Research is essential. Without it, it’s difficult to tell whether you aren’t just trading noise. Practical experience is essential, too. Without it, it’s difficult to find the limitations of your research. Here’s a story that played out in my mind last week. None of these are thoughts that haven’t been thought or written about extensively before, but the juxtaposition of a G-d’s eye view of markets with a minute-level look makes the point pretty well, I think.
First, some research on how great an idea it has been to sell one month straddles on equities since 2000:
Breakdown of P&L (index points) for systematically selling 1M straddles on E-STOXX50. Source: Deutsche Bank
Sell, sell, sell, and not just puts, either. The grey line there – selling 50 delta puts each month – has done better than SX5E over the period, but short calls really help a lot, especially during downturns. One of the findings of this study was that owning further out of the money short-dated puts to hedge your short straddle was not, at least on this index, obviously helpful in risk-adjusted terms. So the only reasonable conclusion would be to strap in and sell everything with a bid, right?
You can apply a naked short straddle view of the world to most assets. Take everyone’s favorite proxy for sectarian religious conflict these days, Japanese government bonds: disheveled Austrian prophets keep looking for doom and paying dearly for the privilege while the pudgy, well-coiffed parishoners of St. Maynard’s and St. Milton’s shuffle by. This is what normal looks like:
June 2013 Japanese government bond futures, March 6 – April 2, 2013, 30 minute bars. Source: TSE
A straddle jockey can make a mental note of that average true range (lower panel) around 0.03 – 0.05, or look at realized vols, or et cetera, and sell accordingly. It has been profitable. The research says so. Until:
June 2013 Japanese government bond futures, March 6 – April 5, 2013, 30 minute bars. Source: TSE
The doomsayers finally got a taste. Supposedly the April 5th action in JGBs was caused by a large Japanese bank or insurer that, surprised by the intensity of Kuroda’s plan, did not wait around to find buyers for all the bonds it wanted to sell. As a small bystander, when you’re into hour two of a selloff like that and buyers are still in hiding, there’s not much choice but to “manage risk”. The average true range now is three times your expected upper limit, your short call is helplessly without gamma, and your short put is eating up the last two months of profits and more. The only small grace is that, because you’re not short a whole strip of downside strikes (variance swap), your short put will run out of gamma, too, and eventually just act like a long futures position.
A clever trader replies here that the position ought to be delta-hedged. That’s fine – we do it – but five-minute jumps are hard to watch, especially when your research and your actions to this point assume at most a daily rebalancing. When people start taking bathroom breaks in shifts it is too tempting to change your “hedging regime” from daily to hourly to every crazy tick lower, which is not noticeably different, in P&L terms, from dumping the position or buying OTM gamma in the first place.
That’s enough, in my mind, to make perpetual naked straddles a non-starter, no matter what the backtest says. We’re not just talking about straddles here, either. Even though JGBs recovered in this case, even though the House finally passed TARP and Draghi said what needed to be said and the world will probably, hopefully, always have enough adults around to keep the bottom from falling out, the problem with strategies like this one is that they ask too much of us. No box is ever completely black and no strategy is ever completely automated as long as there is an off switch.
It doesn’t follow that the edge identified by even the most incurious option seller isn’t really there. The edge is as real as time and carry and the psychology of the average equity holder. The trick is in finding a sustainable way to exploit it, and while ideas are easy to come by, ad hoc practitioner intuition can never be as complete or as reliable as research. So we’ve come full circle: neither the nerds nor the jocks are self-sufficient, and success comes only in a synthesis.