Risk Management, OPM, and Volatility

Enquiring Mish readers just might be asking the following question:
"How do risk management, other people's money, and volatility interrelate"?

Let's start with this article by Bernie Schaeffer entitled Volatility Complacency written in reference to the immediate rebound following the terrorist attacks in London:

Mr. Schaeffer writes: "The pervasiveness of the 'buy the terrorism shock dips' mentality should not be terribly surprising. Buying the dips is what Wall Street does. When stocks tumble, it is in the job description of the so-called 'financial advisor' community to "hold hands" with fearful clients so they don't engage in "panic selling". More often than not, the dips do prove to be foolish times to sell. Of course, in those cases where the dips should be sold and not bought, investors suffer huge and often irredeemable losses (think Enron, WorldCom and the decline off the Nasdaq bubble peak). And then Wall Street shrugs something like 'Jeepers, who would have ever thunk that?' Of far greater concern to me is the belief that this market already reflects a 'terrorism premium' and that 'we are ready for these events to occur'."

Quoting John Succo, a hedge fund manager and writer for Minyanville.Com Schaeffer writes: "We are seeing an acceleration in volatility selling. It is almost a panic." ---(John Succo - 7/7/05)

John Succo is one of the brightest fund managers I know, especially when it comes to volatility trading. Mr. Succo reported on Minyanville that he polled the 5 largest dealers for option activity in the wake of (and on the day of) the terrorist attacks in London. The results were not what one might assume. It seems there was an avalanche of put selling shortly after the options market opened up. No fear, no concern, just more complacency. Any spike in volatility seems to be an excuse to pile on selling volatility as opposed to buying volatility.

Now let's take a look at this July 6th article dealing with Option Plays To Kick The Range-Bound Blues. Bernie Schaeffer, writing for Forbes magazine has this to say:

"The S&P 500 has been mired for the past 18 months in an excruciatingly narrow trading range, but I believe the coming expansion in volatility will blow away those who have been selling option premium to achieve 'income.' In fact, I would not be at all surprised if we were to see a 1,500-point Dow move in either direction before the year is out."

Mr. Schaeffer goes on to say....

"The whole concept of 'income' as a driver for equity investments, which moved to the forefront during the low-volatility environment, is becoming questionable at best. Selling call options against stock you own becomes a downright foolish strategy ahead of a major market move. If the move is to the upside, you've sold away all the big capital appreciation, and if it's to the downside you were inadequately compensated by the paltry call premiums for the risk you assumed."

So what does the article suggest?
Recommendation: Sell the August 60 put (ANFTL) - Abercrombie & Fitch
Recommendation: Sell the August 85 put (TOLTQ)- Toll Brothers
Recommendation: Buy the October 37.50 call (XBAJU) and October 35 put (XBAVG) strangle - EBAY

Those sure seem to be strange recommendations for an article knocking income as a driver for equity investments, and advising people that "Selling options is a foolish strategy ahead of a major market move", especially when one believes "the coming expansion in volatility will blow away those who have been selling option premium"!

I would be remiss if I did not point out that Bernie's third recommendation on EBAY was indeed buying rather than selling volatility. However, the article might have mentioned that given the expense of buying options that far out (October) it will likely take a pretty big move to fight not one but two option premiums for the strategy to work. On a sizeable stock market move, however, I am reasonable confident that EBAY would likely move more than $4 (the approximate time premium at the time of this post), in one direction of the other. The final example was at least consistent with the idea of buying rather than selling volatility.

Those not familiar with options should note that the risk profile of selling puts for income is identical to that of the buy-write, covered call strategy that Schaeffer was knocking in this statement: "Selling call options against stock you own becomes a downright foolish strategy ahead of a major market move".

At Friday's close, two days after the Forbes article came out, you could sell three TOLL puts, collecting $120 minus commissions for the trade. One would then have to pray that if we did see a mammoth move it would be to the upside as opposed to the downside. This does not seem like a viable strategy if one is expecting a huge uptick in volatility, regardless of what support there might be on a stock with high short interest.

Assuming a potential 1500 point DOW swing in either direction does one really want to be selling puts on TOLL for a lousy $40 in premium? Perhaps one could collect $65 or so at the time the Forbes article was published, but articles like this are going to get the average person in deep trouble if there is one misstep. To be fair to Schaeffer, I am going to guess the premiums collected were far better when his recommendation came out than the premiums were at the time the general public is reading the Forbes article.

Furthermore, odds are substantial that one would indeed pocket that $120 or whatever in premium (assuming the short puts were held to expiry). That said, given that the key point of the article was how to profit from an INCREASE in volatility, the recommendations to sell puts badly misses the mark. Selling options is a strategy designed to profit from decreased, not increased volatility.

Also, note that some people will not be satisfied collecting that $120 for 3 puts and will instead sell 60 of them in an attempt to pocket $2400. That strategy works fine until it doesn't. All it takes is a bombing in the US, TOL to unexpectedly warn (the odds are not zero on this) or for some reason investor sentiment to suddenly change. All of a sudden there is a big gap down in homebuilders and the person trying to get an extra $2400 in income is suddenly $30,000 in the hole selling puts.

Given the time delays between Schaeffer's recommendations and when they appeared in the article, Bernie might already have recommended to his clients to take substantial profits on the latest surge in TOL. I have no way of knowing, nor does anyone else except his subscribers. That is a huge problem should anyone attempt on their own accord to follow the "half-advice" listed in such articles.

Please note the above statement was not meant to be a reflection on the service that Mr. Shaeffer provides to his clients. Bernie Schaeffer is one of the more respected names in the business. Instead consider it as a warning that magazines might have space or other considerations and some key details of a trade may have been left out. As I pointed, there are time considerations as well. Those time considerations are even more crucial with options. I am quite confident that Mr. Schaeffer has stop loss and profit talking points, as well as initial risk profiles on how much premium needed to be collected to justify the risk. Unfortunately, those factors were not present in the article.

There is all kinds of general advice floating around about selling puts for income, and in fact there are even some new mutual funds out there using this construct as their "business model". Multiply the above example by the amount of people and hedge funds and mutual funds opting for this strategy and you have a recipe for a huge disaster.

Another point in regards to volatility and risk is that when it is "Other People’s Money" (OPM) you can do or say whatever you want without regards to consequences. Mutual funds collect their fees whether stocks go up or down. The fact is however, that in order to keep the money coming in, Wall Street has a vested interest in keeping all the news positive, 100% of the time. It seems to help ad revenue as well as fund inflows. If there is any chance for a positive spin, news will be spun positive. Take the June employment numbers for example. Although the numbers were way light vs. expectations, unemployment dropped because the participation rate dropped. A falling participation rate in a "recovery" is hardly a sign of strength. Of course the news headline "Bulletin: U.S. jobless rate of 5% is lowest since September 2001" touted the drop in unemployment rather than the numbers miss. Biased reporting like this goes on day in and day out, every day of the week simply because it is the media's best interest to keep it biased.

If Mutual Funds did not have a mentality of 100% long, 100% of the time with no regard for risk, perhaps we would see some real analysis coming out of Wall Street. That is a moral hazard when dealing with OPM in a 100% bullish climate. I suspect that somewhere near the bottom of the bear market when it will be time to go long and buy and hold for the duration, no one will believe it having been burnt too many times in the process. Make a mental note than when we start to see huge inflows into "long and short/market neutral" mutual funds the bear market will likely be nearly over.

In a related OPM story, I received a cold call yesterday from an options broker touting oil and natural gas. Sometimes I listen to these pitches just for the fun of it. His line was "Don't you want to make money?" I asked him how many oil and gas futures he had. His answer was "None. It would be a conflict of interest to have any". Since when is it a "conflict of interest" to follow your own advice? The first thought in my mind was that was one of the stupidest things I have ever heard on a call like that (and I have heard a lot of them). The second thought in my mind was that cold calls touting energy commodities after this run-up just might be a nice contrarian indication.

My commodities account is at Alaron. The head metals broker I deal with trades his own recommendations both long and short, as does the head grains trader. There is no conflict of interest for them to do so. In fact I want people to have their own money on the line when they make a recommendation (as long as they are not purposely front running it). By the way, front running penny stocks might be possible, but front running futures recommendations would be totally useless. Just in case anyone is wondering, no I will not receive any benefit from this plug for Alaron.

I can't confirm this but I am told by another source I highly respect that put selling was very popular right before the 87 crash. On that note, given the near panic selling of volatility premiums lately, I think I will pass on trying to collect volatility premiums on a few August TOL puts (even though I think Schaeffer will have yet another 100% winner).

Notes to Bernie Schaeffer:

1) I am not trying to knock any of the recommendations in the Forbes article per se. I do not know the circumstances at the time of your recommendations or any other conditions or restriction you placed on those recommendations.

2) I have tremendous respect for your knowledge about options and options trading. You know more about options than I will probably ever learn. I enjoyed both of your articles mentioned in this blog and I regularly read your work. Hopefully the public is now better educated about the volatility risks that you mentioned.

3) I do have problems with the article as presented by Forbes. Specifically I question recommendations to short puts in an article supposedly written to stress taking advantage of increased volatility. I have my doubts the public will get the basic idea of the article, at least in conjunction with the recommendations listed. Hopefully no one follows those recommendations without understanding what they are doing and why. I assume that in actual practice your recommendations give advice on how much premium to collect for the risk as well as stop loss targets. If so, the article missed critical points on risk management. I am only using this opportunity to point out the risks of blindly following magazine recommendations, especially short volatility recommendations, that may have "undefined" and/or huge risks.

4) I have a sneaky suspicion you were not the one picking those recommendations to go with that article.

5) Got any volatility plays for us that are better representative of going long volatility rather than shorting it?

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/