Dropping the Claw

Vol# 187: July 25th, 2024

Earlier this summer I found myself playing the worst carnival game known to man - the dreaded claw. 

These obviously rigged fun boxes are a disaster for parents and a gold mine for arcades. The claw is too weak to grab anything, but every furry teddy bear is just begging to be held. Don’t spend much time lining up the perfect drop. 

Looking down into expectant eyes, we were two wolves facing off on this decision. The temptation of plush rewards balanced against a distinctly limited supply of tokens. How do you explain a carny’s tricks to a four year old?

Whether at America’s oldest wooden carousel, or just living rent free inside your head, this face off between fear and greed is a constant battle when presented with any opportunity. Too much or too little of either results in a bad decision. 

Certain individuals are naturally more risk acceptant. Others are plagued with analysis paralysis.  All of our tolerances change as we age - I’m not jumping off the same cliffs I did as a kid. 

Spend some time in crypto and you’ll meet plenty of traders who take a 50% hit and immediately start asking about how to double down and make it all back. At the other extreme is the prepper who can’t stop talking about his new safe to hold a .44 magnum and silver bullion. 

Fortunately neither of these (real) people are my clients. If only it was that easy. Assessing risk tolerance is one of the most important decisions we have to make, and when mapping that to options strategies presents a highly nuanced translation. 

Most “risk tests” look like they came straight out of a Series 65 workbook. They’re dry. “Would you prefer 5% guaranteed in a year or a 50% chance at 12%?”  or “A trusted geologist friend wants to open a exploratory venture with a 20% chance of success but 50x potential returns - how many weekly paychecks are you investing?”

If there’s any one that I do like, it’s the “Balloon Test” that combines adaptation, calculations, and sequential decision making under emotional stress. Kinda like the markets. Play a round or two, and the balloon popping becomes as visceral as the first down 2% day in 356 trading days. 

The basic idea is that you blow up a balloon and earn a little bit of money each time the balloon grows. At each turn you can either “Collect” or “Pump”, risking a pop or taking the money to the bank. Risk takers have to make estimates about the randomness of popping intervals to optimize their inflation and profit taking. 

The test has a formal name (BART - Balloon Analog Risk Task), and academics have found a number of correlations between real world behavior and scores on the test. Smokers score higher. Stress increases risk taking in men, but reduces it in women. In adolescents, BART scores directly align with the probability of motor vehicle incidents.

It’s easy to be a skeptic about tests. SATs or Meyers-Briggs, a single score or pigeon hole lacks the dimension to describe every unique snowflake. Even the ranking metric with BART will shade the results. Do you tally total earnings? Count of pops? Average pumps before a pop? 

When considering the right amount of financial risk, we have to include multiple factors. Pumping a balloon measures the appetite and tolerance for risk, but it doesn’t say much about capacity. The first two are personality traits, but the third is mostly about the size of your bank account. Do you want the risk, can you emotionally handle the downturns, and can you afford it?

Options are a scalpel for risk management, because they can help manage and define all of these.  Even if you don’t want the risk - let me show you over here to our collar department. Push back taxes, collect the dividends, and protect your exposure. Tie it on for any size or tenor. 

For the most popular options strategy - covered calls - there are several knobs to turn as we translate risk tolerance and objectives into actual traded contracts. 

Perhaps the most important selection will be the underlying product. This strategy is mostly about the delta, so choose wisely.  The premium collection structurally introduces negative skewness. You keep the returns on the downside, but give up the right tail. Issues that don’t go down often provide better risk adjusted returns than ones that go up a lot. 

Capacity might be a decision here as strategies have minimum bars for round lots, but the selection between tech, energy, or REITs is mostly about appetite. Low volatility and high dividends probably mean only pennies of premium. 

Covered call risk is not necessarily a binary decision. So long as you have more than 200 shares, the magnitude of your overlay is adjustable. (It’s also tranche-able.) Writing calls against only 50% of your shares changes the distribution of returns, and mitigates that skewness. 

---

If I sell a thirty delta covered call, does that mean my equity allocation is only 70% of the notional?

This week in Portfolio Design we’ll investigate how to manage covered call allocations in a portfolio. What is the appropriate balance of tenor and delta? What does the research say about absolute performance? Finally, we’ll consider how to right size an allocation based on your chosen strategy. 

---

The tolerance for risk on a covered call is as much about drawdowns as it is fear of missing out. Agreeing to give away your shares at a predetermined price is a type of hedge, and it’s never a fun day when your hedges are paying. 

When comparing different covered call strategies, the delta is a simple short hand for how often you expect to under perform. Twenty delta means you should expect to get assigned about once every five turns. And the more liquid the product, the more likely that estimate is correct. (See VRP + Liquidity)

Getting called away is about missing the upside of returns, but it’s also about locking in price levels. Buy and hold weathers ups and downs without creating tax implications or adjusting basis. But when you’re buying in a call and rolling “up and out”, or letting it get called away and repurchasing shares, this transaction is a hiccup in your PnL. 

If stock falls down again, you’ve bought high. Now there’s an additional risk of setting a call too low so as not to middle yourself. Maybe it’s worth the time and high premiums, maybe it’s not. That's a function of your conviction, and yours alone.  

Tenor is a similar debate. Shorter tenors offer tempting annualized premiums, but much similar risks to the high delta trades - frequent adjustments are required. 

The pure theory around covered calls says they are simply a vol trade, and in many cases you’d be better off selling your shares. (Check out Moontower for Kris’s explanation.). The skewness in returns is demonstrable both academically and in practice. 

But as with risk tolerances, investors have different utilities, and increases in returns also tends to increase risk aversion. A covered call is attractive because of that declining appetite at higher levels of wealth - “I’d be happy to sell there.”

While there’s a variety of research on covered call performance - most of it’s pretty formulaic and says you’re better off not - one of the more interesting pieces I’ve come across suggests that we should consider the attractiveness of these strategies outside the typical mean-variance optimization framework.¹

Classic portfolio optimization says we should optimize on the highest possible mean returns, and the lowest standard deviation of those. Basically the Sharpe Ratio. What the Stochastic Dominance model says, is that these are only the first two moments, and we need to consider a third order - decreasing absolute risk aversion and preference for skewness. Counterintuitively, there’s some evidence that covered calls outperform here. 

What the academic research says about a covered call strategy is unlikely to change most people’s minds. The vast majority of these trades are done based on feel, and whether the prices line up with an intuition and appropriate trade off at this point in time. 

But as you select stocks, adjust structures, and evaluate the price of options; consider the risks you are taking on here. Every strike and tenor selection is a tweak to the potential outcomes. 

1. There are a number of caveats about the paper, and we’ll dig more into them tomorrow with Portfolio Design. It only focuses on a limited number of options, from many years ago, traded on the moderately liquid Swiss exchange. That said, the point about investor priorities rings true regardless - there is often more than just risk and return.