Should a BH investor never use futures/options?

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Johno
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Re: Should a BH investor never use futures/options?

Post by Johno »

skepticalobserver wrote:Johno:
1. When using futures to hedge a cash security position this usually means shorting the appropriate futures contract.
2. The basis risk I was referring to is the widening of the spread between the cash position, which serves as margin, and the futures. When the market flash crashes (or really crashes) the spread gets way out of whack, bidders disappear, stop loss orders are meaningless and your broker deploys a couple of oversized guys to find you for more margin. From what I’ve observed, hedging requires vigilance.
3. Remember “portfolio insurance?” It was another name for hedging and in 1987 it hedged a lot of traders into bankruptcy.
4. I would recommend hedging if it’s done with other people’s money—and you take a fee.
1. That wasn't what was being discussed prior to your post that I saw, but rather using a long futures position as a substitute for cash security. Anyway hedging a long position in a cash security is another possible application of futures. For example if one needs to rebalance by selling stocks after a market rise to prevent an excessive allocation to equities, one might go short stock index futures in tax deferred rather than sell cash ETF/MF's in taxable and realize capital gains, assuming no more long positions in tax deferred left to sell. Then if the market reverses course and the rebalancing trade is to buy more stock, just get rid of the short futures position. It can be tax efficient.
2. No this still isn't correct. You can't directly post stocks as margin against a futures position, with any broker I know, just cash. You can post stocks as margin for a margin loan, different topic. And if you're short stock index futures and there's a flash crash, you are making a margin call on the exchange and broker, not the other way around.
3. Portfolio insurance meant replicating put options on the index by maintaining a dynamic short position equal to the (constantly varying) delta of a put option if you'd owned one. That's some steps removed from a static hedge, between rebalancing intervals, of some index ETF's with futures to minimize buying and selling in taxable, which again is the major reason I'd see to be short equity index futures as an individual non-speculating investor.
4. I don't think you've established a solid factual basis for that. And I've repeated several times, and I've seen no objection from other posters who aren't reflexively hostile to derivatives, that you have to pay attention. If you want to run your portfolio totally hands off for long periods, then not suitable.
Park
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Re: Should a BH investor never use futures/options?

Post by Park »

26USC wrote:You can sell out of the money puts on SPY and get paid to rebalance when markets fall.
+1

You can also sell out of the money calls on SPY and and get paid to rebalance when markets rise. That idea is from Johno.
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ogd
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Re: Should a BH investor never use futures/options?

Post by ogd »

Park wrote:
26USC wrote:You can sell out of the money puts on SPY and get paid to rebalance when markets fall.
+1

You can also sell out of the money calls on SPY and and get paid to rebalance when markets rise. That idea is from Johno.
No. Or rather, this is a poor description of the transaction.

The rebalancing I want to do, "buy/sell at market prices once they cross $X" is worthless to a prospective option buyer -- they can do that without holding options. What you actually get paid for is the interval between the time the price crosses $X and the time you actually get to rebalance (still at $X), which is altogether a very different proposal.
Tanelorn
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Re: Should a BH investor never use futures/options?

Post by Tanelorn »

ogd wrote:The rebalancing I want to do, "buy/sell at market prices once they cross $X" is worthless to a prospective option buyer -- they can do that without holding options. What you actually get paid for is the interval between the time the price crosses $X and the time you actually get to rebalance (still at $X), which is altogether a very different proposal.
If you only ever make up your mind to rebalance today, and with no pre-determined plan for the future, you're right you can't get paid anything for that via options. However, if like many BHs, you have a plan in advance for rebalancing if markets rise/fall by say 5%, then you can sell 5% out of the money options and get paid for that willingness to buy stocks if they fall and sell them if they rise. Better yet, you can get paid even if that doesn't happen!
madbrain
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Re: Should a BH investor never use futures/options?

Post by madbrain »

Tanelorn wrote: If you only ever make up your mind to rebalance today, and with no pre-determined plan for the future, you're right you can't get paid anything for that via options. However, if like many BHs, you have a plan in advance for rebalancing if markets rise/fall by say 5%, then you can sell 5% out of the money options and get paid for that willingness to buy stocks if they fall and sell them if they rise. Better yet, you can get paid even if that doesn't happen!
There are a couple problems with this - if you are talking about selling out-of-the-money calls, as it appears you are.
a) unless you are trading on margin, you would need to keep enough cash as collateral to purchase at the strike price when you sell the call
b) your collateral money won't be earning anything - no interest, dividends, etc
c) the most you can win in this transaction is you get to keep the option premium. That may be relatively small, for out of the money options. But this depends on volatility and expiration date of the option.
d) if stocks fall below your strike price, for example, at expiration, you still have to buy the stock at the strike price you originally chose.
For example, you sold a call at 5% out of the money, but market drops 7% at expiration. Now you have to buy at 2% above current price.
Of course, you could also buy the call back at any time before expiration, but doing so will be more expensive if the call has gone from out-of-the-money to in-the-money. You will lose money on your option trade, in that case, and potentially lose more than if you had invested your collateral in the index instead.
Ie. there is still potential for you to lose in this option selling transaction. If there wasn't such potential, nobody else would take the other side of the bet.
Beliavsky
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Re: Should a BH investor never use futures/options?

Post by Beliavsky »

Dave55 wrote:I was a runner and phone clerk on the floor of the New York Mercantile Exchange and then graduated to a Futures Broker for institutional petroleum clients back in the 80's. Futures are a highly speculative instrument, one in which you can lose more money than you "bet".
This depends entirely on position-sizing. If I have $1 million, put it in T-bills, and go long Treasury bond futures with notional of $1 million, that is the same as having $1 million in Treasury bonds. That is a less risky portfolio than having the entire $1 million in the S&P 500. Since Treasury bond futures margins are only about 3% of notional, you can leverage your $1 million to own $30 million of Treasury bonds. But no one is forcing you to do so.
Bill M
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Re: Should a BH investor never use futures/options?

Post by Bill M »

Writing covered calls is a simple process and limited downside risk. But what is the upside gain? My experience says very little. (FWIW, I'm approved at Level 5)

A simple comparison --- If you go to the racetrack, and for each race bet on the favored horse to "show" - out of 10 races you'll likely win the bet on eight, lose the bet on two, and come out even for the day.

To turn covered calls into a gain, you need to do some timing, e.g. not writing the calls during big rallies. How? By writing the calls and they closing the position if a rally starts. That kind of behavior is properly called speculating.
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Ketawa
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Re: Should a BH investor never use futures/options?

Post by Ketawa »

Lots of uninformed responses in this thread. There is at least one reason that a BH might use options, and that is to TLH when equities go up.

Generating TLH opportunities by writing call options

I do not implement this strategy right now since I have a mortgage and prioritize paying it down first, but I may resume it in the next couple years.
Johno
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Re: Should a BH investor never use futures/options?

Post by Johno »

madbrain wrote:
Tanelorn wrote: If you only ever make up your mind to rebalance today, and with no pre-determined plan for the future, you're right you can't get paid anything for that via options. However, if like many BHs, you have a plan in advance for rebalancing if markets rise/fall by say 5%, then you can sell 5% out of the money options and get paid for that willingness to buy stocks if they fall and sell them if they rise. Better yet, you can get paid even if that doesn't happen!
There are a couple problems with this - if you are talking about selling out-of-the-money calls, as it appears you are.
a) unless you are trading on margin, you would need to keep enough cash as collateral to purchase at the strike price when you sell the call
b) your collateral money won't be earning anything - no interest, dividends, etc
c) the most you can win in this transaction is you get to keep the option premium. That may be relatively small, for out of the money options. But this depends on volatility and expiration date of the option.
d) if stocks fall below your strike price, for example, at expiration, you still have to buy the stock at the strike price you originally chose.
For example, you sold a call at 5% out of the money, but market drops 7% at expiration. Now you have to buy at 2% above current price.
Of course, you could also buy the call back at any time before expiration, but doing so will be more expensive if the call has gone from out-of-the-money to in-the-money. You will lose money on your option trade, in that case, and potentially lose more than if you had invested your collateral in the index instead.
Ie. there is still potential for you to lose in this option selling transaction. If there wasn't such potential, nobody else would take the other side of the bet.
For out of the money covered calls you have this confused.
a) if calls are covered, by definition there's no margin required
b) same point
c) true relatively small, but as opposed to zero for a strict rebalancing rule with no option
d) I don't get this at all. The case you mentioned would be to sell call out of the money to 'monetize' the rebalancing rule. If the stock doesn't end above the rebalancing level ie the option strike, the option isn't exercised, and nothing else happens either. You don't have to buy any stock, unless the stock ends up below your rebalancing level on the downside, in which case if you just sold a covered call and no put, you just buy to rebalance as normal; the call has no effect in that case except having received the premium.

The actual relationship of option selling to rebalancing is this. Assume your rebalancing rule is set in advance to sell/buy a certain amount of stock at given prices. This should be the case for a normal rebalancing rule. You can model what your equity % would be at given prices, give or take the effect of the non-equity proportion also changing in value in those cases, but that should be a relatively minor effect. Then derive how many shares that would equate to buy/sell of a particular index ETF at that price to rebalance. If your rule is set in stone that way, the option does basically 'monetize' it.

Beisdes the potential effect of non-stock movement on your equity %, the other mismatch is this: if you don't sell the option, you just sell the shares of the ETF to rebalance whenever the price reaches the rebalancing level. If you sell the option struck at the rebalancing level, you only end up selling the shares, basically*, if the ETF share price is above the rebalancing level at the end of the option period. Historical analysis could give you an idea how much difference that typically makes for relatively short option periods: not much.

For selling puts, which would be naked, there's more of a margin issue, unless you have a broker who allows naked puts on the index futures at reasonable margin. Interactive Brokers long did, but is now changing their policy.

In summary for covered call selling, it does not make sense if based on no particular desire to sell at the strike but just 'hoping' the options don't get exercised so you can make a little more return. Assuming you reject the first idea as naive but still have no rebalancing rule (perhaps if 100% equities) it's debatable whether covered call selling has a favorable effect on risk v return: for covered at-the-money calls it has been favorable over long periods, significantly higher Sharpe Ratio than the underlying, though not always and no gtee for the future, like any persistent anomaly; for out-of-the-money calls it's more doubtful. However under a rebalancing rule, if you already assume you'd sell shares at a given higher than current price, only subject to the slight mismatch mentioned, monetizing that with a covered call is a more interesting idea IMO.

*In general the option is 'worth more alive than dead' to the party you sell it to, so if the ETF price goes above the strike during the period but ends below the strike, they will generally be rational not to have exercised the option. Dividends during the period could affect that since the option will be (US exchanged traded options are) excercisable in theory at any time. But for options on the index itself itself or on futures the option shouldn't and won't be exercised unless above the strike *at expiry* of the option.
Tanelorn
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Re: Should a BH investor never use futures/options?

Post by Tanelorn »

madbrain wrote:
Tanelorn wrote: If you only ever make up your mind to rebalance today, and with no pre-determined plan for the future, you're right you can't get paid anything for that via options. However, if like many BHs, you have a plan in advance for rebalancing if markets rise/fall by say 5%, then you can sell 5% out of the money options and get paid for that willingness to buy stocks if they fall and sell them if they rise. Better yet, you can get paid even if that doesn't happen!
There are a couple problems with this - if you are talking about selling out-of-the-money calls, as it appears you are.
a) unless you are trading on margin, you would need to keep enough cash as collateral to purchase at the strike price when you sell the call
b) your collateral money won't be earning anything - no interest, dividends, etc
c) the most you can win in this transaction is you get to keep the option premium. That may be relatively small, for out of the money options. But this depends on volatility and expiration date of the option.
d) if stocks fall below your strike price, for example, at expiration, you still have to buy the stock at the strike price you originally chose.
For example, you sold a call at 5% out of the money, but market drops 7% at expiration. Now you have to buy at 2% above current price.
Of course, you could also buy the call back at any time before expiration, but doing so will be more expensive if the call has gone from out-of-the-money to in-the-money. You will lose money on your option trade, in that case, and potentially lose more than if you had invested your collateral in the index instead.
Ie. there is still potential for you to lose in this option selling transaction. If there wasn't such potential, nobody else would take the other side of the bet.
A) the calls you write are "covered calls", covered by your long stock position. If stocks rise, you are willing to sell some to rebalance and they will be called away. If you don't write calls on exactly the same thing, say SPY calls vs the VTI ETF, you would want a margin account so you didn't need to set aside cash uninvested. The VTI will be more than sufficient collateral for the calls, given you're probably only writing calls on 5-10% of your stock position anyway for rebalancing purposes.
B) not applicable, see above, and that's even assuming you could talk the Fed into making cash worth something again :(
C) true, but it's free money, less transaction costs, and forces you to stick to your rebalancing plan even if you would have otherwise taken more risk out of greed, laziness, etc.
D) your example should have the market rising for the bad case of calls, or the market falling for the bad case for puts, but I understand what you mean. Let's consider calls and a rising market. this isn't an opportunity cost most of the time nor is it on average. Say the market slowly rose 7% well in advance of options expiration, and now you get assigned on your 5% above the original market value calls. You might think you'd have been better off if you rebalanced at 7% and made more money (true), but that would have been taking more risk than your rebalancing plan called for. If you'd followed your 5% rebalancing plan, you'd have sold those shares when the market hit 5%, missed out on that last 2% gain, and not gotten paid the call option premium either.

Now what ogd refers to is the situation where the market is say at +5% going into call options expiration (at your strike price), you get assigned, and then the market rises over the weekend to +7%. Now you missed out on 2% by selling at 5% and didn't get paid for it, but you just got unlucky. If the market had fallen over the weekend to +3% instead, now you'd be happy you sold at 5% and pocketed an extra 2%. Assuming we don't know anything about the average overnight move of the market, this effect will average out to zero.

You can go through all the same arguments in reverse for writing puts and the market falling, instead of writing calls and the market rising.

Edit: I see I crossed posts with Johno, also fixed one point I got backwards about options.
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ogd
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Re: Should a BH investor never use futures/options?

Post by ogd »

Tanelorn wrote:
ogd wrote:The rebalancing I want to do, "buy/sell at market prices once they cross $X" is worthless to a prospective option buyer -- they can do that without holding options. What you actually get paid for is the interval between the time the price crosses $X and the time you actually get to rebalance (still at $X), which is altogether a very different proposal.
If you only ever make up your mind to rebalance today, and with no pre-determined plan for the future, you're right you can't get paid anything for that via options. However, if like many BHs, you have a plan in advance for rebalancing if markets rise/fall by say 5%, then you can sell 5% out of the money options and get paid for that willingness to buy stocks if they fall and sell them if they rise. Better yet, you can get paid even if that doesn't happen!
Once again, no. This is not what you get paid for at all.

Let's break it down, shall we. The put option I sold means that:

a) I am willing to buy stocks once they fall 5%.
b) But rather than buying right away, I am willing to spend a limited amount of time after the drop sitting on pure, unrewarded risk (I lose if they fall further, don't win if they rebound).

Like I said, the a) part is worthless. The option buyer doesn't need my permission to sell stocks once they fall, they can do that for free. Instead, b) is the entirety of what I get paid for. Why then would you insist on describing the option as payment for a) ? When b) is not some insignificant detail, but accounts for all of the option premium.

I know you and others understand the mechanics, I just take issue with over-simplified descriptions of option positions. "Telegraphed rebalancing" is not a good description.

The problem with b) is that it tilts the outcome against me. Because I've sold the option, I don't actually get to rebalance when my target is hit; instead, I get the worst of the possible outcomes going forward. This is what makes it a bad deal, or more accurately a risk/reward imbalance that I'd better get paid quite a bit for having assumed.
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Ketawa
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Re: Should a BH investor never use futures/options?

Post by Ketawa »

ogd wrote:Once again, no. This is not what you get paid for at all.

Let's break it down, shall we. The put option I sold means that:

a) I am willing to buy stocks once they fall 5%.
b) But rather than buying right away, I am willing to spend a limited amount of time after the drop sitting on pure, unrewarded risk (I lose if they fall further, don't win if they rebound).

Like I said, the a) part is worthless. The option buyer doesn't need my permission to sell stocks once they fall, they can do that for free. Instead, b) is the entirety of what I get paid for. Why then would you insist on describing the option as payment for a) ? When b) is not some insignificant detail, but accounts for all of the option premium.

I know you and others understand the mechanics, I just take issue with over-simplified descriptions of option positions. "Telegraphed rebalancing" is not a good description.

The problem with b) is that it tilts the outcome against me. Because I've sold the option, I don't actually get to rebalance when my target is hit; instead, I get the worst of the possible outcomes going forward. This is what makes it a bad deal, or more accurately a risk/reward imbalance that I'd better get paid quite a bit for having assumed.
IMO it's not accurate to say that the risk is unrewarded in b). You were rewarded in the past with the option premium, but even going forward there is potential reward. Options have extrinsic value and it's highest when the underlying is at the strike. It also decays as time goes by. Being short the option, you gain if the underlying moves away from the strike and/or as time goes by.

After all, in sufficiently liquid markets you should expect the cost to reflect risk/reward. If b) was truly uncompensated, nobody would ever take the other side of the trade, but someone smart is currently offering to sell you a put at the strike for many liquid index ETFs, e.g. SPY, EFA, EEM.
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ogd
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Re: Should a BH investor never use futures/options?

Post by ogd »

Ketawa wrote: IMO it's not accurate to say that the risk is unrewarded in b). You were rewarded in the past with the option premium, but even going forward there is potential reward. Options have extrinsic value and it's highest when the underlying is at the strike. It also decays as time goes by. Being short the option, you gain if the underlying moves away from the strike and/or as time goes by.

After all, in sufficiently liquid markets you should expect the cost to reflect risk/reward. If b) was truly uncompensated, nobody would ever take the other side of the trade, but someone smart is currently offering to sell you a put at the strike for many liquid index ETFs, e.g. SPY, EFA, EEM.
Well, the way I account for it is that I already got paid and after that payment there is no more reward; the best that can possibly happen is that my liability due to the option drops to zero. This helps me visualize what I got paid for.

Anyway, this isn't the main issue -- my point is that these tradeoffs happen in b), whereas a) is not worth anything. It's therefore misleading to describe the option as rewarding me for a), the rebalancing I was planning to do.
Johno
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Re: Should a BH investor never use futures/options?

Post by Johno »

ogd wrote:
Tanelorn wrote:
ogd wrote:The rebalancing I want to do, "buy/sell at market prices once they cross $X" is worthless to a prospective option buyer -- they can do that without holding options. What you actually get paid for is the interval between the time the price crosses $X and the time you actually get to rebalance (still at $X), which is altogether a very different proposal.
If you only ever make up your mind to rebalance today, and with no pre-determined plan for the future, you're right you can't get paid anything for that via options. However, if like many BHs, you have a plan in advance for rebalancing if markets rise/fall by say 5%, then you can sell 5% out of the money options and get paid for that willingness to buy stocks if they fall and sell them if they rise. Better yet, you can get paid even if that doesn't happen!
Once again, no. This is not what you get paid for at all.

Let's break it down, shall we. The put option I sold means that:

a) I am willing to buy stocks once they fall 5%.
b) But rather than buying right away, I am willing to spend a limited amount of time after the drop sitting on pure, unrewarded risk (I lose if they fall further, don't win if they rebound).

Like I said, the a) part is worthless. The option buyer doesn't need my permission to sell stocks once they fall, they can do that for free. Instead, b) is the entirety of what I get paid for. Why then would you insist on describing the option as payment for a) ? When b) is not some insignificant detail, but accounts for all of the option premium.
Outcome a is of course not why the buyer bought the put, he loses (the premium) in those cases as well as any case where the stock goes up. But I think we'd confuse ourselves looking at it from his perspective. Rather let's stick to the rebalancer's perspective, because the plan to buy a given amount of stock if the price falls 5% is a specific condition applying only to those set it for themselves as a rule. One could also just say ''I *might* buy the stock if it falls 5%, but I have to wait and see', in which case the option is clearly giving up the right to 'wait and see'. But let's just assume for now the person would strictly rebalance according to price.

1. If the stock never gets to -5% in the period, the put seller simply receives the premium. Nothing at all happens to the 'traditional' rebalancer. That difference isn't nothing, it's receiving the premium, and that can't be ignored.

2. If the stock ends below -5% never having touched any upper rebalancing (sell) barrier, the put seller buys at -5% but is further compensated by the premium. The traditional rebalancer simply buys at -5%. Again the clear and simple difference is that the option seller gets a premium, traditional reblancer doesn't.

3. But say the stock touches -5% during the period but ends up above -5%. Now the option seller gets the premium but nothing else happens (as explained above, it's unlikely if the trade is set up right that the option would be exercised before the end of the period). The traditional rebalancer buys the stock at -5% when it gets there and makes some gain on that, either to the end of the period or to when/if it hits an upper rebalancing barrier before the end of the period, multiple times theoretically possibly though increasingly unlikely. Either could come out ahead depending on the relative gain from -5% v the size of the premium.

This is what I was referring to in the paragraph above, for sold call case, which I'll repeat:
"Be[si]des the potential effect of non-stock movement on your equity %, the other mismatch is this: if you don't sell the option, you just sell the shares of the ETF to rebalance whenever the price reaches the rebalancing level. If you sell the option struck at the rebalancing level, you only end up selling the shares, basically, if the ETF share price is above the rebalancing level at the end of the option period. Historical analysis could give you an idea how much difference that typically makes for relatively short option periods: not much."

I think it's also your point in b), but we must consider how likely this is. And we must consider first of all that any particular form of rebalancing as an enhancer of risk v return is itself strictly an empirical result. Likewise there are statements by respected (including here) guru's about crafting rebalancing around not-strictly-efficient phenomena like momentum, so we must be careful to be consistent about accepting and rejecting historical results or claims of less than complete and universal efficiency. I see no obvious reason to reject the possibility that committing oneself to a rebalancing rule is doing something for free when somebody would pay you to do something similar enough to make it worthwhile. And it is similar, not identical, and does not dominate traditional rebalancing in any conceivable case. Otherwise I (for one) would have said, 'this is the way to rebalance' rather than calling it interesting. :D

Also I'd note that there's no requirement the general idea only be done at particular strikes. I sell at-the-money calls lately to reblance, counting their delta against the rest of my position to keep it at the level I want, with adjustments as necessary. The potential benefit there is the history of short ATM equity index options tending to be overpriced. That's not as demonstrably true for higher than money strikes, though more true for below money strikes (but of course not gteed in any case).
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ogd
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Re: Should a BH investor never use futures/options?

Post by ogd »

Johno: I agree with everything you say above, and in particular the #3 which highlights the tradeoff you are making, letting go of the potential gains of rebalancing. I don't even dispute that it's a good tradeoff historically with options tending to be overpriced (with the usual objections that "some things that could have happened didn't happen" and "the future might be quite different, wrt both option prices and the bad scenarios that might get realized more frequently").

What I object to is this kind of statement: "you were going to rebalance anyway, and now you get paid for doing it. It's almost too good to be true." Well, it is too good to be true. You get paid for making some specific and rather delicate changes to your rebalancing strategy, not for the rebalancing commitment itself. These changes might be worth it. But you have to make them to get paid, and they account for the entire option premium. So the option needs to be described in terms of that tradeoff, and not in terms of the [worthless] rebalancing commitment.

Edit: just a reminder of the statements I was replying to:
Tanelorn wrote:However, if like many BHs, you have a plan in advance for rebalancing if markets rise/fall by say 5%, then you can sell 5% out of the money options and get paid for that willingness to buy stocks if they fall and sell them if they rise.
Park wrote:You can also sell out of the money calls on SPY and and get paid to rebalance when markets rise. That idea is from Johno.
26USC wrote:You can sell out of the money puts on SPY and get paid to rebalance when markets fall.
, none of which mention the difference between regular, at-market-prices rebalancing and the delay / lopsided risk-reward that the option is designed to force upon you, a difference that is essential to the position as opposed to a minor detail.
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Re: Should a BH investor never use futures/options?

Post by Tanelorn »

Ogd- I don't see why you think the risk around expiration is lopsided and uncompensated. The options market is very efficient for things like SPY or ES options - I'm sure the Wall St wizards have figured out whatever risk you're describing and price it carefully. If you assume the market is efficient up to the spreads involved, you are being compensated for all the risks you take.

One comment on Johno's scenario where the stock drops and touches the 5% put strike but rallies back before expiration, triggering the instantaneous rebalancer to make a profitable trade but the options-based one to do nothing. This can potentially happen repeatedly, leading to opportunity costs if not actual losses. What's happening here is that selling an option is making a bet on expected volatility vs realized volatility - the option seller is taking the market concensus, and the options buyer is hoping it will be higher than that. The case of the market jumping back and forth repeatedly between 0% and -5% is a case of unexpectedly high realized vol, which is why it would have been better to have been long the option and delta hedge (which is what the instantaneous rebalancer is doing) compared to the case of the options seller. Remember that this downside volatility, and only of sufficient size to trigger the rebalancing rule, is the only type of volatility that results in the instant rebalancer gaining. There are many ways that the market could be more volatile than expected but not help the rebalancer - it could move around a lot, but never reach -5%, it could go up more than down, etc. All those are figured into the options price, but only a small fraction of those get the instantaneous rebalancer coming out ahead.

I stand by the statement that for efficient options markets you come out ahead on average by selling the option to express your rebalancing rule.
Park
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Re: Should a BH investor never use futures/options?

Post by Park »

Until I read this thread, I thought the only role for futures/options for myself was if I wanted leverage, especially in a tax advantaged account. Leverage is a controversial topic in this forum, and there are some excelllent reasons for that.

But rebalancing isn't. I'd like to thank posters in this thread for pointing out that options are another way for an experienced investor to rebalance.
itstoomuch
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Re: Should a BH investor never use futures/options?

Post by itstoomuch »

Park wrote:Until I read this thread, I thought the only role for futures/options for myself was if I wanted leverage, especially in a tax advantaged account. Leverage is a controversial topic in this forum, and there are some excelllent reasons for that.

But rebalancing isn't. I'd like to thank posters in this thread for pointing out that options are another way for an experienced investor to rebalance.
I use options as "insurance"
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ogd
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Re: Should a BH investor never use futures/options?

Post by ogd »

Tanelorn wrote:Ogd- I don't see why you think the risk around expiration is lopsided and uncompensated. The options market is very efficient for things like SPY or ES options - I'm sure the Wall St wizards have figured out whatever risk you're describing and price it carefully. If you assume the market is efficient up to the spreads involved, you are being compensated for all the risks you take.
Those descriptions, in the context I was using them, were factual and unrelated to the price you got or market efficiency. When I say "uncompensated risk going forward" it's to describe the nature of your position once the market gets to the rebalancing point, in contrast to the rebalancer. When I say "lopsided risk/reward" it's because the short-option position, by nature, limits your reward while leaving you with all the risk. It doesn't mean it's not a good deal -- if by some miracle you got an outstanding price from some schmuck who didn't know what they were doing, that's great. But your position is quite different than if you were dealing with stocks alone, and those differences have to be acknowledged.
Tanelorn wrote:One comment on Johno's scenario where the stock drops and touches the 5% put strike but rallies back before expiration, triggering the instantaneous rebalancer to make a profitable trade but the options-based one to do nothing. This can potentially happen repeatedly, leading to opportunity costs if not actual losses.
...
There are many ways that the market could be more volatile than expected but not help the rebalancer - it could move around a lot, but never reach -5%, it could go up more than down, etc. All those are figured into the options price, but only a small fraction of those get the instantaneous rebalancer coming out ahead.
Far from being "a small fraction" of what figures into option price, this scenario is exactly what you got paid for.

Look at it from the buyer's perspective. They hold the stock already, so they already get all the upside. They could sell the stocks (for free -- no option needed) if the market drops by 5%, therefore avoiding the downside past that point. The one thing the option gives them is the ability to wait for re-appreciation without taking the risk of further depreciation; in other words taking the best outcome for them going forward (hence, "option") and leaving you with the worst. It's not some small detail, it's the essence of the option.
Tanelorn wrote:What's happening here is that selling an option is making a bet on expected volatility vs realized volatility - the option seller is taking the market concensus, and the options buyer is hoping it will be higher than that.
YES! Excellent! That's exactly what it is! Can we please stick to calling it that instead of "announcing your rebalancing"? Then we can discuss the tradeoffs reasonably, instead of making it sound like you're getting something for nothing (or for "something you were going to do anyway").
Tanelorn wrote:I stand by the statement that for efficient options markets you come out ahead on average by selling the option to express your rebalancing rule.
No. For the fourth time or so, "expressing your rebalancing rule" is worthless. Here's a challenge: we can write a contract that says "if the SPY reaches $X in the next Y days, I will immediately buy some SPY at market prices", i.e. what rebalancers do. Tweak the X and Y however you want and see if you can find a buyer willing to pay anything for this. You won't, of course -- there's nothing in it for them. You have to tweak the timing and price of the purchase, i.e. the "immediately" and "at market prices", which shows that you get paid for something completely different.
Waba
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Re: Should a BH investor never use futures/options?

Post by Waba »

What I like about options is that when the market has a down day I'm all happy because IV is up and I can sell premium.

OCD investors should totally use options.
lee1026
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Re: Should a BH investor never use futures/options?

Post by lee1026 »

2. Quarterly contracts, and higher bid-offer spread in longer dated contracts generally means it's most economic just hold the front contract and roll the position 4 times a year. Thus, 8 trades (buy/sell each of the 4 quarterly contracts) per year. The first two contracts generally trade on a .25 bid to offer near expiry of the closer one, ie .125 bid-mid. So if selling on the bid and buying on the offer, at $50/tick, it's 8*(.125*50+3) bid offer and commission, $53 v notional amount at today's price ~2050*50=$102,500, if so ~5bps synthetic 'expense ratio'. It's often possible to get done on the same side of the market on both trades (hit the bid after getting hit on the bid yourself, lift the offer after getting lifted on the offer yourself, if market hasn't moved in that instant) though it's also possible that the market moves unfavorably between the two trades. There would be certain obvious pitfalls to avoid (trying to do it during a scheduled economic release, etc) and one could 'diversify' by rolling the position in pieces if larger than one contract. Anyway a different average bid-offer loss might be assumed but .125 is reasonable IME.
Eminis are cash settled. There are no good reason to trade 8 times as opposed to just wait for the final settlement and then buy the next contract, so 4 trades a year instead. That will halve your costs.
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