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This can be seen in historical market data, and from an efficient markets point of view, should be expected to persist in the future as a rational risk premium for the transfer of risk from a willing buyer to a willing seller.
Stop and think with me for a moment about the concept of passive vs. active. I believe it's wise to only invest in strategies ("factors") with an underlying expected return, before any active management is applied. In other words, the market naturally makes you money over time without any requirement of an investment manager's "skill" to be able to select securities and/or time entries and exits. This is important because academic research has documented manager skill in decades of historical mutual fund performance to exist less than would even be randomly expected (especially after fees and taxes).
As an example of a passively managed VRP strategy, the CBOE has been publishing their S&P 500 Put write index for years, with historical data going back to 1986. Since then, a passive strategy of selling fully cash secured one-month at the money (ATM) S&P 500 puts, with collateral assumed to be held in a money market account holding US Treasury bills, would have produced returns similar to the S&P 500 index itself. Due to the nature of ATM puts, risk (measured as volatility and drawdown) was less than the underlying index, resulting in about a 30% increase in Sharpe Ratio.
Put selling is robust across markets as well, as can also been seen in CBOE's historical data for PUTR, where the same methodology is applied to the Russell 2000 index. With liquid option markets on ETF's like EFA and EEM, a globally diversified equity put write strategy could be constructed with attractive characteristics vs. a traditional mutual fund or ETF that only holds the underlying equities. (Readers can backtest these ideas for free for an entire week with a free trial of the highly recommended ORATS Wheel)
The authors also present an interesting case study of how investor behavior tends to create significant demand for and value placed on insurance like investments, such as buying puts to hedge a position or portfolio. These preferences and behavioral biases cause an overestimation of downside risk, documented by a Yale University survey conducted where both retail and institutional investors were asked to estimate the probability of a "catastrophic stock market crash" within the next six months. Since 1989, with few exceptions, a majority of both groups consistently believe that there is a greater than 10% chance of such, yet in reality the historical likelihood of such an event has been approximately 1%. This overestimation of crash risk may be part of the explanation of the persistent VRP seen in option and volatility futures pricing where option and volatility futures buyers are willing to pay, and sellers require receipt, of a large premium to transfer risk from one party to another.
On the opposite end of the option spectrum is call options, where the VRP has also been documented to exist (and can be seen in CBOE's BXMD index in the chart above), although for slightly different reasons. Call options can be thought of as lottery tickets, where a buyer spends a small amount of money to have the potential for a large payoff if the underlying asset moves much farther and faster to the upside than the market expected. This preference for positive skew results in a call option VRP that can also be captured by option sellers in a variety of different ways, including covered calls and short strangles where short puts and calls are combined into one (usually) delta neutral position.
I'll finish with the conclusion from AQR's paper, but before I do, a word of caution. The reason you often hear "options are risky" is because people often are under-educated about the inherent leverage built into options. Remember, one contract is the equivalent of 100 shares of the underlying. Don't rely on your broker's margin requirement as any indication of how many contracts you should sell any more than you'd rely on a sports car's ability to drive 180 MPH as any indication of how fast you should drive. In our firm, we believe that any skill that may persist in financial markets is in having a deep understanding of portfolio construction, and then the discipline to have a long term mindset when most others don't.
Jesse Blom is a licensed investment advisor and Vice President of Lorintine Capital, LP. He provides investment advice to clients all over the United States and around the world. Jesse has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™ professional. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse has a Bachelor of Science in Finance from Oral Roberts University. Jesse oversees the LC Diversified forum and contributes to the Steady Condors newsletter.
A lack of bears is often more important than Bulls being at high levels, but the net between the two being over 30% always puts a selloff on watch. Given the recent deterioration in sectors like Financials, and Aerospace/Defense within Industrials, and a flattening out in breadth last week, this looks even more important to pay attention to. While buying fear is often much easier than selling complacency, when a number of factors suggest we're getting close to a near-term peak in prices.
Summary: For all the potential market moving events this past week, SPX surely failed to show much volatility and by Friday's close, SPX was within 1 point of levels hit the prior Friday's close, despite two Summits, 3 Central bank meetings, the T/TWX merger announcement just to name a few of the events from last week. Last week was billed as one of the biggest weeks all year with regards to potential market moving events, but just goes to show how little these events often matter in the short run.
The inaction in the SPX however, didn't quite do justice to the sector rotation that was ongoing, nor to the drawdown in positive breadth while investors continued to pile into call options to take advantage of FANG stocks. The Equity Put/call ratio has now approached nearly the same low levels which were seen back at the late January highs. Moreover, while SPX and DJIA, along with TRAN have not joined the NASDAQ at new highs, other more broad based indices have shown even weaker price action lately and the NY Composite index, which includes all common stocks, including ADR's REITS and listings of foreign companies fell to the lowest levels in about 7 trading days last Friday.
Below I list the 10 concerns that I shared in this past Thursday's Morning Technical Comment, but for the benefit of those who do not receive these reports during the week, here they are: The combination of these factors suggest upside should truly prove muted in the upcoming weeks, and likely to coincide with equities turning down:
1) Negative momentum divergence is present on intra-day charts of S&P while weekly NASDAQ and SOX charts have shown negative divergence in momentum.
2) Percentage of stocks trading above their 10-day moving average has reached 85% as of 6/11/18 the highest since April, while the percentage of stocks above their 50-day m.a. reached 75% yesterday, the highest since February. While momentum is not really overbought on daily nor weekly basis, Overbought conditions have been present on monthly charts for some time.
3) Intermarket divergence is present, as the NASDAQ's push to new highs has NOT been met with similar movement by SPX, DJIA, TRAN, or other indices, and the Russell 2k moving back to new highs might seem encouraging, but it's certainly not a broad-based move among the broader market averages and indices like New York Composite are still below March highs. NY Composite, as the charts show below, fell to the lowest level in over seven days last Friday, which certainly tells a bit of a different picture.
4) Price divergence with many of the developed world markets outside the US has also been an issue, as NASDAQ's push to new highs was certainly not followed by Europe's SX5E, SXXP, or most of Asia. This looks to be another important cautionary market "tell"
5) Decidedly weaker price action out of Financials (-1.90% last week) which has been lagging nearly for a month now, and Technology also has dropped off meaningfully in the last one and three months. Technology was barely positive last week and has dropped to third place in 1 and 3 month rankings. Financials meanwhile is down for the year performance wise and the second to last sector performance wise out of 11 on a three-month basis (-4.81% - S&P 500 Financials index through Bloomberg 6/14/18)
6) Technology has gotten quite overbought, with SOX and NASDAQ near March highs and relative charts of Tech to SPX showing evidence of trying to peak out, not unlike what was seen in March, or last November. After such a strong run in the SOX and FANG in May, this looked to bring many investors back into the fold while now Tech could underperform
7) Sentiment concerns- We've seen bullish sentiment per Investors intelligence now rise for the 5th straight week to 55%, above March highs, while Bears lie at 17%. Ned Davis Research (NDR) Crowd Sentiment poll is the highest they've seen since early February, while Equity put/call data had reached the low 50s as of early last week on its 10-day moving average, the lowest reading since late January when stocks peaked.
8) Seasonality concerns- June tends to be a very poor month seasonally in mid-term election years the worst of all 12 months, showing an average return since 1950 of -1.7% (SPX) and thus far gains have proven robust in the first two weeks to the tune of over 2% until yesterday. The last couple weeks could very well help to spoil the Bulls party as mean reversion and bearish seasonality kicks in again this year.
9) Demark signals of exhaustion- We've seen NDX, DJIA, SPX all signal evidence of counter-trend exhaustion on this rally for the first time since the bounce began in early May. Now many sector ETF's also show similar signs, and this could grow in nature in the event S&P were to attempt to push back up to 2805-2815 into early next week. It's unlikely in my opinion that seeing these across many indices and sectors means they should be ignored.
10) Cycles point to mid-June for a possible turn, and this area lines up with former mid-month peaks that have been seen also in recent months. When just casually looking at February, March, April and May, weve seen a specific pattern of these indices bottoming early in the month and peaking mid-month. This looks to potentially be the case in June and also in July of this year.
SHORT-TERM / INTERMEDIATE-TERM TECHNICAL THOUGHTS ON SPX DIRECTION:
Short-term (3-5 days): Bearish- The downturn in Financials lately along with industrials caused breadth to flatten out substantially this last week, a troublesome development when sentiment has gotten back to such bullish levels during a seasonally bearish time. Technology looks prone to weakening in the upcoming week, and should cause equities to fall into late June before any near-term bottom. Given the rally into mid-month, June is likely to play out like the last few months, and produce selling pressure now into end of month before any bottom. Technically this should be a short-term correction only at this time but a breach of 2740 would allow for a test of late May lows near 2676 while a more extreme pullback likely reaches 2650 before stabilizing.
Intermediate-term (3-5 months)- Bearish- It's thought that markets are nearing an initial inflection point given the seasonal trends combining with other cycles which could allow for gains to be met with solid resistance throughout the back half of June. An above average pullback looks likely into July, and if sentiment can contract sufficiently, this might warrant a bullish stance into the Fall before cutting back exposure again. But it's thought that Technology is nearing important resistance and the bounce in some of the other sectors hasn't proven nearly strong enough to combat a slowdown in Tech. Whereas longer-term uptrends from 2016 are intact and Advance/Decline is back at new highs, the risk/reward for equities rallying through the balance of June is sub-par, and gains should be used for profit-taking. However, it's thought that a larger pullback likely should still constitute a buying opportunity for a push higher into the Fall before any larger selloff gets underway. While short-term support lies at 2740 and then 2675-85, the Intermediate-term support to buy lies down at 2450-2550.
This week we'll look at some charts of five distinct charts that illustrate some of the troubling technical developments within the Equity market and sectors, followed by five Stock write-ups. Three bullish, and two bearish. Stock-wise, TSG, EMN ,and HCA on the positive side, while negative developments and attractive short setups recently in BA and FOSL.
NY Composite- (NYA)- Far weaker than SPX, NASDAQ
New York Composite(NYA)- This index is arguably one of the more broad-based indices that incorporate all NYSE stocks, so when it fails to rally to the same extent of NASDAQ, or SPX of late, its wise to pay attention. NYA fell last Friday to the lowest levels in over seven days' time, and as the daily chart shows, price is lower than May peaks and remains on par with levels hit back in March. This sideways pattern in the broader market since mid-February is far different from the bullish charts seen in many Technology names and other indices, and shows a far more neutral trend. This inability to climb back to even retrace 50% of the move down from late January is a bit disconcerting, and will be important to see when this pattern is broken either to the upside or the downside. Into the end of June and potentially July, it's likely that trendline support down near 12500 is tested.
XLF/SPX- (Financials vs SPX- Relative) Financials initially peaked out right when the broader markets did in late January and have moved steadily lower since February, violating uptrends vs SPX back in April of this year. This is a negative development and given signs of Treasuries extending gains lately (Yields pulling back and failing to move back over 2.94%, it's likely that this sector weakens even further in the short run. One should be quite selective when trying to own the Financials sector. For those that feel the need to be positioned long, stocks like TCBS, V, CME, AMTD, SCHW, are among the best to own, and many of the Exchange and E-brokers, not to mention Regional banks have acted far better than the Money-center banks of late.
Industrials ETF- (XLI) Industrials have also fallen out of favor lately, but much of the near-term weakness has occurred within the Aerospace and Defense group, not really the Rails. While the Airlines have tried to stabilize lately, this group remains a longer-term laggard in performance and should be avoided. Technical trends from early May show prices having violated the uptrend and now price has given back nearly half of the gain from the May rally. Overall, the need for selectivity in this group is paramount to success.
Technology vs SPX- Tech has shown increasing signs of peaking out in the last week and has been gradually underperforming since early May- TD Sequential sell signals (13-Countdown) was just triggered last Friday on S&P 500 Information Technology index vs SPX on relative charts, and this shows the extent to which Tech has gone through periods of above-average performance, followed by mean reversion and underperformance. Last November and this most recent March were both periods where Tech peaked out and fell , and ratio charts suggest this recent Boom in "FANG" stocks has put Tech in a similar position to underperform in late June/July.
NYSE Advance/Decline- The A/D line looks to have peaked out over a week ago, and daily charts show the presence of counter-trend exhaustion indicators having appeared on this key breadth gauge for the first time since bottoming out in February. The downturn in breadth, with minimal breadth readings of 3/2 positive or even "Negative" breadth, is important during times when equities are trying to mount a rally, and suggest that equities need to be watched carefully in the days ahead for evidence of stronger selling and violation of key support.
The Stars Group (TSG- $37.80) -Bullish for move to $40+ This stock looks quite attractive in the short run, following its push back to new weekly highs after having consolidated for the last five weeks at a level right above prior highs in 2014. The ability of price to have pushed back to new highs the last two days of last week is a real positive and should lead to an upcoming rally back to new high territory. Weekly and monthly momentum are overbought, yet structurally TSG is in good shape technically after having moved above 2014 highs and consolidated to relieve some of the near-term overbought conditions. Until this begins to show evidence of giving back its recent consolidation and falling to new multi-week lows, it's right to position long, expecting a push up to over $40. Under $36.40 postpones the advance.
Eastman Chemical (EMN- $108.92) Constructive Base bodes well for upcoming breakout- This pattern is quite bullish given the structure of this chart since March of this year, when EMN began its consolidation following the early year runup from February lows. As daily charts show, the lowest low happened in April, followed by two successive higher lows, while highs have roughly all occurred near the same levels. This pattern typically suggests a move back to new high territory and given the constructive price action recently in the Chemicals, EMN stands out as one to own and add on strength. Key upside areas of importance in this chart lie just above $110 at early June highs. LastFriday's bullish engulfing pattern make a test of this level likely, and should result in this being exceeded, driving EMN back to test May highs and over. Overall, this appears like a good risk/reward for longs, despite markets showing some shaky signs of late and long positions recommended, with upside targets near $112, then $115, with a move back under $105 postponing the rally.
HCA Healthcare (HCA-$106.51) Bullish Cup and Handle breakout- Despite a looming broader market pullback, HCA stands out as one to own, as the recent Cup and Handle pattern which was exceeded and now challenging January peaks, remains quite bullish and should give way to additional gains in the weeks and months ahead. Daily charts show the uptrend giving way back in March of this year. Yet the resulting damage proved minimal and HCA has pushed back to new weekly all-time highs just in the last week. The recent strength looks to signify a breakout of its larger weekly/monthly Cup and Handle pattern which began back in 2015 (not shown). Rallies up to $110-$115 look likely in the short run, while a pullback down under $99.48 would be necessary to cancel out the bullish factors in this daily chart. Overall, long positions are recommended, looking to buy any minor pullback.
Fossil (FOSL- $29.49) Attractive to fade this rally from $29.50-$30.50 early this week. Overall, the near-term FOSL pattern certainly seems anything but bearish, yet this rally from single digits to near $29 since late 2017, rising over 4 fold, has occurred after some stabilization following the 90% correction from 2013 into lows late last year. While the near-term rally is certainly impressive, it will take some time before this can manage more gains off its lows. To put this rally into perspective, even after this very sharp advance, FOSL has still not even recouped 20% of its entire decline off the 2013 highs. Now near-term momentum has become quite overbought while counter-trend signals of exhaustion are present for the first time off the lows on daily charts. This looks to be one case where going against this momentum could pay off in the near-term, and to be on the lookout for evidence of a greater peak in the rally from late last year, thinking any larger rebound off the lows will take time.
Boeing (BA- $357.88) - Further weakness likely after having reached the most overbought levels in 30+ years, then breaking down. In the short run, BA is unattractive at current levels technically, and looks to have begun a short-term correction which started in the last week. Further downside appears likely in the next 4-6 weeks to near-term technical targets at $336, then $311 which marked the late March intra-day lows and lies just above its 200-day m.a. Technically, the break of its one-month trend is a concern, along with evidence of bearish momentum divergence after reaching the most overbought levels in over 30 years. The stock traded down to $102 in early February 2016 before ratcheting up to over $350 in just a bit more than two years time. Looking back, monthly RSI has only reached above 75 on six occasions in the last 30 years, and four of those six resulted in corrections of at least 50% in the years ahead. (See 2006, 2000, 1996, 1990, 2013, 1986 for examples of stock behavior when momentum grows this overbought for BA. Overall, the consolidation over the last four months is merely neutral, not bearish, and would take a break of $311, so this is what to look for in the months ahead to think the longer-term pullback is getting underway. At present, just short-term weakness is expected into late June/July.
As President/Founder of Newton Advisors, LLC, Mark Newton has more than 25 years of buy and sell-side experience in the financial services industry. He formerly worked with Diamondback Capital Management, where he served as a technical analyst and portfolio manager, and prior to that, with Morgan Stanley in New York City as their technical strategist. Before moving to the New York City area in 2004, Mark traded equity options as a market maker/floor trader at the CBOE, and worked in risk management. Mark is a member of the Market Technicians Association, and former member of the CBOE, CBOT, and PHLX. He graduated with a BS in Finance from Virginia Tech in 1991 and obtained his Chartered Market Technician designation in 2002. His expertise is primarily in using advanced methods of technical analysis to identify stocks, commodities, and currencies with above-average risk/reward characteristics that can maximize returns and minimize risk. In addition to employing standard technical tools to identify trend duration, relative strength, and momentum, Mr. Newton utilizes counter-trend analysis to identify potential trend exhaustion and reversals of trend. He appears frequently on CNBC, Bloomberg, Real Vision, and has done interviews with Fox Business, TheStreet.com and Sina in the past.
VIX options settle in cash and trade in the European style. European style options cannot be exercised until expiration. The options can be opened or closed anytime before expiration. You don’t need to worry about ending up with an unwanted position in VIX after expiration. If your VIX options expire In-The-Money (ITM), you get a cash payout. The payout is the difference between the strike price and the VRO quotation on the expiration day (basically the amount the option is ITM). For example, the payout would be $2.50 if the strike price of your call option strike was $15 and the VRO was $17.50.
Expiration Days: VIX options do not expire on the same days as equity options. The Expiration Date (usually a Wednesday) will be identified explicitly in the expiration date of the product. If that Wednesday is a market holiday, the Expiration Date will be on the next business day. On the expiration Wednesday the only SPX options used in the VIX calculation are the ones that expire in 30 days. Last Trading Day for VIX options is the business day prior to the Expiration Date of each contract expiration. When the Last Trading Day is moved because of a Cboe holiday, the Last Trading Day for an expiring VIX option contract will be the day immediately preceding the last regularly scheduled trading day.
The exercise-settlement value for VIX options (Ticker: VRO) is a Special Opening Quotation (SOQ) of VIX calculated from the sequence of opening prices during regular trading hours for SPX of the options used to calculate the index on the settlement date. The opening price for any series in which there is no trade shall be the average of that option's bid price and ask price as determined at the opening of trading. Click here for Settlement Information for VIX options. For example:
Table courtesy of projectoption.com.
Contract Expirations: Up to six 6 weekly expirations and up to 12 standard (monthly) expirations in VIX options may be listed. The 6 weekly expirations shall be for the nearest weekly expirations from the actual listing date and standard (monthly) expirations in VIX options are not counted as part of the maximum six weekly expirations permitted for VIX options. Like the VIX monthlys, VIX weeklys usually expire on Wednesdays.
VIX Options Trading Hours are 8:30 a.m. to 3:15 p.m. Central time (Chicago time). Extended hours are 2:00 a.m. to 8:15 a.m. Central time (Chicago time). CBOE extended trading hours for VIX options in 2015. The ability to trade popular VIX options after the close of the market provides traders with a useful alternative, especially from overseas market participants looking to gain exposure to the U.S. market and equity market volatility. VIX options are among of the most actively traded contracts the options market has to offer.
VIX options are based on a VIX futures, not the spot index ($VIX) quote. Therefore VIX options prices are based on the VIX futures prices rather than the current cash VIX index. To understand the price action in VIX options, look at VIX futures. This can lead to unusual pricing of some VIX strategies. For example, VIX calendars can trade at negative values. This is something that can never happen with equity options.
Hedging with VIX options: VIX can be used as a hedging tool because VIX it has a strong negative correlation to the SPX – and is generally about four times more volatile. For this reason, traders many times would buy of out of the money calls on the VIX as a relatively inexpensive way to hedge long portfolio positions. Similar hedges can be constructed using VIX futures or the VIX ETNs.
VIX is a mean-reverting index. Many times, spikes in the VIX do not last and usually drop back to moderate levels soon after. So, unless the expiration date is very near, the market will take into account the mean-reverting nature of the VIX when estimating the forward VIX. Hence, VIX calls are many times heavily discounted whenever the VIX spikes.
VIX options time sensitivity: VIX Index is the most sensitive to volatility changes, while VIX futures with further settlement dates are less sensitive. As a result, longer-term options on the VIX are less sensitive to changes implied volatility. For example, between September 2nd and October 10th 2008, the following movements occurred in each volatility product:
Sep. 02 - Oct. 10 Change
October VIX Future
November VIX Future
December VIX Future
Table courtesy of projectoption.com.
So, while trading long-term options on the VIX might give you more time to be right, volatility will need to experience much more significant fluctuations for your positions to profit.
Option Greeks for VIX options (e.g. Implied Volatility, Delta, Gamma, Theta) shown by most brokers are wrong. Options chains are usually based on the VIX index as the underlying security for the options. In reality the appropriate volatility future contract is the underlying. For example, August VIX options are based on August VIX futures, not VIX spot.
Whenever I see trades that I’m not necessarily executing, but that I feel will give my Cabot Options Trader subscribers a feel for market tone, a trade idea or, if nothing else, a bit of options education, I email them a feature I call, “Stocks on Watch.”
Here is an options trade made on June 12th which is a perfect example of how hedge funds use options, from a recent “Stocks on Watch”.
Stocks on Watch: Workday (WDAY)
As I’ve written several times in the last week, option order flow has turned mixed. In fact, all five days last week, bullish and bearish trades were split nearly 50/50. This, along with the many upcoming global events, has kept me from adding new bullish positions.
However, this morning a trader opened a massive bullish position in Workday (WDAY). Here are the details of the trade:
Buyer of 12,500 WDAY January 110 Calls for $23.70 – Stock at 126
This trade is interesting for a couple of reasons.
The $29.6 million of money at risk is clearly a large amount of premium bought. And is the largest single call buy that I can remember in the last month.
Also, with the stock trading at 110, this trader is buying deep in-the-money calls. So why would he pay such a high premium vs. buying calls at the 130 or 135 strike for significantly less?
The answer is all about leverage.
With this purchase, the trader risked $29.6 million in premium. However, he has big upside potential as he is buying-in-the-money calls, which will move almost one for one with the stock. If WDAY stock goes up $2, these 12,500 calls will go up nearly $2. He essentially controls 1.25 million shares because the calls are so far in-the-money.
If the trader wanted to have similar exposure through a straight stock purchase, 1.25 million shares would cost him approximately $157 million.
So the trader gets similar upside exposure to WDAY with the purchase of the calls, but with $127 million less at risk.
Typically traders execute this strategy if they have high conviction that the stock is going higher.
Choosing which expiration date and what strike to purchase when evaluating calls and puts can be overwhelming for beginner options traders. There are seemingly endless choices.
My general rule is that if you don’t have high conviction in a stock’s direction, buy slightly out-of-the-money calls/puts. This reduces your dollars at risk in case your stock thesis is incorrect.
And if you have high conviction in a stock’s direction, much like the WDAY trader, buy in-the-money or at-the-money calls/puts.
And in the past year we have seen similar deep in-the-money trades in Micron (MU), Alibaba (BABA) and Square (SQ). And buying in-the-money calls is a favorite strategy of legendary hedge fund traders David Tepper, George Soros, Carl Icahn and Warren Buffett.
This WDAY trade is what makes the power of options so intriguing. When you use options, you risk pennies to make dollars. Or in the case of hedge funds and institutions, millions of dollars to make many millions of dollars.
Jacob is a professional options trader and editor of Cabot Options Trader. He is also the founder of OptionsAce.com, an options mentoring program for novice to experienced traders. Using his proprietary options scans, Jacob creates and manages positions in equities based on risk/reward and volatility expectations. Jacob developed his proprietary risk management system during his years as an options market maker on the Chicago Board of Options Exchange and at a top tier options trading company from 1999 - 2012. You can follow Jacob on Twitter.
Reversing the positions to short call and long put creates a synthetic short stock, and completely changes the risk.
This is because with a short call, market risk is higher. But there are ways to mitigate the risk.
A couple of examples based on the closing prices of June 14 and estimating a $5 trading fee for single options in each case:
Amazon (AMZN) $1,723.86
1725put, ask 18.50 = $1,855
1725call, bid 17.95 = $1,790
Net debit = $65
Chipotle (CMG) $460.44
460put, ask 6.40 = $645
460call, bid 6.40 = $635
Net credit = $10
In both cases, the leverage is attractive. For a net of $65, you take control of 100 shares of Amazon, trading above $`1,700 per share. In the case of Chipotle, you gain the same control for only $10, with the stock trading above $460.
The position performs well if the underlying price declines. By expiration, you gain one point in the synthetic position for each point of price decline below the strike. In either case, if the stock does decline, your return will be substantial.
This is a cheaper and better leveraged alternative to shorting stock or buying long puts without the leverage. However, that short call does present risk. Another factor to remember is that you need to have collateral posted in your margin account.
Collateral requirement is equal to 20% of the strike value, minus premium received for a short position. The short call on Amazon requires $36,175 in your margin account; and for Chipotle, the margin is $9,840.
The high leverage of this position makes it attractive, but the short call risk cannot be ignored. There are four ways to mitigate this risk:
Stock ownership. If you also hold a position in the stock, the uncovered call is converted to a covered call. This eliminates the market risk of the synthetic short stock trade. It also turns the position into a risk hedge, eliminating market risk below the strike. For example, if you set up an Amazon synthetic short stock like the one above, and the underlying price fell to $1,710, you lose 14 points in the underlying; but you gain 14 points in the long put, so the synthetic sets up an offset to protect your equity position.
Create a buffer between strike and price. The examples were all based on opening a synthetic at the money. You can also create a position with a buffer between the current price and the short call strike. For example, in the case of Amazon, you could pick a 1742.50 strike for the short call, receiving premium of 10.60 (net $1,055). The long put could be opened at a 1705 strike, costing 10.50 (total $1,055). In this case two adjustments are made. First, you pay $775 net debit for the synthetic and gain a buffer of nearly 19 points. Second, your downside protection in the long put starts at the lower strike of 1705, so your risk exposure is also about 19 points. By diagonalizing the synthetic, you get a risk reduction on the short side, and a modified risk hedge on the long side.
Use short-term expiration. By focusing on extremely short-term expirations, time decay helps reduce short call risks, while still providing downside protection. In the examples, a 7-day term until expiration was used. Time decay between Friday 6/15 and Monday, 6/18 is expected to be substantial, usually about one-third of remaining time value.
Time entry for underlying movement above resistance. When price breaks out above resistance, especially with a gap, it is most likely to retrace back into range. By timing entry of the synthetic short stock to this moment, you maximize potential for short-term profits while reducing the risk of short call exercise.
The synthetic short stock is a promising trade in terms of risk hedging; but managing the exercise risk also needs to be part of the strategy. Combining synthetic short and long stock positions as part of a highly leveraged swing trading strategy is an effective technique as well.
Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.
After all, option positions are usually held until something happens. For example, the stock moves or time passes, or volatility changes etc.
Any decision to exit (or hold or adjust) the position should be based on the current risk of the position. In other words: If you want to own the position as it is, then own it. If risk is too large, or profit potential is too small, or it you are not comfortable with the current trade, then do something: adjust, reduce size, or exit. If that play locks in a loss, so be it. That is not of primary importance.
Any position that you hold must have the potential to earn enough cash to justify the risk associated with holding. Estimating the probability of success is one factor to consider when making the hold/fold decision. As long as risk is not too high – and that's most of the time – traders who sell time premium (trading iron condors for example) collect their profits as time passes.
To be a profitable trader, you take your profits as they come, accept losses when that's the best decision, but don't concentrate on those factors. Instead, the key, and the most important item on which to focus is risk. That's the risk management skill that prevents large losses. That in turn translates into exiting risky positions, regardless of whether they are profitable or currently under water. Being willing to do whatever is necessary to get out of dangerous positions is the winner's mindset.
Those who do not agree argue that failing to pay attention to whether a position is profitable before exiting gives the trader little chance for success. The thought is : If you don't trade for profits, how can you ever know when to exit a position?
Here is a note from Christopher who takes the other side of my argument:
The theory that profit and loss doesn't matter naturally assumes that you have a "perfect" assessment of the odds of a given trading position. In an imaginary world, whereby "current risk" can be measured to perfection, prior gains and losses never matter because we can always mathematically control our risk of ruin. In the real world nobody can perfectly gauge "current risk" and hence ignoring prior gains and losses can lead to ruin.
Stop losses should be employed when we have reason to believe that our measure of "current risk" is in error.
If you disagree, look up "Long Term Capital Management" for further evidence.
Christopher Cole from Artemis Capital
In discussing what role current profitability should play in deciding when to exit a trade, I was offering my opinion on how traders should manage position risk. The idea is that the inexperienced trader would benefit by following this advice because it overcomes a common blind spot. I was also hoping that the experienced trader may discover something he/she had previously overlooked.
My point is simply this: Do you want to own any given position, right now, at its current price and under current market conditions? Nothing else matters. If you have no desire to own it, I strongly recommend closing. If that results in a loss, then that's the way it has to be. That's far better than continuing to hold a risky trade – planning to exit as soon as the trade turns profitable.
I noticed a very timely blog from Felix Salmon regarding the US Government's decision to sell some of its
shares of General Motors at the IPO price:
"The next big tranche of bailout repayment funds, of course, is going to arrive tomorrow, with the upsized GM IPO. The size of the stake that Treasury’s selling has been growing impressively, and at this point it looks as though taxpayers are going to end up owning just 33% of GM, down from 61% right now.
The more shares that the government sells in the low $30s, of course, the harder it’s going to be for Treasury to realize an average price of $44 per share for its stake by the time its last share of stock has been sold. That’s the point at which the government breaks even on the deal.
But I’m glad that Treasury isn’t letting such considerations stop it—holding on to stock just because it’s trading below some arbitrary 0% return figure is simply speculating in the stock market, and it’s not Treasury’s job to be a stock-market speculator."
You don't have to agree, but this discussion is hardly comparable to LCTM. I'm not talking about adding to the trade in gigantic size. They were absolutely certain that they were correct in their assessment. They grew the position size. They refused to believe that what they were seeing was real. And they had no real conception of risk because ther risk-evaluation model was flawed. In their (brilliant) minds, they ignored one very basic principle for traders: "Markets can remain irrational longer than you can remain solvent." [John Maynard Keynes]
Every trade eventually requires a hold/exit decision. When using options, an additional choice becomes available: hold through expiration. I don't believe it's a good idea to hold a loser, just because it is a loser. There's a time to own a position (potential reward justifies the risk) and there is a time to get out (risk too high when considering potential gain). I am certain that you recognize that not every trade can be a winner. Thus, holding losers with the hope of making every trade profitable is not viable. First, it will never happen. Second, traders would hold any poor (risky) position simply because he/she refuses to take a loss.
I believe that a good trade decision does not have to take into consideration whether the current trade is showing a profit or loss. I'm not saying that you must ignore that factor (I ignore it), but it should not be the primary factor in your exit decision.
Nor does the decision have to depend on an accurate assessment of future prospects. However, current risk is easy to measure when a trader adopts limited risk and limited reward strategies. I always know the best and worst possible scenarios and trade to avoid the worst case. To me, decisions cannot get any easier than that. How else can a trader manage risk? I either want this position in my portfolio or I don't. I may be unable to make a perfect assessment of the probability of winning, but I know how much can be won and lost.
Why hold a trade when you have a negative opinion of future prospects? Just so you don't have to lock in a loss? That makes no sense to me.
Here's an example of my bottom line: You can exit a specific trade by paying $100. How can it matter whether you sold this position and collected $200 (and would have a profit) or $50 (and would have a loss)? Do you want to own it or not. The price is $100 right now. Nothing else matters..
Christopher, I believe this is a matter of perspective. And apparently we have different perspectives. There's nothing wrong with that.
Thanks for writing.
Mark Wolfinger has been in the options business since 1977, when he began his career as a floor trader at the Chicago Board Options Exchange (CBOE). Since leaving the Exchange, Mark has been giving trading seminars as well as providing individual mentoring via telephone, email and his premium Options For Rookies blog. Mark has published four books about options. His Options For Rookies book is a classic primer and a must read for every options trader. Mark holds a BS from Brooklyn College and a PhD in chemistry from Northwestern University.
I will explain what option volatility is and why it’s important. I’ll also discuss the difference between historical volatility and implied volatility and how you can use this in your trading, including examples. I’ll then look at some of the main options trading strategies and how rising and falling volatility will affect them. This discussion will give you a detailed understanding of how you can use volatility in your trading.
OPTION TRADING VOLATILITY EXPLAINED
Option volatility is a key concept for option traders and even if you are a beginner, you should try to have at least a basic understanding. Option volatility is reflected by the Greek symbol Vega which is defined as the amount that the price of an option changes compared to a 1% change in volatility. In other words, an options Vega is a measure of the impact of changes in the underlying volatility on the option price. All else being equal (no movement in share price, interest rates and no passage of time), option prices will increase if there is an increase in volatility and decrease if there is a decrease in volatility. Therefore, it stands to reason that buyers of options (those that are long either calls or puts), will benefit from increased volatility and sellers will benefit from decreased volatility. The same can be said for spreads, debit spreads (trades where you pay to place the trade) will benefit from increased volatility while credit spreads (you receive money after placing the trade) will benefit from decreased volatility.
Here is a theoretical example to demonstrate the idea. Let’s look at a stock priced at 50. Consider a 6-month call option with a strike price of 50:
If the implied volatility is 90, the option price is $12.50
If the implied volatility is 50, the option price is $7.25
If the implied volatility is 30, the option price is $4.50
This shows you that, the higher the implied volatility, the higher the option price.Below you can see three screen shots reflecting a simple at-the-money long call with 3 different levels of volatility.
The first picture shows the call as it is now, with no change in volatility. You can see that the current breakeven with 67 days to expiry is 117.74 (current SPY price) and if the stock rose today to 120, you would have $120.63 in profit.
The second picture shows the call same call but with a 50% increase in volatility (this is an extreme example to demonstrate my point). You can see that the current breakeven with 67 days to expiry is now 95.34 and if the stock rose today to 120, you would have $1,125.22 in profit.
The third picture shows the call same call but with a 20% decrease in volatility. You can see that the current breakeven with 67 days to expiry is now 123.86 and if the stock rose today to 120, you would have a loss of $279.99.
WHY IS IT IMPORTANT?
One of the main reasons for needing to understand option volatility, is that it will allow you to evaluate whether options are cheap or expensive by comparing Implied Volatility (IV) to Historical Volatility (HV).
Below is an example of the historical volatility and implied volatility for AAPL. This data you can get for free very easily from www.ivolatility.com. You can see that at the time, AAPL’s Historical Volatility was between 25-30% for the last 10-30 days and the current level of Implied Volatility is around 35%. This shows you that traders were expecting big moves in AAPL going into August 2011. You can also see that the current levels of IV, are much closer to the 52 week high than the 52 week low. This indicates that this was potentially a good time to look at strategies that benefit from a fall in IV.
Here we are looking at this same information shown graphically. You can see there was a huge spike in mid-October 2010. This coincided with a 6% drop in AAPL stock price. Drops like this cause investors to become fearful and this heightened level of fear is a great chance for options traders to pick up extra premium via net selling strategies such as credit spreads. Or, if you were a holder of AAPL stock, you could use the volatility spike as a good time to sell some covered calls and pick up more income than you usually would for this strategy. Generally when you see IV spikes like this, they are short lived, but be aware that things can and do get worse, such as in 2008, so don’t just assume that volatility will return to normal levels within a few days or weeks.
Every option strategy has an associated Greek value known as Vega, or position Vega. Therefore, as implied volatility levels change, there will be an impact on the strategy performance. Positive Vega strategies (like long puts and calls, backspreads and long strangles/straddles) do best when implied volatility levels rise. Negative Vega strategies (like short puts and calls, ratio spreads and short strangles/ straddles) do best when implied volatility levels fall. Clearly, knowing where implied volatility levels are and where they are likely to go after you’ve placed a trade can make all the difference in the outcome of strategy.
HISTORICAL VOLATILITY AND IMPLIED VOLATILITY
We know Historical Volatility is calculated by measuring the stocks past price movements. It is a known figure as it is based on past data. I want go into the details of how to calculate HV, as it is very easy to do in excel. The data is readily available for you in any case, so you generally will not need to calculate it yourself. The main point you need to know here is that, in general stocks that have had large price swings in the past will have high levels of Historical Volatility. As options traders, we are more interested in how volatile a stock is likely to be during the duration of our trade. Historical Volatility will give some guide to how volatile a stock is, but that is no way to predict future volatility. The best we can do is estimate it and this is where Implied Vol comes in.
– Implied Volatility is an estimate, made by professional traders and market makers of the future volatility of a stock. It is a key input in options pricing models.
– The Black Scholes model is the most popular pricing model, and while I won’t go into the calculation in detail here, it is based on certain inputs, of which Vega is the most subjective (as future volatility cannot be known) and therefore, gives us the greatest chance to exploit our view of Vega compared to other traders.
– Implied Volatility takes into account any events that are known to be occurring during the lifetime of the option that may have a significant impact on the price of the underlying stock. This could include and earnings announcement or the release of drug trial results for a pharmaceutical company. The current state of the general market is also incorporated in Implied Vol. If markets are calm, volatility estimates are low, but during times of market stress volatility estimates will be raised. One very simple way to keep an eye on the general market levels of volatility is to monitor the VIX Index.
HOW TO TAKE ADVANTAGE BY TRADING IMPLIED VOLATILITY
The way I like to take advantage by trading implied volatility is through Iron Condors. With this trade you are selling an OTM Call and an OTM Put and buying a Call further out on the upside and buying a put further out on the downside. Let’s look at an example and assume we place the following trade today (Oct 14,2011):
Sell 10 Nov 110 SPY Puts @ 1.16
Buy 10 Nov 105 SPY Puts @ 0.71
Sell 10 Nov 125 SPY Calls @ 2.13
Buy 10 Nov 130 SPY Calls @ 0.56
For this trade, we would receive a net credit of $2,020 and this would be the profit on the trade if SPY finishes between 110 and 125 at expiry. We would also profit from this trade if (all else being equal), implied volatility falls.
The first picture is the payoff diagram for the trade mentioned above straight after it was placed. Notice how we are short Vega of -80.53. This means, the net position will benefit from a fall in Implied Vol.
The second picture shows what the payoff diagram would look like if there was a 50% drop in Implied vol. This is a fairly extreme example I know, but it demonstrates the point.
The CBOE Market Volatility Index or “The VIX” as it is more commonly referred is the best measure of general market volatility. It is sometimes also referred as the Fear Index as it is a proxy for the level of fear in the market. When the VIX is high, there is a lot of fear in the market, when the VIX is low, it can indicate that market participants are complacent. As option traders, we can monitor the VIX and use it to help us in our trading decisions. Watch the video below to find out more.There are a number of other strategies you can when trading implied volatility, but Iron condors are by far my favorite strategy to take advantage of high levels of implied vol.
How To Trade Volatility Using the VIX Index - YouTube
I hope you found this information useful. Let me know in the comments below what you favorite strategy is for trading implied volatility.
Here’s to your success!
The following video explains some of the ideas discussed above in more detail.
How To Trade Volatility - YouTube
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. He likes to focus on short volatility strategies. Gavin has written 5 books on options trading, 3 of which were bestsellers. He launched Options Trading IQ in 2010 to teach people how to trade options and eliminate all the Bullsh*t that’s out there. You can follow Gavin on Twitter. The original article can be found here.
They get all wrapped up in their trading results each day, sometimes new traders will even be watching their results each hour. They judge their trading by whether they make money on each trade. A good trade is when they make money and a bad trade is when they lose money. They are results driven; they may not even have a process. They have it all backwards; it is having the right trading process that will make you a profitable trader in the long term. Trading results can be random in the short term. New traders can focus too much on making money in the short term while professional traders are focusing on making the right decisions so they will be profitable in the long term.
Many times new traders see everything in black and white at the beginning; they can judge the quality of their trading by money and results. A trend trader can step back and judge the quality of their trading by whether they followed the process by trading their system with a plan. If a trend trader is in a drawdown they are able to understand that the market may not have been conducive to their system in the short term. If you are a trend trader and the markets you are trading are not in trends for a few months then of course you will likely not be profitable. A new trader that is results focused will jus thing that the trend trader’s process does not work. A trend trader is just trading their process waiting for the next trend to bring capital gains.
A trend trader understands that their part in the trading process is to develop and back test a trading system and then trade it with discipline using risk management and a trading plan. Once they enter a trade they can’t control whether it is profitable or not. A trend trader can control his entry, position size, stop loss, and trailing stop but not the price action.
Process centered trading is where a trader judges the quality of his trading by how well he followed his process. Process oriented trading can result in long term success if the trader has a winning system. Trading a process lowers the levels of stress and confusion in trading. It focuses the trader on simply executing what they already know is a valid system that should lead to long term profits. Results centered trading judges the quality of the trading on whether money was made or lost. The problem with results oriented thinking is that bad trading can result in short term profitability but in the long term a trader was just experiencing luck or a specific market environment that made them profitable. Big wins can also be just the results of risking too much capital but being on the right side of a move, the results could also be a blow up if it was bad risk management with position sizing that lead to those gains. When good results come from a bad trading process the results do not stay good long term. Bad results that happen while following a good trading process are usually only in the short term.
A process oriented trend trader has five core beliefs:
The edge that they have in their system will result in profitability in the long term.
They do not let their emotions or egos get caught up in short term results. They understand the randomness of results on shorter time frames.
They understand they only have control over systematic trading execution not trading results.
They are not trying to predict what the market will do in the future they can only control what they will do in the present moment.
They do not get euphoric with winning trades are depressed with losing trades.
A process oriented trader’s job is not to predict, have an opinion, or prove anything. Their only job is to stick to their rules, take their signals, and follow their process.
Trend trading tips:
Once you have a trend trading system your job is to follow it .
Focus on the trading process not the trading results.
Focus on what you can control.
Do not become emotionally moved by wins or losses.
Trade position sizes that enable you to follow your trading process without overwhelming stress or emotions.
Steve Burns has been investing in the stock market successfully for over 20 years and has been an active trader for over 14 years. Steve took to blogging and social media by founding New Trader U in 2011. He is the author of seventeen books about the stock market. Steve has been featured as a top Darvas System trader and interviewed for the Wall Street Journal, Traders Magazine, and Michael Covel. He has also been a contributor to Traders Planet, ZenTrader, and See It Market. You can follow Steve on Twitter. This article is used here with permission and originally appeared here.
“After spending many years in Wall Street and after making and losing millions of dollars I want to tell you this: it never was my thinking that made the big money for me. It was always my sitting. Got that? My sitting tight! It is no trick at all to be right on the market. I’ve known many [traders] who were right at exactly the right time, and began buying or selling stocks when prices were at the very level that should show the greatest profit. And their experience invariably matched mine; that is, they made no real money out of it. [Traders] who can both be right and sit tight are uncommon. I found it one of the hardest things to learn. But it is only after a stock operator has firmly grasped this that he can make the big money.” – Jesse Livermore
“Sheer will and determination is no substitute for something that actually works.” – Jason Klatt
“Everyday I assume every position I have is wrong.” – Paul Tudor Jones
“I just wait until there is money lying in the corner, and all I have to do is go over there and pick it up. I do nothing in the meantime.” – Jim Rogers
“You can lose your opinion of you can lose your money.” – Adam Grimes
“I have two basic rules about winning in trading as well as in life: 1. If you don’t bet, you can’t win. 2. If you lose all your chips, you can’t bet.” – Larry Hite
“Cut your losses. Cut your losses. Cut your losses. Then maybe you have a chance.” – Ed Seykota
“Bulls make money, bears make money, pigs get slaughtered.”
“Take your profits or someone else will take them for you.” – J.J. Evans
“Beware of trading quotes.” – Andreas Clenow
“The desire for constant action irrespective of underlying conditions is responsible for many losses in Wall Street.” – Jesse Livermore
“There is a huge difference between a good trade and good trading.” – Steve Burns
“The market is a device for transferring money from the impatient to the patient.”- Warren Buffet
“Never let a win go to your head, or a loss to your heart.” – Chuck D.
“Some people make shoes. Some people make houses. We make money, and people are willing to pay us a lot to make money for them.” – Monroe Trout
“Only The Game , Can Teach You The Game” – Jesse Livermore
“Losers average losers.” (Sign in Paul Tudor Jones office).
“Trade the market in front of you, not the one you want!” – Scott Redler
“Trade What’s Happening…Not What You Think Is Gonna Happen.” – Doug Gregory @SharpTraders
“In trading the impossible happens about twice a year.” – Henri M Simoes
“The trend is your friend – until it stabs you in the back with a chopstick.” – @StockCats
“He who knows when he can fight and when he cannot will be victorious.” – Sun Tzu
“Michael Marcus taught me one other thing that is absolutely critical: You have to be willing to make mistakes regularly; there is nothing wrong with it. Michael taught me about making your best judgment, being wrong, making your next best judgment, being wrong, making your third best judgment, and then doubling your money.” – Bruce Kovner
“Where you want to be is always in control, never wishing, always trading, and always first and foremost protecting your butt.” – Paul Tudor Jones
“The game of speculation is the most uniformly fascinating game in the world. But it is not a game for the stupid, the mentally lazy, the person of inferior emotional balance, or the get-rich-quick adventurer. They will die poor.” – Jesse Livermore
“A rising tide lifts all boats over the wall of worry and exposes bears swimming naked.” – @StockCats
“All you need is one pattern to make a living.” – Linda Raschke
“All the math you need in the stock market you get in the fourth grade.” - Peter Lynch
“5/1 risk/reward ratio allows you to have a hit rate of 20%. I can actually be a complete imbecile. I can be wrong 80% of time and still not lose.” – Paul Tudor Jones
“The core problem, however, is the need to fit markets into a style of trading rather than finding ways to trade that fit with market behavior.” – Brett Steenbarger
“If you don’t respect risk, eventually they’ll carry you out.” – Larry Hite
“The trend is your friend until the end when it bends.” – Ed Seykota
“Once you find the system that works for your style/personality and confidence is gained, wash, rinse, repeat over and over again.” – @Sunrisetrader
“Dangers of watching every tick are twofold: overtrading and increased chances of prematurely liquidating good positions” – Jack Schwager
“If you can’t take a small loss, sooner or later you will take the mother of all losses.” – Ed Seykota
In trading, everything works sometimes and nothing works always.”
“The market can stay irrational longer than you can stay solvent.” – John Maynard Keynes
“IF YOU WANT TO BE A LEDGE… FIND YOUR EDGE…” – Tom Dante @Trader_Dante
“By living the philosophy that my winners are always in front of me, it is not so painful to take a loss.” – Marty Schwartz
“Sometimes the best trade is no trade.” – Anonymous
“Hope is bogus emotion that only costs you money.” – Jim Cramer
“One day does not make a trend.” – Anonymous
“It’s OK to be wrong; it’s unforgivable to stay wrong.” -Martin Zweig
“Amateurs think about how much money they can make. Professionals think about how much money they could lose.” – Jack Schwager (paraphrase)
“Opportunities come infrequently. When it rains gold put out a bucket not a thimble.” – Warren Buffet
“Don’t fight the Fed.” – Marty Zwieg
“You’re going to learn a million things, then you need to forget them all and focus on one.” – @SunriseTrader
“The obvious rarely happens, the unexpected constantly occurs.” – Jesse Livermore
“Stocks are bought not in fear but in hope. They are typically sold out of fear.” – Justin Mamis
“Accepting losses is the most important single investment device to insure safety of capital.” – Gerald M. Loeb
Thanks to everyone who shared these great quotes!
Steve Burns has been investing in the stock market successfully for over 20 years and has been an active trader for over 14 years. Steve took to blogging and social media by founding New Trader U in 2011. He is the author of seventeen books about the stock market. Steve has been featured as a top Darvas System trader and interviewed for the Wall Street Journal, Traders Magazine, and Michael Covel. He has also been a contributor to Traders Planet, ZenTrader, and See It Market. You can follow Steve on Twitter. This article is used here with permission and originally appeared here.
Let's start with the most criticized villains: hedge funds.
According to Barclay (tracking more than 2,000 hedge funds), the average Hedge Fund return in 2015 was +0.04%. Of course, this is before management fees and everything else. More details here.
It is a common practice in the industry to use the 2-20 scheme, meaning 2% management fee on your assets, plus 20% of your gains in the year. Needless to say, the average guy lost money.
Let's move on to the second most criticized villain: mutual funds
For mutual funds I decided to go with a sample of one of the most representative institutions when it comes to wealth management: RBC. I took a look at some of the most popular funds, those with catchy words in the name like "Balanced", "Value", "Global", "Income", "Growth".
If we average out those 2015 returns, we have +0.56% among these 5 big pools. Never forget the average management fee is around 2% per year.
Since inception, they average about 6% annual returns (not too bad), but the 2% management fees turn it into 3% to 4% real returns after fees.....so when you factor in inflation,... yes, you guessed it.
Finally the least hated, in fact most times venerated index funds:
I just kept it simple with the super popular VTI (Vanguard Total Stock Market ETF) VTI's price at the beginning of the year was 105.94 vs 104.34 at the end of the year. With the addition of distributions it finishes the year slightly positive.
According to Morning Star the total return in 2015 was +0.36% for VTI.
Not beating the simple strategy of holding SPY is something I won't criticize in this article. I have talked about that before. I myself have under-performed the market in some periods in the past. However, one thing must necessarily be said:
If these funds were delivering inferior returns BUT were protecting investors from severe corrections, then we could argue that they have a mission, that they play a vital role: They under-perform in exchange for protecting investors from serious corrections. It's the price to pay in order for our money to be safe. Yet, that's generally very far from being true. Most mutual/hedge funds generally under-perform during market rallies, and over-correct during market sell-offs. In addition, you are not protected against crashes, looking at the history of most mutual funds in 2008, they corrected between 30% and 60%, some even more. And I'm saying "most", not "all" simply because many mutual funds that we have today hadn't been born back then.
This naturally leads people to think: "what the hell! I'm going to passively follow an index". It seems to be slightly better than giving your money to a Mutual Fund or Hedge Fund, but not by much. The index will not save you from the corrections and bear markets. And the saddest part of the story is that you are guaranteed to ALWAYS under-perform. It is mathematically impossible to match the index that you follow, whichever it is. Why? Well, to start off the vehicles you invest in in order to follow the index have a management fee. Yes, usually small, but still a management fee. That alone is enough to guarantee under-performance in respect with the index. Then you also have execution slippage, Bid-Ask differential. That, eats up a little more. Finally, you have trading costs, a.k.a commissions you pay your broker for facilitating the actual buying and selling of shares. When all this is included, index followers usually under-perform the index by 1% to 2% in the long run.
As of this writing, VTI's average annual performance since inception is +5.88%. As explained earlier, the investor is guaranteed to be getting less than that.
Why not do it yourself?
Saying that nobody will take care of your money better than yourself is so cliche. But man it is so damn true.
Yes, most individuals under-perform, but most individuals do not put the effort to improve their skills, to learn solid trading approaches with better historical risk-adjusted returns.
Most people under-perform, but you are not "most people". Imagine what this world would be if every successful person stopped fighting and improving just because "the majority fails". What would Lebron be if at some point he'd stopped to think: "Why bother? Most aspiring basketball players don't make it to the NBA". What if Joe Di Maggio had said: "Screw it. I'm not even going to make the effort. Most baseball players never get to play Major League Baseball". Every successful entrepreneur, every successful musician, every successful writer, surgeon, engineer...Mathematically speaking, they all started with huge odds against them, just based on the results of the general population.
Most people are lazy by nature, and prefer to invest their time browsing pictures of hot photo-shopped girls on Instagram. You are not like "most people". Even if you browse for some hotties on the Internet, the single fact that you are reading this site demonstrates you are not like "most people". After all, it takes a special kind of liver to be able to read this annoying site for a prolonged period of time.
Why not grow your money yourself, with calculated risks and action plans instead of the constant nervousness produced by the concerns that the markets will always crash tomorrow and I have no idea how the hell my fund manager will react? Why significantly reduce your returns due to paying someone for the privilege of this constant fear?
The numbers, the numbers don't lie.
This article was originally published here by Henrik aka The Lazy Trader. Henrik trades Iron Condors, Credit Spreads, Dividend Growth investing, Cash Secured Puts, Covered Calls, ETF Rotation, Forex. He likes to share his passion with others, educate and learn something from everybody. You can follow Henrik on Twitter.
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