"Derivatives are financial weapons of mass destruction." -Warren Buffett
When Warren Buffett uttered the famous phrase above, derivatives were most certainly on the outs. The subprime mortgage crisis was greatly exacerbated by huge bilateral derivatives obligations that caused eye-watering and historic losses for Uncle Sam. Less apparent is the way derivatives improve our lives on a daily basis by allowing market participants to effectively manage, define, and mitigate risk.
Top 10 Financial Institutions That Benefited from the AIG Bailout: Nearly $40 Billion Was Transferred to Major Counterparties Between September and December 2008.
In a sense Buffett was correct about one thing. Derivatives are leveraged and so do mimic the properties of weapons of mass destruction in some ways. Just as a nuclear weapon will have a greater yield than a conventional one, derivatives can create high returns over short periods that simply aren't possible through only owning the underlying.
When you think of the market as a competition versus other market participants, like most professional investors do, then the appeal of these "weapons" becomes immediately apparent. If you're trying to beat the benchmark, the easiest way to do it, is by leveraging your returns. Of course, like most things in markets, this is a double edges sword.
But it's very important to remember that trades like the long strangle we recommended on Nvidia on 8/8/24 here at Punk Rock Traders, which is up 145% as of yesterday's close, simply would not be possible without using financial weapons of mass destruction. So, if you're a sophisticated investor looking for a way to use you small size to help achieve alpha, there's potentially a lot of money to be made in using derivatives to augment returns.
There are several advantages to using derivatives for smaller investors looking to achieve high alpha trades that larger entities may not be able to take advantage of.
Ability to operate in thinner markets with lower open interest.
Ability to use leverage to augment returns.
Ability to define risk and control downside exposure.
Ability to get exposure to implied volatility.
The last point is typically the focus of our first trade of the week, which centers on trading options on the CBOE Volatility Index, or $VIX. Implied volatility moves faster than price, and realized volatility is lower than implied volatility. Both these things can be exploited for a trader's gain. The fear index is advantageous for small investors for several reasons.
One thing I like about the options on this index is that they are European expiration and settle in cash. This means when you hit a home run, like previous trades I've recommended below, you get paid out in cash and don't have to worry with any exercise or settlement.
On October 10th, I wrote an article where I recommended the December 20 $17 put options which paid $4.69 (entry $1.42) per contract on the date of settlement, and the December 20 $16 put options paid $3.69 (entry $0.91). This means they experienced a respective price gain of 230% and 327%
Despite some climbs associated with building geopolitical risk as Israel and Iran engaged in saber rattling. I recommended using the June 18th $14 put options to short volatility again in April. I recommended them at $0.52, and they printed on 6/18 at $1.61. That is a price gain of 210%.
If you use time value and the characteristics of European expiration correctly you can mitigate the volatility of a trade. We recently achieved this with our VIX trades which expire in November. Their price volatility has been relatively controlled because of thin markets.
While the $18 and $23 puts we recommended are up in the double digits, they aren't the triple digit gains that would have occurred had we recommended the same strikes at different expirations. This was by design given the uncertainty at the time of the recommendations.
VIX Futures Historical Prices: Comparison of Volatility Levels Across Various Dates in August 2024, Highlighting Market Contango and Backwardation Patterns Relative to October 2008.
Now though, after an epic volatility collapse that ranks as the most precipitous drop in the history of the index, it appears the $VIX has entered one of its two common regimes, and that it will likely hang out between $10 and $20 for the next one month. I theorize the massive volatility event in the beginning of August was a local low, and that the VIX will most likely remain in the relatively subdued regime that defined the early summer.
On days like today, when volatility experiences a significantly bigger spike then the underlying it can symbolize investors getting prepared for a catalyst like the upcoming Jackson Hole meeting. However, I think realized volatility around this event will be less than expectations. I think it is likely Powell will pave the way for a September cut. If not, the market could certainly throw a tantrum, but I think this is a low probability outcome.
CBOE Volatility Index (VIX). Source: Schwab
As our triple digit long strangle on Nvidia suggests, we are bullish on the upcoming earnings, and I think this will drag down volatility at the index level when it is resolves. Therefore I think it is a tactical opportunity to buy the $15 VIX puts for around $1.00. I think these options have a good chance of expiring ITM, or at least having a chance to sell at a higher premium before expiration. You must buy today while $VIX is still up.
Buy September 18th, 2024 $15 put options on the $VIX. They are priced at about $1.00. Buy today!
HOLD the November 20th $23 puts and $18 puts in anticipation of a post-election volatility crush.
There is 29 days to expiration, and I am betting that the VIX will continue reverting to its mean, which is lower than the current level. This is a risky trade, and if the VIX spikes it could certainly end at zero. Don't make this trade unless you understand how to monitor the Greeks and have experience trading options.
Comparison of Volatility Strategy Usage: U.S. Hedge Funds Lead with 35% Adoption, Followed by U.S. Asset Managers at 18%, and European Investors at 6%.
Financial weapons of mass destruction are risky, but they are also particularly useful when trying to beat the benchmark. As you can see, US hedge funds that employ volatility strategies significantly outperform the competition that does not.
So, as small investors, we can employ these financial weapons of mass destructions in ways that help us punch above our weight in terms of returns. The principle of this weekly trading column is that implied volatility moves faster than price, and when it does, we want to get some alpha from it. We want to make derivatives into weapons of wealth creation!
