Buying puts that are unlikely to pay off but hit big when they do
Posted by John Reed on
A stock broker recently told me his firm could protect me from losses in the stock market. When I immediately asked how, he essentially fled the discussion.
.
I said it sounds like selling short (buying put options).
.
I have also said that I take an insurance rather than an investing or gambling approach to finance. My approach to impending high or hyperinflation is to essentially “buy insurance” against it.
.
The investing approach would be to buy gold or TIPS bonds or maybe stocks in companies that do a lot of exporting.
.
The gambling approach would be to hock everything to borrow up to your eyeballs and buy hard assets with the loan proceeds. That’s like putting your home, car, savings, everything on odd in a roulette game—only there you precisely know the odds and the expected value of such a bet would be negative.
.
The problem with each is they are high cost and subject you to the being too early is the same as being wrong problem.
.
With insurance, like on your home, you pay a relatively small premium. It pays off big is there is a fire or lawsuit, but not at all if there is not.
.
That is a sort of “black swan” approach to finance. That was invented by Nassim Nicholas Taleb. I read his book and reviewed it back in the day.
.
He is now quite rich.
.
Similar mechanism. He buys put options, but only those that pay off if there is a big crash in some asset. That is analogous to a high deductible in insurance.
.
In theory, high deductibles greatly reduce the insurance premium. That removes the “being early is the same s being wrong” problem. It also means you profit from big crashes, but get nothing from small ones. The key suggestion is that the counterparties in these puts are greatly undervaluing the likelihood of the crashes and thereby making bad bets.
.
They get to keep the small beer of puts that are never in the money, but risk losing their ass on the occasional ones that are really in the money. To put it in MBA terms, the expected value of the black swan bets is POSITIVE. Small likelihood multiplied by huge crash is a big positive number.
.
I am not an options buy, but it sounds like they are doing something like the following. A stock is currently selling for $20. I buy a put from you with a strike price of, say, $3. You figure I am an idiot, that the price will never fall that much, so you sell it to me for 3¢ a share or some such. If the price falls to say $1, I make out like a bandit because I can sell it to you for $3 when I only paid 3¢.
.
It has been said that all sales of investment assets stem from a disagreement about the value of the asset. The seller thinks it is less that the buyer thinks.
.
The dark swan strategy stems from a disagreement about the probability of a bad event. The dollar magnitude—price—is written right into the put contract. So there is no disagreement about price. The disagreement is about likelihood. Because Taleb’s price is so low, he has no great cost or damage from being early, but his reward is so great, that even a low probability event pays off big.
.
Mad magazine used to have a Spy vs. Spy regular feature. This is actuary vs. actuary.
.
Today’s WSJ has a long article about Taleb and his one-time Empirica partner Mark Spitznagel cashing on on various big crashes, namely, Black Monday 1987, 1997 Asian financial crisis, the 1999 dot-com boom, the SubPrime Crisis.
.
I have recently described a home with a mortgage as the world’s greatest short. One advantage it has over buying puts is there is no counterparty risk.
.
If you buy a put that forces someone to pay you far more than the current price of a stock, what if he reneges? That was a big deal in the famous The Big Short. As the subPrime mortgages crashed, counterparties were getting squirrelly, refusing to provide current prices and so on.
.
With the home mortgage as a short against the purchasing power of the US dollar, You have no counterparty who has to do anything. If the purchasing power of the dollar falls (inflation) or collapses to nothing (hyperinflation), you simply get to continue to own the appreciating with inflation house and the mortgage lender gets to receive nothing but no longer worth anything USD payments from you. If they try to sell their mortgage on which you are the borrower, they get little or nothing for it.
.
I know that stock brokers have various ways to make sure that put sellers pay off when they lose big. And those seem to have worked out for Taleb and Spitznagel. And generally the Big Short guys got paid off. But the home mortgage short does not require the counterparty to pay out any money. They have zero opportunity to renege. So there is no counterparty risk.
.
I strongly recommend reading the Scott Paterson article in today’s WSJ and reading more about the black swan/gray swan insurance approach. (I do not care for the swan names. It is just bad events that the vast majority of people erroneously think are wildly unlikely.)
.
I said it sounds like selling short (buying put options).
.
I have also said that I take an insurance rather than an investing or gambling approach to finance. My approach to impending high or hyperinflation is to essentially “buy insurance” against it.
.
The investing approach would be to buy gold or TIPS bonds or maybe stocks in companies that do a lot of exporting.
.
The gambling approach would be to hock everything to borrow up to your eyeballs and buy hard assets with the loan proceeds. That’s like putting your home, car, savings, everything on odd in a roulette game—only there you precisely know the odds and the expected value of such a bet would be negative.
.
The problem with each is they are high cost and subject you to the being too early is the same as being wrong problem.
.
With insurance, like on your home, you pay a relatively small premium. It pays off big is there is a fire or lawsuit, but not at all if there is not.
.
That is a sort of “black swan” approach to finance. That was invented by Nassim Nicholas Taleb. I read his book and reviewed it back in the day.
.
He is now quite rich.
.
Similar mechanism. He buys put options, but only those that pay off if there is a big crash in some asset. That is analogous to a high deductible in insurance.
.
In theory, high deductibles greatly reduce the insurance premium. That removes the “being early is the same s being wrong” problem. It also means you profit from big crashes, but get nothing from small ones. The key suggestion is that the counterparties in these puts are greatly undervaluing the likelihood of the crashes and thereby making bad bets.
.
They get to keep the small beer of puts that are never in the money, but risk losing their ass on the occasional ones that are really in the money. To put it in MBA terms, the expected value of the black swan bets is POSITIVE. Small likelihood multiplied by huge crash is a big positive number.
.
I am not an options buy, but it sounds like they are doing something like the following. A stock is currently selling for $20. I buy a put from you with a strike price of, say, $3. You figure I am an idiot, that the price will never fall that much, so you sell it to me for 3¢ a share or some such. If the price falls to say $1, I make out like a bandit because I can sell it to you for $3 when I only paid 3¢.
.
It has been said that all sales of investment assets stem from a disagreement about the value of the asset. The seller thinks it is less that the buyer thinks.
.
The dark swan strategy stems from a disagreement about the probability of a bad event. The dollar magnitude—price—is written right into the put contract. So there is no disagreement about price. The disagreement is about likelihood. Because Taleb’s price is so low, he has no great cost or damage from being early, but his reward is so great, that even a low probability event pays off big.
.
Mad magazine used to have a Spy vs. Spy regular feature. This is actuary vs. actuary.
.
Today’s WSJ has a long article about Taleb and his one-time Empirica partner Mark Spitznagel cashing on on various big crashes, namely, Black Monday 1987, 1997 Asian financial crisis, the 1999 dot-com boom, the SubPrime Crisis.
.
I have recently described a home with a mortgage as the world’s greatest short. One advantage it has over buying puts is there is no counterparty risk.
.
If you buy a put that forces someone to pay you far more than the current price of a stock, what if he reneges? That was a big deal in the famous The Big Short. As the subPrime mortgages crashed, counterparties were getting squirrelly, refusing to provide current prices and so on.
.
With the home mortgage as a short against the purchasing power of the US dollar, You have no counterparty who has to do anything. If the purchasing power of the dollar falls (inflation) or collapses to nothing (hyperinflation), you simply get to continue to own the appreciating with inflation house and the mortgage lender gets to receive nothing but no longer worth anything USD payments from you. If they try to sell their mortgage on which you are the borrower, they get little or nothing for it.
.
I know that stock brokers have various ways to make sure that put sellers pay off when they lose big. And those seem to have worked out for Taleb and Spitznagel. And generally the Big Short guys got paid off. But the home mortgage short does not require the counterparty to pay out any money. They have zero opportunity to renege. So there is no counterparty risk.
.
I strongly recommend reading the Scott Paterson article in today’s WSJ and reading more about the black swan/gray swan insurance approach. (I do not care for the swan names. It is just bad events that the vast majority of people erroneously think are wildly unlikely.)
Share this post
0 comment