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Making Money in Flat Markets

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Harvesting Risk Premia with the Defined Risk Strategy

Most peo­ple know the Defined Risk Strat­e­gy by our mot­to: “Always Invest­ed, Always Hedged.” The first two pri­ma­ry com­po­nents of the DRS seek to bal­ance each oth­er out, like the dif­fer­ent sides of a see-saw, with the equi­ty por­tion being #1 (“Always Invest­ed”) and the hedge por­tion being #2 (“Always Hedged”):



Always Invested, Always Hedged Seesaw | Making Money in Flat Markets | Swan Blog | Swan Global Investments

When the mar­kets are down, the equi­ty por­tion of the DRS is down, but the hedge por­tion is up and does well, and vice ver­sa.

While we believe it is pru­dent to always be pre­pared for a bear mar­ket, there is a prob­lem with being “always hedged”—the car­ry­ing cost. Even though we do what we can to min­i­mize the car­ry­ing cost of the hedge and even though we have large mar­ket expo­sure, the hedge will be a drag on per­for­mance in up mar­kets. That’s where the third leg of the DRS stool comes into play.


Potential Profit Zone

Unlike the first two com­po­nents of the strat­e­gy, which are very long-term in nature, the income/premium col­lec­tion trades are short-term in nature. What we typ­i­cal­ly do is simul­ta­ne­ous­ly sell both a call and a put, out-of-the-mon­ey, and col­lect the pre­mi­ums from both. Known as a Short Stran­gle, these trades are set up to be mar­ket neu­tral so that ini­tial­ly the risks are equal­ly bal­anced between the upside and the down­side.

The idea is that we brack­et the mar­ket, and if the mar­ket stays with­in this range over sev­er­al weeks, we will be able to close out the trade and repeat the process 12–15 times a year.

Potential Profit Zone | Swan Global Investments

Source: Swan Glob­al Invest­ments

We have rather mod­est goals for each trade, hop­ing to col­lect some­where between 0.30% and 0.50% per trade. If we do this suc­cess­ful­ly, we hope to gen­er­ate enough return to help off­set some, or all, of the car­ry­ing cost of the hedge in a flat or slight­ly ris­ing mar­ket.

The risk in this trade, how­ev­er, is if the mar­ket moves too far in either direc­tion and starts get­ting close to those strike prices. We are very cog­nizant of those risks, and this is where our active man­age­ment comes into play.

The vast major­i­ty of our port­fo­lio man­age­ment team—the traders, the risk offi­cers, the PMs themselves—are ded­i­cat­ed to work­ing this trade and keep­ing this trade with­in accept­able risk bound­aries. If the mar­ket does move too far up or down we will imple­ment addi­tion­al adjust­ment trades to help mit­i­gate risk, keep the trade mar­ket neu­tral, and try to claw back any loss­es an indi­vid­ual trade might incur.


The Gap Advantage

The dynam­ic that these pre­mi­um col­lec­tion trades are try­ing to exploit is the gap between implied volatil­i­ty and real­ized volatil­i­ty. Implied volatil­i­ty is what dri­ves the price of the options we sell, where­as real­ized volatil­i­ty is what actu­al­ly hap­pens in the mar­ket. Often, this spread is pos­i­tive, which means peo­ple tend to over­pay for short-term pro­tec­tion giv­ing us the oppor­tu­ni­ty to seek prof­itable income trades by sell­ing short-term calls and puts.

Implied vs Realized Volatility Spread | Swan Global Investments

Source: Bloomberg and SG Finan­cial Engi­neer­ing, from 1/2/1990 to 9/29/2017

The anal­o­gy is much like car renter’s insur­ance. When rent­ing a car from Hertz or Alamo, peo­ple tend to over­pay for the short-term pro­tec­tion the com­pa­ny offers, even though the prob­a­bil­i­ty of them get­ting in an acci­dent in a sin­gle day or week is quite low. Car rental com­pa­nies “har­vest” this pre­mi­um from their wide num­ber of renters. Yes, occa­sion­al­ly, they may have to pay out a claim, but more often than not sell­ing short-term insur­ance across a wide client base is a very prof­itable activ­i­ty for them.

We have a sim­i­lar dynam­ic with these trades. Like the car rental com­pa­ny, we sell poten­tial pro­tec­tion to peo­ple who fear a major down­town. When they don’t exer­cise their option, we make a prof­it.

Usu­al­ly, the spread between implied and real­ized volatil­i­ty is pos­i­tive (dis­played in green in the graph above), and we try to cap­ture that. That spread exists dur­ing peri­ods of both high and low volatil­i­ty. Occa­sion­al­ly, it does go neg­a­tive, and yes, we will lose on these trades from time to time, but over­all this has been a prof­itable endeav­or for us and an impor­tant diver­si­fy­ing part of the strat­e­gy when com­bined with long equi­ty and put options.


A Synergistic Approach

By incor­po­rat­ing the pre­mi­um col­lec­tion into the DRS, we hope to accom­plish three things:

  1. Increase up cap­ture in ris­ing mar­kets
  2. Sub­si­dize the cost of the hedge in flat mar­kets
  3. Prof­it from pan­ic and over­re­ac­tion in down mar­kets

While the pre­mi­um col­lec­tion trades are man­aged sep­a­rate­ly from the equi­ty and hedge posi­tions, it is impor­tant to remem­ber that the DRS is designed so that the three ele­ments com­ple­ment each oth­er:  The equi­ty posi­tion is meant to par­tic­i­pate in up mar­kets; the hedge posi­tion pro­tects in down mar­kets; and the pre­mi­um col­lec­tion trades tend to do well in flat mar­kets.

Defined Risk Strategy Process | Swan Global Investments

It is high­ly unlike­ly, if not impos­si­ble, to imag­ine a sce­nario when all three legs of the stool are pos­i­tive at the same time. By the same token, it is hard to con­ceive of a mar­ket envi­ron­ment when all three ele­ments are neg­a­tive at the same time. This is all by design, as the three ele­ments are designed as “checks and bal­ances” on each oth­er. By com­bin­ing the equi­ty, the hedge, and the pre­mi­um col­lec­tion the goal of the DRS is to have the whole be greater than the sum of its parts.


About the Author:

Marc Odo, Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Director of Investment Solutions - Swan Global InvestmentsMarc Odo, CFA®, CAIA®, CIPM®, CFP®, Direc­tor of Invest­ment Solu­tions, is respon­si­ble for help­ing clients and prospects gain a detailed under­stand­ing of Swan’s Defined Risk Strat­e­gy, includ­ing how it fits into an over­all invest­ment strat­e­gy. For­mer­ly, Marc was the Direc­tor of Research for 11 years at Zephyr Asso­ciates.




Impor­tant Notes and Dis­clo­sures:

Swan Glob­al Invest­ments, LLC is a SEC reg­is­tered Invest­ment Advi­sor that spe­cial­izes in man­ag­ing mon­ey using the pro­pri­etary Defined Risk Strat­e­gy (“DRS”). SEC reg­is­tra­tion does not denote any spe­cial train­ing or qual­i­fi­ca­tion con­ferred by the SEC. Swan offers and man­ages the DRS for investors includ­ing indi­vid­u­als, insti­tu­tions and oth­er invest­ment advi­sor firms. Any his­tor­i­cal num­bers, awards and recog­ni­tions pre­sent­ed are based on the per­for­mance of a (GIPS®) com­pos­ite, Swan’s DRS Select Com­pos­ite, which includes non-qual­i­fied dis­cre­tionary accounts invest­ed in since incep­tion, July 1997, and are net of fees and expens­es. Swan claims com­pli­ance with the Glob­al Invest­ment Per­for­mance Stan­dards (GIPS®).

All Swan prod­ucts uti­lize the Defined Risk Strat­e­gy (“DRS”), but may vary by asset class, reg­u­la­to­ry offer­ing type, etc. Accord­ing­ly, all Swan DRS prod­uct offer­ings will have dif­fer­ent per­for­mance results due to offer­ing dif­fer­ences and com­par­ing results among the Swan prod­ucts and com­pos­ites may be of lim­it­ed use. All data used here­in; includ­ing the sta­tis­ti­cal infor­ma­tion, ver­i­fi­ca­tion and per­for­mance reports are avail­able upon request. The S&P 500 Index is a mar­ket cap weight­ed index of 500 wide­ly held stocks often used as a proxy for the over­all U.S. equi­ty mar­ket. Index­es are unman­aged and have no fees or expens­es. An invest­ment can­not be made direct­ly in an index. Swan’s invest­ments may con­sist of secu­ri­ties which vary sig­nif­i­cant­ly from those in the bench­mark index­es list­ed above and per­for­mance cal­cu­la­tion meth­ods may not be entire­ly com­pa­ra­ble. Accord­ing­ly, com­par­ing results shown to those of such index­es may be of lim­it­ed use. The adviser’s depen­dence on its DRS process and judg­ments about the attrac­tive­ness, val­ue and poten­tial appre­ci­a­tion of par­tic­u­lar ETFs and options in which the advis­er invests or writes may prove to be incor­rect and may not pro­duce the desired results. There is no guar­an­tee any invest­ment or the DRS will meet its objec­tives. All invest­ments involve the risk of poten­tial invest­ment loss­es as well as the poten­tial for invest­ment gains. Pri­or per­for­mance is not a guar­an­tee of future results and there can be no assur­ance, and investors should not assume, that future per­for­mance will be com­pa­ra­ble to past per­for­mance. All invest­ment strate­gies have the poten­tial for prof­it or loss. Fur­ther infor­ma­tion is avail­able upon request by con­tact­ing the com­pa­ny direct­ly at 970–382-8901 or www.swanglobalinvestments.com297-SGI-110117


By |2018-10-02T11:08:25+00:00November 16th, 2017|Blog|Comments Off on Making Money in Flat Markets