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Tail Hedging - Put Options
#1

Tail Hedging - Put Options

There is a guy named Mark Spitznagel who manages a Hedge Fund who made a fortune, specially during turmoil. He follows the Austrian School view and knows how to invest/bet during this soon-to-explode bubble.

Here's a video explaining his method:





To summarize, the average portfolio use 60% stocks, 40% bonds. Mr. Spitznagel on the other hand, allocate a higher part to stocks and use 1% for Tail Hedge (Put Options). If shit hits the fan he makes a lot of money and buys more stocks on the cheap, compensating the losses. If the market rallies, that 1% options won't hurt the portfolio.

Unfortunately he doesn't give much details on this video. Basically he promotes his fund (Universa Investments). As for his book The Dao of Investing, he doesn't explain either. Just to stay away from stocks when the S&P is above EMA.

Anyone here with knowledge of options could shed some light on that strategy?
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#2

Tail Hedging - Put Options

On a high level: Long stock, long put = call option.

Call option: https://en.wikipedia.org/wiki/Call_option

He isn't doing anything ground breaking. The main concept is the market goes up over time. He buys stocks and buys insurance. Kind of like you buy a house and you buy house insurance.

Long calls vs stock usually has a lower portfolio volatility because of the insurance. The insurance of course drags on the returns.

Does being long calls beat the index? That's a function of market timing on the manager's behalf.
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#3

Tail Hedging - Put Options

Long puts don't work, cost basis reduction is the best strategy to be consistently profitable in all market conditions.

In a study done over 3 years from 2007 to 2009, during a market meltdown when this strategy should of been paying out. Compared just buying 100 shares of SPY, 100 shares of SPY plus long put (married put) and 100 shares plus long put and short call (cashless collar), so basically the short call covered the cost of the long put. All showed losses, you would expect the long put to show the smallest loss. Long stock -$3,029 Married put -$3,079 and Cashless collar -$240.
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#4

Tail Hedging - Put Options

I would like to discuss this topic further.

Let's say you have a $100k. The norm would be:

60/40 stocks/bonds would give you around 2900 usd/year. Not counting fluctuations in stock price. Those are today rates.
60k (x 3.5%y) = 2100
40k (x 2.0%y) = 800

100% stocks will give you 3500 usd/year. That's 20.69% improvement compared to having bonds too. But we have more risk. We know we're in a bubble but we don't know when it's gonna pop.

Using Mr. Spitznagel method would be something like this in a normal market (bubble not exploding):

$99k stocks $1k put options.
99k (x 3.5%) = 3465
Your $1k put options die worthless. You make $3465 instead of $3500. A difference of only 1%. You make 3.465% instead of 3.5%.

This is the specific part I wanna know. Let's say this year the bubble pops. Again with Mr. Spitznagel method:
$99k stocks $1k put options.
99k (x 3.5%) = 3465

You have $1k worth of put options and the market explodes, tanking all your stocks (i.e.: something from -20% to -40%). How are you going to use those put options? In the video Mr. Spitznagel says he uses the extra cash (generated by the put options) to buy more stocks. I'm not familiar with options so my doubt is how much cash those options could generate since they're only 1% of the portfolio to compensate a steep decline in your whole portfolio?

If portfolio stocks lose 20% to 40% in value, the put options need to increase 20x to 40x in value. Is that possible?
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#5

Tail Hedging - Put Options

It is possible for put options to increase that much.

Without even thinking about the math a couple of things to consider regarding this strategy:

1. Puts are a depreciating asset, they eventually expire. Once they expire you have to buy more so it's not just a one off 1% cost.
It's a long volatility play so there's better ways to create a similar hedge using options in VIX, VXX etc.

2. Let's say you get a 10% down move, your puts now have some profit, you need to sell those puts to realise the profit. Problem is you've got no way of knowing if the market is going to drop another 10% or rebound. Those puts are providing protection so it's going to be hard to close them knowing once you do you're no longer protected. What do you do?
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#6

Tail Hedging - Put Options

Would rather be selling naked calls in this climate. Would you be purchasing ATM covered put options in this instance, or how far out of the money would you go?

Puts are not depreciating if the market is going down, on the contrary, they increase in value. What is stopping someone from purchasing a naked put option in assumption of the market going down and just cashing in as its value raises?

"Money over bitches, nigga stick to the script." - Jay-Z
They gonna love me for my ambition.
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#7

Tail Hedging - Put Options

Quote: (01-14-2016 05:42 PM)TheFinalEpic Wrote:  

Would rather be selling naked calls in this climate. Would you be purchasing ATM covered put options in this instance, or how far out of the money would you go?

Puts are not depreciating if the market is going down, on the contrary, they increase in value. What is stopping someone from purchasing a naked put option in assumption of the market going down and just cashing in as its value raises?

I'm with you on selling calls in this climate! With Volatility this hi it's too late to be putting on a put hedge. People usually buy way out of the money puts because they're cheap, so probably around the 5 Delta put. It's a low probability trade, 95% of the time the put will expire worthless.

Nothing is stopping someone from doing it but as I said it's a low probability trade, when you eventually get a down move , will it be enough to cover all the previous losses?
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