Pablo Triana. Corporate Finance Review. Volume 16, Issue 5. Mar/Apr 2012.
Let’s play a game. Imagine I offer you the following two alternatives: a) Make $100 every day with the possibility that you may lose $1,000,000 at once, or b) lose $100 every day with the possibility that you may gain $1,000,000 at once. Which one would you choose?
If you chose the first alternative, you would be in the company of the following well-known players: Wall Street investment banks, AIG, LTCM, Victor Niederhoffer, Barings Bank, and Warren Buffett. They all have something in common: Either they went broke or suffered huge losses.
If you chose the second alternative, you would be in the company of the following, perhaps less well-known, players: Mike Burry, John Paulson, Steve Eisman, and Nassim Taleb. They all have something in common: They made huge gains.
Choosing the second strategy may seem way better, but this is the benefit of hindsight. Many who went for the first alternative got rich without ever blowing up. Many who went for the second alternative bled money without ever striking it rich. So there may be no clear-cut choice; it all depends on who you are as a person. It all probably boils down to a single question.
- Do you fear destruction more than you desire triumph?
- Do you love winning more than you hate losing?
- Do you absolutely need to win, or must you absolutely avoid disaster?
Based on your answers, you would be a different kind of investor-trader-punter (“speculator”). If you avoid the possibility of blowing up, you may never taste the sweetness of victory; if you taste rapid victory, you may get to know the sourness of annihilation.
There are strategies in the markets tailor-made for those willing to risk destruction in return for instant triumph, as well as for those willing to risk bleeding in return for avoiding disaster. A very typical and widespread one concerns the use of options. If you sell options, you can be a winner fast, but you can suddenly die in untold pain. If you buy options, you can look like a loser for a long time, but you can suddenly become king of the world.
The story of the latest financial crisis is a story of option selling: the world’s most influential financial firms decided to sell optionality in a fanatical fashion, reaping very attractive and regular benefits for a while but eventually succumbing to a monstrous death. Market history is littered with such examples. Famed investment sage Warren Buffett, like many before him, decided to sell options. Veteran trader and renowned intellectual Nassim Taleb, on the other hand, decided to buy options. While Buffett would have gone for the first choice in the game proposed at the beginning, Taleb would have gone for the second choice.
So, are you a Warren or a Nassim?
What is an option? It’s the right, but not the obligation, to buy (call option) or sell (put option) something in the future at a pre-agreed price. The underlying asset is what you buy or sell if you exercise the option. It could be almost anything: stocks, commodities, bonds, currencies, weather, or energy prices. Purchasing an option has an upfront known cost, the premium. An option’s strike is the exercise price at which you are entitled to buy or sell the underlying asset. An option’s maturity is the exercise date when you are entitled to buy or sell (so-called “European” options can only be exercised at a single pre-fixed future date; “American” options, in contrast, can be exercised at any point during the life of the contract). An option is “in the money” when the underlying asset is trading at such a level that the option’s owner would receive cash from exercising.
Here’s a call option example: For the right to buy one Google share for $1,000 a month from now (European option), you pay 1 percent today. One month from now Google is at $1,200; you exercise and make $200 gain. One month from now Google is at $700; you don’t exercise (buy in the market). You gain if the underlying asset goes up. Your maximum loss is capped (1 percent premium); maximum gain is unlimited. Now, a put option example: For the right to sell one Google share for $1,000 a month from now; you pay 1.25 percent today. One month from now Google is at $1,200; you don’t exercise (sell in the market). One month from now Google is at $700; you exercise and make $300 gain. You gain if the underlying asset goes down. Your maximum loss is capped (1.25 percent premium); maximum gain is potentially very large. The exposure for the party selling the options is the opposite: collect a maximum gain upfront and face huge losses if the underlying goes up a lot (call option) or down a lot (put option).
So buying options implies a limited and known maximum loss, potentially unlimited and unknown maximum gain, a convex play (pay a little to make a lot; gains are proportionately greater; increasing positive “delta”), bleeding premium cash, betting on big moves, and being long volatility. Conversely, selling options implies a limited and known maximum gain, potentially unlimited and unknown maximum loss, a concave play (make a little to risk a lot; losses are proportionately greater; increasing negative “delta”), picking nickels in front of a steamroller, betting on stable markets, and being short volatility.
Deep out-of-the-money (OTM) options are particularly interesting. The option goes live when the underlying asset is very far away from the strike; thus, for the option’s owner to get a positive payout, asset prices either have to go up a lot (call) or go down a lot (put). These options tend to be very cheap to buy and, in principle, less risky to sell. Changes in the option’s market value are more sensitive to moves in the underlying, as breaching the strike can now be the difference between no payout and a very large one-this is particularly so in the case of so-called exotic, though widely traded, options; for instance, a Google “knock-in” put struck at $700 when Google was trading at $1,000, and that comes alive when Google reaches $400. If at some point during the life of the option that knock-in trigger is breached, that would yield an intrinsic positive value of more than $300, up from $0 a moment earlier. Deep OTM calls are thus a bet on a substantial price spike, while deep OTM puts are a bet on a crash. Both are also bets on wildly enhanced market turbulence. They are, in effect, Anti-Normality plays; you are said to be paying for the tails of the probability distribution, those less likely extreme scenarios.
OTM put selling may be more prevalent than OTM call selling, as well as possibly a better strategy. Simply stated, markets tend to crash more than they tend to suddenly go up by a lot. The so-called volatility skew witnessed in equity markets is testament to that (the prices of OTM puts should be bumped up more than those of OTM calls). You could sell both so that the higher premium earned can cushion losses on the upside or downside, but the exposure to volatility would double.
If the tail event materializes, then we see very bad returns for option sellers (huge losses on very small revenue). If the tail event materializes, then we see very good returns for option buyers (huge gains on very small investment). If the tail event does not materialize, there are very good returns for option sellers (free money, no investment required). If the tail event does not materialize, there are very bad returns for option buyers (all capital is lost).
The temptation to sell those types of options is thus very enticing. You can be a hero for a long time (making free,”riskless” money). Tail events may take a long time or may even never occur. And this strategy has lots of backing; doing the “normal” thing seems right to most, orthodox finance theory is based on the notion that the odds of extremes are negligible, and human psychology may seek instant gratification. Buying the options, on the other hand, may be contra natura. Everybody else is making money all the time while you lose money all the time; they are riding the stable times while you wait for an abnormality to occur. You are crying wolf when everything seems fine; you look loony. You may run out of money, your investors may lose patience, and your sleep quality may suffer. Mike Burry, a big winner from the subprime crisis who began to bet against bad mortgage bonds as early as 2005 and who endured several years of continuously bleeding premium money in his protection-buying trade, was abandoned by his backers just before he made a killing. In spite of his eventual vindication and the many millions earned, Burry decided to close shop, suffering from the exhausting battle fatigue that his chosen strategy demanded. Being a contrarian and buying, not selling, protection against disaster can be a toll on the body and mind.
Option buying may not be for those eager to be accepted in society and invited to fancy parties. There may be something utterly unacceptable in forecasting doom all the time; people may prefer to hang around those who only see rosiness. It may be no coincidence that a lot of option buyers have been contrarians or social outcasts. Steve Eisman constantly irritated people and had a habit of insulting everybody. Mike Burry was a one-eyed loner suffering from Asperger’s disease. Nassim Taleb is a relentless crusader against conventionalisms. On the other hand, many notable sellers of optionality (bulge bracket investment bankers, elite insurance company executives, legendary infallible gurus) couldn’t be more embedded into society’s upper echelons establishment.
When trading options, it is essential to keep in mind margin-related issues. When a short option position goes against the party that sold the option (for instance, when a put seller experiences a decline in the price of the underlying asset or an increase in volatility), that party may be required to post collateral or margin as a kind of guarantee that they can make good on their contractual obligation towards the other party. That is, with options, you can make/lose money even before maturity and even if the underlying asset went against/for you. Option transactions will always be subject to regular margin calls if they were transacted on an official Exchange. If the trade took place bilaterally in the over-the counter market, whether margin payments are demanded would depend on the type of agreement reached by the two parties. Many option sellers thus blow up way before expiration date due to margin calls that can’t be met.
Puts and calls have existed for millennia, but in more recent times, a new vehicle for those bent on betting for or against the extreme event has surfaced, gaining widespread notoriety of late. We are certainly talking of credit default swaps, whereby one party pays (receives) a regular fee every three months, and if a predetermined credit event on a reference bond or loan takes place, they would receive (pay) the difference between the swap’s notional amount and the bond’s or loan’s recovery value. That is, it’s the difference between buying credit protection (buying optionality) and selling credit protection (selling optionality). Were there to be a default or a bankruptcy or a debt restructuring, the party selling protection could be instantly liable for a whole lot of money, possibly much more than the money previously earned through the quarterly fees.
Credit default swaps obviously pose a conundrum. When you are betting for somebody’s bankruptcy, the incentives to cause that bankruptcy may be tempting-akin to buying fire insurance on somebody else’s home. While it may be impossible to make the S&P 500 sink 20 percent and thus render a deep OTM put position highly profitable, can you make somebody (a company, a state entity, a nation) bankrupt? This may be more feasible. When the emergence of disaster can yield untold gains (John Paulson made $20 billion in two years via credit default swaps), very important and influential people may find themselves with an irresistible incentive to enable disaster. The anti-social aspect of the play may be too taxing for many.
Before someone decides whether to buy or sell optionality, two key questions need to be asked. First, what is the likelihood that the big event will take place? Maybe the honest answer is that we can’t know, given how undecipherable human-driven financial markets are. Perhaps an easier question is: Are big events a prevalent aspect of markets? It seems clear that the answer is yes. Orthodox finance theory says “no” (Normal probability distribution). But real life says “yes” (1987 equity crash, 1994 bond crash, 1997 Asian crisis, 1998 LTCM crisis, 2000 Nasdaq bust, 2007 credit crisis, 2011 Euro crisis). But can we accurately time the big event? What if it takes longer for the big event to take place than for us to raise more capital to keep betting for it? You can bleed to death even if you are right. Can you personally stand the heat? Can you be patient?
The second obvious key question is: What is the cost of betting for the big event? It could be so cheap as to make it worthwhile to wait years for a payout. Some people indeed scour the world for “very long odds” opportunities (tail risk wildly mispriced). Cases in point would be credit default swaps on subprime bonds before mid-2007 and on Euro sovereigns before 2010, so cheap it hurt. For instance, AIG sold subprime protection for just 12 basis points and Greece’s CDS spread was almost zero in late 2007.
If you concur that markets are littered with non-normal phenomena and find extremely cheap opportunities to make that bet, you may not care at all about the exact likelihood of the event. You know that you have been handed a lottery ticket where the odds are way higher than conventionally expected. And that may be more than enough for you, no further precision required.
Heaven and Hell
Two well-known and high-profile past cases crisply illustrate the promises and dangers of selling optionality. Before October 1997, Victor Niederhoffer was one of the world’s top hedge fund managers. A superstar University of Chicago Ph.D. who had been a squash champion and had worked with George Soros, Niederhoffer had an enviable track record and was accorded genius status by many. But on that October 27th he blew up, losing everything. He had sold puts on the S&P index, and when the market tanked 7 percent on that date (reverberations from a concurrent financial crisis in Asia), he suffered losses that were too big to swallow. He had to shut down his firm. His belongings, including a notable art collection, were auctioned off. He had to borrow money from his daughters. A depressive period followed. But by 2003, Victor Niederhoffer was back and doing very well again (40 percent-plus annual returns); he won industry awards once more; his key funds yielded +35 percent during the first half of 2007. In late July of that fateful year, the stock market tumbled following the blow up of Bear Stearns subprime hedge funds; August was even worse, with mad volatility levels taking over. Niederhoffer was short volatility, having once more sold lots of options; he faced massive losses. Amid the chaos, the Chicago Mercantile Exchange (where Niederhoffer had transacted) raised margin requirements. Niederhoffer struggled to meet them and had to close his flagship funds, down almost 100 percent. He had experienced his second fatal blow up. In the end, the extreme caught up with him, twice.
Before mid-2007, the Financial Products division at insurance giant AIG was doing great. Profits were aplenty, and employees reaped great rewards. AIG FP had found a goldmine in selling protection on different types of financial assets. Initially, they insured firms holding corporate debt. Then, they switched into asset-backed securities: auto-student loans and prime mortgages. Finally, they dived into the subprime mortgage market. In all, AIG FP would end up selling $500 billion in protection, and $80 billion of that referred to subprime bonds. AIG FP was charging just a few basis points for its hedges to other firms, but calculated on such large notionals, it amounted to tons of income. And it seemed like free money, AIG FP’s mathematical models assuring that the big event that would force AIG FP to owe tons of cash to the protection buyers would never materialize.
This was particularly true in the case of Subprime CDOs, where AIG FP sold protection from the very start of that business. The super senior tranches of CDOs that investment banks were keeping on their balance sheets and hedging through AIG were rated AAA+, and the default correlation among the many bonds making up the CDOs was calculated to be minimal. In other words, all the key metrics appeared to indicate that the CDOs would never go bad and that AIG FP would never suffer losses in that sphere.
In early 2006, AIG decided to stop selling subprime protection, finally smelling something nasty. But the old deals backfired eventually. As we know only too well, the protection on CDOs was eventually needed-in spades. AIG could not meet those gargantuan obligations, and a public rescue had to be orchestrated. Without public funds, the insurance behemoth (along with the investment banks left unprotected) would have been fallen by the shocking materialization of the “improbable” event. Life was great at AIG FP until it was hell. Selling lots of “riskless” risk is fantastic until reality shows its truer, uglier face.
Warren vs. Nassim
So what happened to our two main protagonists in the end? How did their opposing approaches fare?
In 1999, Nassim Taleb founded Empírica hedge fund with his student Mark Spitznagel, with the mandate to bet on the improbable long-odds market happenstance. Empírica made 57 percent positive returns in 2000. Empírica lost 8 percent in 2001 (7 percent gain in September) and 13 percent in 2002.
In 2007, Spitznagel founded Universa hedge fund, with Taleb as adviser. Universa returned plus 115 percent in 2008,23 percent in 2011 (through August). Universa lost 4 percent in 2009 and in 2010. Today, it is considered the leader in tail hedging strategies, and its success (together with the vindication of Taleb’s philosophy by real world developments) has spawned numerous imitators. How much can you make buying optionality? Enough to buy a celebrity’s home. Mark Spitznagel purchased Jennifer Lopez’s Los Angeles mansion for $7.5 million in 2009.
Since 2004, Warren Buffett sold longdated put options on international equity indices as well as credit protection through default swaps on high-yield, states-municipalities, and single corporate names. He collected about $7-$8 billion upfront and extra premium money regularly from some of the swaps. He suffered large mark-to-market volatility throughout, particularly on the puts, but limited real cash losses given the limited collateral agreements that he had entered into with his Wall Street counterparts. As of September 30, 2011, his marked-to-market equity put liabilities amounted to $8.8 billion (i.e., how much cash he is “expected” to eventually lose when the contracts expire), and his credit swaps liabilities amounted to $1.2 billion.
The puts were struck at-the-money, are European style, and will expire through 2018-2026. The maximum possible loss on the puts (notional amount) is $34 billion. The credit position has a notional value of $25 billion, a cap on max losses, and a mix maturity bag. Highyield swaps mature in 2009-2013, statemunicipalities in 2019-2054,corporate in 2013. As of September 30, 2011, collateral postings by Buffett’s Berkshire Hathaway amounted to $443 million.
Buffett suffered no big moves in 2004-2006, but bad news began in earnest in 2007 with a $283 million loss on the puts year-on-year, not surprising given the underperforming equity markets in the second half of the year. Disaster truly struck in 2008, the year that saw the end of several legendary investment banks and brutal market behavior both equity—and credit—wise, with a $5 billion loss on the puts and a $1.7 billion loss on the default swaps. Buffet got some relief in 2009, as things calmed down, with a $2.7 billion gain on the puts and a $790 million gain on the credit swaps.
More good news came in 2010, with a $172 million gain on the puts and a $250 million gain on the credit swaps. But nightmares resurfaced in 2011. In the third quarter, Berkshire Hathaway witnessed a $2 billion loss on the puts and a $250 million loss on the credit swaps.
While puts-related losses are mark-to-market, some credit swaps experienced defaults leading also to real cash losses. Given derivatives accounting rules, all those changes in market value impact Berkshire’s reported earnings, on occasion resulting in severely reduced overall reported profits. Many of Buffett’s setbacks on his defiant puts and default swaps trades have fronted headlines worldwide.
As of year-end 2010, Buffett had suffered $2.5 billion realized (paid) losses on the credit swaps, against original premium raised of $3.4 billion; thus, so far, the Sage of Omaha has experienced positive underwriting profits on the credit plays (and this doesn’t take into account the returns possibly generated on any investment financed with the premium money). Buffett had raised $4.8 billion in premiums from the equity puts, plus a $222 million gain from the unwinding of some contracts (plus, again, possible proceeds from premium invested). No new contracts were entered into in 2010.
Why did Warren Buffet sell optionally? Why did he play with “Weapons of Mass Destruction” (his own words to describe derivatives a few years back)? Well, let’s hear it from the legend himself, as reported to his shareholders: “I believed each contract was mispriced at inception, sometimes dramatically so.” He also said,”Derivative premium is like insurance float: if we break even, we would have enjoyed the use of free money for a long time,” and, “Our expectation is that we will do better than break even.” In other words, he believes he’ll eventually come out ahead. Perhaps, but the story of his positions so far, as well as the historical experiences of other famous option sellers, tells us that the journey may be no picnic.
The Joy of Contentment
The splendid 1981 movie “Chariots of Fire,” about a group of British athletes poised to compete in the 1920s Olympics, offers a fascinating subplot into the human struggle to obtain glory at all cost. Harold Abrahams, a superb 100-metres runner, simply had to win. His desperate quest for victory is an angst that is most likely shared by all those who can only define themselves through winning. Only winning at all times gave Abrahams his value as a person. Only victory gave meaning to his entire existence.
Now, clearly such obsession pushed Abrahams into training harder and harder. In the movie, we see him laboring day in and day out with his prestigious coach. His single-mindedness is undisputable. His unrelenting focus is undeniable. Because of his need to win, Abrahams becomes a much-gifted and prepared runner. His inner demons push him into the best possible shape, effectively bringing the dream of Olympic glory closer. Abrahams’ desperate determination to be the best assures that greatness is indeed feasible.
However, by choosing such an existential path, Abrahams exposed himself to a devastating blow-up; without glory he would lose all sense of purpose, all sense of self, all will to live. By irrevocably giving in to the desire for glory, he opened up the gates of blow-up hell. Unlike his fellow (though much less gifted, and much less obsessed) athlete and friend Aubrey Montague, he had never known the joy of simple contentment. Abrahams, much to his desperation, could not find the road to contentment. He couldn’t find the road to Aubrey (who could never blow up; he was gloriously content).
Perhaps financial markets could use a large dose of contentment. Perhaps if more financial pros were content, less impacting blow-ups would take place as less influential people would take the path to quick glory. Financial players in desperate need to win can make everybody else lose. The avenues to fast richness can be paved with gargantuan risks, to be shared by others down the road. It is not irrational to wonder what need Warren Buffett had to sell more than $50 billion in optionality, to expose his glorious and long reigning firm to such contingencies. Buffett was already a big winner and a big bread earner before he chose to defy the rare event in such scale. It is unlikely that he absolutely needed those $8 billion in premiums. So why do it? Perhaps there are individuals who simply can’t stop conquering, who simply can’t stop pursuing and chasing. Perhaps markets are littered with Alexander the Greats, incapable of turning down the opportunity for a new quick grand victory, regardless of possible negative ramifications. Just like the Greek conqueror eventually exhausted his troops and angered his generals by refusing to stop pursuing, financial conquerors can lead to great tragedies and obliteration. Just like Alexander probably didn’t need that last highly daring (and eventually disastrous) adventure into India, Buffett probably didn’t need that highly daring foray into derivatives territory.
Perhaps many of those who sell optionality agree with Nassim Taleb, even if only in private. Maybe a lot of people believe in rare events but don’t want to make a living betting for rare events. Bleeding to death may appear as wildly unattractive; there is no sure winning, and you will perhaps never be a hero. Maybe a lot of people agree with Taleb, but they don’t want to be like Taleb. They want to win fast rather than wait to win. So they publicly dismiss Taleb’s views and theories, even while privately firmly believing in them. They’d rather sell options, even while firmly believing that option buyers are right. Perhaps, if confronted with the Lebanese-American trader-author, they would echo the words uttered by Harold Abrahams to his friend Montague: “You are my most complete man. You’re brave, compassionate, kind: a content man. That is your secret, contentment; I’ve never known it. I’m forever in pursuit and I don’t even know what I am chasing.”