Two safe havens

By Felix Salmon
November 13, 2009
assertion that there's no safe haven for investors these days. Jared Woodard at Condor Options responded with 1,500 words on how investors in an S&P index fund can buy put options to protect their downside: "any hedging at all is better than none," he writes. Meanwhile, maynardGkeynes left a much shorter comment:

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I got two smart responses to my assertion that there’s no safe haven for investors these days. Jared Woodard at Condor Options responded with 1,500 words on how investors in an S&P index fund can buy put options to protect their downside: “any hedging at all is better than none,” he writes. Meanwhile, maynardGkeynes left a much shorter comment:

TIPS are both easy and obvious.

Of the two, I prefer the TIPS. Why gamble in the stock market at all, if you don’t need to? Jared’s options strategy is akin to buying insurance that your bet won’t pay off, without stopping to wonder why you’re making the bet in the first place. The main advantage to the options strategy is that if things really blow up, and there’s a major stock-market crash on the order of 60% or so, you could actually end up making a profit. But I think an investor who was invested in TIPS during such a chaotic time would be perfectly happy with her choice.

There are two small problems with the TIPS strategy. One is that the tax implications of investing in TIPS can be extremely complicated, and taxpayers might want to consider the cost in accountancy fees before going down that road. The second is that it doesn’t scale: the whole point of financial markets is that they turn savings into investments, and we actually want people with savings to be willing to take a little bit of downside risk.

In that sense, Jared’s strategy of buying long-dated puts and selling them six months before expiry is better. It brings with it most of the upside associated with stock-market investments, it helps move money into equities (which, over the long term, is something society prefers to having it create bubbles in the debt market), and it helps the investor sleep at night with regards to black-swan events. What’s more, it involves a little bit of work: that’s a good thing, since investing shouldn’t be brainlessly easy. On the other hand, it also involves a significant transfer of funds from the Main Street investor to Wall Street, which always makes money on options trading.

Still, both strategies are worth considering for people with investments. In general, I’d recommend the TIPS approach to people who are likely to be able to make money the best way, by earning it: in that case TIPS are a safe place to put your hard-earned cash. (Especially if you are very unlikely to move abroad, and aren’t worried about a falling dollar except insofar as it feeds through into inflation.) On the other hand, people who are looking to earn money through capital rather than labor will probably not be happy with the modest return on TIPS and might be happier with Jared’s approach.


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I support Jared’s approach, with slight modifications. But the major point is that too many investors accept whatever their financial advisors tell them – without understanding that alternatives are available. Better alternatives.

Stock options are designed to reduce risk. If anyone believe owning TIPS is a good long-term investment, well so be it.

But for anyone who wants to own stock market investments with at least a portion of his/her portfolio, then understanding basic option strategies can only help.

Options reduce risk. It’s that simple. I recommend the collar strategy, and Jared recommends half of that strategy. The collar limits profits, but in return, the puts cost little or nothing.

Be informed. Learn how options work. The make an intelligent choice.

Here’s a basic explanation of the collar strategy with an example:

If we lived a in black and white world, perhaps those would be the only 2 choices…

Posted by Big O | Report as abusive

To a first approximation, still, even after what has happened in the last couple of years, you pays your money and you makes your choice, and your choice is more or less a function of risk tolerance. If you want to avoid risk, then choose simple unintermediated positions which involve little risk (extreme case sovereign bonds); if you are comfortable with more risk, then choose simple, unintermediated positions which take on more risk (extreme case emerging market ETFs). Avoid ideosyncratic risk (i.e. do not invest in single equities). And DONT BUY options, which are neither simple nor unintermediated and are sold to you by people who are better informed, and have more time and resources to think about the situation than you do, and would not be selling you the option if they did not think there was something in it for them – if it is only the servicing charge of maintaining the dynamic hedge.

This will not protect you from catastrophe, but it is more likely to do so than any other strategy.

Posted by sean matthews | Report as abusive

Buffett has said the safest investment for a young person is in skills and education. If you are old, educate the youngun’s in your life. Ain’t no government can take away your skillz.

For many Americans up to the eyeballs in high interest debt, a fairly good bet is to pay that down.

Infrastructure may be a decent bet in the coming years. It is tangible and is therefore an inflation hedge. Plus, it is likely that state and local governments under financial duress in the coming years will want to unload assets.

Jim Rogers sees farmland as the best play right now. Again, it’s tangible, hence an inflation hedge. It will continue to be as important as it has been since the dawn of man. Need to find a way to rent that and get decent yield in the interim, if you aren’t a farmer yourself. If you are a farmer, he tells you Maseratis are in your destiny.

Posted by Dan Hess | Report as abusive


I never suggested that anyone buy options as a plan to earn a profit. Option buying for gain is a very difficult task.

And if that person who sells the option is a genius and does know more than you, so what? Your purpose is to protect your assets from destruction. How is the fact that someone may know more than you suggest that your trade is not ideal for your personal situation or that the price is anything but fair? That seller is not the only person selling those options at the same price.

You completely misunderstand the markets. The seller of any option or stock ALWAYS thinks there is something to gain in the trade. And the buyer feels exactly the same. With stocks, someone is right and someone is wrong. But, with options, both parties can gain from the transaction, when one of the parties is reducing risk by hedging a position.

The collar strategy requires the sale of call options and the purchase of put options. This is a worthwhile strategy for the conservative investor.

I’ve venture Faber’s white paper did a fine job of managing risk, avoiding the market collapse, and is fully invested hitting highs now. I’ve been following it for a few years now.

Posted by Barnst | Report as abusive

What about Japanese TIPs? … matched with long-term CDS on Japan, sold six months before expiry.

Posted by VennData | Report as abusive

Mark, maybe I didn’t put the point quite right – what I meant was that you get paid for risk, simple – if you buy intermediated products like options, then someone is taking a cut from that payment – but you have not changed the amount of risk you take on for the money – you have just muddied it up. And the more sophisticated the strategy you have for manging your risk, the more it will cost you, relative to the risk you still hold onto, and the less likely it is to be properly designed.

I understand how markets work very well. Some years ago, I spent time as an external consultant at a bank (which shall remain nameless), building pricing models for their central risk managment, and I got to see their retail options business – one of the striking things about this (which was selling, essentially, packaged collars and similar) was how casual people were – note, not particularly predatory, more with a shrug of the shoulders – about how this was a business of taking money off little old ladies. It was a memorable learning experience.

Posted by sean matthews | Report as abusive

“[Y]ou have not changed the amount of risk you take on for the money – you have just muddied it up.”

This claim is false. A stock position and a collared stock position have strikingly different risk/reward profiles. And the risks of each position are perfectly clear.

Your anecdotes regarding market structure prove too much: if the standard for whether someone should trade a given product is whether liquidity providers make any profit, then no one should ever invest in options, stocks, bonds, or chickens.

Sigh (slaps forehead) – the claim is true. Yes, a stock position and a collared stock position do have strikingly different risk profiles. THEY ALSO COST DIFFERENT AMOUNTS OF MONEY. The difference is the more than amount of risk you have gotten rid of, at the market rate. You can rearrange the amount of risk you want to take on in different future states of the world, but in the end, to first order, you pay for _at least_ the risk you take on (and to second order, the chances are that you take on more risk – as a lot of people have discovered in the last couple of years – and you also have a transaction charge).

If you don’t want risk in your portfolio, buy sovereign bonds. If you want risk, buy a well diversified portfolio of the right sort of equities.

Posted by sean matthews | Report as abusive

“The difference is the more than amount of risk you have gotten rid of, at the market rate.”

If you’re trying to note the presence of a negative volatility risk premium paid by option buyers, you are correct (and with such nice dramatic flourishes!). Academics have noted and analyzed the phenomenon extensively, and many traders exploit it in practice.

That phenomenon does not exclude the fact that it is rational for many investors to pay the vol premium to reduce the risk in their portfolios over a relevant time frame. The vol risk premium is not prohibitively large, it keeps getting smaller, and prior to the financial crisis there were discussions in some circles about whether it would continue to persist at all. For the practical purposes of average investors with their own goals and time horizons, your concerns are misplaced.

The “second order” risks you allude to are obviously not relevant in the case of a risk-defined hedged stock position. Nobody is advocating being naked short convexity here; quite the opposite.