Education Newsletter

What's the Trade?   November 30, 2011

Webinars This Week
DateWebinar TopicPresenterLevel 
November 30
3:30 pm CT
The Versatile Collar TradeJeff McAllister
December 5
4:00 pm CT
TM104: A Basic Intro to spectralANALYSISTravis McGhee

December 7
3:30 pm CT

Trading Around Important EventsJeff McAllister

December 12
4:00 pm CT

TM105: A Basic Intro to strategySEEKTravis McGhee

December 13
3:30 pm CT

Slowing Down Volatility with Vertical Spreads

Greg Loehr


This Week's Education Tip

Short Puts: Many retail traders use short puts to generate income in their accounts. Short puts can also be an excellent way to acquire stock. This is a widely used strategy and is considered one of the most conservative options strategies. The position is very similar to a covered call. Learn more in our free Education section.
I think that most option traders, especially new ones, would assume that a long-call strategy would outperform a long position in the underlying stock and that short puts would be a losing strategy, or at least a highly volatile one. But a recent report challenges these notions.

Buying calls is limited-risk strategy with potentially unlimited profits, at least on paper. You get exposure to the upside with limited downside, but you pay a premium for that asymmetrical payoff.

On the other hand, selling puts is considered highly risky, as you may be forced to buy stock at well above the actual market price on a big decline. It is a strategy that has led to the demise of some very big names.

But a recent report from GMO, a firm that manages $93 billion in assets, did some testing on such strategies. While the main point was to look at the relative performance of low-beta versus high-beta stocks, it did so with a comparison of buying calls and selling puts.

The call-buying strategies significantly underperform owning the market. It is clear that the shorter the term of the options, the more the time decay affects the positions. That is why the one-month calls do the worst.

This makes more sense when we think about the equivalent position. A long call is essentially the same as long stock plus long puts. In this context it is easy to understand the drag on performance of put "insurance" on the portfolio. (It is also an argument for more complex hedging strategies, though some use it as an argument against hedging at all.)

So you are essentially paying a price for an asymmetrical payoff--and the data suggests that you are paying too much.

Conversely, the put-selling strategy significantly outperforms the market. And it does so with a huge reduction in volatility--roughly 30 percent--with a much smaller maximum draw-down. Wait, you say, what about those guys who went out of business selling puts?

Well, a 10 percent average annual return does not justify "2 and 20" hedge-fund fees (which would leave you with a roughly 6 percent return, depending on the math). So institutional traders who take on these positions usually do so with leverage--and sometimes a lot of it.  

The basic idea behind put selling is that you get paid a premium to take on the downside risk of the market. It is known as a "concave" strategy because it has limited upside and increasing exposure to the downside with essentially all the risk of the market (minus the premium).

The lower volatility stems partly from not partaking in the upside. And the smaller downside is related to the higher premiums that come during market stress. The near-term options have greater time decay and pay the most because they have the least premium cushion and therefore the most risk. (See our Education section)

So put selling can have a place in a diversified option portfolio. You certainly have to be careful with it, but you can get paid for taking on risks that others don't want. Just ask Warren Buffett, who is arguably the single biggest put seller in the world.
This market is a lot like Operation Barbarossa, Germany's ill-fated invasion of the Soviet Union during World War II. That attack also started against a complacent enemy.

Russia, after all, was completely unprepared and paralyzed by the lightening blitzkrieg--just as the bulls were stunned by the violence of the August collapse after Standard & Poor's downgraded the U.S. sovereign credit rating. And just as the Germans made huge advances and captured millions of enemy soldiers, the bears have acted with impunity.

Also employing the tactics of doom and terror, bears have sold every rally and knocked down good stocks regardless of earnings quality or the state of the economy. They have ignored real fundamentals and valuations to a point of delusion, dreaming up nightmare scenarios of financial contagion--almost sickly hoping for another 2008.

But then the tide begins to turn. After two years, the Germans were deep in Russia soil but could advance no more. The bears started this week in a similar boat: Their supply line of negative news was running thin, while bullish partisans--strong Black Friday sales and better employment numbers--took pot shots at their officers before disappearing into the woods.

The Germans were bogged down in Stalingrad by late 1942. Instead of attacking all at once, the Russians surrounded them with a giant and invincible force that encircled and eventually destroyed General Paulus' famous 6th Army.

Likewise, the bears were bogged down by the end of last week. They couldn't get the S&P 500 to make new lows, while other metrics of fear like the Swiss franc and the euro/yen pair refused to confirm that the world was ending.

For the bears, this morning's announcement that central banks around the world will print money to solve Europe's problems is like the loss of Stalingrad. The Germans had to achieve total victory over Russia or ultimately lose; in the markets, the doom mongers could win only with a complete collapse of the European financial system. It was a giant binary bet, and it's looking as if they were wrong.

So where does that leave us? With the strongest bullish setup since the summer of 2010. At that time, there was also extreme negativity surrounding Europe, contrasted by persistently good economic data and earnings. We have the same thing now, with an improving labor market and good forward-looking data. Consider these headlines:

  • Planned job cuts fall 13 percent in November from a year earlier, according to Challenger, Gray & Christmas.
  • Private-sector payrolls grew 206,000, beating the 130,000 consensus forecast, according to ADP.
  • Chicago PMI surged to 62.6 in November, up from 58.4 in October and well ahead of the 59 reading expected from analysts. New orders were especially strong.

This follows a GDP report last week that appeared weak on the surface but showed promise for growth. Labor costs remain low, but workers are finding jobs. All of that paints an optimistic picture for the future.

We're essentially getting what we've been predicting for months: The U.S. economy is evolving back into something that's more genuine and less reliant on government stimulus and unsustainable leverage.

The professional economists will continue to say negative things because their models are built for another era. That made them overly optimistic five years ago and forces them to be overly pessimistic now.

So what's the trade? Just as the Russians built up momentum and steamrolled to the west, I think this market has the potential to do something similar.

That's especially true for steel and energy names, most of which have gotten destroyed in the last year. I also suspect that established leaders such as Apple will lag as investors focus on other names that are far more beaten-down: Coal, industrials, and emerging markets. "Risk on!"

Given how much we've moved so quickly, I plan to wait for the 10-day moving average on the S&P 500 starts climbing before putting more capital to work. But that's just a short-term tactic. I expect pullbacks will be shallow in coming weeks.