Where finance meets fantasy: option trading strategies and unicorns

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My three-year-old daughter recently asked for a unicorn for Christmas.

I asked her why and she responded, “Because I want it Daddy – a purple unicorn that can fly.” I told her, “Santa may have one left over from last year and maybe he can bring it this Christmas,” and hoped she would ask for something more likely to be delivered.

While the fantasy and imagination of a three-year-old may seem far removed from the investment world, the retail investment market has seen some very interesting products aimed at meeting the “wants” of investors.

For example, I was recently asked by a prospective client seeking risk management solutions to review an investment trading strategy that proposes to deliver “all of the upside with half of the downside risk” for an equity portfolio.

In all of my years of trading and working within asset management, the core truth I have learned is there is no free lunch. Any product promising as much should be viewed with caution and healthy scepticism.

Not all protection is the same

For years, option-based strategies have been successfully used to reshape equity portfolio return distributions. Equity-income buy-write strategies enable investors to increase near-term income and lower overall portfolio volatility via the option premium received.

Option collar-based strategies that provide explicit downside protection (in addition to the benefits of writing calls on an equity portfolio) have been successful in delivering an alternative yield for investors.

In both cases, as with other hedging strategies, the trade-off is less participation in growth – no free lunch. However, these strategies are relatively easy to understand for retail investors and are usually executed through exchange-traded markets providing low execution and operational risks.

The product – or unicorn – mentioned above, falls within a different category.

The strategy is more akin to a hedge fund or absolute return fund that trades physical options for alpha and provides put protection for an equity portfolio. As with most physical option trading strategies, the amount of protection varies and is limited through spread trades in order to offset the high cost associated with serial physical option purchases.

Further, trader discretion is incorporated in order to time the level of protection and instruments used to further offset the cost of hedging and potentially outperform in an upward moving market. The strategy is unconstrained in the use of more exotic derivatives including OTC bank products and trading the risks inherent within option pricing.

Arguably, it introduces a high degree of complexity for retail investors and their planners to understand. These are multi-dimensional risks, which are more at home in the investment banking and hedge fund world than the retail sector.

Popular option protection strategies include put spreads where the cost of protection is reduced through limiting the amount of downside protection; however, spreads work well when the market falls within a certain range but perform poorly outside of them – just when you need them most during significant market corrections such as the GFC.

Finally, strategies that rely upon discretionary trading simply cannot be modelled and thus are not predictable in their expected performance in any market crisis. Instead, you are hopeful that the manager has placed the right trade at the right time and in the right amount to protect your portfolio.

The unicorn is beginning to look more like a donkey.

Evaluating explicit risk management strategies

When evaluating the suitability of a risk management strategy and whether it will meet its objectives, investors should consider:

  • Complexity: is the strategy using simple and cheap exchange-traded instruments or more complex securities, OTC derivatives and exotic investment bank options? The latter introduce valuation, operational and counter-party risks that have historically been problematic during periods of market stress.
  • Predictability: is the underlying strategy easily modelled and tested through historical stress periods and simulated forward-looking scenarios? Will it hold up in both upward and downward moving markets or are results heavily dependent on manager discretion and timing?
  • Resources: What resources, scale, global presence and track record does the organisation have managing protection strategies through market stress events and at what scale? Many boutique managers don’t offer global scale and are exposed to key-person risk.
  • Scalability: Some option trading strategies which use term structure trades or spreads are not scalable because of the relatively low volumes in the Australian option market (liquidity and execution concerns become more prominent when the market is stressed).

Come this Christmas – or next market downturn – you can be sure that unicorns will be in short supply.

This is article was first published in Professional Planner.