatly: from extremely esoteric terms like kurtosis, to ridiculous names of trading strategies like Iron Condor, Jelly Roll, and Guts Strangle. My favorite strategy name, by the way, is the Buttafuoco, named for Joey Buttafuoco, for those who recall the Amy Fisher story. This strategy describes a variation of a Butterfly spread with different wing ratios. Long story. But most of the terminology for risk management is Greek—Greek letters to be precise. Each letter denotes a risk associated with an option or option portfolio. Below is a brief description of three of them. Be patient, I promise you there is a payoff at the end.
Delta describes the sensitivity of an options price to the price of the underlying stock or future. Think of delta as being your equivalent position in the underlying instrument. One 50 delta call in Apple stock is the same as being long 50 shares of Apple. Buying a call gets you long deltas, selling a call gets you short deltas.
Gamma is more difficult to explain, but in an attempt not to lose or bore you I will skip the technical issues surrounding gamma. Let’s just say gamma describes an option delta’s sensitivity to price movement. Buyers of options are buyers of gamma and desire greater than expected price movement, while sellers of options are short gamma and desire less price movement than expected.
Theta is the change in the value of an option given the passage of time (defined in terms of days). If option buyers get the benefit of profiting from price movement, theta is the price they pay for that benefit. Theta is the time decay of option premium.
Normally, say 99% (not a scientific number) of the time, at the portfolio level, gamma and theta are inversely correlated. If you purchase an option, you become long gamma and short (paying) theta. However, occasionally, through some wicked twist of fate, an option trader can find herself short gamma and short theta. What appears to be impossible, by definition, amounts to receiving neither the benefit of time passing nor the benefit of markets moving. Having been in this position on more than a few occasions, I can tell you it is a no-win situation. Neither price movement nor time is on your side. You are forced to either get out of the position or pray the underlying moves in the direction you want (i.e. your delta position). If I were to invent a name for this strategy it would be the Iron Maiden; trapped in a box lacking the ability to move in any direction.
At this point you are probably asking yourself, “Where’s he going with this? What does this have to do with me?” Well, here it is—for the majority of us investing and saving for retirement, we are all essentially short gamma and short theta--neither time nor volatility are on our side. We are simply at the mercy of price direction. Fortunately, considering most of us are long capital assets which tend to drift higher over the long run, this situation isn’t terminal, but it isn’t without pain and suffering.
The Iron Maiden Pain Trade
So how did we end up in the synthetic position: long delta, short gamma, short theta? Our condition is set by our mortality. Knowing we have a finite time on this planet, for the majority of us, we don’t want to spend it working until death. We set a time horizon for ourselves to retire and that date serves, as what we’d define in options trading, as an expiration date. (From a financial management stand point your retirement is not an expiration, but just a continuation.) But to a large degree it is an expiration of your portfolio’s growth stage and a transition into a distribution stage. This transition is an expiration of sorts. So, in that sense, as we move towards retirement, we exhibit the symptoms of time decay. We require our portfolio to appreciate in value before our retirement arrives. This can occur sometimes quickly and sometimes slowly depending upon the long term economic or financial conditions. Therefore, this is why I consider most of us savers to be short Theta.
The enemy of portfolio appreciation is volatility. I’ve spent a lot of ink in these letters describing the volatility tax and the negative implications of adverse price movement on our portfolios and on our goal’s-based investment plans. Suffice it to say, as we really only benefit from our assets appreciating in price, and volatile price action is counterproductive to our portfolio value, we are consequently short Gamma.
Being subjected to short Gamma and short Theta means that it is not only the depth of our portfolio drawdowns that affect us, it is also the duration of the drawdown. It may be sacrilegious to disagree with Warren Buffett about anything, although his diet seems suspect (enough already with the Cherry Coke and Dairy Queen), but some of his advice to individual investors seems inappropriate or downright dangerous. One thing I believe Mr. Buffett overlooks is the nature of volatility’s impact on investment strategies with defined time horizons. A stock index fund is not designed to reduce the impact of equity volatility at the class level, it is designed to reduce the impact of the volatility at the individual stock level—you retain the risk of the overall stock market. To Warren Buffett this is inconsequential, at 87 his time horizon is still infinitely longer than mine at 45. He invests for Berkshire Hathaway, which he envisions to live on in perpetuity, and I invest for my wife’s and my retirement. Mine expires his doesn’t.
To illustrate the impact of volatility time drag on investment performance let’s compare three portfolios:
· Portfolio 1: A risk-balanced portfolio similar to what we utilize here at Calibrate, levered at 152%.
· Portfolio 2: A standard 60% Total Stock Market Fund/40% US Bond Aggregate Index.
· Portfolio 3 100% S&P 500 Index Fund.
The average annualized return from 1998-2017 for all three portfolios were: 9.86%, 7.11%, and 8.14% respectively. Portfolio 1 achieved its return with an annualized volatility of 8.47%, Portfolio 2 8.97%, and Portfolio 3 14.87%. Now most of us, because we are not computers, do not visualize or emotionally digest what these numbers portend—that’s the problem with statistics. However, we can help put into the context what these volatility numbers represent as a price, in years spent, seeking the advertised annualized returns. Below is a graph of the drawdowns periods for the three portfolios, over the past 20 years.
You can see the deep troughs for the Vanguard Index Fund. We know in retrospect how the story turned out, but in the moment, we were far from certain that a recovery would ever arrive. The happy ending was only there for those who were able to ride it out, or for those whose timing was beneficial. But it also doesn’t tell the entire story either. We often here statistics like 3 hours/day of TV viewership takes X number of years off our life, or smoking cuts our life expectancy by 10 years. These stats are impactful because time mean something to us. Who wouldn’t want to maximize their years? What the drawdown graph doesn’t precisely show, though, is the time lost waiting for recovery, or the total amount of time each portfolio spent below its highwater mark. While no portfolio is immune from drawdowns, not all are created equal. Portfolio 1 spent a total of 89 months out of 240 months underwater, or about 7 years and 5 months. Portfolio 2 spent a total of 118 months or 11 years and 10 months underwater. Portfolio 3, the S&P 500 Index, spent 170 months underwater! 14 years and 2 months out of 20 years trying to claw back to above the previous highs.
Viewed from this perspective we see Theta’s impact on our investment choices. Nearly seven years saved out of 20 years between Portfolio 1 and the stock index. This doesn’t even cover the erosion of money over time caused by inflation. Figure 2% inflation annually for each year spent treading water and you now not only have lost time, but lost money. But inflation aside, what if those were 7 years longer you had to work or 7 years earlier you could’ve retired. What if you even spared half of those years? That, more than anything, seems to help us non-computer-types make sense of all those statistics.
On another note I want to thank you all for reading over the past few months. As a kind request I would like to ask you to take a minute and fill out the survey accessed from the link below. It will help us to know your thoughts as well as give us some guidance on future topics of discussion.
Zach and David
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