May

17

 As bearishness is surfacing in our midst, I thought I better refer to Ken Fisher's latest column in Forbes.

Nigel Davies comments:

There is no doubt that over a long period of time stocks go up. This is not the issue. The problem is that 20% of the time the market is lower five years hence, and 26% of the time two years hence. I also believe that serious housing declines hit stocks.

This has nothing to do with bearish propaganda; these are hard facts. Now there may well be reasons why this is not the case, not least of which is the GaveKal thinking. But I should point out that the GaveKal approach has not been quantified and therefore, unless I'm mistaken, qualifies as 'mumbo'.

But the real issue here is in why any counter-arguments are ignored or shouted down as 'bearish propaganda', even when they are reasonable. Now there is no doubt that bearish propaganda exists, but delusion is not a one-way street.

Ken Fisher's view is untested mumbo, as one can see from the title 'Never Before'. And as I'm quite enjoying playing a bear (albeit one who only ever takes the long side), the obvious answer to this is that if the consumer spending spree comes to an end (because they can no longer use their new found housing wealth as a checking account), earnings yields will shortly be heading south.

Vic mentions:

During the last several years, many chronic bears have submitted original pieces to our site, and if they have a strong point, and argue it well, we are always happy to publish it.

I can't agree with Nigel’s point about some of the two and x year changes being down, as the studies of Fisher and Lorie show that when you look at the distribution of returns by holding periods, that almost all of the seven year returns are up, and an extraordinarily high percentage of them yield returns of more than 15% a year compounded.

These results are completely consistent with those that would be expected from a 10% a year drift with a standard deviation between years of about that much. Many people try to grind against the house in Vegas and we know they all end up broke. To try to grind against a drift like this is sure to end up in the 97% yearly loss that one of the chronic bears (who claims he caught the Feb. 27th debacle) actually experiences. Imagine what the fate of those who actually followed the advice and views of the weekly financial columnist have been — how many times would they have lost 97% in a year while they waited for events like the Oct. 19th, 1987 landslide to occur. How terrible it was that rather than receiving a heads up to cover their shorts and get back in the market, the weekly financial columnist told them that the Oct. 19th, 1987 decline of 25% was just a beginning.

The same is true of the key level boys who state that this or that level, down 5% from the current, is what the pros are watching closely. Are they bullish then or bearish, and what happens to the 10% a year drift against them as they wait for that 'level the pros are watching' to actually occur in the fullness of time?

They will all end up ghosts in Trinity Church, whilst they wait for their key levels, and as it has so often been in the past, my pocket book will always be open to them, whether for a lunch or otherwise.

Hanny Saad offers:

I am one who writes naked puts very frequently and find them very profitable. I am aware of the dangers (or some of the dangers) associated with this practice including specialists gunning for certain active strikes the same way the do with stops, etc., and I sometimes modify the pos. to credit spreads. I even use them instead of limit orders in some cases when I am more aggressive and look for assignment.

Could Vic and Laurel kindly clarify the dangers of this? I am under the impression that writing puts is consistent with the 10%drift and is generally taking a bullish stance to the markets. I am particularly interested in this as I am very active with this strategy and it has been very rewarding in the past, but I hope that the mistress is not hiding behind the curtain to take it all back in one blow. 

Craig Mee adds: 

There was one particularly gifted option trader on the Sydney futures exchange trading floor, who regularly, generated considerable monthly returns trading options, (selling puts, just one of his many strategies) — however each year for many years he would blow up and blow up big, only for a new underwriter to get him back in to trading, (maybe lulled in by his solid monthly record, up until the time it took him out of the game).

Maybe his risk management left a lot to be desired, but as one trader said me after Sept. 11th, for every dollar in the market, you need 10 in the bank (to cover not getting squeezed out of positions and to cover extended and added margin requirements by the clearing houses when volatility goes through the roof).

That one little black swan can kick up some dust.

Gordon Haave comments:

Selling naked puts is not the only strategy where, in essence, you are receiving income in exchange for assuming the risk of very unlikely events. What is great about them is that these events are so rare, that when they happen you (the manager) can shrug them off as a one time event that you have now learned from … and get back in business with new capital.

Chris Cooper responds:

Prof. Haave's words strike me as true. On the other hand, it seems likely that in a market subject to a 10% drift, where that drift is not modeled in the option pricing formulas, there may very well be some positive expectation in selling naked (or semi-naked) puts. Since I have assiduously avoided options in the past because of concerns about liquidity and execution costs, perhaps it is time to reevaluate, but I have several concerns.

A skewed distribution of gains, such as one receives by selling OTM puts, is undesirable for one trading his own money. The market crashes are so rare that it will take many years to see enough of them to trust that you can model their frequency/amplitude. It is thus easy to fool yourself about the expectation of your model, and it is also easy to get wiped out. By hedging you can transform the fat left-side tail into a better-behaved distribution function. Is this what people do in practice, or do they very often run mostly unhedged, since any hedge costs money?I can imagine various ways to hedge, such as: stop-loss on the naked puts; sell futures; buy further OTM puts; and probably many more creative strategies. These can be dynamic or static. What is the best practice, assuming that you need to have good liquidity and keep your hedging costs at a minimum?

Isn't selling a put a combination of a directional bet on the market plus a bet that volatility will not be rising? If so, then does it make sense to separate the two? Buying futures would be the directional component, and one could sell volatility by selling both calls and puts. Am I seeing this correctly, or is there a better way?Is it better to let your OTM puts expire worthless, or does it make sense to sell them before expiration to free up capital?

What about execution costs? The spreads in options always seem high compared to futures or stocks. Am I looking at this in the wrong way? Does it help to sell puts by entering a limit order on the ask, and adjust it based on delta and the underlying? How is liquidity in these markets, compared to futures?

It has always seemed to me that the derivatives markets are obfuscated by jargon.

Russel Sears comments:

The bears' argument is built on the relatively recent housing boom and its extraordinary recent returns, 2000-2005. It is as if the "old economy" insisted its importance in a post dotcom bubble. The bears' argument boils down to: stock market returns are dependent on housing market returns. This may very well have been case recently. But should we be shocked to find a regime change, just as the housing market slumps? Obviously the 100 year drift in the stock market, cannot always be dependent on a 10% drift in the housing market. This is because the housing market is limited by the income level of the typical buyer.
 


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