As a professional options trader, there are two things I will remember most when I look back on this 2008 bear market, and that is; a.) How investors making covered calls are receiving substantial option premiums for taking risks and; b.) How the certainty of a “buy and hold” approach to a well-diversified and structured portfolio was not spared the devastating effects of this bear market sell-off.
REITs, Commodities, Large Caps, International, Emerging Markets, Convertible Bonds, Defensive Stocks, took a beating in 2008. All the companies that were considered “too big to fail”, or so conservative they shouldn’t have failed, did exactly that. . . Whoever said “No two bear markets are the same” was certainly right. Even shares of Warren Buffet’s Berkshire Hathaway (ticker: BRK) have experienced a -54% peak-to-trough trading range since December 2007. There has never been more uncertainty among investors approaching retirement, CFAs and math-minded financial services participants as the market is nervous. the reaction to every “take it to the bank” arbitration in 2008 was temporarily taken offline.
Author Roger Lowenstein has spent considerable time analyzing those who come to trade in the traditional way. In his book, When Genius Failed: The Rise and Fall of Long-Term Capital Management1Lowenstein wrote that “those who are drawn to mathematics and analysis are drawn to fixed income and convertible bond arbitrage because so much of what determines their value is easily quantifiable.”
I suspect that financial planners and sophisticated investors in general are a similar breed. The financial planners I know are well educated, mathematically minded, and contemplative. They are drawn to the certainty of planning, and their vocabulary is peppered with terms like annuity, CAGR, estate planning, efficient frontier, MPT, asset allocation, risk-adjusted return, and diversified portfolio.
On the other hand, those who are drawn to the trading floor, like me, are often emotional, anxious, and highly intuitive. Like hungry street urchins, we rely on quick reflexes and the general belief that it’s more important to be first on an operation than to be right. And like any trader worth their salt, we thirst for a bit of excitement. In fact, we can be described as the liars-poker-double-espresso-filled-undiagnosed-ADD-patients-trading-triple-beta-ETFs-for-anything-less-than-a-level-of- -Volatility-Index-Of-the-70s-is-too-boring industry orphans.
The terms an options floor trader may use on any given day are a bit different than a typical financial planner and include bias, kurtosis, theoretical advantage, risk reversal, I-Wham (Russell 2000 ETF; Symbol: IWM), implied volatility, allocation, dollar-weighted deltasY dirty water.
When I started on the CBOE floor in 1982, I was 22, and most traders in those days were blue-collar, Irish families who approached trading day with the same mindset as a plumber laying pipe or a carpenter framing a wall: it was a job.
I spent most of my CBOE years in the OEX pit, where the practice of hiring MBAs was discouraged, even ridiculed. Why? It was believed that nothing could be taught to a business student. And that might have been true: They weren’t pliable enough to be mentors. Floor traders needed to have an intuitive sense of risk management and quick reflexes to maneuver around short-term market moves. With an eye on disaster, they frequently held out-of-the-money put options. Countless arguments broke out between the manywho understood the mathematical impossibility of a 23 standard deviation move during the 1987 Crash and floor traders who had no idea what a standard deviation was, but knew they would lose their homes if the market fell substantially.
And they thought, without the help of a calculator, their wives would be very, very angry.
Lowenstein cites how Nobel Prize winners Fisher Black, Myron Scholes and Robert Merton, who created the famous option pricing model known as Black-Scholes, disagreed with the fat tails or the steepness of the volatility bias that floor traders have priced out-of-the-money put options. For the creators of the Black-Scholes option pricing model, volatility was a constant log-normal distribution.
“Merton took the assumption one step further,” says Lowenstein. “He assumed that the volatility was so constant that prices would trade in continuous time, without jumps.”
Options traders today need a firm understanding of the nuances of volatility bias, kurtosis, dollar-weighted deltas, and Vega. Yes, we have high-speed computers that process tens of thousands of theoretical values in hundredths of milliseconds and seven billion stock and option quotes per day sent from exchanges.
But can the emotional and often volatile pit trader offer anything to the structured and well-educated financial planner? The answer is yes. The truth is, you don’t need anything more than a simple calculator, the right kind of experience, and often a little bit of innovative thinking to achieve a great rate of return. After all, it is said that some of the best inspiration comes from outside the box.
And who is more out of the box than an options trader?
I was struck by a comment made by CFA Adrian Cronje, who was quoted in the Financial Planning MagazineJanuary 2009 issue, saying, “The good news is that, for the first time in many years, investors are now being paid to take risks.”2
Investors are paid to take risks. Imagine that.
Nowhere is that statement truer than in today’s environment of options trading and covered call writing. To be more precise, investors are paid generously to take less risk. Recent market volatility has created a once-in-a-generation perfect storm, a historic blizzard favoring the individual investor and presenting:
1. Unprecedented levels of option volatility due to the credit crisis
2. The inability of investment banks to participate in trading due to their deleveraging
3. Clearing Firms Uniformly Reduce Risk Across Market Participants
4. Continuous fear of the downside
5. Massive hedge fund deleveraging and 130/30 strategies
6. Generational low interest rates
7. Pensions and endowments are rumored to be selling assets to meet cash obligations rather than rebalancing strategic allocations
Financial planners and investors may want to brush up on basic options theory, especially covered call writing tactics, and read the academic white papers on the higher risk adjusted returns that covered call writing provides, since The nations 76 million baby boomers will seek help from planners and advisors. in rebuilding their portfolios while also turning their “buy-and-hold” portfolios of growth stocks into a vehicle that generates substantial retirement income.
Retirees are tired of listening to the endless buzz of experts discussing the benefits of a higher asset allocation, lower monthly expenses, or touting the benefits of being a Wal-Mart greeter.
Final Notes:
Lowenstein, Roger, When Genius Failed: The Rise and Fall of Long-Term Money Management (New York: Random House, 2001), 67-68, 76-77.
Cronje, Adrian, Financial Planning Magazine, “Is Markowitz wrong?” ;(January 2009)
