Not a Daiquiri
Vol #193: September 5th, 2024
A daiquiri is not a margarita with rum.
I’ve been shaking up a mean margarita1 for several years now. It started in sippy cups as a portable pandemic happy hour for long walks around Logan Square. But until recently I had no idea that our house staple had more in common with the cognac based sidecar.
Think of them both as lime juice spiked summer fun, but the daiquiri and margarita are in completely different cocktail families. At least according to the experts at Death & Co whose Cocktail Codex I've been imbibing recently. The addition of the Grand Marnier liqueur shifts the dimensions of the beverage enough to separate these two at the top of the hierarchy.
If you’ve ever done a lazy margarita (please not a pre-mix) and dropped the curacao, you know something is missing. The unctuous candied orange and savory vanilla bean balance the sharpness of tequila, and bridge the tartness of lime juice.
This revelation led to several rounds of sidecars, and a deeper appreciation of the taco’s favorite pairing. The flavor profile a cocktail delivers is a function of its ingredients AND its structure. The sidecar and the margarita share only one liqueur in common, but their identical proportions mold a similar experience.
Risk is a double chartreuse, and both cocktails deliver you to the same place after a few. If you’re managing exposure - we’re all naked somewhere - the markets will give it to you. But whether you’re buying a bond, call spread, or dividend champion, the asset type matters as much as the specific texture of your risk.
An important concept that’s taught early in mock trading is “likeness” in options. How similar are two calls or puts? What greek(s) are you using to evaluate that? This is fundamental to understanding how a spread will behave across time, stock price, and volatility environments.
Check out No Two Owls are Alike.
In delta space, OTM puts several months away will net against ATM calls expiring tomorrow. Those and all the other greeks quickly start moving orthogonally. A tight call spread with enough days on the clock will see only small changes in value even as theta decays, vol spikes or stock drops. Cross skew and term structure, spreads start to have lots of dimensions of exposure. Particularly if they have independent deliverables like VIX options.
Understanding likeness of different options requires a complete grasp of the risks that drive their prices. Are you buying implied volatility with a hard to borrow put, or is the interest rate cratering back up to flat going to crush you?
The same principles apply when using options to manage equity investments. An overlay strategy like the GULL (a put spread collar) gives you roughly fifty deltas of coverage per contract if you strike it around the money in SPX.
That sounds like a significant offset, but it will change over time. The long put and the short call are fairly similar options right now from a gamma/vega/theta perspective where they mostly net out. Deltas are going in the same direction. If stock moves to or past one of those breakpoints, the position changes quite a bit.
With no time on the clock and sitting in between two strikes, the underlying stock will basically be floating “naked” with little offset. Far through the call strike and you have a nearly pure hedge where you don’t make or lose any money up or down as the position is capped out.
If we talk about likeness in options, we should also talk about likeness in equities and how that impacts our options structuring. Bank of America is not MicroStrategy. It would be silly to write the same call or GULL against them. While the most common hedged equity strategy uses 5/20% OTM puts in SPX - and I think thats a pretty good benchmark - if you do the same strategy in NVDA, I’d push out the downside, and think about how much upside I was capping.
Put enough dividend champions in a basket together with an options overlay, and you basically have a bond. All those equity CUSIPs are eyeing the poolside with the daiquiris, but belong in the smoking lounge with the side car slugging fixed income traders.
The same thing goes for when you start getting into the structuring of products - either vanilla or complex. My favorite (and simplest) structure is buying a call (or put) spread with the interest you expect to earn over that period.
But this is a 99% bond allocation that’s really just fully hedged equity exposure! You have the same PnL as a zero cost collar. If you buy the put expiring next September that protects you at 100% downside from this level (same as your bond) you’d sell the call at the same strike of exposure ($5825) in SPX as you’d get putting your interest towards options spreads.
Creativity is the only limit on what can go into a structured product. ETFs are a blank canvas to jam in every type of irresponsible options strategy. Kris at Moontower picked up one of my earlier blogs on this just today.
These things look and quack like stocks, but behave like anything but them. It’s not just the rigid systematics of these options selling funds, or the mis-characterization of “yield” they earn from strategies.
The returns from the strategies are often completely unrelated to the advertised nature. SVXY is a popular short vol product, but for the most part you don’t actually make money being a vol seller. Returns on the positive side are driven primarily by the contango relationship. This term structure nuance gives a tailwind to rebalancing, where you’re usually selling the further out term more dearly than the near term you’re buying back. That’s sort of short vol, but it’s got the potential to behave quite differently.
If you prefer to trade from the long side, things go just as badly there. In Europe, there’s a 3x Long MicroStrategy ETP that is down 84% year to date, while MicroStrategy the underlying is up 111%.
The catch here - and you’ll see it with the performance tracking in March and April - is that the fund tries to capture the daily returns. Resetting every day creates a compounding dynamic where down markets really hurt. The fees to do this are death by 252 cuts a year. The daily ongoing cost is 9.8bps. Compound that drag alone over a year, and you’re down 22%.
These are extreme examples, but they’re also some of the fastest growing products in the ETP space. When you cobble together financial products to produce a certain return structure, there are quite a few different externalities that you have to be careful of.
Just like a cocktail, if you put too much sweetener into your ETF, headaches are imminent. They’re great passive vehicles for owning stocks, but terrible ways to get exposure to the advertised factors.
Decomposing your PnL is a great way to learn about the likeness of options and how this informs their use. Even with a basic covered call we can see how implied volatility and decay impact your trade - are you making money on the option even if stock goes up? Not making as much as you thought on the way down?
Remember as you adjust the flavors, to also consider the ratios and how the ingredients are going to interact with each other. Hedging is already an exercise in FOMO and guaranteed disappointment. Don’t add under or overexposure to the mix.
Mark’s Margarita Recipe
1 ounce reposado tequila (Cimarron)
1 ounce mezcal (Banhez)
1 ounce curaçao (Grand Marnier)
1 ounce lime juice (fresh)
1 bar spoon agave syrup
Blend the agave spirits and age in small oak barrels for ~1 week. (Optional, but highly encouraged.)
Pour all ingredients into a shaker half filled with ice. Vigorously shake for 30 seconds. Serve in appropriately festive glassware.