Volatility is a feature, not a bug
Vol #13 - October 30th, 2020
When the market lurches around, there can be feelings of physical cringing. It doesn’t help that finance television flashes big red warning signs using the words “meltdown” and “panic”.
Humans are hardwired to be bad at money. We get triggered by the red numbers and feelings of loss. “If I had just sold yesterday”. “My account is down $X, what could I have bought with X?”
Understanding the extent to which we are risk averse, and feel losses more painfully than gains is the Nobel Prize winning work on Prospect Theory by Daniel Khaneman and Amos Tversky. It seems to evolve from our early biology where risk meant death, and feeling pain acutely was necessary to survival.
Not only do we feel pain more sharply, we have this pesky feature of anchoring ourselves to high numbers. You don’t remember your average balance over the last 12 months, you remember the highest number you saw. Any time you’re not at the maximum you feel like you’re at a deficit.
There’s a reason we use the Ulcer Index at Harvested to describe risk. It’s a visceral, physical feeling to know you’re losing money. Describing risk as a standard deviation misses the fact that you feel so much more pain on the downside.
Even knowing all this, it can still feel hard to see prices drop. The first cognitive step that I take is to approach it like a trader, and look at option implied volatility. Options directly price investor expectations of movement and if I see that SPX options are pricing 2% moves every day, I can’t be surprised when that happens.
Then I try to think like a savvy buyer who has been given an opportunity he’s patiently waited for. I recognize that dropping prices help me compound and dollar cost average at lower levels. The best indicator of an asset's performance is the price you pay. Getting more stock for the same dollar amount is a good thing.
The last way I try and frame it, is as a software developer. There’s a truism that “volatility is a feature, not a bug.” Sometimes the things that seem pesky and disruptive to an experience, have a hidden benefit. Volatility cuts both ways, and it drives the equity risk premium. If the asset was stable and consistent, you’d have to sacrifice the return potential.
It’s tough to see the markets churn. No matter how many different lenses you can use to justify it, we’re happier when our balances go up. It’s a constant adjustment, and finding that right balance of different is what we’re here to do.
Thanks for joining us,
Mark Phillips
CEO
What clients are asking us:
How do greeks work in your strategies?
We like to use options greeks to parameterize our strategies, because it allows them to be reactive to different market environments. Rather than fixing a given percentage or dollar amount, by using delta to define strategy aggression we vary our opportunity capture as the prices of options rise and fall.
Do you have an ETF?
We love ETFs for our equity portfolios. They're cheap and easy ways to get access to the broad market. But they don't have the customization potential of options, and they can often mask hidden fees.
Check out our most recent blog to learn more!
When's the next webinar?
How Options Strategies Pay Out got a lot of great feedback for our overview of Downside Capture, and we're going to schedule more on each different strategy.
Stay tuned for an invite, but mark November 11th on your calendar!
Happy Friday!
Last week we talked about trader language, and got a lot of fun feedback! I’d like to dig in more to one specific term, that seems particularly appropriate for this market environment.
The “O’Hare Straddle” is an old pit traders joke about how to handle big and volatile events. Back before computers were handling all the risk management, and there was perfect insight into what was happening on the floor, traders had quite a bit of leeway.
A trader in the pit could execute a trade, and their bosses upstairs or whoever was backing them, might not know about it until the next day, or even later. The trade would happen in the pit, a ticket would get written up, and then sent back to the clearing room by a runner.
Big events meant there could be big money on the line, both to win and lose. Traders have a knack for arbitrage, and the idea with the O’Hare Straddle is to swing for the fences but avoid the consequences.
When volatility is high going into an event (such as a presidential election!) we usually see the volatility come down very big afterwards. The best way to profit from this is using a straddle contract, which buys (or sells) both calls and puts on the same line. The owner of that contract wants a big move, and the writer of the contract wants nothing to happen.
Traders could make a massively risky straddle trade, and head for the airport. They’d buy a one way ticket to a vacation destination, and land with one of two fates. They either had a spectacularly lavish experience should they be a winner, or they could disappear amidst the palm trees.