Is This The Best Investing Strategy For The New "Free Lunch" Normal?

Tyler Durden's picture

In a world in which there is no longer any risk, in which the Fed itself is the Chief Risk Officer of the S&P 500 itself (because either the Fed and central banks will keep on injecting "modest" liquidity and keep rates at zero or below for the indefinite future, or jump right back in with another massive, $1 trillion + liquidity dump the second the S&P dares to suffer a 10% correction), there is no longer any need to hedge as we have shown for the past two years. In fact, the best strategty for the past two years has been to actively go long the most shorted stocks. But as GMO's Ben Inker shows, there may be one other strategy for the new "Free Lunch" new normal that avoids buying stock altogether and which has less volatility, a lower beta and a higher Sharpe ratio than merely buying stocks, while generating the same return: namely constantly selling 1 month ATM puts, rolling, and then selling again. Then again, judging by the ridiculous low VIX, perhaps everyone has already figured this out...

From GMO's Ben Inker:

Free Lunches and the Food Truck Revolution

Over the past year or so, there has been a welcome change to the culinary landscape of the Boston financial district. After two decades of wandering to largely the same old haunts for lunch, I am now faced with a whole new set of inexpensive and tasty choices literally outside our door, changing daily as the food trucks perform their mysterious nightly dance. And while part of me may worry about the general advisability of having a burning wood-fired oven built into a small truck and another part may worry about the long-term impact to my weight and arteries from eating the pizza that comes out of said oven, my taste buds are thrilled, and my wallet has no complaints either. We at GMO have been accused at times of believing that either the world never changes or that when it does change, those changes are generally bad. Well, it may just be the dumplings talking (available on Fridays on the Greenway by Rowes Wharf, $8 for four dumplings along with fried rice and homemade Asian slaw, $1 more if you want to add a spring roll with ginger soy sauce), but the world has indeed changed, and it is good! Food trucks seem to be a genuinely disruptive innovation, lowering the cost of entry for the restaurant business, fighting the tyranny of location, taking advantage of other innovations – every food truck I’ve been to accepts credit cards via Square – and encouraging experimentation, new ideas, and most importantly, better lunches for me and others who work in culinarily challenged areas.

While I’m sure you are happy for me and my newfound culinary contentment, you may well be wondering whether this has any relevance for investing. I believe it does, and the relevance is this: investors spend far too much of their time looking for a free lunch, when they should be looking for the investing equivalent of an inexpensive and tasty food truck meal instead. Tasty food truck meals are far easier to find, and you are much less likely to discover that they come with strings attached that you didn’t think of until it was too late. So what are investing free lunches? Arbitrage opportunities, sources of high returns uncorrelated with the important risks to investors, portfolio construction techniques that reduce those risks without reducing returns, exploitable market inefficiencies that other investors are strangely willing to share the existence of with you. In common parlance, Alpha. I have used the capital A there as a signifier that there is something special about this particular Greek letter that gives it a fascination for investors well beyond what is ascribed to beta, gamma, delta, or the other symbols that finance has appropriated. My colleague Edmund Bellord suggested in a recent team meeting that we replace the term "Alpha" with "Magic Beans" in our conversations to add the proper element of skepticism when the term comes up. This is not to say that Alpha doesn’t exist. There are indeed occasional arbitrage opportunities, the markets do sometimes offer up sources of return uncorrelated to risks we should all care about, and we would be among the last to claim that markets are efficient. But finding Alpha is hard, everybody is on the lookout for it, and as all diligent analysts can tell you, most of the time that an opportunity starts out looking like Alpha, it winds up seeming more mundane as you do more research.

Put Selling and Merger Arbitrage – No Free Lunches Here

Just because an opportunity isn’t a free lunch, however, doesn’t mean it isn’t a tasty food truck meal, and such a meal can easily be an important part of your balanced diet … er, portfolio. So what do I mean by this? To some degree, the difference between a free lunch and a tasty food truck meal is a matter of mind-set. I’ll take the example of put selling, even though some of you may be bored of reading my musing on that particular topic by now. Some investors and strategists have suggested that put selling is a free lunch, and on the face of it, they seem to have a point, as you can see in Table 1, which compares holding the S&P 500 with selling one-month at-the-money (ATM) puts on the S&P 500 since 1983:

One-month puts have provided basically the same return after our estimated transaction costs as a buy and hold of the S&P 500, with a beta of about 0.5, volatility two-thirds that of the index, a Sharpe ratio 50% higher, and a CAPM alpha of 2.6%. To explain these, some strategists have invoked behavioral factors – irrational dislike of the limited upside of the strategy or other investor foibles. To our minds, no such explanations are necessary. Beta and standard deviation are lousy risk measures for a put selling strategy, because almost all of the volatility of the strategy is "bad" volatility. At the end of the day, an investor selling puts on the S&P 500 is taking the same risk as the investor who buys the S&P 500 – both lose money at more or less the same rate when the S&P 500 goes down. If the reason why the stock market has a long-term return above cash is the nature and timing of the losses that periodically befall investors who own it, put selling has all of the same downside, and therefore should offer the same basic upside. It happens to do that in a different manner – through the collection of option premiums instead of participating in the gains of the stock market – but as my colleague Sam Wilderman points out, it is dangerous to confuse the manner investors get paid with the reason why they get paid. Purveyors of option strategies are apt to talk about the "variance risk premium" and "capturing short-term  mean reversion" when analyzing put selling returns. But while these two factors do explain how put selling delivers its returns to investors, they arguably do little to help anyone understand why the returns exist. Variance risk premium (VRP) is a term used to explain the observation that implied volatilities on the S&P 500 and other equity indices are generally higher than the realized volatility of those markets. You can put together strategies that are designed to specifically try to capture the VRP and structure them in a way so that, most of the time, they have little stock market beta. But if you stop and think a bit about why the VRP exists, it starts to become clear that those strategies might not be a good idea. If implied volatilities were an unbiased estimate of future realized volatility for the market, puts and calls would have similar expected returns. We know from put-call parity that being short a put option and long a call option should give the same return above cash as a long investment in the market. If implied volatilities were "fair," the call and put would each be expected to give half the return of the market. Because the put embodies the ugly risk of stocks and the call embodies the pleasant upside, this would be a strange outcome. Why would you expect to get paid half as much as the stock market, in buying a call, while taking none of the downside? The way to shift the returns to the put, where they belong, requires implied volatility to be higher than an unbiased expectation of future volatility, and that gap creates the variance risk premium. Selling volatility therefore should make money over time, but stock markets tend to show much more downside volatility than upside. If you are short volatility, you will find that most of the time you make a little money and periodically you lose a bunch as volatility spikes, and those spikes will almost invariably come when the market is falling. Your VRP trade therefore looks a lot like being short a put, although in this case an out-of-the-money put instead of an at-the-money. Selling out-of-the-money (OTM) puts often seems like a wonderful strategy, chugging away making money consistently with little volatility until, suddenly, it doesn’t. Table 2 shows the characteristics of a 5% OTM put selling strategy.

It works until it doesn't.

It looks wonderful! Beta and volatility are basically half that of ATM puts, and the strategy has an even higher Sharpe ratio than ATM puts, one that most hedge fund managers would be very happy to achieve. It looks, on the face of it, like exactly the sort of strategy that one should be levering up instead of owning dumb old equities. The trouble is, while the strategy seldom loses money, when it does lose is exactly when you’d prefer it didn’t. Table 3 shows you a month and day that most people peddling option selling strategies won’t talk to you about. In part, this is because the main options database that most people use for their analyses only goes back to 1996. But it is quite possible to get options data on S&P 500 futures going back to 1983, so ignoring October 19, 1987 is also about hiding an unpleasant truth.

The 27.8% loss for the day of October 19, 1987 is a 76 standard deviation event for the OTM put selling strategy. While everyone "knows" that put selling does not have normally distributed returns, you can also bet that no one looking at the statistics of a strategy would say to themselves, "You know, I’d really better stress test my portfolio against a 76 standard deviation event just to be on the safe side." But the simple truth is that plenty of strategies that look low-risk much of the time have the potential for profoundly larger losses if something odd, but possible, happens in the financial markets. You would never want to lever such a strategy based on its historical return characteristics, because you cannot be confident you understand the risks based on that limited sample. There are plenty of downturns in which a 5% OTM put selling strategy winds up losing far less than a long equity strategy, but there are some where it is worse, so treating it as one-third the "risk" of a long equity strategy is potentially deadly to your financial well-being.

This is all a long-winded way of saying that put selling is not a free lunch, and something to be levered only by the exceptionally brave, foolhardy, or those who take very seriously the incentives created by a 1 and 20% fee structure. But we still think put selling, in an unlevered form, can at times be a tasty food truck meal. Once you recognize that the reason you are getting paid for selling puts is because you are taking equity downside risk, but the manner in which you get paid is different from owning the market, there may well be some times when the payment for equity downside is better from put selling than owning the stock market. While it would be odd if put selling always gave a better return per unit of "risk" than owning the market, the different return pattern means that some of the time it almost certainly will, and we would contend that a situation in which valuations are higher than normal but not at nosebleed levels may well be such a time.

In a similar vein, merger arbitrage turns out not to be a true arbitrage and therefore not a free lunch, either. Like OTM puts, merger arbitrage looks to have a low correlation with the stock market in normal times, but the correlation rises uncomfortably in times of market stress, which is when you really wish it wouldn’t. Merger arbitrage professionals will talk about getting paid for taking the risk of deals falling through, and that their skill is in better handicapping the likelihood of the deal completing or completing at a higher price than the original offer. The gap between the current price and deal price is indeed the manner in which investors are paid in merger arbitrage, and the skill that a manager has does come from his/her ability to better analyze the probabilities and prices than the other guy. But we would argue that the reason why there is a decent return to the activity of merger arbitrage is that the circumstances in which lots of deals are likely to fail at the same time is one of significant market stress – when credit markets freeze up, equity markets are falling, and acquirers either find themselves unable to raise the money they need to complete a deal or have simply changed their priorities from empire building to survival. But this still leaves merger arbitrage a potentially tasty food truck meal, because of the timing of when it is attractively priced. There are a fair number of hedge funds out there pursuing merger arbitrage strategies, but their capital is finite, and the size and number of deals changes over time. Merger arbitrage is likely to be priced to give interesting returns when the size of the deal pool is large relative to the capital devoted to the activity, which is likely to be when stocks have been rising for a while and executives and investors are feeling confident about the future. This is probably a time when the expected return to owning stocks has fallen, and may well also be a time when investor confidence is reducing the expected return to selling puts directly.

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nink's picture

What does zerohedge mean :-)

kaiserhoff's picture

It works until it doesn't.

Confucius say:  Man who sell puts has bugs in his head, and will soon have hot poker up his ass.

Disclosure:  I have, in the past, sold puts as a cheap way of buying stock.  It has been many moons since I saw anything paper I wanted to buy.

DoChenRollingBearing's picture



Warning: Bearing Guy lost all or part of his money speculating in options (early 1990s).

The bad news: I lost the money.

The good news: It wasn't much, and I have not done that since.

Lesson learned: Don't speculate in stuff you do not understand.

TheLooza's picture

With the market in perpetual ramp mode. yeah selling OTM and Just ITM puts works great......But you fool you best be capping risk using spreads.  Actually a short put butterfly might have a nice risk profile as well, htough transaction costs will add up.

Gift Whores's picture

"Don't speculate in stuff you do not understand."

You are referring to the market in general?

ebworthen's picture

So no risk nor inherent value in the markets.

Thanks FED.

disabledvet's picture

Massive risk makes treasuries the only non correlated asset. Not saying this isn't a crazy investment...just say all...and I mean ALL...the data lead to this one asset class.

Unlike in Europe where yields have collapsed (textbook deflation and Depression) in the USA you have an EPIC rally in equities which creates inflation which blows out the TED spread.

Since it now appears we in fact are in a RECESSION my money is on an epic rally in treasuries "just based on trading fundamentals alone." (Rally since 1983.)

Not sure if we can get the thirty year down to one half of one percent ala Japan...but there will be War with Russia...that is an absolute certainty now in my view...and that means HUGE issuance of both Treasuries and Bunds.

Those two represent by for he largest debt issuance markets in the world...and where the bulk of all liquidity is located "economically speaking." (ECB HQ is brand new and in Frankfurt.)

If Putinism starts to "go wobbly" that would require an Army of Occupation.

This site loves to remind everyone how huge Russia is...and indeed it is.

Indeed it is...

techstrategy's picture

Disabled, you usually pay reasonable stuff, but all this leads to gold, not treasuries.  The only way out of the slow motion deflationary spiral is for the USD to lose value and the mechanism through which that will happen is gold.

ebworthen's picture

disabledvet - Love to ya'

Russia will not back down, ever.

Anyone who has studied their history knows this; our administration are obviously not students of history.

Yeah, it sucks ass that all the retirees have is fucking Treasuries, a house of cards if ever there was one.

Equities are more a house of cards, unless you are on Wall Street with a direct feed and nanosecond transactions.

Or an asshole in CONgress who can do insider trading with no penalty whatsoever; fucking scumbags, fucking treasonous worms.

The entire societal structure has become a giant house of cards - not just equities but the future - the sold out future - sold out to the highest bidder and nearly any bidder other than the American family and worker.

Fuck them all to HELL.

God Bless America.

Oscar's picture

that's why we need to buy gold and silver

DoChenRollingBearing's picture

Good luck with your website!

I too feel that gold & silver (and platinum) are strong buys.

stacking12321's picture

What, no love for palladium, dcrb?

DoChenRollingBearing's picture

Actually I do like Pd as well. and I have a little bit (Canadian Maples).  A metal with many interesting properties.  Platinum is prettier though, just IMO.

I am waiting on 1 toz of IRIDIUM (in sponge form), once I get it and look it over, I will let ZH know where you can find it.  

Only 198,000 oz of Ir are used in the world each year.  Maybe some of us here should corner it?

Oscar's picture

Thanks DoChen.  Feel a bit bad pimping another website here, but I figure I'm not competing with ZH nor am I soliciting any money.  It's just a site dedicated to investing in precious metals.  It's a bit sparse right now, but I will add to it each day

WeNeedaRealGovt's picture

So the banks are controlling risk, and show no signs of letting up. So you keep buying PM after a ~2 year bear. What makes you think the turn is coming so soon?

The banks have the $$ and have made it clear by their actions the S&P is going higher.  Its called TA. Or over-valuation.  Or fully priced.  Just keeps melting up.  Doesn't seem they want to stop and shorts getting continually burned. What makes you think we'll have a correction so soon?

Banks also controlling oil, we would all agree.  Oil supply is seemingly rising faster.  But so is the oil price. Another point for the banks.  Why would they stop now?

Just the fact that the banksters can move the price of gold might make it possibly the worst investment if the banks decide keep doing what they're capable of doing.

Gold players just got burned big time.  You have more hot wars than ever right now.  Planes and bodies falling out the sky!  Gold dropped Friday. But it is Sunday and futures are up $0.80. Silver + $.029. LOL


Oscar's picture

What makes you think the turn is coming so soon?

It's all laid out on the website  I think the reasons are compelling and I put my money where my mouth is.  

stacking12321's picture

"So you keep buying PM after a ~2 year bear. What makes you think the turn is coming so soon?"

5000 years of history indicates that gold (and silver) are long term stores of value. i would rather buy a long term store of value than gamble my money away at a casino.

i don't claim to know what prices will do in the short term.

but the prospects of PMs look very good, from the current beaten-down prices which have minimal downside risk, as they are at or near extraction cost.

Bill of Rights's picture
AK-47s become hot commodity after U.S. sanctions


"We sell some of the Kalashnikov Concern stuff and that has been selling fast," said Robert Keller, manager of K-Var Corp., a Las Vegas-based online gun distributor.

Keller said his company has been sold out of the guns since the sanctions went into effect. On K-Var's web site, AK-47s are listed as "out of stock."

The Obama administration issued sanctions against Russian companies in response to Russia's role in a separatist movement in Ukraine. An increasingly violent civil war between Ukraine's government and the separatists resulted in tragedy Thursday, when a Malaysian Airlines passenger plane was shot down, killing 298 people.

According to the Treasury Department, Kalashnikov Concern is banned from importing its guns -- including the AK-47 and more advanced AK-74 -- into the United States. But, in a statement posted on its Web site, Treasury said Americans are allowed to own, buy and sell the guns, so long as they were already in the U.S. prior to the sanctions.

DoChenRollingBearing's picture

I bought my semi auto Saiga AK-47 (Russian-American JV: Izhevsk-Arsenal, latter near Vegas) about four years ago for $900 and something.  A few months ago, I went and asked how much another would be: $2900!

Russian AKs (typically higher quality than Chinese or Romanian) may go up even more...

Freebird's picture

One day an AK the next a BUK...aah progress

potato's picture

OMFG. I ordered two Russian (Izmasz) online in 2006 and they were $300 (basic) and $500 (upgraded). Wolf 7.62x39 was $160 per thousand rd.

The best thing to get for defense is probably the semi-auto AK-47-style shotgun.  The AA-12 automatic shotgun is the most amazing small arm i have seen but it's not available.

DoChenRollingBearing's picture

I have seen that shotgun on YouTube videos, it is very impressive!  You can see almost anything on YouTube now.

TabakLover's picture

Having a bearish tilt...I love articles like this.  Eveyone needs to start thinking this way ASAP.

nmewn's picture

Said the spider to the fly ;-)

techstrategy's picture

I've been saying for some time that option manipulation broke the market.  The infinite leverage boys abused QE flow to paint the tape while collecting rents via vol selling.  No now they are positioned for the reversal.  Ultimately, they just took the growth cartel's momentum games market wide.  Everyone on this site should use the games against them and convert trash to gold.  Let them hold all the risk.  Trash for cash and gold is the new modern alchemy.

hooligan2009's picture

so i guess bull put or call spreads or bear put or call spreads are out too.... well until QE is withdrawn and we have an interest rate with compensation for correctly measured inflation (million prices or age cohort "common person") and credit risk (hopefully zero over 90-180 days).

spreads are best and have no downside beyond a budgeted capital outlay that (if only) could be funded from 8% interest rates!

Clowns on Acid's picture

Gotta be a sign of the top when ZH has authors talking about selling Puts with Vol at / near historic lows.