As predicted, the momentum is keeping the market afloat while it zigzags. My shorts are suffering small losses, albeit the fall is clearly buffered by my longs in DLTR and DBA that are surging higher with the market.
While I will continue to hold on to my longer term shorts, I couldn’t help but notice that the mommy’s basement trader crowd betting on downfall in SPX is increasing exponentially today. While the popcorn investor is still bullish, you can’t ignore the basement trader sentiment. What if this turns out to be a March 09 or July 09 situation? Can you continue to operate with your overriding thesis that the markets will go down next week, but still protect yourself and even profit from a totally unpredictable move to the upside?
Introducing The Unicorn Trade
So I said to myself why not have a trade just like a black swan but for the exact opposite reason?
In other words, how about trading cheap and deep out of the money options but on the long side using fraction of your portfolio capital? A fraction that you can afford to lose without causing a severe dent to your portfolio. I am going to call it the “Unicorn” trade. So far no one has seen one just like the Black Swan but you cannot overrule the probability of its appearance. And unlike the black swan, this would be a harbinger of blow out rallies.
Okay lets play the two scenarios:
1) If the market goes down, then the overriding thesis and predominant shorts in my portfolio will win. I will have a very small loss on my Unicorn trade when they expire worthless. Big deal, as the overall portfolio should be in green.
2) If the market defies gravity and frustrates the heck out of retail traders, I have a Unicorn protection in my portfolio that could rise far more exponentially due to its current status and price. I may not be able to recoup all my losses in shorts but for the current trading window, I will easily break even between my current long positions and the Unicorn trade.
Looking at the current conditions, if the market breaks the 1126/1130 in a convincing manner, the next stop would be much higher. Most of the traders are not expecting this to happen with conviction and are expecting battle lines to be drawn right around the current levels. Clearly there is lot of technical resistance to support their beliefs. In fact I have been one of them and continue to be so. But I don’t want to be caught unaware if the market takes the path of maximum pain, which it mostly does.
So I searched for cheap and deep out of the money SPY call options. I found some and placed my Unicorn trade as posted on Twitter.
I am not implying the markets will go higher and in fact still looking for them to go down by early next week. I am implying though that if it does go higher in a sustained manner, it would be much higher than anyone is expecting. And I am positioned to gain a bit should that event happen.
Also I understand what a true black swan is. I understand I am using that concept in a milder context. So all you Taleb fans don’t get all sensitive on me.
This is going to be a fun ride. Try the Unicorn. You may like it.
StocksRider
Always enjoy your posts, Stocksrider. Yet another interesting theory from you.
Thanks Kenai. I appreciate it.
The reason why the Unicorn strategy you discussed doesn’t actually work in comparison to Black Swan, is due to the underlying nature of market movements. Markets can drop a lot in a short period of time (we erased 4+ years of gains in 6 months in 08/09). Gains, as the saying goes, climb a wall of worry. They take much longer to be realized on a large enough magnitude. If your using options as your instrument of choice you can see how while one strategy might be a useful hedging mechanism the other, if it occurs at all, will take 3x as long. This means your paying ALOT more in times premiums which erodes your portfolio significantly.
Seraphos1, you make couple of good points. Couple of things –
(1) As I said in my post, I am using the analogy and comparison with Black Swan in a much milder context. In other words, not expecting a rip roaring tit ripping event that would match the magnitude and shorter timeline of a true Black Swan. Hence my options are not that deep out of the money either. They would appreciate should there be an unexpected upswing of about 3% or more from the current levels. Not exactly huge huge, but definitely carries an element of surprise compared to the way traders are thinking today, won’t you say?
(2) You are right in that premiums can erode the portfolio significantly. But they can do so with traumatic effects only if they form a reasonable portion of the portfolio. My position is a very small portion of the overall portfolio. If they expire worthless, I actually know the loss I will be having. The point of this trade was should an unexpected swing to the upside happen, I want to protect my current shorts to a certain extent, and not pay too much out of the pocket, because that would kinda defeat the whole purpose. Also the volatility of my call options is lower than the historical volatility, which gave me an attractive price point.
I admit it is not a perfect trade as it will not completely protect me from my losses in shorts should the market swing upwards. But it is a protection more than anything else that will significantly mitigate my losses.
Finally, here are some real world examples where such a trade would have ended up protecting me – April 21st 2009ish and July 22th 2009ish time frames. In both cases, we were near a double top, conditions were overbought and traders were betting for a correction. The markets continued to march on for another 4-6%. Had I bought similar option calls that had a strike price 2-3% away, they would have all appreciated significantly and given some protection to my shorts.
Feel free to refute the above. I would love to know if there are holes in this theory so I can learn more.
In a more philosophical undertone to this whole post, I am very much intrigued by the concept of having a “Unicorn” trade that is more in line with a Black Swan trade in terms of magnitude, although the above trade was milder. I understand the markets dropped faster in 08/09. But you must have heard that both corrections in bull markets and rallies in bear markets are sharp.
Apologies i misunderstood your post, if all your doing is hedging shorts with some minor calls, then yeah my assessment is moot. If that is indeed what your doing then why not just cover some of your short? or, if you have the capital, go long some names? I don’t really see the benefit to playing calls in this context. Maybe if your volatility premiums are exceptionally low… but other than that…
Still experimenting with the whole concept. I am not trying to apply a Unicorn trade in the same way as just buying some call protection or hedging my portfolio with longs. Because I already have long hedges. Here are the key differences from the usual long hedges:
(1) This is a ultra hedge to cover for a totally unexpected event on the upside.
(2) Make this trade only when premiums of deep OTM calls are low either because expectation of the magnitude of an upswing is fairly low or because volatility is fairly low compared to historical volatility.
(3) Make this trade when the usual long hedges are smaller part of the portfolio simply because you are overall betting on downward direction. If they were the same as shorts, you would never make money because you would be breaking even. You don’t wanna buy long calls either because of the premium you are paying on near the money calls, which again limits your gains.
(4) You can afford to lose the money on this and let it expire to zero. In fact, it should be part of your discipline that unless the unexpected event happens, you should not take out any profits from the unicorn trade until the day of expiration. Kinda defeats the whole purpose.
I guess the only thing different I would have done is buy the deep OTM calls farther out. This is kind of a microcosm of a real Unicorn trade given my time line is very small.
What do you think?
Great post, nice to see some ideas rather than the incessant amount of bitching about where the market “should” be. If we do consolidate here may be an decent trade, thanks for a great idea.
Thanks skayfe
I’m pretty sure that’s still referred to as a black swan, since by definition black swans are only unseen events with an immense impact. I liked the material though.
I think its sort of like the word “apology” which can be, in addition to its common usage, utilized as almost the opposite (a defense or justification). One of the definitions has embedded itself to such an extent that other versions, while correct, aren’t effective at conveying meaning. *Language nerd off*
What Seraphos1 said.
Like the idea of the Unicorn and find it ironic that you said for all of you Nassim Swans out here to not get on you about your strategy not being perfect and yet you read the comments above and….
Anywho how did you pick the unicorn name the magical and mythical creature is that how the trade is supposed to be perceived?
Black swans as you obviously know are rare and huge outlier type of events and so there are 99 white swans in Western Australia and than you suddenly see one outlier the Black Swan and so its a rare event.
sorry if I put to much thought into the name,
TheOne, you got a good thought there. The more apropos name would have been something like a red or a green swan instead of Unicorn, as the latter is “more” mythological. I guess I was focusing more on the underlying concept I wanted to share. Unicorn sounded more catchy. So just went with that.
Having said all of this, probabilistically speaking, you can only prove a mythological or a fictitious character exists but you can never disprove they don’t.