Show Me Your Edge
Vol #170: March 14th, 2024
No matter how many drinks behind a trader you stay at the bar, you’ll never find out their true edge.
Edge is as personal as your weight or salary, and even if you gave it up, it could likely not be replicated by even the most mimetic AI. It takes a unique perspective to not only discover, but maintain the course and execute on a dislocation in the markets.
Markets allocate value - more or less efficiently - and participants come to them to invest their savings or generate income. There’s the active trader at one end of the spectrum against the passive 401(k) at the other end, with a great deal of nuance in between. Both need edges to justify their interactions.
Diversified low fee index investing is a well trodden path. The average fee charged to passive indexers has dropped over 60% in the last 30 years. That now sits at 12 bps while Vanguard is hoovering up trillions at only 4 bps. We have technology, education, and most importantly competition for this ballooning demand to thank.
The edge here is time. Patience is an expensive virtue - fried by MARKETS IN TURMOIL and rumors of a 10/2 inversion - but it pays handsomely in the long run. $1000 a month in an 80/20 stock/bond portfolio for a 40 year career returns about 9.7% a year and turns into $5.3 million. And that’s only half of the monthly 401(k) max limit.
When time is your edge, the compounding cuts both ways. If you layered in a 1% return drag in the form of fees the final result is about 25% lower. Put in a little bit more when you can, squeeze the fees, and eye on the prize. Say no more fam.
Equity risk premium pays you for your patience. That 9.7% a year is several percentage points higher than risk free treasury bills because of volatility. Don’t stop buying the few times a decade when stocks drop by more than 20%.
The most naive investor can capture the equity risk premium. It’s available in any brokerage account and with roughly 15 clicks the entire process can be automated. Besides your pride, the biggest friction is the KYC process and anti-money laundering check points your hard earned cash has to endure.
With equity options, there is no set it and forget it. There are a rapidly increasing number of ETFs that offer options structures in a simple wrapper. But this is grocery store sushi. I’m not so much concerned about them suppressing volatility or creating some sort of derivatives tinder box, as I am with what an undifferentiated approach does for returns.
Options are tools to define, capture, and transform risk. Where share prices are determined in a simple delta-one vector that goes up and down, the price of an option - and thus returns - wiggle across multiple different dimensions. A buy and hold strategy is called burning theta.
The closest absolute edge that options have is the variance risk premium. Over time (and interestingly across asset classes) buyers of options pay for a little bit more movement than the underlyings realize. Sometimes it’s quite a bit more, and sometimes it’s quite a bit less. This is what an income ETF is supposed to capture.
The range of that variance risk premium is a rough measure of market efficiency. Options consistently mispriced to the up or downside means the market place is not a good predictor of future volatility. However, the more liquid something is, the better it is at predicting VRP.
In my post last week on the Portfolio Design blog, I dug into the nature of the relationship between LIQ and the range of VRP levels. Reading from right to left, you have SPY, QQQ, AAPL, trickling down into the fray - still options trading over 20k contracts a day and in the top 5% of listed products. The average VRP gets slimmer the higher liquidity gets.
The relationship also holds within products; days with low liquidity portend a higher VRP. Some of this is due to the positive correlation between implied volatility and liquidity - LIQ goes away when IV spikes. Interestingly, that’s mostly a “low-vol” “high tier” phenomenon - the GMEs and AMCs of the world see the opposite. High vol means it’s time to party.
Bid ask spreads price confidence intervals, and as these widen in times of lower liquidity, it’s no surprise that future VRP is priced less well. The bias is towards options buyers overpaying, because they’re panicking about headline risk.
But even with a bias towards overpayment, the options sellers get compensated for their capacity to bear skew. If the price of ERP is watching your holdings get cut in half a few times, the price of VRP is every once in a while collecting a penny to pay a dollar.
If you can keep your head about you, selling options into low liquidity and higher implied vol should allow you to capture more of that premium. Assuming you have the mental fortitude to sell into both the downdrafts and updrafts, actually applying that trade is fairly complex.
It takes 15 clicks to set up a lifetime of ERP. It takes 15 trades to collect a month’s worth of VRP. The net of the implied vol and historical vol is a very abstract number. Other than over the counter agreements in the tens of millions of dollars, that’s not a tradeable concept.
Covered calls are a very simple way to capture part of this. You’re long the equity realized path, and short some implied volatility. But positive VRP could still be a losing trade. Stock going down, even at a lower than expected rate is still negative PnL.
If you can’t trade variance swaps, you can still try and manage a short premium capture strategy with condors, straddles or strangles. Moving these around to stay short the right amount of volatility while stocks move and strikes go in and out of the money is introducing a lot of friction into a trading strategy.
The rebalancing for an index strategy only happens quarterly, and stock execution is cheaper and finer grained than options execution. This weighting adjustment works very much in the favor of the investor. Outperforming companies are added to, while laggards slowly melt away. Options greeks not only evolve on a daily basis, but the friction and frequency of adjustments are a major performance drag.
Consistently applying the same trade, like a QQQY that sells ATM NDX puts every day, is also going to deliver sub-optimal outcomes. The directional aspect might be a tailwind, but there’s nothing particularly systematic about why that option should be a consistent sale.
Adjusting trades based on delta (i.e. implied volatility levels) is a useful adaptation, but options overlay strategies are more about shifts along the utility curve than adding alpha. Selling calls to buy put spreads transforms the risk, it doesn’t deliver performance.
There are plenty of edges in options. VRP is real and you should sell those puts.1 But passive can’t be an edge. Dumping your money in equity markets and closing your eyes will have you beating most active managers. Blinding selling or buying options will almost certainly be a performance drag.
Not financial advice.