Originally, I typed up a version of this and sent it directly to Eliezer. This was mostly because I wanted to check a bit closer before I made the stuff available to “peer review.”
Having watched the market a bit, and being content with the results, I have retooled it and posted it here. Eliezer, being busy, I’m certain, with other matters, hasn’t yet given me any feedback, so some of my assumptions about the requirements are likely wrong, but I figure he (or someone) will correct me eventually.
Getting The Slump To Pay 100:1 (Or At Least 10:1).
The Thesis Part I:
The investment thesis originally stated is “global stagnation for 30 years.”
There is a conflict in the way the thesis is worded here: “What would be the most efficient way to bet on that, requiring the least initial investment for the highest and earliest payoff under the broadest Slump conditions?” But I will get to that later.
We are looking for an investment strategy to capitalize on the thesis.
We, like most investors, want to get the most “bang for the buck.” We would like to enjoy as much leverage as possible, even (especially) if that doesn’t come from borrowed funds.
The Best Strategy?
I suspect, based on all of this, that we want an options strategy. It provides “organic” leverage, that is, it doesn’t require literally borrowing, and it has the flexibility you are looking for.
In particular, I think we want to do something like the reverse of what Warren Buffett recently did. He sold European puts on major indexes with 15-20 year expiration. “European” puts (options) meaning that they can ONLY be exercised on the expiration date not “American” options which can be exercised by the holder at any time UP TO the expiration.
-Short Options Writing Course (With “Why We Are Not Buffet” Goodness):
When you “Sell Puts” or “Write Puts” you are promising a third party or third parties that you will buy the underlying asset for a particular price at a particular time (or time-frame in American options) IF they exercise the option. They are buying the option, and pay cash for it (usually) when the contract is written or traded. Their option is to sell you (to “put”) the underlying asset at the agreed upon price. As you can see, if things get really dire, and you have sold someone put options, they might want to ask for collateral to be sure they will be paid. Your downside is unlimited. You might have to sell someone a bunch of shares worth $86,000 a share (Berkshire for instance) for $30 per share. You might go insolvent, after all. Your “counterparty” will seek to reduce her “counterparty risk.” This is particular to options writers, or those who SELL PUTS. Or SELL CALLS. Options buyers (who have the option) don’t put up collateral unless they borrowed to buy options.
Obviously, if the underlying asset is higher (lower) than the “strike price” of a put (call) option (the price which will be paid at expiration) the option will go unexercised, or “expire worthless.” The premiums (what the seller was paid for the option on day one) are the seller’s to keep.
It looks like Warren Buffett sold put options that permit the counterparty (Goldman Sachs is expected, but no one knows) to sell him several billion dollars worth of interests in four different global stock indexes in 15-20 years at a price which was set at the then market rate, or near it. Buffett was paid $4.5 billion for the options. One presumes his thesis was to invest that money for a healthy return for 15-20 years and (he hopes) have the options expire worthless. Essentially, this was a bet on long-term global non-stagnation. Sort of the opposite of our bet.
What Buffett managed to negotiate, because he’s Buffett, is NO COLLATERAL CALLS on the options. That is, even if things sink into the ground, he does not have to put up collateral for the options (except in some very exceptional circumstances involving the finances of Berkshire and not the current mark of the options). Otherwise, he might have had a brutal capital call in the billions of dollars with the recent disaster.
Better not try to write/sell options by themselves:
Though it looks like it might be good to just sell calls (the technical opposite of Buffet’s trade) you can’t do what Buffett did. Writing calls in any large quantity, which would be betting on stagnation or deteriorating prices (as suggested by some comment authors), is a bad idea for this collateral reason. If you are wrong you are going to have to come up with cash before the options expire, or you will have to “cover” the calls up front by buying the Index (the “covered call” strategy).
So, we need something else.
Puts don’t work either.
An interesting bit of contrary data to Eliezer’s statement: “in general, it seems to me that other people are not pessimistic enough; they prefer not to stare overlong or overhard into the dark; and they attach too little probability to things operating in a mode outside their past experience.”
Actually, the options market is almost exactly the opposite usually. There are a number of reasons, but primarily as a consequence of the crash of 1987, put options got quite popular as protection and a hedging tool. These tend to be very expensive. (Certainly, Loss Aversion plays a role here, and there are many option traders who look to take advantage of mispriced puts). Warren Buffett is one of these, particularly in his demonstrated love of selling “catastrophe insurance,” which is essentially his way of saying “people are too pessimistic.”
What is our thesis REALLY?
“What would be the most efficient way to bet on that, requiring the least initial investment for the highest and earliest payoff under the broadest Slump conditions?”
Well, the “highest” payoff I’m with. The “earliest” payoff is a problem. You either are betting on 30 years of slump, are you are betting on 1 year of slump for 30 years in a row. Or 5 years of slump 6 times in a row. If you want periodic payments, that’s different than wanting a lump sum after 30 years. I will assume you really want a 30 year slump with payments every year or couple of years in the slump.
You also say “slump” not “crash.” I took this to mean stagnated, but not continually deteriorating prices. This helps us because it makes our option strategy cheaper. Covering prices from $1000 − 0 (buying a put option) is expensive, particularly since I doubt your counterparty is going to make good if the market is really at “0”. (This is like buying dollar denominated insurance on Treasuries. If the Treasury defaults the last thing you will be interested in getting is a big pile of U.S. Dollars).
I suppose we would best measure economic “stagnation” with stock indexes or the like. We are, I think, really making a bet on volatility. We are betting that for 30 years we won’t see big swings up or down. 30 years of… just “blah.” We are also betting on “anchored volatility.” That is volatility from a particular price with an extending time frame, not 30 day volatility averages, and not average daily volatility or some scrolling time window measure.
Return Models for Options:
What we really want is an options return model that looks like this (where x-axis is price of the underlying asset and y-axis is returns to us).
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Profit when the asset price just sits there. “There” being some price we think represents the “settle point” for “the 30 year slump.” This is a “sideways strategy.” The two options strategies we are looking for here are a Long Call Condor and a Long Put Condor.
Technical Details:
Basically, we buy a call at the low end of the range you want to cover. Then we sell two middle strike calls that represent the ends of our top level, buy a call at the top of our expected price range for the underlying.
Expected Returns:
I decided to take a look at what this might cost and what the market might return for this strategy. I did this with S&P 500 options because they tend to have good liquidity and therefore we could (one imagines) get good prices. Also, the S&P 500 index changes with the economy. Its components are rotated in and out. It tends to be a good representative slice of general economic progress (or lack thereof) and not stuck on any particular sector or company. Really, the index is linked to the future expected earnings of a decently representative slice of the economy.
Obviously, options prices depend on expected volatility so the actual returns on the play will vary year to year as your cost to put on the strategy varies. If anyone is really interested I will check into this.
As I write this, the S&P 500 index is sitting at 827.50. Let’s assume that we want a strategy that will pay us every year that it ends in the same place it started +/- around 10%. So, something that will pay us off if the price falls between 750 and 910 in December. Or something.
Using S&P 500 options it’s not hard to construct a scenario that will pay up to 1000%+ on an investment like this in December 2010 if the S&P 500 closes at 827.50 (its closing price today) on 12/17/2010, and pays at least SOMETHING if we end up anywhere between 750 and 900 or so.
Basically, for $4,300 in investment you will see the maximum return of $45,700 anywhere between 800.15 and 849.50.
Of course, the reason this pays off so well is because the market thinks you are fool for betting it. But, then the line between genius and fool is fine and judged in hindsight.
If you consider it an insurance policy, $4,300 as insurance from stagnation (but NOT a catastrophic crash) with a 10x payoff is pretty good. But you are insuring for a VERY thin slice of possible worlds in December 2010-- especially if our dataset is near infinite! ;) Obviously, if we widen the middle, our returns diminish.
In addition, you have American options here. That means if mid-way through the year you are in your profit band, you can take the profits whenever you like. For example:
If in June of 2010 the S&P 500 was at 827.50, your options would be worth 131% of what you paid. You could sell them right there. (Or wait). By September, with no change in price, you are looking at 231% returns.
Of course, you could renew the bet each year, resetting to the current price. And you could bet more. $10,000 pays out over 100,000, obviously, in the right circumstances.
I would be VERY curious to hear if this is anything like Eliezer intended.
“How would your strategy be different if the goal was to get a modest return in a stagnating market, a larger return in a market crash, and a loss in the event of sustained growth? Do you think there is a way to guard against transient bubbles?”
Well, you could supplement the strategy with out of the money puts, that would pay more farther down to the downside, but you’d be really limiting your return with that. In fact, puts are so expensive right now that adding options that give you just a 200% return on this position when the S&P 500 hits 300 (this would be amazingly bad) drops your original stagnation position’s returns to −20%.
I’ll do a more detailed strategy and see what kind of returns we can create to cover the “way down” side.