August 2014 - Bankers Anonymous

August 30, 2014September 3, 2014

Options Trading Part II – The ‘Currency’ of Options

Please see related introductory Post: Options Trading Part I – NFW Edition

normal_curve — Options trading begins with assumptions about future volatility based on past price volatility of the instrument

How Wall Street thinks about options trading

Non-professionals who engage in options typically do not understand the ‘currency’ in which they’re trading.

By ‘currency’, I don’t mean option-users remain unaware of their US dollars.

I mean that professional options traders use a mathematical valuation called ‘volatility’ which your average retail[1] options speculator does not even consider.

What is volatility?

Volatility – not the price of the stock or the price of the option – determines the value of an option. Volatility measures the underlying value of an option. Volatility also is how an options trader comes up with the price of an option in dollars.

In math terms, volatility is expressed as a single number describing the frequency and magnitude of price changes over any given amount of time.

The mathematics of volatility – the single comparable number that describes the frequency and magnitude of price changes over any year – involve assuming a standard model for the distribution of prices. Some traders may use a ‘normal’ bell curve distribution of probable prices, but others can use ‘non-normal’ probability curves in sophisticated options trading.

Technically, the “annual volatility” of a stock is the standard deviation of yearly logarithmic returns on that stock.

A high ‘volatility’ number means the stock price spends significant periods of time outside of your ‘normal’ expected distribution. If the stock price lands on the outside ‘tails’ of a normal bell curve, the ‘vol’ number will be high. If the stock price trades within the high-probability tight band of a bell curve, the ‘vol’ number will be low.

If you buy or sell an option with a high ‘vol,’ the premium, or cost, of the option will be high, to reflect the expectation that the stock prices over time will land on the ‘tails’ of a normal bell curve. If you buy or sell an option with a low ‘vol,’ the premium or cost of the option will be low, reflecting its expected narrow trading band.

Did I lose you yet? That’s fine. You only need to remember one thing.

The important thing to remember is that if you don’t know how to calculate the mathematics of volatility then you have no idea what you are buying and selling when it comes to options. I’m fairly certain the author of the “sell puts!” newsletter did not explain the mathematics of ‘vol’ trading[2] to his audience.

Please see related Posts:

Option Trading Part I – NFW edition

Options Trading Part III – Delta hedging options from a trader’s perspective

[1] By ‘retail’ in this post I mean non-institutional investors. I mean: you and me.

[2] Come to think of it, trading options without understanding vol leaves you as blind as an individual who purchases stocks based on the ‘price’ of the stock, without modeling the underlying future cashflows of the company. Now wait, that would describe 99% of all individual stock investors. Hmmmmmm. What does that say about whether most of us should buy individual stocks? Let me think about that…

Post read (1890) times.

August 29, 2014September 3, 2014

Options Trading Part I – NFW Edition

This is a highly speculative trade, not an investment, so run away, retail investor!

A friend in the finance-writing space sent me a query not long ago about the idea of “selling puts” as an appropriate and lucrative investment activity.

Following my swift reply of “NFW[1],” she asked for an explanation. After all, a friend of hers had been writing a regular ‘investment newsletter’ describing all the clever money he made writing puts on stocks. The newsletter-writer described a ‘win-win,’ in which either the put seller pockets the option-premium, or manages to purchase stocks at a discount to current prices.

Selling puts, I should explain, involves giving your counterpart the option, for a limited amount of time (between one and three months, typically) of selling you shares at a set price. A ‘put seller’ often picks a price lower than current prices.

For giving someone else this option, the put-seller pockets some money, known as the option premium.

How about an example?

XYZ stock sells for $50 in the market today.

I sell 3-month puts, let’s say 1,000 of them, with a ‘strike price’ at $40. That gives the put-buyer the right to sell me up to 1,000 shares of XYZ at $40 anytime for the next 3 months. For that privilege the put-buyer pays me – I’ll make this number up – $3 per put. In this example, I pocket $3,000 in premium ($3 x 1,000 puts).

In my most optimistic moments, I can tell myself that I ‘win’ if I just pocket $3,000, and I also ‘win’ if the shares of XYZ drop and I end up buying up to 1,000 shares at a 20% discount to the current market price.

Run away

However, I’m here to tell you to run, not walk, away from put selling. Do not try this at home, for a few reasons.

I’ll list them in increasing order of importance.

First, options trading for non-institutional investors (you and me) are always speculative trades, not investments, because they are short-term in nature. “Investing” means that your time horizon spans more than 5 years, disqualifying all but the most exotic options, none of which are available to you and me.

Second, options for retail investors – because they are slightly exotic and opaque – involve costs that make them inappropriate for non-professionals, trading in small sizes.

Third – Most importantly for this particular ‘newsletter advisor’:

You’re telling individual investors to sell puts? Are you f-ing kidding me?

Put-selling-sucks — NB: Whoever wrote this is a moron

This is the kind of bull-market nonsense that only people who have been in the market for about 3 minutes would fall for.

Do you know that phrase “bending over to pick up nickels before the oncoming bulldozer?

That’s you, when you sell puts.

You make a little bit of money this week, you make a little bit of money next month, you collect a few more nickels for a couple of months, and then BAM! You are dead.

And you never even saw that bulldozer before you became part of the asphalt. Because the market will always, always (ALWAYS!) punish put sellers.

It’s a rule written down somewhere that they only show you AFTER your investment portfolio has been taken out on a white sheet and dumped into a shallow grave.

Put sellers are like the lone teenager in the horror movie who says “Did you guys hear that noise? I’m just going to check that out with my dim flashlight, by myself. You guys stay here.”

put-selling-is-a-horror-cliche — Put selling always ends up as a horror movie cliche

I do not believe that markets have anthropomorphic personalities, or particularly recognizable patterns, or act as sentient beings, except in this one instance: put sellers always get killed. It’s just a rule.

Put-selling as a ‘synthetic long’ in the market

Prior to getting killed as a slaughter-house put-seller, you should understand that selling a portfolio of puts acts as a proxy for being long, or bullishly exposed, to a stock or set of stocks. Provided the stock goes sideways or up, put-selling provides a nice stream of income based on the non-exercised put options.

In addition, like many other derivatives, options give investors ‘leverage,’ by exposing an investor’s portfolio to larger movements in markets than would be otherwise available through regular stock purchasing.

Because put-selling resembles a synthetic long and leveraged position in the market, put sellers may briefly (all too briefly!) fool themselves into believing they’ve stumbled upon a neat and uniquely profitable way to ‘play’ the market. I think this is what the put-seller newsletter pushed, wittingly or not, on its audience. As long as the market basically goes up, put-selling appears even more profitable than buying ordinary stocks.

Then, as I mentioned, you’re financially wiped out. Because leverage goes both ways, and put sellers always get smushed.

Ok, now that I’ve told you my strongly held opinion of this guy’s newsletter garbage, I will spend the next two posts teaching interested folks a bit more about the options market.

Please see subsequent related posts:

Options Trading Part II – The “Currency” is Vol, not $

Options Trading Part III – Delta-hedging options from a Trader’s Perspective

[1] That stands for “No Flipping Way”

Post read (4467) times.

August 25, 2014

Currency Exchange Thoughts

Editor’s Note: A version of this column appeared in the San Antonio Express-News this morning.

When we decided to move to San Antonio five years ago, my only condition to my wife was that we would travel as a family outside of Texas for some time during the worst Summer months.

I had already encountered wise words from a pre-air conditioning era:

“If I owned two houses, one in Texas and the other in Hell, I would rent out the one in Texas and live in Hell!”

How will all of this relate to finance, you may ask? I’ll tell you why. We had a lovely family trip to Europe this Summer.

And the main point of mentioning a family trip to Europe, as always, is to talk about currency exchange. Am I right?

Back in the bad old days of travel, planning to exchange your currency mattered. Three methods prevailed, all of them terrible.

Method one: A highly Type A personality would visit her bank weeks in advance of a trip and request a conversion of a set amount of dollars into the destination country currency. Your bank, assuming it was large enough to do currency conversions, would fulfill your request at some terrible rate of exchange to make up for the fact that this was an inconvenience for them.

Method two: Purchase traveler’s checks. These goofy checks in overly large denominations required one personal signature in the upper left corner ahead of time before you left the bank premises. Make sure you sign in the right place! No! Not there! And don’t sign both lines! You’re doing it wrong. Arrgh.

Once you landed in the destination country any vender from whom you wanted to make a purchase refused to actually take traveler’s checks.

Instead, the traveler’s checks required you to travel for three days by burro to find an actual bank willing to make the exchange, where you would need to show your passport and give a blood sample to verify your identity. If I recall correctly, the wait at the bank teller in the destination country typically lasted 18 hours, for security purposes.

Method three: Change money at the destination airport. Anyone not Type A enough for the first two methods did this. Of course this meant that you paid an exchange rate reserved for the dumbest people on the planet.

Having successfully changed currency by one of these three methods, usually in an amount too large for your needs, you would need to safeguard the precious new Monopoly-play money at all costs.

This new fear of lost currency led perversely to a visceral abomination known as ‘the fanny pack.’

Nothing says “I don’t belong here and I’m probably carrying both my passport and too much currency right here around my waist where you could probably steal it if you really wanted to” quite like those fanny pack fashion horror shows.

But, of course, we all used them. It happened, after all, in the distant past, when hair styles were universally offensive and clothing was humorous.

These days, currency exchange problems are nearly non-existent. Your debit card works at ATMs available in the foreign country on almost as many corners as a Starbucks, and you can take out just as much or as little as you need. The currency exchange rate for an ATM withdrawal, typically, is extremely fair, as it reflects the wholesale exchange rate of large banks, rather than the bandido rate of an airport exchange kiosk catering to Type B individuals.

Speaking of exchange rates, I experienced one financial innovation this Summer upon exchanging currency at the first ATM I visited in Europe. Before completing my withdrawal, the ATM menu asked whether I would like to ‘lock in’ a certain exchange rate, or ‘take the risk’ of whatever market rate I received from my bank.

Being financially savvy, I recognized the trick here, and I would recommend fellow travelers confronted with this choice at the foreign ATM to forgo the ‘locked rate.’

I feel certain that the ‘safety’ of the exchange rate is really the rate analogous to the airport kiosk, playing on the fears of a traveler.

Take the risk, as there’s a 50% chance you do better, and a 50% chance you do worse, if the currency fluctuates wildly during your trip.

By locking the exchange rate at the ATM, however, I’m 100% certain you will get a rate that suits the bank best, not you.

By the way, does this clever column make my fanny pack look any better? I’m asking for a friend.

Post read (1907) times.

August 21, 2014

Like Visiting An Old Friend – Bad Debt Buying

In my pre-Bankers Anonymous days, one of my primary investing activities was purchasing charged-off consumer debt.

If you have no idea what that means, I recommend reading this New York Times Magazine article from last weekend.

Few people have written about this niche of the financial world.

While Jake Halpern’s account is a bit sensationalistic compared to everyday debt-buying life – most days did not involve gun-toting shakedowns and ex-cons – he captures a good amount of the stress and uncertainty about investing there.

Some day, I’ll write the book describing the highs and mostly lows of charged-off debt buying.

Post read (1357) times.

August 18, 2014August 18, 2014

Dan Loeb Comes To A Sleepy Town

Editor’s note: A version of this post appeared in the San Antonio Express-News under my “So…Money” column, “Dan Loeb Is Not ‘San Antonio Nice’.”

It’s probably hard for non-San Antonians to understand the importance of this one medium-sized company for the city’s image of itself. Rackspace is the darling of San Antonio’s business community, a single company carrying on its shoulders the hopes of 21st Century economic development to this sleep South Texas city. Rackspace’s faltering stock price, competitive pressure from internet giants Google, Amazon and Microsoft, and management changes at the top all make city boosters understandably nervous.

Most San Antonians do not know hedge funder Dan Loeb, so I thought I’d review some highlights of his style to an audience unfamiliar with him.

Third Point’s Dan Loeb has earned a place in the pantheon of the Top-10 most-talked-about hedge fund managers in the world, in part through his investing acumen, and in larger part through his acerbic letters to management of companies where Third Point LLC has taken a significant stake, and where he sees underperformance.

Loeb is a finance writer’s dream, because he provides the kind of quotable “He said!” and then “Can you believe he said back?” chisme that fueled all of our 7^th grade social lives.

I am reasonably certain that nothing that Dan Loeb does with respect to Rackspace will have any effect on the lives of people in San Antonio, except for maybe one or two top management Rackers who he seeks to personally humiliate. This will not be pleasant for them.

When Loeb does write about them, however, we will all have a front row seat to the boxing ring in which a smart and brutal man swings to land heavy punches on smart, less brutal, men.

In most cases in my writing I strive to remain above the “He said, she said” fray about finance, because of its profound irrelevance to real people’s actual lives.

But I confess that a small, evil, part of me is curious about the upcoming spectacle. I think this makes me not quite “San Antonio nice” yet.

If you have not sampled Dan Loeb’s so-called poison pen yet, let me introduce you to a few of his classics.

In 2006, to the insufficiently responsive board of directors of Nabi Biopharmaceuticals, Loeb wrote: “you hide your heads in the nearest warm aperture in an apparent “ostrich defense” and ignore your shareholders…in the hope that the Company’s owners will go away before your next annual meeting.”

To the CEO of a Spokane, WA-based lumber company named Potlatch corporation Loeb famously wrote in 2003 “Since you ascended to your current role of Chief Value Destroyer (“C.V.D.”) when you assumed the formal title of C.E.O in 1999, the shares have dropped over 45%, a destruction of shareholder value in excess of $520 million.” About underfunding the firm’s pension plan, Loeb lashed out to the CEO “Your sorry excuse that ‘everyone else does it’ is reminiscent of a teenager who uses peer pressure as a pretext to explain his drug problem. I only wish that I could recommend a recovery program for you and [then C.F.O.] Gerald Zuelhke for your apparent addiction that could be called “Value Destroyers Anonymous.”

To the directors of high-end auction house Sotheby’s, in 2013, Loeb penned “We acknowledge that Sotheby’s is a luxury brand, but there appears to be some confusion – This does not entitle senior management to live a life of luxury at the expense of shareholders.”

In that same letter Loeb further criticized Sotheby’s core art strategy, writing “It is apparent to us from our meeting that you do not fully grasp the central importance of contemporary and modern art to the company’s growth strategy, which is highly problematic since these are the categories expanding most rapidly among new collectors.” Sotheby’s, by the way, changed strategy and invited Loeb’s preferred three new board members.

On the subject of the underperforming shares of tech companies, Loeb can be particularly brutal, as when he relentlessly attacked Yahoo’s CEO Scott Thompson as well a board member Patti Hart for inaccuracies on their professional resumes. Thompson left shortly thereafter and was succeeded in the CEO position by Marissa Mayer.

Cultural clashes with high-profile brash commentators have a history of setting San Antonians teeth on edge. I’m thinking of Charles Barkley’s recent comments during the playoffs about women from the city. If Loeb does launch one of his poison pen attacks, I assume Rackspace will find the city rallying to its defense.

Because Dan Loeb is not San Antonio nice.

Post read (1488) times.

August 15, 2014December 22, 2014

Book Review: How To Avoid Financial Tangles

If you ever read any novels by Jane Austen, Anthony Trollope, or Charles Dickens you quickly realize that the most important goal of 19^th Century English life was securing – through a fortunate birth or a strategic marriage – a steady income based on the rents of private property.

The plots of all their novels hinge on this uncertain quest. All of their protagonists seek to navigate the twists and turns of what may euphemistically be termed ‘financial tangles.’

Popular culture – at least in the US – no longer focuses quite so much on this singular struggle, as our movies tend to teach either one of two lessons. It’s either ‘true love overcomes all obstacles’ or ‘underdogs can overcome powerful antagonists through pluck and an intriguing bromance.’[1]

Despite the shift in popular culture, however, I would argue that avoiding financial tangles remains the central struggle of real life in the 21 Century.

I mention this because I wandered into a used bookstore recently, found myself at the finance section, and a book named How To Avoid Financial Tanglesby The American Institute For Economic Research fell into my hands. [2]

Financial tangles? That sounded interesting, as did the fact that the AIER is in Great Barrington Massachusetts. Massachusetts! My people! This should be good, I thought.

I noticed the first edition of the book was published in 1938 (a good year for financial tangles) and has been updated periodically since then. I also noticed 1938 represents a sort of halfway point in time between the Dickens & Trollope era and our own day, although my copy from the bookstore was published in 1995.

I’ve been reading through it slowly since.

What many of us need to know about financial tangles goes beyond what can be gleaned for free from a finance blog. On the other hand, we do not want to start incurring lawyers’ and accountants’ fees whenever we might step into a tangle.

We often need something relatively sophisticated, but at the same time not overly technical.

This book offers a kind of half-way technical approach. You will not find clever Clint Eastwood references to explain insurance concepts, or clever Sci-Fi analogies for quantitative trading, but you will get a starter briefing on important issues of real estate, trusts, wills and estates, insurance and contracts – basically all of the stuff of 19^th Century English novels.

Do you know the difference between joint tenancy and tenancy by the entirety? You better believe Lizzy Bennet knew. Are you familiar with Trusts for Minors? The lawyers in Jarndyce & Jarndyce were. Do you know the most important principles for designing a Will? The residents of Barsetshire did.

Do you have a will? Do you know why you should have one? Do you know why people – even relatively non-wealthy people – create trusts?

How To Avoid Financial Tangles can help you self-educate, most likely in advance of speaking with an attorney or some other specialist.

I’m not saying you will love reading this as much as you do reading Trollope, Dickens and Austen, but this is a solid place to start the modern process of avoiding financial tangles.

Please see post: All Bankers Anonymous reviews in one place!

[1] I defy you to come up with a major Hollywood movie that doesn’t follow one of these two patterns. See? You can’t do it.

[2] For those of you under age 40, “books” used to come in a paper, glue, ink, and cardboard format that could be physically held. This brought tremendous obvious disadvantages to people who read “books” this way. You couldn’t create an infinite number of copies at the press of a button. You could not Google search for key words, or check your precise % already read. You could not even cut and paste favorite passages to your Twitter account, without doing irreversible damage to the original book with scissors. Anyway, for this old style of book, believe it or not but there are still actual buildings where “physical book” fetishists still lurk, touching and handling the old-style paper and ink things. Used bookstores – and physical bookstores for that matter – now exist only outside of the “real economy” and may be safely ignored by all of you under age 40.

Post read (4876) times.