Having your cake and eating two

Backtest Notebooks

It took me a long time to understand the phrase “have your cake and eat it too.”

Being more of a pie guy myself, it didn’t resonate - wasn’t the point of cake to eat it?

But even better than having a slice, is keeping the cake around for the future while also having some today. However the two are fundamentally irreconcilable. If you’ve got a sweet tooth, something else has to give.

There are plenty of ways to solve this problem - go to the bakery, pull out the flour, even lean into your diet - but they all cost something. You don’t get the positive sides of two polar opposites for free.

When I explain the spectrum of what options can do to a portfolio, the same problem occurs. Ranging from zero cost collars to YOLO put/call buy/selling, investors can completely neutralize their holdings or turn them into a pile of lottery tickets. But they usually want both.

At the extremes it’s easy to understand what’s going on. Derivatives act as a pure hedge, or a pure accelerant. There’s almost no good reason to smash nickels for income, and extremely rare situations where you want to buy the lottery ticket - despite what you see on social media. On the other hand there might be more nuance to collars than you think - they can be clever interest rate sensitive borrowing tools.

Wading into the grey area where options sparkle with the allure of protection and participation, we have a variety of strategies that seem to offer a little bit of both. Naively a covered call does offer some downside protection, but as we’ve seen with the TSLA study, when stock drops short premium is a pittance of a consolation prize.

Properly buffering a hedged equity position gets the closest you can, but there are a lot of mechanics to doing so correctly. Roll timing and strike setting are important. And even with all that you’re still giving away pure returns.

When we turn our eyes to leveraged strategies, the cost of the returns is almost always paid in volatility. In “the best 30 deltas you can buy” I compared the returns of synthetic deltas that capture a volatility risk premium with the returns of vanilla stock deltas. A lot of hay for a little pay, and the pay very much depends on the market environment.

While you don’t need a backtest to tell you that leverage always gets you on the downside, what to do about it isn’t so simple. The response to this post had a number of questions about how you could hedge away those extreme moves.

Today in Backtest Notebooks, we’ll expand on the risk reversal by layering in downside protection via a put spread 1x2.