Despite the well-known concerns many have about the complexity of leveraged ETFs and options on them, speculators haven’t hesitated to express their views by trading significant volume in options on TBT, the ProShares UltraShort 20+ Year Treasury ETF. The table below shows call prices and open interest for TBT options expiring in September.

The open interest at the 33 strike represents, at current prices, about $1.9M – of course, many of these contracts were probably bought at much higher levels. This call activity strikes me as remarkable, considering that TBT’s momentum has barely slowed, with no sign of a reversal; I don’t much care for technical analysis, but given that some of the traders buying TBT calls presumably do, I wonder what it is they think they’re seeing? Is this just an expensive round of bottom-fishing?

We’re taking a more measured approach. Our iron condor options newsletter service has never really been just about that one type of options spread: we also discuss topics like delta hedging, the theory behind option selling strategies, and experiments with new strategies. We added a new experimental component last week, trading options on interest rates (via the TLT ETF).

We have a trade open right now for October expiration that will be dynamically delta-hedged as necessary. Instead of staking out a plain directional thesis, we’re more interested in trading the difference between the elevated implied volatility in these options and the quieter historical volatility. TLT October at-the-money puts have an implied volatility above 21%, while the ETF has exhibited volatility recently of about 19% annualized. Since 2003, the average 21-day historical volatility of the ETF has been just 11%. We are pretty comfortable, therefore, with a bet on things quieting down a bit from here, but even if implied volatility continues to lift, we’ll be profitable at expiration as long as the volatility exhibited by the underlying is less than 21% or so. This sort of approach won’t achieve dramatic returns, but it also frees us from depending on some miraculous reversal, news event, or economic surprise.

Investors withdrew a staggering $33.12 billion from domestic stock market mutual funds in the first seven months of this year, according to the Investment Company Institute, the mutual fund industry trade group. Now many are choosing investments they deem safer, like bonds.

If that pace continues, more money will be pulled out of these mutual funds in 2010 than in any year since the 1980s, with the exception of 2008, when the global financial crisis peaked.

Yesterday Paul Krugman reinforced the retail investor’s view in his op-ed, “This Is Not a Recovery”:

…in any sense that matters. And policy makers should be doing everything they can to change that fact.

The small sliver of truth in claims of continuing recovery is the fact that G.D.P. is still rising: we’re not in a classic recession, in which everything goes down. But so what?

The important question is whether growth is fast enough to bring down sky-high unemployment. We need about 2.5 percent growth just to keep unemployment from rising, and much faster growth to bring it significantly down. Yet growth is currently running somewhere between 1 and 2 percent, with a good chance that it will slow even further in the months ahead.

…All of this is obvious. Yet policy makers are in denial.

Krugman’s suggestions, among which were that the Fed can “buy more long-term and private debt; it can push down long-term interest rates by announcing its intention to keep short-term rates low; it can raise its medium-term target for inflation, making it less attractive for businesses to simply sit on their cash,” were answered this morning in Chairman Bernanke’s speech to central bankers. Bernanke advocated buying more Treasury securities and keeping interest rates low for longer than the market currently expects.

The Rich Get…Grumpier

This week Spectrem Group released its latest surveys of wealthy investors’ confidence, and millionaires, in particular, are not happy.

“Millionaires posted their biggest decline in investment confidence in more than a year in August, while affluent investors saw their confidence decline for a third-straight month. The millionaires’ decline is particularly troubling since it suggests millionaires, typically more sophisticated than the broader affluent population, are reverting to a bearish frame of mind,” said George H. Walper, Jr., President of Spectrem Group.

And why are the rich so pessimistic? When the company asked those “affluent” investors (defined as having investable assets topping $500,000) what most influenced their outlook, the leading answer was…no, not the economy, or even unemployment (though they were number three and number two, respectively)—but “the political environment”. Sure, a weak economy and lots of people on the dole are bad, but what we really have to worry about is that there’s a Democrat in the White House and the Republicans don’t have any constructive ideas. And these are the people getting the fat pay checks?

The Pragmatic Capitalist puts the blame for resurgent instability on overly optimistic Wall Street Analysts, for having coaxed investors into buying during a long-term bear market and thus making the bulls vulnerable to another leg down:

The key component holding this market together is the continuing strength of earnings when compared to expectations. The continued optimism in the analyst community leaves the market extremely susceptible to losses at this point in the cycle. Earnings are the linchpin holding it all together which leads me to believe that the market’s greatest threat at current levels could very well be Wall Street itself as analysts continue to forecast robust earnings and macroeconomic growth in an environment that is looking increasingly fragile.

Chris Clair of Reuters HedgeWorld, on the other hand, blames overly optimisitic economists. In Wednesday’s “Alternative Reality” column, Clair asks, “Do people feel even worse about the economy when the numbers badly miss analysts’ forecasts than they would if the numbers were merely reported with no comparison to an estimate? If you ask me what the weather is going to be tomorrow and I say, in my very best George Plimpton, ‘Sunny. Seventy-two.’ and it turns out to be raining and 56, do you feel worse for having your expectations dashed than if you’d simply woken up and seen that it was cloudy and raining?”

His conclusion?

To me, making financial decisions using predictions on jobless numbers or GDP is little removed from using the point spread in the sports section to the same end. It can be fun and interesting, but let’s not put too much emphasis on it. The games are settled on the field, and the economic turbulence will play out independent of economists’ estimates.

Go to the Source

Of course, there’s plenty of blame to go around, and perhaps the most deserving recipient is the guy who actually lost a quarter of your money. Hedge-fund news site FINalternatives reports that some 50 clients have been engaged in a law suit against the Opulent Lite hedge fund managed by the son of a Silicon Valley entrepreneur. The manager, Neil Godbole, apparently pleads incompetence, according to my interpretation of his comments quoted in the story. The investors claim that there was a “systematic and organized family scheme” to cover up losses. I tend toward the more positive view of human nature, but something about this stinks of the baser side.

Now, there are two ways to look at all this. 1) The obvious perspective: It’s the beginning of another major leg down; 2) The contrarian view: Such negative sentiment is indicative of a bottom (intermediate-term, at least).

The technical picture is mixed, with momentum turning up and sentiment indicators still weak. But our income strategies don’t depend on predicting market direction—we buy volatility when it’s low and sell when it’s high, all the time targeting a delta-neutral risk profile. We sometimes gain an edge from a directional bias, but that isn’t a fundamental component of our strategies. In up, down or sideways markets, our strategies are developed to outperform.*

From 1990 to 2006, the GDP share of the financial sector in the broad sense increased in the United States from 23% to 31%.
-Már Gudmundsson, Bank for International Settlements, 2008

This point has been made many times before – and better – by others, but while reading a Times article on a recent breakthrough in the analysis of junk DNA, it struck me again how poorly organized our society is. Instead of creating incentives for people to pursue work in genetics and environmental science and all the other fields that might solve urgent, significant problems, we take a huge percentage of the smartest and best college graduates and stick them in the financial sector, where they can – in the absolutely best case – make the portfolios of wealthy individuals and institutions slightly more efficient or more profitable. I’m tempted to agree with Paul Volcker that the only meaningful financial innovation in recent history has been the automated teller machine. I say that as someone who spends a lot of time and effort fiddling with options and futures, and I can do so without fear of contradiction because I’m not foolish enough to equate “meaningful” with “profitable.”

Leaving aside the worst-case outcomes of pushing so much talent into finance – and we’re arguably living through those outcomes now – even an optimal scenario looks like an outrageous failure of that supreme object of American faith, the free market. Even if we imagine a world in which the American credit super-cycle was able to continue indefinitely, and further posit that the collective output of Wall Street wasn’t just to dump everyone into one big ETF – and hey, tack on any other wild counterfactuals you want – I still don’t understand why the size of the U.S. financial sector isn’t prima facie evidence against the rationality and efficiency of a market economy. We’ve got a good society here, with plenty of smart and hard-working people, and we had to go and waste it on something as derivative as finance. (There’s an old, unfair joke that “those who can’t do, teach;” I wonder if, in a similar vein, we can say that those who can’t succeed in maths, physics, economics, or prostitution do finance.)

The disconnect is clear enough, I think: we humans care about things like quality of life, about having breathable air and potable water, and even about things like the arts and humanities. But markets struggle to recognize the value of any of those things: if you strip away all the quasi-religious reverence that the Western world has for markets and remember that they are, after all, just one method for processing information, then it seems much clearer that the needs of human societies are inadequately served by market systems. With enough hand-waving about regulatory capture and political corruption and so on, it might be possible to mitigate the particular example of the over-allocation of “human capital” (a nasty, embarrassing phrase) to the finance sector. But, ultimately, the inability of markets to deal with the major problems we face must be taken seriously: call this or that individual issue a “negative externality” if you want, brush it under the rug, and keep reading your Mises or Friedman or Hayek. But as the problems pile up, pretty soon it starts looking like all externalities.

But I think it bears repeating that none of the retail products on offer is all that attractive as a buy-and-hold candidate for hedging tail risk, and it sounds like some of the managed institutional products aren’t all that nuanced, either:

About 20% of the 30 large institutional clients served by Russell Implementation Services are explicitly managing tail risk through dynamic asset allocation approaches, while the rest “wrestle” with the considerable cost of tail-risk hedging, said Michael Thomas, chief investment officer of Russell Implementation Services…

Mr. Thomas’ group recently priced an options overlay that would provide protection for the next 12 months for a decline greater than 10% of the Standard & Poor’s 500 index at a cost of 6.7% of the assets to be protected. [link, h/t World Beta]

Whether you’re hedging risk with VIX-based products or with conventional options strategies, any heavy-handed “always on” approach to hedging is going to be too expensive to be worth the trouble. One tail-risk fund mentioned in the article above “could lose a minimum of between 1% and 1.5% per month or between 12% and 18% per year just from the cost of the options strategy.” That’s a pretty steep hurdle to clear. If you like those kinds of costs but manage less capital, you can achieve similar portfolio-crushing protection by buying a full allocation of VXX and sitting on it.

Where cumbersome and expensive strategies fail, light-footed and cheaper alternatives might prevail. I’ve already alluded to a teaser alternative using VIX futures with a little more allocation nuance, and I think that’s really the key. As Adam mentions, overpaying for hedges when premiums are historically elevated is a bad idea; better to take a small portion here (so that your core portfolio isn’t completely exposed) and then scale into your hedge position as either a) the cost of protection becomes historically cheap, or b) actual market volatility gives a warrant to increased long volatility exposure. At the moment, the market is offering neither cheap protection nor sufficient historical volatility.

Another notion about which I’m skeptical is the idea that investors need protection in numerous asset classes, i.e. equities, credit, commodities, currencies, etc., especially under the auspices of one managed product. I’m not even talking about scenario-based protection, which is another matter entirely (who could possibly know the timing and extent of these Michael Bay scripts yet-to-be-written, sufficient to overcome the expenses and opportunity costs to have hedges waiting around for them to come true?).  I just mean that, in most crises, correlations spike and there are few places to hide, so why pay for what is essentially the same bet many times over in different asset classes? It makes sense to me that a bond fund might seek credit protection and ignore equities; what I don’t understand are these all-in-one packaged products.

Performance Data

The table below (click to enlarge) includes Calendar Options performance data for the fourth quarter, for the past year (trailing twelve months) and since inception. We’re now including the CBOE Volatility Arbitrage Strategy Benchmark (VTY), because we believe it represents a more comparable strategy than either simply being long the S&P500, or other benchmarks we’ve used in the past. The table is followed by a graph of our returns since inception, compared to these two benchmarks.

Note that all returns are measured from expiration to expiration and do not include the cost of commissions.

As we head into the third quarter, the July cycle continued the trend of better performance under similar conditions with the improvements [available to Calendar Options subscribers only] we made in April. July was our most challenging month since February, when our Model Portfolio loss was more than 9%—and yet we still significantly outperformed the S&P 500, with a Model Portfolio return of –3.74%, compared to a –4.71% return for the S&P.

The one circumstance we may be able to improve on with further refinements to the strategy is the whipsaw bottom. No strategy can avoid occasional losses, but I’ll be looking at ways to increase our odds of doing better when we’re in a bottoming climax, without compromising the risk-management rules we’ve put in place to protect ourselves from outlier events (i.e., crashes).