Litecoin Investor Now Diversifying into Greek Bonds

Savvy tech investor and amateur boxing aspirant, Peter Smith, is diversifying his Litecoin assets into Greek bonds.  Known as a contrarians’ contrarian, Peter claimed that “despite his losses on Litecoin, he’s hoping to make it all back on Greek bonds.”

Lending to the Greek people, Peter claimed they “would totally be good for the money” and that their allocation of capital would be “at least as profitable as my litecoin equity investments.”

‘Yanis is the Best Man to Manage my Litecoins’

He has since described Yanis Varoufakis, the Greek Finance Minister, as a ‘pretty amazing on Twitter’ and hence ‘credit worthy for my precious litecoins’.

Litecoin stimulus will be directed towards productive enterprises in Greece

Commenting on his investment thesis, Peter explained, “I like to think I see the future more futuristically than the future sees itself”

Hedging Against Getting Paid in Stock

A lot of employees these days are paid in the form of stock options or shares directly.  A friend of mine recently took a job where he will be paid a substantial sum in shares one year from now.  The dollar value of those shares today is quite a lot of money.  But he’s worried about a serious downturn, in which his shares will be worth significantly less.  I suspect that privately, he would rather have simply been paid the equivalent value in cash.  Of course he can’t air that publicly, accepting stock is a gesture of confidence of the company.

So how can my friend get paid in stock, but also reduce his exposure to its volatility?  He can use stock options.

Let’s say that he’s receiving Apple Stock (he’s not, it’s just an example).  For the sake of argument, let’s say he’ll receive 100 AAPL shares on exactly June 17th, 2016.  AAPL shares currently cost $126.75 each, so 100 shares are worth $12,675.  Let’s ignore taxes for the sake of simplicity (usually a dangerous assumption).  My friend, let’s call him Simon, can buy an AAPL put to protect him against downside risk.  He could buy an AAPL put at $125 a share expiring on June 17th, 2016.  This currently costs $11.65 per share, or $1165.  This gives him full downside protection for an entire year.  Still, it’s quite expensive, amounting to 9% of the value of the shares.  If Simon still believes that AAPL could rise, but is also fearful of a crash, buying a put only, at high cost, may be logical.  Note that it is not irrational to both be fearful of a crash and optimistic of a rise; that’s merely a bet against the status quo.  But in any case, buying the downside protection for 9% of the underlying shares is expensive.

But what if Simon wants utter certainty?  What if he wants the equivalent of guaranteed cash?  Simon could both buy a put and sell a call.  This means he has downside protection and has yielded his claims to any future upside.  A call at $125 expiring on 6-17-2016 sells for $12.75 per share, or $1275 for 100 shares.

If one buys a put and sells a call while holding the underlying shares, one has entered into a collar options position.  This is a roundabout way of defusing one’s exposure to shares while still owning the shares.

From theoptionsguide.com

Buying a put and selling the call will give you a net position of $12.75 – $11.65 =  $1.1 per share.  Since we chose a strike price of our options at $125, but the current price is $126.75, we are implicitly forfeiting $1.75 per share.  This was reflected in the higher price we fetched for the call option.  So let’s account for this:

$1.1 – $1.75 = -$0.65 per share.  

This is the actual price for hedging against volatility in AAPL shares for the next year.  It’s about 0.5% of the cost of the underlying; it’s actually exceptionally cheap.  You won’t collect dividends because the underlying shares are being held by someone else in the interim.

If you quit your job early and don’t get awarded the shares, you become exposed to an upward movement in the share price.  In effect, you will have sold a call that you can no longer cover.  Most brokerages won’t let you do this unless you actually have the shares under their management; they don’t want clients getting unduly exposed.  So a safer way to actually do this is, instead of selling a single call, sell a bear call spread.

In the case of AAPL, instead of only selling a call at $125, we could additionally have bought another call at $150 for a relatively cheap $4.25.  This would protect us, if we got fired and did not actually receive the underlying shares, a massive AAPL price movement to $200 a share would not hurt us.  We would only have to pay for any difference between $125 and $150.  Paying $4.25 per share hurts our costs though, making us pay -$0.65 – $4.25 = -$4.9 per share.  This is now about 3% of the underlying.  We also need to hold ($150-$125 ) * 100 = $2500 idle in our brokerage account to cover the call spread we sold.

Although it sounds tedious, it’s still an extremely safe way to hedge against stock grants.  Best yet, Apple will have no way of knowing that Simon, the loyal employee, is secretly hedging against a decline in its price.  Thus he can publicly embrace his faith in the company, while privately protecting himself.  In the mean time, he’ll have translated volatile stock grants into guaranteed cash.

Using Options to Infer Implied Probabilities

Options say a lot about what the market thinks about the future.  You can directly discern the market’s opinion about the probability of future price changes through the prices of options. The difference between options prices directly correlates to the implied probability of events as express by the market. So for instance, consider if you sold an Apple call at $132 (expiring next week let’s say) and bought one at $133.  This means you’re liable for the $1 dollar difference per share.  If Apple trades above $133 per share in a week, you must pay the $1 difference.  If it trades below $132 next week, you pay nothing and keep the premium.  Between $132 and $133 you pay a linearly increasing amount.  This is called a selling a bearish call spread.

from wikinvest.com

An options spread is an extremely structured way to take a market position in that it is explicit what one’s implied odds are.  It’s not open ended; there is a definite payoff or a definite loss within known bounds.  You know exactly the risks you are taking.

So, for example, if I sell an Apple call option at $132 for $2 and buy a call at $133 for $1.8, I get a net premium of $0.20 per share.  But my net liability is $1 per share.  If Apple shares trade at above $133, I am liable for the dollar difference.  I am hedged against further increases because I bought the $133 call.  But because I also received a $0.20 premium, my greatest potential loss is $0.8 per share. The bet has 4:1 odds. Thus the $0.20 price difference means that the market believes that the chance that Apple stock will exceed $132 is only 20%.

You can look at the difference between sets of options to calculate the implied probability all along the curve.  What is the probability that Apple will trade between exactly $129 and $129.5 by next week?  You can infer the market’s opinion on that directly from options spreads.  I am building a tool to do this at www.impliedprofit.com.  It’s in a really primitive state now but… expect more soon.  See this example for the S&P500 ETF expiring on 12-31-2015.

Note that these probabilities have nothing to do with what will actually happen.  They are simply the implied odds from real market prices of various events.  If you have a strong opinion that contradicts these implied probabilities, you should take a position, in either direction.

Another fascinating aspect is that, in theory, the implied probabilities from puts and calls should be equivalent, because of put-call parity.  You can always construct a position mirrored in both calls or puts.  So any discrepancy should be arbitraged away at zero risk.  In practice, highly liquid options like SPY show close symmetry, whereas illiquid ones often diverge.

Finally, one of my favorite things about options spreads is that you can make money from a negative opinion.  You can simply state that something will not happen.  If you’re right, you can make a lot of money.  You know exactly what the risks are.  So you could say, for instance, that AAPL will not exceed 135 in the next 2 months, and make a return from that opinion.  Or you could even express opinions about pairs trading, such as ‘if SPY rises, AAPL will not also go down’.  Being able to profit from negative statements is a novel trading feature that’s hard to tap into by simply being long or short the underlying.

 

Shorting Volatility on the FOMC Announcement

I figured that the Fed will pretty much always be dovish on these meetings.  Unless they are absolutely forced to raise rates, and perhaps not even then, don’t expect any concrete moves towards higher interest rates anytime soon.  At best they may talk the talk of the potential for raising rates, or following ‘data-driven policy’.  Without the hard backing of actual rate changes, these words are meaningless.  The data itself can be sliced and diced and interpreted so as to give infinite latitude to these bureaucrats.

The market expected dovishness too, based on the volatility chart (VIX).  It increased to only a moderate 14-15.  This is still quite a low level of volatility.  So very few believed that there would be anything unexpected.  Still, it was enough.

Immediately before the meeting, I bought an at-the-money call option on SVXY expiring this week.  This is an insanely risky thing to do under normal circumstances.  It is literally buying an option on options.  An option on volatility-linked ETFs is the financial equivalent of a dirty bomb.

My call was short term bearish on volatility (since SVXY is anti-volatility).  This goes against my general thesis of being long volatility.  I’m a big believer in black swans and the unknowns we don’t know we don’t know.  So ordinarily I’d hate shorting volatility as a short term move.  But given the predictability of FOMC responses, I felt that the risks were justified.  It was essentially financial speculation on politics.

I bought and a few minutes later, the minutes came out.  Rates would not be raised.  The VIX fell immediately.  I vacillated as to whether to sell the call, which had gained value, or whether to hold out for more.  Aware of the extreme time decay of the option I was holding, I opted to sell with a generous 25% profit.

Even though it worked this time, this type of trade should only be entered with a sober understanding of the extreme risks.  I usually assess an investment decision by asking the question “Would I feel stupid if this trade lost money?”  If the answer is ‘No’, it means that I have an investment thesis so sound it can overcome my own emotions.  If the answer is ‘Yes’, the trade is a dangerous one, because if it turns negative, I may start to make mistakes.  Thankfully I didn’t end up having to face that test on this particular trade.  But probably if it had lost money, I’d have felt exceptionally stupid.

As I listened to the remainder of Yellen’s press conference, it struck me as odd that the monotonic utterings of this woman could send markets into such a tizzy.  As her words drearily plodded on, I could see markets gyrating in hair-pin turns.  No doubt fancy algorithms were parsing her words into trades faster than any human could.  Every turn of phrase was reflected instantaneously in the price.  When the video cut out momentarily, I hardly missed it; the price reflected with fatal accuracy the gist of her words.