Shorting seriously out of favor

[frommi]

The guy who sold you the puts could very well be sitting on a large concentrated position that he wants to hold onto for tax purposes only, but would otherwise like to diversify his downside risk.

 

So he purchases at-the-money puts to diversify his downside risk, and he write puts on a diversified group of names that he does not otherwise have a position in.  The premiums collected from the naked puts he writes are used to fund the puts he purchases as insurance.

 

So he he moves his previously concentrated risk into a basket of other names.

 

Don't assume he is running on a very thin line.  It may be completely the opposite -- he was on a thin line before with his concentration, and now he is being very conservative.

 

Haha, didn`t know it was you! :)

Seriously, take a look whats going on in the sell-options-for-income forums. There are lots of sheep to get shaved in the next downmove.

[Liberty]

"Crazy" people were talking about how a crash was coming for the housing market years before 2007, too. Just because things take longer than people assume, doesn't mean they're wrong.

 

I'm not calling anyone crazy. But consider the fact that some of those same people who got that call right before the crisis stayed bearish after it and missed or partly missed one of the best rebounds ever. Crystal balls are rare (John Paulson's halo certainly doesn't shine the way it used to). I certainly don't have one.

 

Every time I say that I don't know, people seem to read "I don't think anything can go wrong, the bull market will continue". That's not what I'm saying. Maybe we'll drop 20% tomorrow. But I can't invest as if that's going to be the case, because I don't know.

 

Personally, I find it odd (indeed, too good to be true) that we had a ton of excess with the tech bubble and housing bubble and markets didn't pay much at all for it.

 

What do you think should have happened? 15 years or bear market? A break-down of the economy, with soup queues in the streets and 20% unemployment?

 

We've already discussed this. I find this moralistic approach (people should be punished for their excesses) not useful when it comes to investing. And it did take 5 years for the market to go back to its high water mark, so it's not like there was no pain (esp. considering the bubble's epicenter wasn't in the stock market).

[Guest]

"Crazy" people were talking about how a crash was coming for the housing market years before 2007, too. Just because things take longer than people assume, doesn't mean they're wrong.

 

I'm not calling anyone crazy. But consider the fact that some of those same people who got that call right before the crisis stayed bearish after it and missed or partly missed one of the best rebounds ever. Crystal balls are rare (John Paulson's halo certainly doesn't shine the way it used to). I certainly don't have one.

 

Every time I say that I don't know, people seem to read "I don't think anything can go wrong, the bull market will continue". That's not what I'm saying. Maybe we'll drop 20% tomorrow. But I can't invest as if that's going to be the case, because I don't know.

 

Personally, I find it odd (indeed, too good to be true) that we had a ton of excess with the tech bubble and housing bubble and markets didn't pay much at all for it.

 

What do you think should have happened? 15 years or bear market? A break-down of the economy, with soup queues in the streets and 20% unemployment?

 

We've already discussed this. I find this moralistic approach (people should be punished for their excesses) not useful when it comes to investing. And it did take 5 years for the market to go back to its high water mark, so it's not like there was no pain (esp. considering the bubble's epicenter wasn't in the stock market).

 

I don't know what should have happened. I'd think it would have been more pain than what we had, though.  I would hazard a guess, perhaps, valuations would have been would have shot dramatically below their historical averages (as least with CAPE they were only slightly below historical averages but didn't really overshoot much - and yes, I know it's not perfect). I would expect that the "worse recession since the great depression" would have been worse than the 70s, at least...or at least close to it. It's funny how these things usually play out. Things are great for a while (dot com boom) then...they're not. Things are great for a while (housing)...then they're not. When one plays with economic forces through financial engineering things have a funny way of playing out to unintended consequences - especially since we are so short sighted these days. 

 

With that being said, I do appreciate your counter arguments in the Macro Musings thread. It's good to have a challenging viewpoint. I think they way you are thinking is the right way about not timing. However, at least here in the US, a decent chuck of our money is tied into 401k plan. Many times, we have only mutual funds for choices. So it's impossible to find undervalued companies when you can't buy individual stocks.

[hyten1]

i for one already have a hard time finding good ideas and just focus on that.

 

i want to LASER FOCUS, LASER FOCUS on finding undervalue situations (i periodically scan my portfolio for things that i no longer want or believe or thesis no longer hold)

 

it is very tempting to time markets, get out at the high, get in at the lower, but i have not been able to do this. it is very tempting to have bought the puts when market start to dive. i am not eric.

 

also the cost of a sell is very high (that is why puts are so tempting vs outright sell). there is tax, then there is the fact you have to find something else that will make up the tax loss and its potential appreciation.

 

this thinking has change a little bit on what i would buy, i want something that i would/could hold on a bit longer (this doesn't mean i don't invest in tempting special situations)

 

hy

 

 

EDIT: i do periodically but puts and/or sell them

 

 

"Crazy" people were talking about how a crash was coming for the housing market years before 2007, too. Just because things take longer than people assume, doesn't mean they're wrong.

 

I'm not calling anyone crazy. But consider the fact that some of those same people who got that call right before the crisis stayed bearish after it and missed or partly missed one of the best rebounds ever. Crystal balls are rare (John Paulson's halo certainly doesn't shine the way it used to). I certainly don't have one.

 

Every time I say that I don't know, people seem to read "I don't think anything can go wrong, the bull market will continue". That's not what I'm saying. Maybe we'll drop 20% tomorrow. But I can't invest as if that's going to be the case, because I don't know.

 

Personally, I find it odd (indeed, too good to be true) that we had a ton of excess with the tech bubble and housing bubble and markets didn't pay much at all for it.

 

What do you think should have happened? 15 years or bear market? A break-down of the economy, with soup queues in the streets and 20% unemployment?

 

We've already discussed this. I find this moralistic approach (people should be punished for their excesses) not useful when it comes to investing. And it did take 5 years for the market to go back to its high water mark, so it's not like there was no pain (esp. considering the bubble's epicenter wasn't in the stock market).

[gary17]

Hi Eric

So I gather you write puts to finance buying puts on certain concentrated position you own. Let's call it BAC. And you sold SHLD puts to finance BAC's insurance.

 

But what if SHLD drops so much now you have to buy the commons?  (my understanding is as a seller you pocket the premium up front. But if the price gets below the strike you have to buy to sell to the buyer of the put option)

 

Thanks!

 

 

Think about the other side of that trade. The one who sold me the puts is running on a very thin line, i would never do that with such low premiums and that huge amount of risk.

 

The guy who sold you the puts could very well be sitting on a large concentrated position that he wants to hold onto for tax purposes only, but would otherwise like to diversify his downside risk.

 

So he purchases at-the-money puts to diversify his downside risk, and he write puts on a diversified group of names that he does not otherwise have a position in.  The premiums collected from the naked puts he writes are used to fund the puts he purchases as insurance.

 

So he he moves his previously concentrated risk into a basket of other names.

 

Don't assume he is running on a very thin line.  It may be completely the opposite -- he was on a thin line before with his concentration, and now he is being very conservative.

[ERICOPOLY]

But what if SHLD drops so much now you have to buy the commons?

 

I take it there is a 3 day settling period and then the shares are delivered.

[Liberty]

I don't know what should have happened. I'd think it would have been more pain than what we had, though.  I would hazard a guess, perhaps, valuations would have been would have shot dramatically below their historical averages (as least with CAPE they were only slightly below historical averages but didn't really overshoot much - and yes, I know it's not perfect). I would expect that the "worse recession since the great depression" would have been worse than the 70s, at least...or at least close to it. It's funny how these things usually play out. Things are great for a while (dot com boom) then...they're not. Things are great for a while (housing)...then they're not. When one plays with economic forces through financial engineering things have a funny way of playing out to unintended consequences - especially since we are so short sighted these days.

 

I think we have to be careful with comparisons based on just 1-2 variables. There are many more things going on.

 

f.ex., of course valuations will go much lower when interest rates are 8-10% or more than when they are 0-2%. The opportunity costs are very different.

 

Of course marco-economic mismanagement can make a bad situation worse. F.ex. the recent financial crisis would've not doubt been much worse if the fed had cut off liquidity instead of adding some, since most of the problem in the financial sector wasn't that everything was worthless all of a sudden (some stuff was, but far from all), but rather that nobody had cash to finance short term obligations and nobody wanted to buy anything from anyone else until uncertainty was lifted and they knew what was toxic and what was fine. GE and WFC and JNJ didn't all suddenly become worth a fraction of what they were worth the week before, their stock prices didn't fall off a cliff because of a nuclear war that wiped out their factories and customers... The 1970s had all kinds of SNAFUs that made things worse than they could have been with saner policies.

 

Anyway, it's all so complex that I don't find it worth trying to predict. It's fun to read about, but I leave it outside my decision-making as much as possible. If a specific business is too expensive, then it's too expensive.

[gary17]

But what if SHLD drops so much now you have to buy the commons?

 

I take it there is a 3 day settling period and then the shares are delivered.

 

meaning you'd sell your other holdings to finance buying the SHLD shares ?  so in order for this strategy to work you are finding a cheap, cheap stock that the probability of hitting the strike is acceptably low... (?)

[ERICOPOLY]

But what if SHLD drops so much now you have to buy the commons?

 

I take it there is a 3 day settling period and then the shares are delivered.

 

meaning you'd sell your other holdings to finance buying the SHLD shares ?  so in order for this strategy to work you are finding a cheap, cheap stock that the probability of hitting the strike is acceptably low... (?)

 

Why would I need to sell holdings that are protected by puts?

[gary17]

may be i'm not getting the complete picture

 

let's say i buy BAC commons and BAC puts to set up an artificial 'call' 

 

and now i sell SHLD puts to pocket the premium to pay for the BAC puts I bought. 

 

so if SHLD collapses... i need to buy SHLD commons to satisfy the naked puts i sold...    so i either have cash ready to buy or i sell other holdings to buy SHLD? 

 

or have i got this completely wrong?

[ERICOPOLY]

so if SHLD collapses... i need to buy SHLD commons to satisfy the naked puts i sold...    so i either have cash ready to buy or i sell other holdings to buy SHLD? 

 

or have i got this completely wrong?

 

 

I do this in a portfolio margin account.  I won't get a margin call if SHLD collapses and I get assigned, because the BAC position is hedged with a put.

 

I will temporarily have a margin loan utilized to own the SHLD shares.  Let's say you have religious reasons why you cannot have a margin loan.  Fine, then sell the SHLD shares and replace them by writing in-the-money puts with the same strike that you started out with before you got assigned.

 

 

[moody202]

I take it there is a 3 day settling period and then the shares are delivered.

Eric - Could you elaborate on the point you are making here? I feel I have an idea about what you are saying but am trying to understand it better.

 

I will temporarily have a margin loan utilized to own the SHLD shares. 

What would you do at this point? Would you sell your newly acquired shares and take the loss (assuming its trading below your assigned price)? Or you are comfortable holding the SHLD shares for the medium to long term and the put you sold on SHLD was at a price point you were comfortable buying SHLD at?