Blessed by the Potato

I didn’t quote it in my last post on the options collar, but it has been said that “options are a zero-sum game”. Options are basically a side bet on the market: for one person to make money, another person had to take the opposite side of the bet and lose. In fact, it’s worse than that, since both parties have to pay fees.

The big problem with zero-sum games is that over the long run you can’t expect to do well (the exception being if you have the skill to take your winnings from other people). That is, after all, what zero-sum means: money/value isn’t produced out of nowhere, it’s only made at the expense of other players.

So why isn’t the stock market itself a zero-sum game? For starters, it’s because the shares represent ownership of actual (generally) profitable companies. You can expect that, as a part owner, you will share in the fortunes of the company through dividends if nothing else. Put another way, over the long term the stock market tracks the economy because it owns a large part of it, so as long as the economy itself isn’t zero sum, everyone can win on the market (and indeed, the very long-term trend has been gains above and beyond inflation in the market as a whole). This doesn’t necessarily hold for very short time periods though, such as day-trading. I’ve also heard the argument that the stock market isn’t zero-sum because there isn’t a counterbalancing position for every share: companies can issue stock (and somewhat more rarely, buy back stock), and so there are more longs in the market than shorts, so therefore it’s not zero-sum. That’s kind of a neat, symmetric mathematical/logical approach, but I like the economic explanation since it seems to have more explanatory power to me — I can see where the money for everyone is coming from.

What else is a zero-sum game? Well, foreign exchange markets are generally considered to be zero-sum games (or again, minus-sum after fees). After all, currency itself doesn’t create value, it merely stores it. There are fiddly external things that can influence that, like interest rate differential “carry trades” that are supported by other pressures maintaining an exchange rate, but for the most part if you’re thinking of following those forex ads, you should understand that the only way to make money is to bet against other people and win.

MW has been popping up in the comments sections of a lot of blogs recently touting an options collar strategy. Larry MacDonald recently briefly touched on the issue. This is an advanced method for reducing risk in your portfolio: you buy an option, essentially insurance, that limits your maximum loss. You then sell the right to buy your shares at a higher price to someone else — that limits your maximum profit, since if the stock goes above that, the person who bought your option will call your shares away. You trade off some of your potential upside to limit your downside. After stomach-wrenching losses in the market over the last year, it sounds pretty attractive.

However, the costs are usually (slightly) stacked against you. Let’s take the example of XIU, an exchange-traded fund tracking the TSX 60.

Today, you could have bought XIU for $16.40. Let’s say you wanted to limit your losses to ~10%, so you want to buy a put at $15 — the ask on that is $0.30 for a put that expires in December. To cover that cost you sell a call for $18 at $0.30 that also expires in December. This collar limits your downside to 8.5% and your upside to 9.8%. Doesn’t sound too bad so far: at almost no cash cost to yourself (there will be commissions as well) you manged to limit your risk while still allowing yourself to reap a decent profit. However, there are a few wrinkles in the collar:

First of all, the commissions are going to be somewhat draining. If we’re dealing with someone somewhat early on in their investing career, then they might have $20k to invest in any one ETF. If the commission is $20 for both halves of the collar, and it has to be reapplied twice a year, you’re looking at only 20 basis points of drag, 0.2%, about what the MER on an ETF is to begin with. Naturally, if you’ve got more money invested the commissions become less oppressive in a percentage basis, but you might run into liquidity problems with the options and pay more in the spread. See comment by MW below, I over-estimated the typical commission for options.

Secondly, there’s the small matter of positive expectation: generally, you expect your stocks to go up, so it’s not like this collar is quite as balanced as it looks: if you expect a 3% average return over the time period of the options (6% over the whole year), then you’re protecting against a return that’s 11.5% below what you expect, but giving up anything that’s more than 6.8% above average. Of course, that ties in to the idea of the risk premium: this strategy reduces risk, so you can’t expect a premium in expected returns. More safety comes at a higher price, and Michael James has a good post on this with a nice graph showing that your expected return actually goes down as you try to draw a tighter collar, to the point where you could have a negative expected return if you want to have a very low risk tolerance.

The next wrinkle is what happens if one of your options is executed? If the market goes down then at least you’re protected — the collar worked for you in this case. But then what do you do? Do you buy back in at a lower price? Do you try to time the market lower? It can add some confusion, and will require some degree of hands-on monitoring (which, IMHO, does not go along with the investor personality that needs this protection). But the bigger issue is what happens if your stocks get called? If the market goes up say 15% in a short time period and you miss out on 5% of that, do you wait to see if it goes back down, or just buy back in right away? If you don’t believe in market timing, and buy back in right away after your options are triggered, then why get the options in the first place? If you do believe in market timing, then why not just do that?

Option collars can be a useful tool to reduce the risk in your portfolio, but IMHO they are too complicated for the benefit they provide. A large portion of fixed income (bonds, GICs) can provide stability and predictably low returns without the hassle. For example, if you wanted to keep your losses at less than 10%, and you figured the largest likely stock market loss was 30% (yes, we did have a larger decline than that recently, but it was also fairly short-lived at that depth), then with 1/3 of your portfolio in stocks and 2/3 in bonds, you’d be set for safety.

The options collar will outperform the largely fixed income portfolio in the cases where stocks to better than bonds, since it’s 100% stocks, even past the point where the stocks get called. It will underperform when stocks do poorly relative to bonds, despite the insurance. Past the point where the call is made, things get tricky because of the issue of market timing and how long it takes you to get back into stocks with a new collar in place, and what gains you miss out on in the meantime. So what we need is a more robust model that includes iterations, cycling through potential market returns and seeing what happens. The best way to do that would probably be with a Monte Carlo simulation, but unfortunately I’m not the person to do that (maybe Michael James will give it a whirl if we ask him nicely?). Here’s one quick shot in the dark though: assuming we have a collar of roughly +/- 10%/yr, fixed income gives 4.4%/year*, and stock returns are along the X-axis, we get the returns in figure 1 (inspired by MJ’s figures).

* – I originally had 3% here for the fixed income part, but in the graphs forgot to multiply that by 2/3 since only that portion of the portfolio earns the interest. It’s easier to change the text to 4.4%, which is still not unreasonable for fixed income, than to go back and redo the graphs :)

Figure 1: the options collar outperforms the fixed income method to safety when stock returns are between 5 and 20%, and again when losses are more than 30%.

Now if we had a good year, say up 15% (and for reference, the market is up over 50% from the bottom last March) and the upper bound of the option collar was exceeded, and we missed out on 5% of the growth before buying back in to the market, we’d start the next iteration down 5% relative to the buy-and-hold portfolios (though the blended portfolio would also be down relative to the all-stock portfolio), and for the next year we’d be looking at the potential returns of figure 2, iteration after a 15% increase in the market.

Figure 2: After the market goes up 15%, if the portfolio with the options collar insurance lags by 5% before it is reestablished, then for the following year it will be behind the all-stock portfolio for all points except >15% loss for stocks, but thanks to the large (but not huge) return of stocks, it is fairing better relative to the blended fixed income. Note that this figure isn’t exact because I haven’t properly accounted for compound returns (if you go up 15% one year, and down 15% the next, you don’t end up back at 0).

If there was a bad year, where the insurance aspect of the collar paid off, and the market dropped 15% (with the collar making you only suffer 10% of that), then we’d be in the situation of figure 3 for the second iteration. Again, I made the mistake of not properly accounting for the compounding, so the numbers aren’t quite right. Nonetheless, you see that even when the collar paid off — when the market was down substantially, the following year the blended fixed income portfolio, which is more hands-off to manage, still outperformed. You’d need to suffer a loss of something like 30% before the options collar starts to outperform the blended portfolio, though in good times (as long as they’re not too good), as mentioned above, the higher stock exposure with the options collar portfolio will beat out the blended one.

Figure 3:

Just from these cases and the complexity, I’m tempted to ignore the possibility of using options collars to manage volatility for me, and I especially won’t be recommending it to more novice investors, who in my experience are the ones who are more averse to stock market losses. Depending on the outcomes, it might outperform a hands-off portfolio with both fixed income and equities, but I’m not convinced there’s enough merit here to make it worth my time to figure out how to run the Monte Carlo simulation that would be needed to see how worthwhile it is as a strategy. This could also be coloured by the fact that I’m looking into this in 2009, as the recent market turmoil may be making the options more expensive than they would be in more normal markets (that is, zero net cost collars might normally be more bullish).

And now, since I don’t like having mistakes up here for long, the corrections to figures 2 and 3. Here I’ve converted things into dollar figures, assuming a $1000 initial portfolio in the first year, and then starting with the proper value in the second year/iteration for corrected figure 2 and 3. I’ve also added a portfolio with 1/3 fixed income (since with the smallish numbers we’re talking here, the protection is equivalent to the options collar — you’d need a >30% loss for the options collar to beat the 2/3 fixed income in that respect). The fixed income portfolios have been rebalanced to maintain the weighting.

Corrected figure 2 (portfolio value instead of percentages, after year 1 15% increase in stocks, collar misses 5% of gain):

Corrected figure 3 (portfolio value instead of percentages, after year 1 15% drop in stocks, collar avoids 5% of loss):

So except for very large losses in the market, a modest amount of fixed income exposure will give better returns with almost as much protection, and a lot less hands-on factors to get in the way! One could argue that the collar is meant exactly for those times when “very large losses in the market” do take place, but those are quite rare, especially if you can have a bit of patience: this year’s market meltdown was one of the worst ever, having gone down over 50% at the bottom; but after just a few months of rallying now, we’re “only” at about a 35% loss from the peak.

By now I know most of you are “TLDRing” this post with all the graphs, but what can I say, I’m a geek.

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A natural gas stove is all the rage these days, and I have no idea why.

There’s the efficiency thing: when you want heat, it makes more sense to just burn the natural gas yourself rather than have the power plant do it, send the energy by electricity, and then reconvert to heat. That gives natural gas a bit of a cost advantage. However, that’s assuming that the heat produced actually goes into the food, which has not been my experience lately. On my electric stove, almost all the heat goes into the pot. On my parents’ gas stove, a ridiculous amount of heat escapes around the side of the pot, and often makes the handles too hot to touch.

I’ve heard that they’re faster, but that’s just not been my experience. If I crank either my stove or my parents’ stove up to max, the water boils in about the same amount of time. They are more responsive, so if you want to go from max to min or vice-versa, that happens much more quickly, but I don’t see that as a huge benefit. Along with this is usually a statement that “a chef can exactly control the heat under a pot with gas”, but I personally cannot master that when I go visit my parents. There, I find that the floor level heat on a gas stove is way hotter than what I usually want — my electric stove has a number of settings that can keep a pot warm/hot but not above boiling, for instance, when I want to melt but not brown butter.

One benefit that the electric stoves can’t touch is that they can operate in a power outage — but there’s only been like four days in my life where that was important.

Then they have all the downsides: the escaping heat, making handles too hot; the fact that it’s an open flame, which is much more hazardous. The small (but non-zero) risk of a gas leak.

Underneath the range, the gas oven changes things for the cookie perfectionist: suddenly the oven isn’t a “dry heat” any more. The exhaust gasses (Co2 and water vapour) affect how things rise and brown. Plus the fan constantly runs so they’re a lot noisier, which is important as more entertaining/socializing is done in the kitchen.

They’re widely seen as a prestige thing, advertised as a feature for houses and condos. I know a lot of people who swear by gas stoves, and I recognize that it’s a personal preference, so I’m glad that Wayfare is also an electric person. I’m kind of curious as to the actual real-world efficiency of a gas stove (given the heat escaping issue), but while I know how to measure the electricity usage of an electric stove, I’m not sure how to measure gas usage with a gas stove.

Another natural gas appliance I haven’t quite wrapped my head around is the gas fireplace. I suppose they are considerably safer and more convenient than a wood fireplace, but I just don’t really see the point: they’re almost always trapped behind glass, so you may as well just turn on the “fireplace channel” on your TV (maybe record it next Potatomas and pop the DVD in as necessary) — you miss out on many of the elements of a fireplace experience, including being able to burn things like marshmallows and incriminating documents, and also the survivalist element of having the ability to make heat and cook when society falls apart. Many times the heat they give off is unwanted in the room and just vented away, though of course there’s always the issue of the pilot light: my parents’ gas fireplace is hot to touch all the time, like, hazardously so, just from the heat of the pilot light. Drives me crazy. So Wayfare and I are looking at potential new places to move to since our time in the lovely, mould-infested century-old home we’re in now is almost up, and we’re looking at floorplans that say “optional gas fireplace here” and just praying that the unit we’ll be looking at doesn’t have it.

The recent news that a pedestrian was killed by a cyclist riding on the sidewalk was shocking. For some, it’s lead to a refiring of the debate over whether bikes belong on the sidewalk or the road. Of course, this freak incident is so shocking because it is so rare, and unfortunately some people aren’t taking that the right way: cyclists on sidewalks hardly ever seriously hurt pedestrians, that’s why this is news. Cyclists are frequently hurt by cars (though throwing a monkey wrench into the whole argument is that overwhelmingly more accidents are between cars and pedestrians, which are generally separated!). Not helping matters in this debate is that despite the death that did occur, it was a case where the bike belonged on the sidewalk: it was a 15-year old boy on a bike with tires small enough that the law says he should have been on the sidewalk, in an area of the city with few pedestrians, and cars that regularly zip by at 80 (the limit is 60 km/h).

The answer is that cyclists don’t quite belong with either group, so the best solution is dedicated bike lanes with physical barriers to cars. But that’s a fantasy, not something that’s going to happen in a city that’s already built up. Ignoring that solution I fall back on the one I use myself when riding my bike: when I’m going fast, and/or when there are lots of people on the sidewalk, and when the cars are going slow, I ride on the street (like in downtown areas). When the cars are fast and the pedestrians are missing (such as suburban areas), I ride on the sidewalk (though on sidestreets where there is no appreciable traffic, I’ll stay on the road).

Unfortunately, we can’t rely on common sense alone, otherwise we wouldn’t need laws in the first place, and the law doesn’t seem to like taking a “wherever they damned well please, according to the conditions” stance, so we get the rules that cyclists belong on the street.

The heated debate also seems to be stirring up some motorist anger towards other bending of the rules by cyclists, especially not stopping at stop signs. Heck, I’m guilty of this myself on my bike: it takes effort to get back up to speed from a full stop, and in side-street riding you can hit a stop sign every block! Plus it’s not nearly the same issue with a bike rolling through than a car: a bike will have more manoeuvrability and can stop faster, and is going slow enough that they can check for oncoming traffic safely without having to stop (or for that matter, slow significantly).

Douglas Adams has figured out how to possess mortals from beyond the grave and is residing in Neil Gaiman’s brain!!

Ok…

Let me back up a smidge. I like Neil Gaiman’s stuff, I’m rarely disappointed. Sandman and Death were good graphic novel fare, and though the only novel whose title I can remember is American Gods, I’ve enjoyed the 3 or 4 of those I’ve read, too (I thought the Graveyard Book could have been… thicker, but that didn’t stop me from enjoying what was there; indeed, wishing there was more of it is probably high praise). So it was a pretty safe bet that I’d enjoy Anansi Boys as well.

I did.

What I didn’t expect though was that about 3/4 of the way through the book he would suddenly start to channel Douglas Adams (especially that whole bit with the lime). I was laughing out loud (literally) at some points towards the end there. I don’t know if he started getting sleep deprived while writing, or what happened to make the last bit so much more light-hearted, whimsical, and random, but I enjoyed it.