7 ms·

What does the tail risk look like on this strategy and what kind of annual return do you expect?

by hntrader 6y ago

omarhaneef 6y ago
You’re taking the tail risk on the down side but you’ve sold it on the upside for extra yield.
- artemonster 6y ago
  I undestand words but I have absolutely no clue what you're talking about. Can you recommend some books on the topic?
  - rusticpenn 6y ago
    Yes, me too. I just read about someone calle 1ronyman on Reddit, and I am interested too.
  - im3w1l 6y ago
    The "tail" in tail risk referes to the tails of a probability distribution. A normal distribution has "thin" tails. The probability of huge outliers is pretty low. If you have tail risk, then it means you have a decent chance of losing a lot more money than the typical variation. Your returns might look like +1.1, +0.9, +1.2 +1.05, -3. So your profit is pretty predictable with little variation, until suddenly you lose a lot of money.
  - omarhaneef 6y ago
    I would look up two terms: Covered calls Naked puts If you want to go heavy duty into it I recommend the Hull book (options, futures and other derivatives) but for your purposes the investopedia articles are enough. Basically naked puts means you’re selling downside insurance so if the stock crashes you eat the loss. Covered calls mean you sell upside risk but have the stock so if it goes up you make a little.
    - beezle 6y ago
      Hull is a great book and is not too heavy on the math. However, for someone just getting their feet wet, Options as a Strategic Investment by MacMillan is a classic.
  - wbl 6y ago
    The only book you should read is John Bogel's. Do what he says like Goldman partners, Bank of America senior executives, almost every economist does with their money and stick it in low cost diversified mutual funds. Or you can learn stochastic calculus and end up in the same place once you realize half of all active traders do worse than the market, before fees.
    - joshribakoff 6y ago
      Buffet sells 5b in options premium a year
      - atomicnumber3 6y ago
        I think a big distinction that retail traders need to come to terms with is that, while yes, technically you can make reasonably good sums of money with various trading strategies of various risk profiles, as one person, so many of them are just not worth the trouble. If your passion is this sort of thing, by all means, go ahead. But it's like running a homelab. Yes, you can get pretty decent "savings" (vs running in AWS/DO) but I can guarantee you, you will end up in the basement replugging ethernet cables trying to figure out which one is the bad one while your family and relatives are waiting upstairs, fairly bemused, for you to fix "the internet". It's possible, but as a person with a life, unless it's your passion, I'd recommend just not. Do the financial equivalent of paying DigitalOcean 5 dollars a month: buy sp500 etfs and sit on them.
        hntrader 6y ago
        I wonder if we can invest in a fund manager who does this strategy. And if it's so good then why do pension funds and endowments not allocate to it typically.
    - smabie 6y ago
      None of the kinds of people you listed are good at trading (esp economists). From experience, professional traders do tend to use passive indices for part of their PA, but also actively trade a portion. But you're right in that if you don't have a passion for it, you'll never be able to truly outperform spy on a risk adjusted basis. However, if you do have the knowledge and the passion, I definitely think you can. Investing is personal, and just holding spy doesn't fulfill everyone's objectives. Here's an example of a strategy that outperforms spy in most cases: 1/3 of your portfolio goes to upro (3x leveraged spy) and 2/3s goes to a bond fund/etf. As long as the bond etf returns above the upro expense ratio (~1%), you will outperform. From my backtests, this strategy will earn you an extra 1-2% return a year, while also having a slightly higher risk adjusted returns. I list the above as a great example because it's the kind of strategy that is great for a PA: easy to manage, doesn't require babysitting, and backed by solid academic research. When people think active vs passive, they think actively trading single stocks vs just holding an index. My point is that you can use some quant-lite strategies that tilt your portfolio to eek out a little return. You don't have to be trading everyday or even holding anything except ETFs.
im3w1l 6y ago
Selling a deep in the money put behaves like owning the stock (probably with margin, but it depends on how many puts you are selling compared to your reserves of cash and short term "safe" bonds) except that you are capping your gains. The further towards out of the money you go the more it behaves like picking up pennies in front of a steamroller. But an interesting quirk of selling puts compared to calls is that the downside is limited. The stock can't go below 0.
- hntrader 6y ago
  That gives me a good intuitive picture. I'd really love a basic online simulator where I can plug in portfolio characteristics (eg percent of calls Vs puts, ATM Vs OTM) and simulate an equity curve over the last ten years. I could build my own of course but I think a tool like this would be generally useful for investors.
Schweigi 6y ago
I did make my own option trading algo which is similar to the one in the Git Hub repo (but I used Scala, which gave me additional returns, jk :) ). Return totally depends on the delta of the options you write and the option symbols in your basket. Mine could be configured to be between 10-100+%. The higher the return the more volatile. The idea of using multiple symbols like SPY and TLT is to reduce the tail risk. But in the end there is still tail risk like for example in the crash of 2015. Making the strategy delta neutral with hedging could improve it but I never completed that part. There is an interesting book with all the math by Euan Sinclair about option writing and how to minimize the risk if you are interested.
- hannofcart 6y ago
  Another way to reduce tail risk when selling options is to simply hedge with a protective call/put at a higher or lower strike respectively. Sufficiently far off strikes will have minimal impacts on returns while reducing tail risk.
  - scruple 6y ago
    These are known as a Poor Man's Covered Calls and Poor Man's Covered Puts.

What does the tail risk look like on this strategy and what kind of annual return do you expect?

omarhaneef 6y ago

You’re taking the tail risk on the down side but you’ve sold it on the upside for extra yield.

artemonster 6y ago
I undestand words but I have absolutely no clue what you're talking about. Can you recommend some books on the topic?
- rusticpenn 6y ago
  Yes, me too. I just read about someone calle 1ronyman on Reddit, and I am interested too.
- im3w1l 6y ago
  The "tail" in tail risk referes to the tails of a probability distribution. A normal distribution has "thin" tails. The probability of huge outliers is pretty low. If you have tail risk, then it means you have a decent chance of losing a lot more money than the typical variation. Your returns might look like +1.1, +0.9, +1.2 +1.05, -3. So your profit is pretty predictable with little variation, until suddenly you lose a lot of money.
- omarhaneef 6y ago
  I would look up two terms: Covered calls Naked puts If you want to go heavy duty into it I recommend the Hull book (options, futures and other derivatives) but for your purposes the investopedia articles are enough. Basically naked puts means you’re selling downside insurance so if the stock crashes you eat the loss. Covered calls mean you sell upside risk but have the stock so if it goes up you make a little.
  - beezle 6y ago
    Hull is a great book and is not too heavy on the math. However, for someone just getting their feet wet, Options as a Strategic Investment by MacMillan is a classic.
- wbl 6y ago
  The only book you should read is John Bogel's. Do what he says like Goldman partners, Bank of America senior executives, almost every economist does with their money and stick it in low cost diversified mutual funds. Or you can learn stochastic calculus and end up in the same place once you realize half of all active traders do worse than the market, before fees.
  - joshribakoff 6y ago
    Buffet sells 5b in options premium a year
    - atomicnumber3 6y ago
      I think a big distinction that retail traders need to come to terms with is that, while yes, technically you can make reasonably good sums of money with various trading strategies of various risk profiles, as one person, so many of them are just not worth the trouble. If your passion is this sort of thing, by all means, go ahead. But it's like running a homelab. Yes, you can get pretty decent "savings" (vs running in AWS/DO) but I can guarantee you, you will end up in the basement replugging ethernet cables trying to figure out which one is the bad one while your family and relatives are waiting upstairs, fairly bemused, for you to fix "the internet". It's possible, but as a person with a life, unless it's your passion, I'd recommend just not. Do the financial equivalent of paying DigitalOcean 5 dollars a month: buy sp500 etfs and sit on them.
      - hntrader 6y ago
        I wonder if we can invest in a fund manager who does this strategy. And if it's so good then why do pension funds and endowments not allocate to it typically.
  - smabie 6y ago
    None of the kinds of people you listed are good at trading (esp economists). From experience, professional traders do tend to use passive indices for part of their PA, but also actively trade a portion. But you're right in that if you don't have a passion for it, you'll never be able to truly outperform spy on a risk adjusted basis. However, if you do have the knowledge and the passion, I definitely think you can. Investing is personal, and just holding spy doesn't fulfill everyone's objectives. Here's an example of a strategy that outperforms spy in most cases: 1/3 of your portfolio goes to upro (3x leveraged spy) and 2/3s goes to a bond fund/etf. As long as the bond etf returns above the upro expense ratio (~1%), you will outperform. From my backtests, this strategy will earn you an extra 1-2% return a year, while also having a slightly higher risk adjusted returns. I list the above as a great example because it's the kind of strategy that is great for a PA: easy to manage, doesn't require babysitting, and backed by solid academic research. When people think active vs passive, they think actively trading single stocks vs just holding an index. My point is that you can use some quant-lite strategies that tilt your portfolio to eek out a little return. You don't have to be trading everyday or even holding anything except ETFs.

im3w1l 6y ago

Selling a deep in the money put behaves like owning the stock (probably with margin, but it depends on how many puts you are selling compared to your reserves of cash and short term "safe" bonds) except that you are capping your gains. The further towards out of the money you go the more it behaves like picking up pennies in front of a steamroller. But an interesting quirk of selling puts compared to calls is that the downside is limited. The stock can't go below 0.

hntrader 6y ago
That gives me a good intuitive picture. I'd really love a basic online simulator where I can plug in portfolio characteristics (eg percent of calls Vs puts, ATM Vs OTM) and simulate an equity curve over the last ten years. I could build my own of course but I think a tool like this would be generally useful for investors.

Schweigi 6y ago

I did make my own option trading algo which is similar to the one in the Git Hub repo (but I used Scala, which gave me additional returns, jk :) ). Return totally depends on the delta of the options you write and the option symbols in your basket. Mine could be configured to be between 10-100+%. The higher the return the more volatile. The idea of using multiple symbols like SPY and TLT is to reduce the tail risk. But in the end there is still tail risk like for example in the crash of 2015. Making the strategy delta neutral with hedging could improve it but I never completed that part. There is an interesting book with all the math by Euan Sinclair about option writing and how to minimize the risk if you are interested.

hannofcart 6y ago
Another way to reduce tail risk when selling options is to simply hedge with a protective call/put at a higher or lower strike respectively. Sufficiently far off strikes will have minimal impacts on returns while reducing tail risk.
- scruple 6y ago
  These are known as a Poor Man's Covered Calls and Poor Man's Covered Puts.