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My Take on Asset Managers

Today I want to discuss my dynamic attitude toward the asset management industry.

I consider the following terms to be synonymous: asset managers, wealth managers, and investment advisers.

Throughout the course of this blog, I have not been so kind toward the asset management industry. Examples of posts where I have expressed a negative bias are here, here, and here.

I was a big more neutral toward asset managers here.

I was more positive and understanding when I decided to challenge my previous claim that the financial industry has brainwashed America.

After some further deliberation, I reached some logical conclusions here.

The asset management industry is far from perfect. Some advisers are shady and others are fraudulent. Some advisers incorrectly assert that options are too risky for retail investors while others are ignorant about derivatives altogether. Although this may represent a breech of fiduciary duty, an alternative perspective is warranted.

Without the services of asset managers, many people would basically be storing their money under a mattress. Interest rates were close to zero for nearly a decade while the average annual stock return is upwards of 11% (S&P 500 since 1926). If not for wealth managers, stocks would be an inaccessible vehicle because so many are clueless about how to do it.

I probably have two paths if I choose to bypass the asset management industry: trade for myself or bed mattress [crawl space]. One need not be a genius to be a self-directed trader but I have discussed some prerequisites. Also, as CJ suggested with the analogy of brushing teeth, the average worker may lack the flexibility to do this altogether.

Asset managers may be flawed but in the end I believe they are necessary. Regardless of their ignorance about derivatives, their consequent lower performance, and their expensive fee structure (debatable), the difference between mattress and stocks is significant. Net-net, they have a wide margin for error beyond which they can still provide a valuable service and achieve their advertised goals.

Musings on Naked Puts in Retirement Accounts (Part 4)

If a vertical spread lowers the standard deviation (SD) of returns and max drawdown (DD) compared to a naked put (NP) then its résumé is bolstered as an alternative candidate for retirement accounts. This was an unlikely result in the first example studied.

Rather than quintupling position size for the vertical spread, what if I double it? The potential return would be $4 (rather than $10), which is a 33% increase over the NP. The NP risk is now cut by 80% (rather than 50%) to $20K, which is the breakeven for both trades.

The risk graph now looks like this:

Naked put vs. put vertical risk graph (unequal contract sizes example 2) (4-3-17)

Like the previous example, the vertical spread outperforms if the market rises or if the market falls less than 7%. If the market falls between 7% and 20% then the naked put outperforms. If the market falls more than 20% then the vertical spread outperforms. A market correction over 20% is more likely than a market correction over 50% and this is where the risk metrics (SD of returns and max DD) would be improved by the vertical spread.

Of course, the vertical spread could be traded in equal position size to the NP. This would generate the first graph shown in Part 3. In that case, no gap of underperformance exists for the vertical spread and any market correction over 10% would generate better risk metrics for the vertical spread.

So going back to my statement in Part 1, does the vertical spread actually improve risk metrics?

The largest market crashes (e.g. fall 2008) will give rise to a lower SD of returns and a lower max DD for vertical spreads.

Unfortunately, these severe crashes occur so rarely that it’s hard to plan a trading strategy around them. The vertical spreads may or may not yield improved risk metrics depending on whether the market corrects, how often it corrects, and the exact magnitude of corrections during the time interval studied.

Compared to NP’s, vertical spreads may improve risk metrics. This is far from guaranteed.

Musings on Naked Puts in Retirement Accounts (Part 3)

Today I resume discussion of vertical spreads instead of naked puts (NP) in retirement accounts. I mentioned previously that [OTM] vertical spreads don’t usually affect standard deviation (SD) of returns or maximum drawdown (DD). In case of a significant market downturn, however, they certainly can.

Let’s begin with the risk graph comparison posted earlier:

Naked put vs. put vertical risk graph (3-13-17)

Notice how the green line (vertical spread at expiration) goes horizontal once the market drops ~16% to 419. That is where max loss is hit. The farther the market drops beyond that point, the more the NP (purple line) loses relative to the vertical spread. This represents a lower SD of returns and a lower max DD for the outperforming vertical spread.

This analysis assumes equal position size and offers an important distinction between ROI and gross PnL. In percentage terms, the vertical spread loses more than the NP if market falls the 16%: 100% for the vertical spread versus [under] 16% [buffered by initial premium collected] for the NP. In terms of gross dollars, the NP and vertical spread lose similar amounts until the vertical spread has lost 100% at which point the NP continues to lose more. 16% is the loss threshold beyond which the vertical spread delivers a lower SD of returns and a lower max DD than the NP.

Now let’s reconsider the naked 1000 put example I presented here. If I sell a 1000 put for $3.00 then [gross] risk is $100,000. If I buy the 900 put for $1.00 then I cut risk by 90%. I could, therefore, trade five times as many verticals while still halving the NP risk. Potential ROI on the vertical spread would be 6.7-fold greater.

Here are the risk graphs of the vertical spread (red line) and NP (blue line):

Naked put vs. put vertical risk graph (unequal contract sizes) (3-30-17)

The problem with the vertical spread is the possibility of losing the entire $50K should the market fall from 1000 to 900 (10%). For the NP to lose $50K the market would have to fall to 500 (50%), which is circled in red. In this case, the vertical spread outperforms if the market rises or if the market falls less than 7%. If the market falls between 7% and 50% then the NP outperforms. If the market falls more than 50% then the vertical spread outperforms.

Because a fall over 50% is so unlikely, this particular vertical spread position would probably post a larger SD of returns and a larger max DD than the NP were the market to enter a meaningful correction.

In the next post I will compare a different vertical spread position to see how it measures up.

End-of-Day Versus Intraday Trading (Part 2)

As I mentioned last time, a big part of the debate between end-of-day (EOD) and intraday trading involves the difference between the probabilities of touching and expiring. The markets are often regarded as random (Brownian motion). When a particular price level is reached, the market then has a 50/50 chance of moving higher or moving lower. The probability of expiring beyond that level is therefore less than the probability of touching it.

For intraday trading, this may be both an advantage and disadvantage. More winners can be exited intraday, which is an advantage. More losers—some of which would otherwise go on to be winners—will also be exited intraday, which is a disadvantage. On trend days, exiting losers (winners) intraday will avoid (preclude) what could otherwise be larger EOD losses (profits), which is an advantage (disadvantage).

This debate is not getting any easier.

Price action aside, another disadvantage to intraday trading is the need to be available and/or take action more than once and possibly whenever the market is open. This takes a lot of flexibility out of the workday.

The biggest disadvantage to intraday trading is arguably a much more complex (or impossible) backtesting proposition. OptionVue (OV) provides data every half hour. If I am going to “trade like I backtest” (mentioned here and here) then I must monitor trades every 30 minutes. Such backtesting would more than quintuple my current 2-5 months per backtest. Continuous market monitoring represents another magnitude of complexity because significant volatility can occur even between 30-minute prints. Backtesting this trading time frame would therefore require a much more granular database.*

As a net seller of option premium, I find time decay to be more certain than typical [random] price action. Every 24 hours an option gets one day closer to expiration. Implied volatility increase can offset time decay in the short-term but this only happens in some instances of down markets, which is [significantly] less than 50% of the time.

Given this additional reasoning, my gut instinct is to give the nod to EOD over intraday trading. A trade is more likely to be exited at an intraday stop-loss for the additional reason that option decay into the close may improve the PnL. Being directionally long also favors EOD trading by giving more time to allow for positive drift. The observations that many trades have small MAEs and only a select few have huge MAEs is additional evidence in favor of longer trade duration (EOD).

For me, the exponential complexity or impossibility of backtesting is the proverbial nail in the coffin for intraday trading. These restrictions actually make me wonder whether the perceived benefit of enhanced intraday opportunity is more illusion than anything else.

* – Any discretionary strategy that uses alerts to signal entries, exits, or adjustments implies this sort of intraday, continuous-monitoring approach.

End-Of-Day Versus Intraday Trading (Part 1)

One thing that came to mind from my recent blog series on backtesting frustration was the distinction between end-of-day (EOD) and intraday trading.

The most important aspect of EOD trading for me is once daily. This is much different from intraday trading where I could be watching the market continuously. For the sake of this discussion I will assume EOD takes place at the close but I really feel the exact time is arbitrary as long as it is consistent (e.g. 10:30 AM, 3:35 PM, etc.).

EOD trading has pluses and minuses. Checking in on the market once daily is a plus. This makes for a very flexible work schedule. Another plus is the opportunity to realize windfall profits in excess of my target. On the other hand, I believe the biggest minus is the potential to realize windfall losses. If the loss at trading time is beyond my stop then I must take it no matter how bad it is.

One advantage of intraday trading is a greater opportunity to exit trades at a price target. This is because the probability of touching a certain profit level exceeds the probability of closing at that level. Suppose I am up 8% on a long stock trade with a 10% profit target. A small amount of market volatility the next day will likely push the trade to +10%. To close at +10%, though, the market has to have an up day. In this case I would not be able to capitalize on so many of the choppy days where the market is higher intraday before closing lower.

Another advantage to intraday trading is the opportunity to realize tighter stops. Suppose my trade with a 15% stop-loss closed down 14% yesterday. As an EOD trader, should the downtrend continue today then who knows how far beyond -15% the trade might be when I have to exit at the close? Were I trading intraday, I could likely exit much closer to that -15%.

This is also a disadvantage to intraday trading, however. I may sometimes get stopped out for a loss on trades that briefly fall below my stop only to see them reverse higher as they ride off into the sunset without me, never looking back.

EOD or intraday? This is a tough, tough deliberation.

I will continue next time.

Musings on Naked Puts in Retirement Accounts (Part 2)

Today I want to continue the comparison between vertical spreads and naked puts (NP) to better understand the pros/cons when traded in retirement accounts.

Employing leverage makes for a more compelling IRA strategy but a very clear and present danger exists. Look at the graph shown in the previous post. At expiration, a 100% loss on the vertical spread will be incurred if the market falls to 419. The naked put, in this case, will have lost no more than (497 – 419) / 497 * 100% = 16%.

Market crash scenarios must therefore be considered. Throughout history, the market has periodically incurred drops equal to or greater than the magnitude just described. I must limit position size as an attempt to prevent total spread risk from striking too damaging a psychological blow to my total net worth in case this should occur.

Wrapping my brain around the concept of leverage has been challenging. In the first blog post hyperlinked above, I wrote:

> Suppose I sell a 1000 put for $3.00 and buy a 500 put
> for $0.30. I have sacrificed 10% of my potential return
> to halve my risk. If I traded two of these spreads then
> I have similar risk to the single naked 1000 put and my
> potential profit is $2.70 * 2 = $5.40 instead of $3.00.

The italicized clause is correct: risk in either case is roughly $1,000 * $100/contract = $100,000. However, the market must crash to zero for the NP to realize max loss. The market must only drop to 500 for max loss to be realized on the vertical spread. This is extremely rare but think back to the 2008 financial crisis for a point of reference.

In Part 1 of the link hypertexted above, I wrote:

> A leveraged account can go to zero long before the
> underlying assets do.

Leverage is dangerous because losses are magnified when the market moves against me. This is the flip side of what makes leverage attractive: lowering the cost to enter a position.

The vertical spread is like a NP on steroids. While total risk is decreased (assuming constant position size), the probability of losing everything at risk is increased. For this reason and because a NP qualifies under the “unlimited risk” umbrella, my instincts recommend limiting portfolio allocation for these short premium strategies to 20%.

I think the vertical spread can offer one additional benefit in case of that dreaded market crash. This I will cover next time.

Musings on Naked Puts in Retirement Accounts (Part 1)

I am not a proponent of trading naked puts (NP) in retirement accounts. The addition of a long put converts the NP to a put vertical spread. Might the vertical be a candidate for retirement account trading?

My argument against NPs in retirement accounts begins with the observation that retirement accounts cannot be margin accounts. I was unable to find a particular regulation that prohibits this but I don’t know of any brokerage that allows an [Roth] IRA to support any kind of loan. Margin is a loan, which would therefore be prohibited in an [Roth] IRA account.

Being resigned to trade NPs in a cash account simply does not seem like an attractive use of capital. If I have a $100,000 account then I can only sell one 1000 NP. If the put trades for $3.00 then this is a 0.3% return. If I can do this once per month then my potential annualized return is about 3.6%. As Shania Twain used to say, that don’t impress me much.

Portfolio margin—not suitable for a retirement account (see above)—makes the most sense to me for trading NPs.

Employing leverage by purchase of a long put is one alternative to make NPs more attractive for retirement accounts. In the previous example, if I buy the 900 put for $1.00 then I cut risk by 90%. Now I might be looking at a return of 2% per month or 24% per year. This is worth considering.

While purchase of the long significantly boosts potential ROI, it is not a panacea. The vertical spread does not affect maximum drawdown (DD) unless the market falls far enough to put the long put ITM. If the long put is purchased for cheap then this represents a significant market crash, which is rare. Similarly, the vertical spread does not decrease standard deviation of returns (another measure of risk as discussed here and here) unless that “significant market crash” occurs.

To illustrate, below is a risk graph of a naked put and a put vertical spread:

Naked put vs. put vertical risk graph (3-13-17)

The red arrows highlight how the vertical spread stops losing money by 419 on the downside (green line) whereas the NP continues to lose money as the market drops below 419 (brown line).

Other disadvantages to the vertical spread include the additional cost and transaction fees. Being two options instead of one, a vertical spread usually incurs twice the transaction fees as a NP. Based on my experience trading in fast-moving markets, I would expect to pay [much] more than 2x under these rare conditions. This makes sense to me because under these circumstances, the most efficient way for a market maker to survive is by taking the simplest trades and executing them quickly to serially mediate risk.

I will continue this discussion next time.

Leverage (Part 2)

I left off discussing the concept of leverage with regard to my previous backtesting. Today I will go one step further.

I believe maximum drawdown (DD) is as important a performance component as net income (also “total return”) because use of max DD to calculate position size can minimize risk of Ruin. If you don’t care about blowing up (i.e. Ruin) then it’s simply a matter of what can keep you from a good night’s sleep. DD is the answer here as well.

Position size is one of two ways leverage may be managed. Investment advisers assess risk tolerance in an attempt to help clients maintain a good night’s sleep. Account size and risk tolerance together viewed in terms of variable DD levels determine position size. This is not an exact science because maximum DD is only known in retrospect, which is why it’s called “investing” rather than just “winning.”

In Naked Put Study 2, maximum DD is 3.7x larger for long shares than for naked puts (NP). If I position sized the long shares properly to maintain that good night’s sleep then the NP position sizing could have been up to 3.7x larger without incurring a worse DD. This equates to net income 127% larger for NPs than for long shares.

Besides changing position size, the second way to manage leverage is to employ put credit spreads instead of NPs. I brainstormed this idea here and here.

The long put offsets “unlimited risk” by narrowing the width of the spread. If I sell a 1000 put then the potential loss is 1,000 points * $100/point = $100,000. If I also buy a 500 put for dirt cheap then my potential loss is only (1000 – 500) points * $100/point = $50,000. I halve my risk for only a slight decrease in net profit. Employing leverage in this way creates a cheaper trade with a similar potential return.

The benefit of buying long puts may be seen by equating the total risk. Suppose I sell a 1000 put for $3.00 and buy a 500 put for $0.30. I have sacrificed 10% of my potential return to halve my risk. If I traded two of these spreads then I have similar risk to the single naked 1000 put and my potential profit is $2.70 * 2 = $5.40 instead of $3.00. That is an increase of 80%.

I prefer some decrease in total risk when I employ leverage. Instead of selling two 1000 puts for $6.00 and incurring $200,000 risk, perhaps I sell three 1000/500 spreads and incur $150,000 risk while having a potential profit of $2.70 * 3 = $8.10. This is a 35% increase in profit potential with a 25% decrease in risk. I like that.

Leverage (Part 1)

When I think about the largest catastrophes ever attributable to options (arguably LTCM and the 2008 financial crisis, which involved an alphabet soup of derivatives), one word that sums up the root cause is “leverage.”

Leverage is important—not only when it comes to television but most assuredly when it comes to options. Investopedia defines leverage as: “the use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment.” It goes on:

     > For example, say you have $1,000 to invest.
     > This amount could be invested in 10 shares of
     > Microsoft (MSFT) stock, but to increase leverage,
     > you could invest the $1,000 in five options
     > contracts. You would then control 500 shares
     > instead of just 10.

A cash account that does not allow trading on margin employs no leverage. The only way to “blow up,” or lose everything, is to invest the entire account and see the underlying assets (for long positions) go to zero. It’s very rare that stock prices go to zero (e.g. corporate bankruptcy). No broad-based (U.S.) index has ever gone to zero.

While leverage is exciting because upside exceeds 1:1, the same may occur on the downside resulting in a greater risk of blowing up. A leveraged account can go to zero long before the underlying assets do.

I have previously done research aiming to compare performance between long shares and naked puts (NP) while keeping leverage constant. This discussion can be seen here and here. I added $5M of risk each day and when I removed risk in one group, I removed the same amount of risk in the other.

The graphs shown here and here are particularly powerful. They show the NP strategy to generate a lower gross return and a much lower drawdown (DD).

While increasing leverage is effectively an increase in position size, position size can be too large without employing any leverage. Long shares purchased in cash accounts are not utilizing margin but the account can still blow up. In retrospect, the position size can always be said to have been too large. The minimum capital to trade a strategy is at least the maximum DD ever seen and the longer a backtest, the more likely the backtested max DD is to meet or exceed future market pullbacks. This certainly is not guaranteed and given a long enough trading horizon is not even likely.

I will continue next time.

Are You Getting What You Paid For?

The title of this post is the first line of the November 2016 AAII Journal “Editor’s Note” written by Charles Rotblut, CFA. I previously established that having someone else do the investing is going to cost in terms of fees and probably performance. I believe paying fees is okay as long as one knows exactly what fees are being paid.

Rotblut writes:

     > Even a 1% [management] fee should raise
     > questions… If both the S&P 500 and the fund
     > achieve a 7% return, you lose 14%… your after-
     > fee gain is not 7%, but 6%, a 14% difference.

This is misleading. Calculating percentage of percentages is a great way to magnify numbers and make them seem more sensational. To recoup a 1% fee, my adviser needs to do 1% better than the benchmark—not 14%.

     > It’s not unusual to see companies pitch
     > newsletters and strategies promising market-
     > beating returns. Ask how they are calculated
     > and you will often find out that they are
     > based on backtesting or paper trades. Run
     > the strategy in an actual portfolio where
     > trading and transaction costs matter and
     > the returns may be significantly lower.

These are excellent points. I mentioned this here in addition to a lengthy discussion beginning here.

My latest realization is that most people are probably paying more than just advisory fees. The management fee is most common and this goes straight to the adviser. My experience suggests most advisers buy mutual funds or ETFs for their clients and as shown in prospectus examples, all of these funds charge operating fees at the very minimum. So whether I hire a human or robo-adviser, I will likely be paying fees to the fund companies in addition to the advisory management fee. These additional fees may remain hidden unless I study the prospectus or ask the adviser.

     > …if you are going to pay for active
     > management or professional advice, be
     > sure you are getting what you pay for.

This sounds good but how can it possibly be measured? For many people, I think customer satisfaction is as straightforward as beating the “benchmark” and/or seeing the investments grow.

Rotblut further explains:

     > Are you getting better returns, more income,
     > better education on how to invest or help
     > in staying disciplined over the long term?
     > [italics mine]

I covered the first two above. #3 is meaningless. “Better” education: better than what? I doubt I could even assess this. #4 is also meaningless because “help in staying disciplined over the long term” is only something that can be evaluated in retrospect. Bailing out in the midst of a market crash means I wasn’t disciplined if the market subsequently rebounds leaving me on the sidelines. Years of paying fees may pass before an event like this ever occurs.

When shopping for a financial adviser, I think it is important to identify the complete fee structure to allow for apples-to-apples comparison between different services. I’m skeptical as to whether I can determine if I am (will be) getting what I pay for. The meaningful decision is whether I want to bite the bullet and pay someone else for what I would otherwise have to do myself.