Still image from TikTok user @robinhoodkid’s video explaining call options.
Sign Of A Market Top?
ValueWalk founder Jacob Wolinsky was one of a number of financial Twitter personalities who shared this viral TikTok video about call options last week.
Baupost's investment process involves "never-ending" gleaning of facts to help support investment ideas Seth Klarman writes in his end-of-year letter to investors. In the letter, a copy of which ValueWalk has been able to review, the value investor describes the Baupost Group's process to identify ideas and answer the most critical questions about its potential Read More
— jacob Wolinsky (@JacobWolinsky) December 14, 2020
One observer suggested that this was a sign of a market top: the social media equivalent of cab drivers giving stock tips (note for Zoomers: there was time before Uber and Lyft when cab drivers could afford to buy stocks).
We don’t know whether this is a market top, but we do know a way you can invest confidently in the face of that uncertainty.
Investing Confidently In The Face Of Uncertainty
Here’s our approach, in a nutshell:
- Look for securities that have been going up.
- Gauge options market sentiment to see which ones savvy traders think will continue to go up and estimate their returns over the next six months.
- Calculate the cost of optimally hedging them over that time frame.
- Subtract the hedging costs from the return estimates, and sort for names with the highest potential returns, net of hedging cost.
- Buy and hedge a handful of the names from the top of that list.
That’s the basic approach; for a detailed look at our security selection process, see this article where we demonstrate it using the iShares Silver Trust (SLV) ETF as an example. The point of this approach is if the market keeps going up, you’ll do well; and if it doesn’t, your downside will be strictly limited.
Wait A Minute, Don’t Most Options Expire Worthless?
Out-of-the-money options certainly do expire worthless, but with this approach we want the puts we buy to expire worthless. Let’s look at a real world example to illustrate.
Let’s say you had $2 million to invest on June 11th, and you went to our site and indicated you were unwilling to risk a decline of more than 20% over the next six months. Here’s the hedged portfolio our site would have presented you with then (you can use this approach with portfolios as small as $30,000; here’s an example).
Hedged portfolio created by Portfolio Armor on June 11th, 2020.
That portfolio had AMD (AMD), MongoDB (MDB), Nvidia (NVDA), RingCentral (RNG), Sea Ltd (SE), Shopify (SHOP), and Twilio (TWLO) as primary securities, selected based on the process we summarized above: they had the highest potential returns net of hedging costs, according to our analysis. Our site used a tightly collared position in Erie Indemnity (ERIE) to absorb leftover cash after rounding down the primary positions to round lots.
Here’s how that portfolio performed after six months:
That portfolio finished up 26.43%, net of hedging and trading costs, while SPY was up 22.89% over the same period. Note the closing put option values, circled in red: All at $0.
Okay, But What If The Market Tanks?
Here’s an example where that happened. Back on September 11th of 2019, here’s the hedged portfolio the site would have presented you if you entered the same dollar amount and risk tolerance then. This portfolio included Blackstone (BX), Cambrex (CBM), Churchill Downs (CHDN), Lululemon (LULU), MarketAxess (MKTX), Pilgrim’s Pride (PPC), Twitter (TWTR), and West Pharmaceuticals (WST).
Since these portfolios last for 6 months, this one finished near the market bottom in March. Here’s how it did.
Congratulations! Most of your put positions didn’t expire worthless this time. But that’s because most of your underlying securities sank. You were hedged though, so you were only down 11.63% versus SPY which was down 16.86%.
The Moral Of The Story
If you can’t time the market top, don’t worry about it. Buy and hedge a handful of names that a) look like they’re going up and b) are relatively cheap to hedge. Don’t worry about your put options expiring worthless. You want that to happen because your underlying securities did well.