Options as a Ballast when Real Bond Yields are Negative

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Post Reply
Topic Author
EfficientInvestor
Posts: 364
Joined: Thu Nov 01, 2018 7:02 pm
Location: Alabama

Options as a Ballast when Real Bond Yields are Negative

Post by EfficientInvestor »

Historically, especially over the last 40 years, bonds (specifically US treasury bonds) have been a great ballast for a portfolio. When stocks have dipped, yields have generally fallen, bonds have increased in price and the portfolio as a whole has remained more stable. Bonds have acted as nice insurance against stock holdings. But they have acted like a type of insurance that you actually get paid to hold instead of having to pay a premium like with typical insurance contracts.

This has been discussed in many threads on the forum, but now that bond yields are so low, we can't necessarily expect the same response from bonds during stock downturns going forward. There is just only so low yields can go, especially when the FED holding firm at 0%. We also can't get paid to hold them as insurance anymore. Even long term yields of 1.3% are expected to have negative real yield assuming a 2% inflation. A conservative 50/50 portfolio with intermediate treasuries (e.g. IEF) held for the bonds is seeing half of the portfolio subject to somewhere around a -1.4% real return if you assume a 2% inflation. The insurance that used to pay us to hold it is now costing us in the form of a negative real yield.

Now that it effectively costs money (in real terms) to hold bonds as insurance, many have said it is time to consider alternatives. However, most of what I have read recommends swapping out bonds for quality stocks w/ good dividends or for higher yielding bonds. That doesn't make sense to me given that you are making the portfolio more risky. That begs the question...is there an alternative to bonds that allows us to maintain similar risk as before but not cost so much as the negative real return we are having to accept by holding bonds?

Enter option contracts...

Before making the case for the use of options contracts, let's establish a few assumptions:

1. The expected return of the S&P 500 (SPY) going forward will be 6%. This assumption doesn't matter much for the sake of this post, I just need a reference point from which to base comparisons. Let's assume 1.6% of that return will be dividends.
2. The expected return of intermediate treasuries (IEF) going forward will be the current SEC yield of 0.59%. Let's just call it 0.6% for ease.
3. Based on the above, the expected return of a 50% SPY/50% IEF portfolio is 3.3%.
4. The expected max drawdown of SPY will be similar to the 2008 crash...55%
5. The expected max drawdown of 50% SPY/50% IEF will be similar to the 2008 crash...20%

Let's assume you are a conservative investor and you are currently holding a 50/50 portfolio that has a 3.3% expected return and a max drawdown potential of -20%. This will be our basis for comparison.

Now let's compare that with using options instead of bonds. Instead of being 50/50, you just hold 100% stock. In order to control your risk, you buy put options. However, put options aren't free. As with any insurance, they cost a premium. But you are a conservative investor that would have otherwise only had 50% of your allocation in stocks. Therefore, you sell call options against 50% of your stock holdings because you were otherwise going to have that portion in bonds anyway. Whatever premium you can bring in from selling the call options against 50% of your holdings will go towards the purchase of put options against all of your holdings. The level of max drawdown protection will be based on how much premium you can get for the calls.

Here is an example of what this would look like using the closing prices from today in SPY (closing underlying price today was 357.78):

Image

For every 1 at-the-money call you sell on the Dec 2021 contract, you can buy 2 put options at the 292 strike of the same expiration. This results in the following:

1. The expected return is the return of 50% stock plus the return of the dividend of the other 50% stock owned that we have sold off the upside for. Therefore, our expected return is 6%x0.5 + 1.6%x0.5 = 3.8%.
2. The max drawdown is 292/357.78 = -18.4%. If you take into account 1 year worth of dividends, this reduces to -16.8%. Take note that this max drawdown could only occur at the end of the holding period. Anytime prior to that, the options would still have extrinsic value remaining and would offset some of the max drawdown.
3. Your odds of a worst year scenario occurring are greater than a 50/50 portfolio since you are only relying on stocks. This is where the, "there is no free lunch" concept starts to kick in a little. A 50/50 portfolio would need stocks to drop twice as much in order to have the same worst year as what is being proposed. However, by using the options, you are assured that you can't have a lower drawdown/worst year than the strike price in a given year. You can also mitigate this risk by using 2-year options and then rolling when there is 1 year left. By doing so, you always have a good amount of extrinsic value remaining on the options and that continues to provide the hedge so that your options don't expire during the middle of a bid drawdown.
4. The starting delta of the portfolio is 1 - 0.21 - 0.52/2 = 0.53. Therefore, the daily fluctuations will be similar to being 50% stock since the delta is a reflection of how much your position moves in relation to the underlying. If you were to start with 2-year options and roll them after 1 year, the 0.53 delta would be your delta at the end of the holding period. This is an example of how you can maintain the hedge I am referring to in point #3.
5. Understanding options can take a good bit of time. However, this could all be implemented in just 1 trade per year.

Question:

1. What are general thoughts on this analysis and whether it is worthwhile as an alternate to holding bonds?

Additional Comment:

This analysis does not take into account the fact that you can buy puts at longer dates (preferably 2 years out and rolled once per year) and then sell the calls at shorter durations like 1 month out. Buy doing so, you should be able to take advantage of the fact that premiums for shorter duration contracts decay faster than longer duration contracts. Therefore, you can either bring in more premium by selling calls against the same number of contracts or bring in similar amounts of premium by selling calls against a smaller portion of your holdings.
000
Posts: 3250
Joined: Thu Jul 23, 2020 12:04 am

Re: Options as a Ballast when Real Bond Yields are Negative

Post by 000 »

I have been waiting for this post on bogleheads.org for a long time, thank you for making it, and I will be watching this thread with interest.

One question: what do you do with the cash you receive when the ATM calls you sold are exercised by your counterparty?
Topic Author
EfficientInvestor
Posts: 364
Joined: Thu Nov 01, 2018 7:02 pm
Location: Alabama

Re: Options as a Ballast when Real Bond Yields are Negative

Post by EfficientInvestor »

000 wrote: Thu Nov 19, 2020 10:31 pm I have been waiting for this post on bogleheads.org for a long time, thank you for making it, and I will be watching this thread with interest.

One question: what do you do with the cash you receive when the ATM calls you sold are exercised by your counterparty?
I personally never let it get to that point. I roll my calls up and out when the call option gets around a 0.95 delta so that my underlying doesn't get called away.
User avatar
grabiner
Advisory Board
Posts: 28207
Joined: Tue Feb 20, 2007 11:58 pm
Location: Columbia, MD

Re: Options as a Ballast when Real Bond Yields are Negative

Post by grabiner »

Put-call parity says that buying a put and a call on the same stock at the same strike price is equivalent to selling the stock and investing at the risk-free rate. That is, if you hold a share of stock, write a call at $100, and buy a put at $100, you are guaranteed to have $100 when the options expire, as the call forces you to sell the stock for $100 if it is worth more than $100, and the put allows you to sell the stock for $100 if it is worth less than $100. Thus the combination of these three has the same value as a risk-free investment such as a Treasury bill worth $100 on that date.

In your example, you are buying a put and writing a call at different strike prices, but assuming the options are fairly priced, you still shouldn't be getting a free lunch. Given a fixed delta (change in portfolio value relative to change in stock market value), you should get the same returns whether you use options or hold less stock. The difference between the two is that the delta of an option-based portfolio will change as the market changes.

The disadvantage of this strategy, compared to just reducing your stock allocation, is higher tax and transaction costs. You will lose spreads every time you trade an option, and you may have capital gains on your options, or on the stock if calls are exercised.
Wiki David Grabiner
000
Posts: 3250
Joined: Thu Jul 23, 2020 12:04 am

Re: Options as a Ballast when Real Bond Yields are Negative

Post by 000 »

EfficientInvestor wrote: Thu Nov 19, 2020 10:36 pm I personally never let it get to that point. I roll my calls up and out when the call option gets around a 0.95 delta so that my underlying doesn't get called away.
Have you compared this strategy to just buying deep OTM puts and not selling any calls? This would require the investor to eat the cost of the puts on an ongoing basis, but the upside would be unlimited.
Topic Author
EfficientInvestor
Posts: 364
Joined: Thu Nov 01, 2018 7:02 pm
Location: Alabama

Re: Options as a Ballast when Real Bond Yields are Negative

Post by EfficientInvestor »

000 wrote: Thu Nov 19, 2020 10:42 pm
EfficientInvestor wrote: Thu Nov 19, 2020 10:36 pm I personally never let it get to that point. I roll my calls up and out when the call option gets around a 0.95 delta so that my underlying doesn't get called away.
Have you compared this strategy to just buying deep OTM puts and not selling any calls? This would require the investor to eat the cost of the puts on an ongoing basis, but the upside would be unlimited.
Not specifically. But just at a surface level, I would say it's a losing proposition. If you were to only buy the 292 puts, you would have to pay 4% of the current underlying for them. So the expected return of the whole portfolio would only be 2%.
Topic Author
EfficientInvestor
Posts: 364
Joined: Thu Nov 01, 2018 7:02 pm
Location: Alabama

Re: Options as a Ballast when Real Bond Yields are Negative

Post by EfficientInvestor »

grabiner wrote: Thu Nov 19, 2020 10:37 pm Put-call parity says that buying a put and a call on the same stock at the same strike price is equivalent to selling the stock and investing at the risk-free rate. That is, if you hold a share of stock, write a call at $100, and buy a put at $100, you are guaranteed to have $100 when the options expire, as the call forces you to sell the stock for $100 if it is worth more than $100, and the put allows you to sell the stock for $100 if it is worth less than $100. Thus the combination of these three has the same value as a risk-free investment such as a Treasury bill worth $100 on that date.

In your example, you are buying a put and writing a call at different strike prices, but assuming the options are fairly priced, you still shouldn't be getting a free lunch. Given a fixed delta (change in portfolio value relative to change in stock market value), you should get the same returns whether you use options or hold less stock. The difference between the two is that the delta of an option-based portfolio will change as the market changes.

The disadvantage of this strategy, compared to just reducing your stock allocation, is higher tax and transaction costs. You will lose spreads every time you trade an option, and you may have capital gains on your options, or on the stock if calls are exercised.
Good points. I think a 50/50 portfolio might do better in average years and this portfolio would do better in extreme high or low years. For instance, a 50/50 portfolio can have (and has had) larger drawdowns than what I am proposing.

Also, I didn't want to get too into the weeds on the initial post, but your points are a big reason why I buy longer dated options and sell shorter dated. It makes a big difference since the theta values of 1 month options that I sell are 3-4x higher than 1 to 2 year puts I am buying.
checkyourmath
Posts: 68
Joined: Wed Nov 18, 2020 12:46 pm

Re: Options as a Ballast when Real Bond Yields are Negative

Post by checkyourmath »

In the world of quant trading we have officially gone insane if options trading for everyday folks comes a realistic trend. I recommend following the short interest index. Any given day with a higher ratio than 10 percent should scare you. Everyone is hunting for yield. I love the idea but for average folks Jim Simons is literally waiting in the weeds ready to steal your lunch money. Right now long term puts are probably the best hedge but there are way too many unknowns for me. I like the never lose money philosophy.
NoRegret
Posts: 144
Joined: Sat Dec 16, 2017 2:00 am
Location: California

Re: Options as a Ballast when Real Bond Yields are Negative

Post by NoRegret »

EfficientInvestor wrote: Thu Nov 19, 2020 10:23 pm Historically, especially over the last 40 years, bonds (specifically US treasury bonds) have been a great ballast for a portfolio. When stocks have dipped, yields have generally fallen, bonds have increased in price and the portfolio as a whole has remained more stable. Bonds have acted as nice insurance against stock holdings. But they have acted like a type of insurance that you actually get paid to hold instead of having to pay a premium like with typical insurance contracts.

This has been discussed in many threads on the forum, but now that bond yields are so low, we can't necessarily expect the same response from bonds during stock downturns going forward. There is just only so low yields can go, especially when the FED holding firm at 0%. We also can't get paid to hold them as insurance anymore. Even long term yields of 1.3% are expected to have negative real yield assuming a 2% inflation. A conservative 50/50 portfolio with intermediate treasuries (e.g. IEF) held for the bonds is seeing half of the portfolio subject to somewhere around a -1.4% real return if you assume a 2% inflation. The insurance that used to pay us to hold it is now costing us in the form of a negative real yield.

Now that it effectively costs money (in real terms) to hold bonds as insurance, many have said it is time to consider alternatives. However, most of what I have read recommends swapping out bonds for quality stocks w/ good dividends or for higher yielding bonds. That doesn't make sense to me given that you are making the portfolio more risky. That begs the question...is there an alternative to bonds that allows us to maintain similar risk as before but not cost so much as the negative real return we are having to accept by holding bonds?

Enter option contracts...

Before making the case for the use of options contracts, let's establish a few assumptions:

1. The expected return of the S&P 500 (SPY) going forward will be 6%. This assumption doesn't matter much for the sake of this post, I just need a reference point from which to base comparisons. Let's assume 1.6% of that return will be dividends.
2. The expected return of intermediate treasuries (IEF) going forward will be the current SEC yield of 0.59%. Let's just call it 0.6% for ease.
3. Based on the above, the expected return of a 50% SPY/50% IEF portfolio is 3.3%.
4. The expected max drawdown of SPY will be similar to the 2008 crash...55%
5. The expected max drawdown of 50% SPY/50% IEF will be similar to the 2008 crash...20%

Let's assume you are a conservative investor and you are currently holding a 50/50 portfolio that has a 3.3% expected return and a max drawdown potential of -20%. This will be our basis for comparison.

Now let's compare that with using options instead of bonds. Instead of being 50/50, you just hold 100% stock. In order to control your risk, you buy put options. However, put options aren't free. As with any insurance, they cost a premium. But you are a conservative investor that would have otherwise only had 50% of your allocation in stocks. Therefore, you sell call options against 50% of your stock holdings because you were otherwise going to have that portion in bonds anyway. Whatever premium you can bring in from selling the call options against 50% of your holdings will go towards the purchase of put options against all of your holdings. The level of max drawdown protection will be based on how much premium you can get for the calls.

Here is an example of what this would look like using the closing prices from today in SPY (closing underlying price today was 357.78):

Image

For every 1 at-the-money call you sell on the Dec 2021 contract, you can buy 2 put options at the 292 strike of the same expiration. This results in the following:

1. The expected return is the return of 50% stock plus the return of the dividend of the other 50% stock owned that we have sold off the upside for. Therefore, our expected return is 6%x0.5 + 1.6%x0.5 = 3.8%.
2. The max drawdown is 292/357.78 = -18.4%. If you take into account 1 year worth of dividends, this reduces to -16.8%. Take note that this max drawdown could only occur at the end of the holding period. Anytime prior to that, the options would still have extrinsic value remaining and would offset some of the max drawdown.
3. Your odds of a worst year scenario occurring are greater than a 50/50 portfolio since you are only relying on stocks. This is where the, "there is no free lunch" concept starts to kick in a little. A 50/50 portfolio would need stocks to drop twice as much in order to have the same worst year as what is being proposed. However, by using the options, you are assured that you can't have a lower drawdown/worst year than the strike price in a given year. You can also mitigate this risk by using 2-year options and then rolling when there is 1 year left. By doing so, you always have a good amount of extrinsic value remaining on the options and that continues to provide the hedge so that your options don't expire during the middle of a bid drawdown.
4. The starting delta of the portfolio is 1 - 0.21 - 0.52/2 = 0.53. Therefore, the daily fluctuations will be similar to being 50% stock since the delta is a reflection of how much your position moves in relation to the underlying. If you were to start with 2-year options and roll them after 1 year, the 0.53 delta would be your delta at the end of the holding period. This is an example of how you can maintain the hedge I am referring to in point #3.
5. Understanding options can take a good bit of time. However, this could all be implemented in just 1 trade per year.

Question:

1. What are general thoughts on this analysis and whether it is worthwhile as an alternate to holding bonds?

Additional Comment:

This analysis does not take into account the fact that you can buy puts at longer dates (preferably 2 years out and rolled once per year) and then sell the calls at shorter durations like 1 month out. Buy doing so, you should be able to take advantage of the fact that premiums for shorter duration contracts decay faster than longer duration contracts. Therefore, you can either bring in more premium by selling calls against the same number of contracts or bring in similar amounts of premium by selling calls against a smaller portion of your holdings.
I’m not against using options to transform return/risk to your liking. Though any specific strategy will have its own pain points, in your case max loss is SPY down less than 18% and bonds up.

Sometimes the option combo is referred to as risk reversal. You can adjust the strikes to your liking. I personally would prefer to go further OTM on both ends. It should be net long Vega, so you want to put it on when VIX is low, and SPY is peaking.

Key is to map out your portfolio PnL curve and be prepared for it.
Market timer targeting long term cycles -- aiming for several key decisions per asset class per decade
User avatar
AerialWombat
Posts: 1854
Joined: Tue May 29, 2018 1:07 pm
Location: Cash Canyon / Cashville

Re: Options as a Ballast when Real Bond Yields are Negative

Post by AerialWombat »

No. Just...no. I shall stick with my CD’s and broad, low cost muni bond funds.
Topic Author
EfficientInvestor
Posts: 364
Joined: Thu Nov 01, 2018 7:02 pm
Location: Alabama

Re: Options as a Ballast when Real Bond Yields are Negative

Post by EfficientInvestor »

NoRegret wrote: Thu Nov 19, 2020 11:05 pm I personally would prefer to go further OTM on both ends. It should be net long Vega, so you want to put it on when VIX is low, and SPY is peaking.
I agree and I was only using the strike prices shown as an example for the sake of entry-level conversation. I like to go further out on the puts as well and only buy insurance for events that I don't want to self insure. I also used to sell calls further up around .30 delta. However, recently, I have been more inclined to sell around 0.50 delta and do so against a smaller % of my holdings. That allows me to maximize my theta decay per contract sold and also reduces the portion of my holdings that are covered (limited upside potential).

As for vega and VIX, I agree. VIX is just now getting low enough to where I would consider buying puts against all holdings. Lately I have been more inclined to sell a greater number of calls instead of buying puts in order to hit my overall delta targets.
unbiased
Posts: 66
Joined: Sat Apr 25, 2020 5:46 pm

Re: Options as a Ballast when Real Bond Yields are Negative

Post by unbiased »

While you can work out the math, you should also have a strong plan for your behavior (what you will actually do) in a rapidly-declining March-like environment during a borderline liquidity crisis. Are you going to exercise your put, taking capital gains? Just sell the put and have "cash" on the side -- hoping you get the timing right? Keep rolling them forward into ever-more-expensive puts? These are tough choices to make rationally when it's the apocalypse.

I went into the March crash with call options on the VIX and puts on SPY plus some individual equity holdings. I cashed them out -- and made a little money -- but didn't always get the timing right--then all hell broke loose. Sure, made a few bucks, but never seen a crazier options market where things "just didn't make sense" -- puts became too expensive for realistic protection and the crazy elevated VIX (80+!) made directional bets pointless. In the end, these options softened the blow a smidge, but I was constantly amazed at how swiftly the market kept falling long after I took profits from the options. The options--in practice--provided less protection than I expected.

I would investigate how the options market behaved during the March liquidity crisis -- when you really needed it -- before deciding that this strategy would deliver what you expect, since you're assessing the costs of doing so now as the VIX is touching a more rational level.

For me, the March madness (and the stress of it) made me decide to take behavior risk off the table and instead allocate a portion of my equity portfolio to an actively managed systematic options strategy that delivered (JHQAX).
Topic Author
EfficientInvestor
Posts: 364
Joined: Thu Nov 01, 2018 7:02 pm
Location: Alabama

Re: Options as a Ballast when Real Bond Yields are Negative

Post by EfficientInvestor »

unbiased wrote: Fri Nov 20, 2020 12:10 am While you can work out the math, you should also have a strong plan for your behavior (what you will actually do) in a rapidly-declining March-like environment during a borderline liquidity crisis. Are you going to exercise your put, taking capital gains? Just sell the put and have "cash" on the side -- hoping you get the timing right? Keep rolling them forward into ever-more-expensive puts? These are tough choices to make rationally when it's the apocalypse.

I went into the March crash with call options on the VIX and puts on SPY plus some individual equity holdings. I cashed them out -- and made a little money -- but didn't always get the timing right--then all hell broke loose. Sure, made a few bucks, but never seen a crazier options market where things "just didn't make sense" -- puts became too expensive for realistic protection and the crazy elevated VIX (80+!) made directional bets pointless. In the end, these options softened the blow a smidge, but I was constantly amazed at how swiftly the market kept falling long after I took profits from the options. The options--in practice--provided less protection than I expected.

I would investigate how the options market behaved during the March liquidity crisis -- when you really needed it -- before deciding that this strategy would deliver what you expect, since you're assessing the costs of doing so now as the VIX is touching a more rational level.

For me, the March madness (and the stress of it) made me decide to take behavior risk off the table and instead allocate a portion of my equity portfolio to an actively managed systematic options strategy that delivered (JHQAX).
Thanks for the good input. I was also long options going into March but it didn’t phase me much at all because they were long term holds that I didn’t have to worry about managing. My general rule is to buy options 2 years out and then roll them with 1 year remaining. If volatility is high when it is time to roll, I may hold onto them a little longer until it subsides. However, the price of the options between year 1 and 2 isn’t as affected by volatility, so it doesn’t have as bad an effect on me when I’m trying to roll out from 1 year to 2 years.
aristotelian
Posts: 8233
Joined: Wed Jan 11, 2017 8:05 pm

Re: Options as a Ballast when Real Bond Yields are Negative

Post by aristotelian »

I think if you are patient, interest rates will normalize and bonds will resume their ballast effect. Just before COVID, the 30Y Treasury was already below 2.0%. It dropped below 1.2% in April 2020 and performed exactly as intended. Now it has already gotten back above 1.7% and the recovery still has a ways to go. If you do a Google search you can find tons of articles from 2019 speculating that bonds may never play their diversifying role in a world of low bond yields and yet they did just that during the COVID crash. It just stands to reason that when the market is panicking out of stocks, the money has to go somewhere and those safe assets will increase in value.

You could also leverage the bond side using a fund like NTSX or TMF. Even though you would be giving up some return, you would achieve your goal of amplifying the ballast effect during bad times.
User avatar
Uncorrelated
Posts: 1102
Joined: Sun Oct 13, 2019 3:16 pm

Re: Options as a Ballast when Real Bond Yields are Negative

Post by Uncorrelated »

The argument for alternative investments seems ill-supported:
  • You state that real bond yields are negative.
  • Subsequently, you state that it cannot be relied on that bonds will perform their protective tasks in the future because the fed is holding a nominal yield floor of 0%. This has nothing do wo with the first claim.
  • No reason is given why low yields (real or nominal) make options more attractive. Almost all asset pricing research is based on some premium relative to the risk free rate. Is this premium higher when the real risk free rate is low? Which testable hypothesis indicates that?
If the argument is that options were always attractive, or they they were never attractive, okay. If the argument is that options are suddenly a better deal because real yields are low, I don't see any evidence indicating that.


Putting that aside, let's look at the strategy itself. I view the options market as an efficient insurance market. It is not possible to perform risk free arbitrage, but you can certainly expose yourself to certain risks. This can result in a net gain in utility if your risk aversion is different than the market aggregate. When viewed through this lens, what evidence is there that your strategy is effective in insuring yourself against risks that you are about, but the market doesn't care about. Obviously if you insure yourself against risks that the rest of the market also cares about in equal proportion, the insurance will be fairly priced.


Some option can be implemented as a hedging portfolio. For example if the index is at 300 and you purchase a call at 200, this can be replicated by purchasing some amount of stocks and slowly reducing the amount of stock when the index becomes closer to 200. In a risk neutral world this is generally worse (not mean-variance optimal) than holding a constant proportion of stock. What utility function should an user have to support an investment in options? Is your strategy close to optimal for such an utility function?

Stay away from max drawdown, it's not making any sense. The correct portfolio depends on the probability distribution of outcomes, not on the lowest possible outcome (which, for most strategies including yours, is a 100% loss).
stormcrow
Posts: 93
Joined: Thu Nov 21, 2019 4:12 pm

Re: Options as a Ballast when Real Bond Yields are Negative

Post by stormcrow »

On a somewhat related note, if you want QQQ exposure and don't mind paying some points to have someone manage the options for you, $NUSI may be of interest.
JackoC
Posts: 1841
Joined: Sun Aug 12, 2018 11:14 am

Re: Options as a Ballast when Real Bond Yields are Negative

Post by JackoC »

000 wrote: Thu Nov 19, 2020 10:42 pm
EfficientInvestor wrote: Thu Nov 19, 2020 10:36 pm I personally never let it get to that point. I roll my calls up and out when the call option gets around a 0.95 delta so that my underlying doesn't get called away.
Have you compared this strategy to just buying deep OTM puts and not selling any calls? This would require the investor to eat the cost of the puts on an ongoing basis, but the upside would be unlimited.
It seems the firms which sell put buying tail risk hedging do not sell calls. It's maybe intuitive that you'd want to cover some of the cost of the puts that way, but the black box services (like Universa) or now put tail hedge ETF's (like TAIL) don't seem to. They show historical results where 100% S&P with (put buying) tail hedge can look pretty good v 60/40, both in terms of return, std dev and max loss. The CBOE's VXTH index (long S&P plus VIX call buying per simple rule, no option selling) is transparent, no black box proprietary element. It's now ahead of the S&P going back years, based on the spectacular performance of VIX calls in a fairly short period this past spring, if following that rule, with S&P itself then bouncing right back. Each can decide for themselves how much of a fluke that was. Tail hedge strategies naturally tend to look better in the wake of crises, worse after long periods of relative tranquility.
http://www.cboe.com/blogs/options-hub/2 ... vxth-index
http://www.cboe.com/index/dashboard/vxth#vxth-overview

Also on a 'philosophical' basis to make a portfolio containing a lot of stocks more 'antifragile' you arguably want to buy volatility. Besides tail hedge index put/VIX call buying, another approach is 'active long volatility' where you either buy puts or *buy* calls depending on market movement. That idea is promoted by Artemis in paper below, the subject of a couple of recent threads. They claim the past 90 yrs optimal portfolio would have included 21% in 'active long volatility', defined pretty simply for the purposes of the paper (buying 2.5% OTM puts or calls if SPX had moved down/up more than 5% in the last couple of months), though the firm is selling a black box approach they claim is superior to that.
https://artemiscm.docsend.com/view/taygkbn

PS, the reason this might be more relevant now is not necessarily that ex ante option and bond pricing (in a 60/40) was more favorable to bonds in the past and more favorable to options now, we assume both basically efficiently priced then and now. It's that ex post bond returns were so good in last 30 or so years (when real options prices existed IOW, Artemis is synthetizing option prices before that in the paper mentioned). Now bonds are priced at significantly lower *expected* real return than their *realized* return in the long secular yield drop, which is hard to filter out of backward looking analysis.
HawkeyePierce
Posts: 1563
Joined: Tue Mar 05, 2019 10:29 pm
Location: Colorado

Re: Options as a Ballast when Real Bond Yields are Negative

Post by HawkeyePierce »

Why options over futures a la NTSX? 90% equity exposure balanced against 60% nominal bond exposure via leverage.
JackoC
Posts: 1841
Joined: Sun Aug 12, 2018 11:14 am

Re: Options as a Ballast when Real Bond Yields are Negative

Post by JackoC »

HawkeyePierce wrote: Fri Nov 20, 2020 12:55 pm Why options over futures a la NTSX? 90% equity exposure balanced against 60% nominal bond exposure via leverage.
The risk parity type leveraged approach depends even more on assuming a particular correlation between stock and bonds prices than 60/40, just a ramped up version. But such correlations tend to be unstable. Index puts don't depend on any assumption about what asset A will do when Asset B goes down based on past data. If the index ends up below the strike by more than premium the option makes money. It's only subject to counterparty risk which is pretty marginal for exchange traded options. VIX calls are a little more subject to a correlation assumption, but a pretty straightforward one, that increase in relative option prices and big down moves tend to come together. That's not 100% ironclad*, but a less tenuous assumption than how bond and stock prices will correlate in the future.

Also if again comparing to option strategies the natural period is when options were widely traded, last ~30 yrs, during which there also happened to be a secular bull market in bonds, but expected bond returns are very low now. OTOH, if you can find an only pretty good hedge against stock downturns which costs nothing, that might still be better than a closer to ironclad hedge against stock disaster that subtracts significant return, like continuously buying index puts. That's also the idea behind 'active long volatility', a strategy to end up more often that not on the right side of a high volatility environment via options with something that didn't lose money (or as much as continuous put buying) historically.

*also, VXTH's rules assume you buy no VIX calls when the VIX is particularly low so it doesn't protect against 'bolts from the blue' the way continuous purchase of below-the-money index puts does.
000
Posts: 3250
Joined: Thu Jul 23, 2020 12:04 am

Re: Options as a Ballast when Real Bond Yields are Negative

Post by 000 »

JackoC wrote: Fri Nov 20, 2020 11:16 am Also on a 'philosophical' basis to make a portfolio containing a lot of stocks more 'antifragile' you arguably want to buy volatility. Besides tail hedge index put/VIX call buying, another approach is 'active long volatility' where you either buy puts or *buy* calls depending on market movement. That idea is promoted by Artemis in paper below, the subject of a couple of recent threads. They claim the past 90 yrs optimal portfolio would have included 21% in 'active long volatility', defined pretty simply for the purposes of the paper (buying 2.5% OTM puts or calls if SPX had moved down/up more than 5% in the last couple of months), though the firm is selling a black box approach they claim is superior to that.
https://artemiscm.docsend.com/view/taygkbn
Do you think it is possible for stocks to lose a lot of value without becoming too volatile?

I think so, perhaps due to a long sequence of minor issues that play out over a few years.
loukycpa
Posts: 79
Joined: Wed Aug 05, 2020 9:52 am

Re: Options as a Ballast when Real Bond Yields are Negative

Post by loukycpa »

Does a typical balanced fund (Vanguard Wellington or Vanguard Balanced Index for example) use options in a similar way to manage risk/enhance returns? Do we know what the results typically have been (versus two or three fund portfolio with regular rebalancing)?

Complete novice here when it comes to the use of options in a portfolio. My first instinct is to think that a fund management team would have tremendous advantages over a small individual investor trying to do this due to scale, skill, etc.
User avatar
Forester
Posts: 1606
Joined: Sat Jan 19, 2019 2:50 pm
Location: UK

Re: Options as a Ballast when Real Bond Yields are Negative

Post by Forester »

Uncorrelated wrote: Fri Nov 20, 2020 8:39 am The argument for alternative investments seems ill-supported:
  • You state that real bond yields are negative.
  • Subsequently, you state that it cannot be relied on that bonds will perform their protective tasks in the future because the fed is holding a nominal yield floor of 0%. This has nothing do wo with the first claim.
  • No reason is given why low yields (real or nominal) make options more attractive. Almost all asset pricing research is based on some premium relative to the risk free rate. Is this premium higher when the real risk free rate is low? Which testable hypothesis indicates that?
If the argument is that options were always attractive, or they they were never attractive, okay. If the argument is that options are suddenly a better deal because real yields are low, I don't see any evidence indicating that.


Putting that aside, let's look at the strategy itself. I view the options market as an efficient insurance market. It is not possible to perform risk free arbitrage, but you can certainly expose yourself to certain risks. This can result in a net gain in utility if your risk aversion is different than the market aggregate. When viewed through this lens, what evidence is there that your strategy is effective in insuring yourself against risks that you are about, but the market doesn't care about. Obviously if you insure yourself against risks that the rest of the market also cares about in equal proportion, the insurance will be fairly priced.


Some option can be implemented as a hedging portfolio. For example if the index is at 300 and you purchase a call at 200, this can be replicated by purchasing some amount of stocks and slowly reducing the amount of stock when the index becomes closer to 200. In a risk neutral world this is generally worse (not mean-variance optimal) than holding a constant proportion of stock. What utility function should an user have to support an investment in options? Is your strategy close to optimal for such an utility function?

Stay away from max drawdown, it's not making any sense. The correct portfolio depends on the probability distribution of outcomes, not on the lowest possible outcome (which, for most strategies including yours, is a 100% loss).
I doubt options are always efficiently priced... fat tails. No one wants insurance in December '17 or January '20 when the market is calm and going up. Everyone seeks insurance in 2010/11/12, when the probability of an imminent 50% market drop is low.
glorat
Posts: 726
Joined: Thu Apr 18, 2019 2:17 am

Re: Options as a Ballast when Real Bond Yields are Negative

Post by glorat »

Forester wrote: Sat Nov 21, 2020 5:54 am I doubt options are always efficiently priced... fat tails. No one wants insurance in December '17 or January '20 when the market is calm and going up. Everyone seeks insurance in 2010/11/12, when the probability of an imminent 50% market drop is low.
In the industry, this refers to the smile and skew of the option price premium.

Options with strike at the money tend to command the lowest premiums. Away from ATM is more expensive. That's smile.

Then options with strike heavily below the current price (ie protection against big market drops) command the biggest premium. That's skew

They are efficiently priced in the sense the above smile/skew are readily known effects in the options market due to supply/demand and market makers deal with them well (also called volatility traders).

As for me as a retail person, trying to make a buy and hold strategy, if I ever considered the concept by the OP, I'd only buy ATM options for lowest premium and as the market "probably" goes up I'd sell the in the money options. I'd also only tend to do this when volatility is generally lower than average (like VIX being low) which directly means option premiums are also low
JackoC
Posts: 1841
Joined: Sun Aug 12, 2018 11:14 am

Re: Options as a Ballast when Real Bond Yields are Negative

Post by JackoC »

000 wrote: Fri Nov 20, 2020 4:45 pm
JackoC wrote: Fri Nov 20, 2020 11:16 am Also on a 'philosophical' basis to make a portfolio containing a lot of stocks more 'antifragile' you arguably want to buy volatility. Besides tail hedge index put/VIX call buying, another approach is 'active long volatility' where you either buy puts or *buy* calls depending on market movement. That idea is promoted by Artemis in paper below, the subject of a couple of recent threads. They claim the past 90 yrs optimal portfolio would have included 21% in 'active long volatility', defined pretty simply for the purposes of the paper (buying 2.5% OTM puts or calls if SPX had moved down/up more than 5% in the last couple of months), though the firm is selling a black box approach they claim is superior to that.
https://artemiscm.docsend.com/view/taygkbn
Do you think it is possible for stocks to lose a lot of value without becoming too volatile?
I think so, perhaps due to a long sequence of minor issues that play out over a few years.
Definitely possible, but apparently the simple 'active long vol' rule used in that paper performed well in general over past 90 yrs*, keeping in mind it also bought calls when the market was trending up (the criterion for being long puts or calls was SPX down/up >5% in previous 63 trading days IIRC). Likewise on VXTH's rule** that would seem open to suspicion of overfitting to its particular data set. In that shorter period (since 90's) there were not big declines without VIX spikes (and also VIX spikes without lasting declines, huge case this past spring) but I agree gradual large stock decline without high VIX can't be ruled out.

Both VXTH and 'active long vol' depend on inferring correlation relationships which continual index put buying does not. However again we're comparing to a standard way of cushioning shocks, stock+govt bond, which is heavily reliant on a particular correlation assumption that could flip strongly in the other direction (if market sells off heavily because of an inflation spike or other loss of confidence in the effective 'risklessness' of govt bonds).

*with caveat that index option prices prior to the 1980's were synthesized by regression analysis of the relationship between market realized vol and trend and the implied vol curve in 'modern' times to estimate what the implied vols hence option prices would have been before options price data.
**buy nothing when forward VIX (basically the futures price) <15, 1%/mo of portfolio spent on VIX calls with VIX 15>30, 1/2%/mo 30>50, no options if VIX >50.
User avatar
grabiner
Advisory Board
Posts: 28207
Joined: Tue Feb 20, 2007 11:58 pm
Location: Columbia, MD

Re: Options as a Ballast when Real Bond Yields are Negative

Post by grabiner »

loukycpa wrote: Sat Nov 21, 2020 4:45 am Does a typical balanced fund (Vanguard Wellington or Vanguard Balanced Index for example) use options in a similar way to manage risk/enhance returns? Do we know what the results typically have been (versus two or three fund portfolio with regular rebalancing)?
Most balanced funds don't use options to manage risk or returns. They may use options to create a neutral position and maintain liquidity. For example, if the S&P 500 index is at 3000, a fund tracking the index might hold $1500 in cash and $1500 on an option to buy the index at 1500, rather than $3000 worth of stock. If investors redeem shares of the fund, the fund can sell cash and the single option, rather than selling individual stocks.

Vanguard Balanced Index is identical to a two-fund portfolio with regular rebalancing; the index it tracks is 60% Total Stock Market Index and 40% Total Bond Market Index, and it must rebalance if stocks go up or down. Wellington may outperform or underperform an index because its stock and bond holdings do not match the index holdings; it holds more corporate bonds than the index, and has a value bias in its stock holdings.
Wiki David Grabiner
Post Reply