Getting Paid to Take Risk

As a professional options trader, there are two things I will remember most as I look back at this bear market of 2008, and that is; a.) How covered call writing investors are receiving substantial option premiums to take risk and; b.) How the certainty of a “buy and hold” approach of a well diversified, structured portfolio was not spared from the devastating effects of this bear market liquidation.

REIT’s, commodities, large cap, international, emerging markets, convertible bonds, defensive stocks, took severe beatings in 2008. Every company that was considered “too big to fail”, or so conservative that it shouldn’t have failed, did just that. Whoever said “No two bear markets are alike” certainly got that right. Even Warren Buffet’s Berkshire Hathaway stock (Symbol: BRK) experienced a -54% peak-to-trough trading range in since December 2007. There has never more uncertainty among Investors approaching retirement, CFA’s and mathematically minded financial services participants, as the market’s nervous reaction to every “take it to the bank” arbitrage in 2008 became temporarily disconnected.

Author Roger Lowenstein has spent considerable time analyzing those who come to trading by way of the traditional route. In his book, When Genius Failed: The Rise and Fall of Long Term Capital Management1, Lowenstein wrote that “those who are attracted to mathematics and analysis are drawn to fixed income and convertible bond arbitrage because much of what determines their value is readily quantifiable.”

I suspect financial planners and sophisticated investors in general, are a similar breed. The financial planners I know are well educated, mathematically minded, and contemplative. They’re attracted to the certainty of planning, and their vocabularies are peppered with terms like annuity, CAGR, estate planning, efficient frontier, MPT, asset allocation, risk-adjusted return, and diversified portfolio.

On the other hand, those attracted to floor trading, like me are typically 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 a trade than it is to be right. And like any self-respecting trader, we thirst for a little excitement. In fact, we can be described as the liar’s-poker-double-espresso-filled-undiagnosed-ADD-patients-who-trade-triple-beta-ETFs-because-anything-less-than-a-Volatility-Index-level-of-70-is-too-boring orphans of the industry.

 

Terms that an options floor trader may use on any given day are a bit different than those of a typical financial planner and include skew, kurtosis, theoretical edge, risk reversal, I-Wham (Russell 2000 ETF; Symbol: IWM), implied volatility, assignment, dollar-weighted deltas, and slop.

When I started on the trading floor of the CBOE in 1982, I was 22, and the majority of the traders in those days were from blue collar, Irish families who treated day-trading with the same mentality as a plumber who lays pipe or a carpenter who frames a wall: it was a job.

I spent the majority of my years at the CBOE in the OEX pit, where the practice of hiring MBAs was discouraged – even derided. Why? It was believed that you couldn’t teach a business major anything. And that might have been true: they weren’t pliable enough to mentor. Floor traders needed to have an intuitive sense of risk management and quick reflexes to maneuver around short term market moves. With an eye toward disaster, they frequently owned out-of-the-money puts. Countless arguments erupted between the quants, who understood the mathematical impossibility of a 23 standard deviation move during the Crash of 1987 and the floor traders who had no idea what a standard deviation was, but who did know that they would lose their homes if the market dropped substantially.

And they figured – without the aid of a calculator – that their wives would be really, really mad.

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 steepness of volatility skew that floor traders priced into out-of-the-money put options. To the creators of the Black-Scholes option pricing model, volatility was a constant, log-normal distribution.

“Merton carried the assumption a step further,” Lowenstein says. “He assumed volatility was so constant that prices would trade in continuous time, without any jumps.”

Today’s options traders need a firm grasp on the nuances of volatility skew, 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, well educated financial planner? The answer is yes. The truth is that you don’t need anything other than a simple calculator, the right kind of experience, and often, a little out-of-the-box thinking to achieve a terrific rate of return. After all, it is said that some of the best inspirations come from outside the box.

And who is more outside the box than an options trader?

I was struck by a comment made by CFA Adrian Cronje, who was quoted in the Journal of Financial Planning, January, 2009 issue, as saying, “The good news is that for the first time in many years, investors are now being paid to take risks.”2

Investors are being paid to take risks. Imagine that.

Nowhere is that statement truer than in the current environment of options trading and covered call writing. To be more accurate, investors are getting paid handsomely to take less risk. Recent market volatility has created a once-in-a-generation perfect storm, a history making blizzard favoring the individual investor and featuring:

1. Unprecedentedly high option volatility levels due to the credit crisis

2. The inability of investment banks to participate in trading due to their de-leveraging

3. Clearing firms uniformly reducing risk across all market participants

4. Continued fear of the downside

5. Massive de-leveraging of hedge funds and 130/30 strategies

6. Generational low interest rates

7. Pensions and endowments 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 option theory especially covered call writing tactics and read the academic white papers on the higher risk adjusted returns covered call writing provides as the nations 76 million baby boomers will be looking to planners and advisors for help in rebuilding their portfolios and simultaneously converting their “buy and hold” portfolios of growth stocks to a vehicle that delivers substantial retirement income.

Retirees are tired of hearing the endless droning from pundits discussing the benefits of greater asset allocation, cutting monthly expenses or promoting the benefits of being a Wal-Mart greeter.

Endnotes:

Lowenstein, Roger, When Genius Failed: The Rise and Fall of Long Term Capital Management (New York: Random House, 2001), 67-68, 76-77.

Cronje, Adrian, Journal of Financial Planning, “Is Markowitz Wrong?” ;(Jan 2009)