I’m undertaking a 1000-day reinvention project, blogging here daily to track my progress. In Friday Flash, I share an epiphany or aha moment from the past week.
In Skin in the Game: Hidden Asymmetries in Daily Life, Nassim Nicholas Taleb writes:
By definition, what works cannot be irrational; about every single person I know who has chronically failed in business shares that mental block, the failure to realize if something stupid works (and makes money), it cannot be stupid.
I’ve been experimenting with trading an options wheel strategy for income generation with my non-retirement account. It is going well so far in that I’ve produced an annualized return on investment better than I could have with the S&P 500 during that time and, more important, the approach seems to suit my personality. I need an investing and income generation approach that I can stick with.
Saying it works, however, is misleading. Depending on how you implement it, it can work in bull markets, neutral markets, and even in choppy markets moving down. It likely won’t perform well in an extended bear market, though it may have a better risk profile than buying and holding in that situation.
Still, I question myself and think “this is stupid, why don’t I just go long in equities like a normal investor?” That’s where Taleb’s idea — that what works isn’t stupid — comes to my rescue. But at the same time, Taleb would say I’m investing in the wrong way; that I’m not sufficiently attentive to the fat tail of risk when selling options, as the wheel demands.
Am I being fooled by randomness?
Taleb’s first popular book was Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets, in which he argues that luck, not skill, often drives success, especially in finance. I’ve requested that book from the library but don’t have it yet, so I’m relying on online writeups about the book to recall its main arguments. And I’ll refer to it as FIB here.
I am trained as a probabilist — I have a PhD in Research Methods and Statistics and an MS in Statistics as well. I know about random numbers, probability distributions, expected value, Bayes’ theorem, and more. But as Taleb notes in FIB, “Outside of textbooks and casinos, probability almost never presents itself as a mathematical problem.” We operate in situations where we don’t know the probabilities of various outcomes and furthermore, we don’t even know which outcomes might happen.
A key point that Taleb makes in FIB is that we tend to attribute some kinds of good outcomes, such as in trading, to skill rather than luck:
[W]e often have the mistaken impression that a strategy is an excellent strategy, or an entrepreneur a person endowed with “vision,” or a trader a talented trader, only to realize that 99.9% of their past performance is attributable to chance, and chance alone. Ask a profitable investor to explain the reasons for his success; he will offer some deep and convincing interpretation of the results. Frequently, these delusions are intentional and deserve to bear the name “charlatanism.”
I read about other traders making incredible returns with options. They share their systems and congratulate themselves, touting their superior skill. But I can’t help but think: yes, you got lucky to choose to trade options on highly volatile technology stocks in a euphoric tech bull market, and so far it has worked. But that was as much or more luck than skill.
But that doesn’t mean there is zero skill involved. Taleb writes:
Let me make it clear here : Of course chance favors the prepared! Hard work, showing up on time, wearing a clean (preferably white) shirt, using deodorant, and some such conventional things contribute to success— they are certainly necessary but may be insufficient as they do not cause success. The same applies to the conventional values of persistence, doggedness and perseverance: necessary, very necessary. One needs to go out and buy a lottery ticket in order to win. Does it mean that the work involved in the trip to the store caused the winning? Of course skills count, but they do count less in highly random environments than they do in dentistry.
No, I am not saying that what your grandmother told you about the value of work ethics is wrong! Furthermore, as most successes are caused by very few “windows of opportunity,” failing to grab one can be deadly for one’s career. Take your luck!
Taleb would say that my options wheel strategy is inherently flawed, in that I am selling options instead of buying them. From The New Yorker review of FIB:
Taleb… has constructed a trading philosophy predicated entirely on the existence of black swans on the possibility of some random, unexpected event sweeping the markets. He never sells options, then. He only buys them. He’s never the one who can lose a great deal of money if G.M. stock suddenly plunges. Nor does he ever bet on the market’s moving in one direction or another. That would require Taleb to assume that he understands the market, and he knows that he doesn’t. He doesn’t have Warren Buffett’s confidence. So he buys options on both sides—on the possibility of the market’s moving both up and down. And he doesn’t bet on minor fluctuations in the market. Why bother? If everyone else is vastly underestimating the possibility of rare events, then an option on G.M. at, say, forty dollars is going to be undervalued. So Taleb buys out-of-the-money options by the truckload. He buys them for hundreds of different stocks, and if they expire worthless he simply buys more. Taleb doesn’t even invest in stocks—not for Empirica and not for his own personal account. Buying a stock, unlike buying an option, is a gamble that the future will represent an improved version of the past. And who knows whether that will be true? So all Taleb’s personal wealth—and the hundreds of millions of dollars that Empirica has in reserve—is in Treasury bills. Few on Wall Street have taken the practice of buying options to such extremes. But if anything completely out of the ordinary happens to the stock-market—if some random event sends a jolt through Wall Street and pushes G.M. to, say, twenty dol-lars—Nassim Taleb will not end up in a dowdy apartment in Athens. He will be very rich.
It is true that selling puts has much more risk than buying puts. When you buy a put, you are buying the right to sell shares of a particular stock (or ETF or other investment) at a certain price no matter what the actual price is, for a period of time up to the expiration date. When you, conversely, sell a put, you are on the other side of that contract. You have the obligation to buy the stock at the strike price if the buyer of the put contract demands that you do. In practice, they will demand you do so if the price of the stock falls below the strike price.
The buyer of the put has only the put premium — what they pay for the options contract — at risk. The seller of the put, on the other hand, earns the premium but may lose up to the entire cost of purchasing the shares, if the option is exercised, and if the shares then go to zero.
But note that investors who go long stocks, whether that’s by buying and holding an S&P 500 index fund or doing something more complicated, also have their entire capital at risk. The S&P 500 index could go to zero, for example in the case of nuclear war. Taleb is not wrong about the tail risk of being long stocks or selling put options. But most people ignore fat tail risk.
Taleb contradicts himself
In Skin in the Game, Taleb says “if something works it’s not stupid,” and in Fooled by Randomness, he implies that selling options is stupid because of the theoretical tail risk, that could become a real catastrophe. But in many situations selling options works. So is it stupid or not?
In FIB, Taleb writes “that which came with the help of luck could be taken away by luck (and often rapidly and unexpectedly at that). The flipside, which deserves to be considered as well (in fact it is even more of our concern), is that things that come with little help from luck are more resistant to randomness.”
So instead of choosing a strategy which depends upon Taleb’s famed black swans (events that happen that are very rare and that upend the system you’re depending on), maybe choose a strategy that has more to do with skill than luck? Or modify a strategy that depends upon luck with attention to skill, and amelioration of risk via that skillfulness?
Here’s where I’m working to make my wheel strategy less dependent on luck:
- I’m diversifying the positions on which I sell puts. While in a broad market drawdown I may be assigned on everything at once, immediately putting me underwater on a bunch of positions, in usual markets we see some sectors doing well and some poorly. Diversification helps not just with long-only stock portfolios, but also in options trading.
- I’m using technical analysis with a little bit of fundamental research to decide which stocks to sell puts on. Looking for charts that are neutral to bullish and haven’t just seen a parabolic run-up should help me make money on puts, assuming, again, there isn’t a broad market decline.
- I’m keeping 50% of my portfolio out of the wheel for now so that should there be a drawdown I will have cash available to sell puts on now-cheaper stocks, presumably with higher volatility (resulting in better premiums from selling the puts).
- I have guidelines I follow for when to roll puts (close the current contract and open a new one further out in time) if the stock price is under pressure, or if there is only a shortish time left to expiration.
- I could as well put in place some hedges such as extremely out-of-the-money puts on $SPY, which would curb my losses in case of a crash or bear market. This, however, is a drag on a portfolio’s returns.
- I’m watching broad market trends and charts to see if there is evidence of weakness that could lead to a correction or crash.
Maybe my wheeling will blow up and I’ll live to regret the choice to use it. My bigger regret so far is that I didn’t start it sooner, seeing as how it can provide results comparable to or better than long-only investing with reduced risk. And, importantly, it suits my temperament so it may be a plan I can stick with.