Things That Go Bump In The Night

Same with markets. Things turn out right a ridiculous amount of the time. Pennywise only shows up once every 27 years. Should we be scared about his market equivalent?

Like many children with over-developed imaginations, I was always scared of things that go bump in the night. To this day I remember vividly the events (all fictional, of course) that frightened me so badly, like this scene from the 1979 made-for-TV movie of Stephen King’s Salem’s Lot, where little vampirized Danny tries to get his friend to open the upstairs window and let him in. You see, vampires have to be invited into your house. You have to give them permission to destroy you.

Hold that thought.

Anyway … as a child, I convinced myself that I could keep myself and my family safe from these malevolent forces and evil eyes if only I surrounded myself with the proper talismans (mostly stuffed animals, arranged just so around the bed) and said the proper words to God before going to sleep.

And it worked! This was classic magical thinking, just like that used by so many of our smartest and most powerful adults to protect us from the malevolent forces of economic recession and political decay.

I’d love to say that I’ve outgrown these fears that I know are irrational, but the truth is that I still surround myself with protective talismans and carry them with me wherever I go … a couple of lucky pennies, sure, but also a lucky dime (h/t Scrooge McDuck); one of the many chestnuts that I’ve rubbed between thumb and fingers till it’s oiled black and smooth, thinking this was my uniquely private charm until I recently found a well-worn chestnut hidden away in my grandfather’s rolltop desk; fortunes from cookies I ate 20+ years ago; my half of the turkey wishbone from this Thanksgiving, where my wife and I always not-so-secretly try to let the other win; an ancient post-it note wishing me luck, scribbled by one of my kids not for any particular reason, but just because. Powerful magics, all.

I’ll bet any amount of money that everyone reading this note has their own protective talismans. Maybe not as over-the-top as me, but you have them. This has always been my can’t-miss Turing test — the question you ask of an intelligence you can’t see to determine if it’s human or machine — what’s your talisman? What’s your charm of protection or luck? Every human being has a talisman. No machine would. It’s like asking a computer what mnemonic device it uses to remember something like the colors in the spectrum of visible light … the name Roy G. Biv has no meaning to a non-human intelligence other than as a curiosity of a less-capable species.

In investment and allocation circles, we have a name for these magical protections against spooky market forces that go bump in the night. We call them hedges. Now I’m not talking about hedge funds per se. I’m talking about the ad hoc hedges used by naturally long-only allocators like foundations and endowments and pension funds and big family offices. I’m talking about the ad hoc hedges used by naturally long-only investors like everyone with an IRA. I’m talking about how everyone reading this note has, at one time or another, gotten scared about markets and decided to hedge their professional portfolio or personal account with something that will make money if markets go down. Not as part of a considered review of risk tolerances and return projections and portfolio convexity (whatever THAT means). Not as part of an intentional portfolio that might include a long-volatility manager or a dedicated short fund. But just because we’re scared of something going bump in the night, and we need a talisman to ward off the bogeyman.

The most common of these casual hedges, the investment equivalent of a lucky penny, is the put option, and its most common expression is the put spread.

Quick review! A put is an option where you’re betting on whether the underlying thing, say the S&P 500, will go down below a certain price level before the expiration date of the option. So if I buy a put option that’s “struck” at a price level 5% below where the S&P 500 is today, and that option expires three months from today, then in three months my put option will only have value if the S&P 500 is at least 5% below its current price. The farther below that 5% strike price, the more money the option is worth.

A put spread is when I both buy AND sell a put option. Slightly different put options, of course, otherwise I’d just be buying and selling the same thing, but the difference between the two options — either in expiration time or (more commonly) the strike price — is the “spread” that I’m now betting on. So let’s say I bought a three-month put option struck at 5% down on the S&P 500 and sold a three-month put option struck at 15% down. When those options expire, I’ll make money on the put I bought if the S&P 500 is down at least 5%, and I’ll make a little money on the put I sold (limited to the price someone paid me for the option in the first place) if the S&P 500 avoids being down more than 15%.

Why would I do this complicated little dance? I do it in order to reduce the net cost of the put option I’m buying (the one struck at 5% down in this example). I want to buy some “insurance” on my portfolio that will pay off if the market is down more than 5%, and I can reduce the cost of buying that more-than-5%-decline insurance policy by selling someone else a more-than-15%-decline insurance policy. I mean … yeah, I’m scared of a 5% bogeyman attacking the market, but a 15% bogeyman? In the next three months? C’mon, that’s crazy talk. I’m not THAT scared.