Primer #5: Destination vs Path
Primer #5
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Earlier we established that options help “complete” the market. This gives you more choice by allowing you to make finer-tuned bets. The secondary bonus to constructing bets using options is it forces you to be more rigorous about your thesis.
The flexibility of options allow you to speculate or manage your risk with respect to destination or path.
The destination can be thought of as the return when you close your position, while the path considers your unrealized gains and losses en route to that destination. Asset managers, during bouts of underperformance, will try to redirect their clients’ focus to the “long run”. That's code for destination.
The path, ie getting to the destination, will cause you to second-guess yourself. There's a fine line between justified patience and overconfident stubbornness.
If you have a view about the expected return of an asset in X years (ie the destination) should you care about the path?
While the answer is personal, path deserves its tribute. The path of an asset is both a source of information and noise. How an investor incorporates the data will influence how they manage the position. Options can be used to exploit views on path or protect an investor from its influence on their behavior.
Path Blindness
Principal-agent conflicts in asset management lead to perverse incentives where an investor will actively try to avoid path risks to preserve a sense of return stability.
A cynic following the incentives may notice a fiduciary's preference for private assets that are less volatile simply because their marks are stale. This is like avoiding bloodwork because you don’t want to find out your cholesterol is too high.
Of course the slow-to-mark investments are still volatile. The fundamentals of the private business are correlated with the public market volatility. A private fund that is slow to mark its assets down is not going to let you redeem at the optimistic mark. This costs you the opportunity to sell the private shares and rebalance into heavily discounted public markets.
A less cynical framing of such investors is they are giving up liquidity because it will behaviorally “save them from their own fearful trading”. We would frame this as “selling the option to rebalance at zero”.
Path blindness has innocent causes as well. You may hear some investors argue in favor of individual bonds instead of a bond fund. They worry that bond fund prices move around and have no real expiration, so when interest rates rise your losses are somehow more real. But if you buy a bond and hold it to maturity you can put your head in the sand, and never lose.
This is a misunderstanding. AQR’s Cliff Asness argues that these investors are falling for a real vs nominal illusion. If interest rates rise, the investor holding individual bonds that will keep payoff at par has still lost in a real sense. The capital returned is worth less in a world where rates have risen to compensate for inflation. The bond fund is effectively taking your loss today rather than later. If you sell your bond for a loss, you can reinvest at a higher yield going forward. Exactly what happens in a bond fund.
Managing Path With Options
It's possible to deal with path without acting like an ostrich. Many option structures allow you to "risk budget". This means constructing trades with fixed payoffs allowing you to select your maximum loss in advance. This is useful if you want to bet on a destination without worrying about the zigs and zags.
Destination Focus
Vertical spreads allow you to make model-free distributional bets on where the stock expires. If you buy a $5 wide call vertical spread for $1 you are risking $1 to make $4. If you are correct on your call at least 20% of the time, this is a winning strategy. Similarly, if you believed the odds of the stock moving beyond the further strike was less than 20% you could short the spread at $1. Your maximum loss of $4 is known in advance.
If you do not hedge a long option or long vertical position, your maximum loss is limited to your premium. You cannot be “shaken” out of a trade because of margin or path.
⚠️Caution: If you delta hedge a long option position you can lose far more than the premium even if you get the direction correct. You can buy puts because you're bearish and still lose even if the stock price falls. How? You grossly overpay for the volatility. If you would have delta-hedged by buying shares you would have lost even more!
Path Focus
Options can also be used in ways that expose you to path if you choose to focus on how the market will move, not just where it will go. Buying options and delta hedging them until expiration is a bet on interim market moves without an explicit view on destination.
The flipside to the word of caution above is the trader who sold you those puts and delta hedged won on both the puts and the short stock position!
Key Takeaway
Path matters. As the components of a portfolio fluctuate, there are opportunities to rebalance. Options, when combined with the liquidity of public markets, offer the flexibility and control to manage or even exploit path.
References
How would you trade if you knew the future but not the path?
A trading puzzle: how much would you pay to know the closing price of SP500 in one month?
Options and Path
What The Widowmaker Can Teach Us About Trade Prospecting And Fool’s Gold
Key Excerpt: The Curious Case of Natural Gas Calendar Spread OptionsMarket prices are clever. They can balance the wagers of path vs terminal value investors simultaneously.
You can see how calendar spread options are priced so that the path of the gas price is highly respected, even if there’s strong consensus about the terminal value of the famous March-April futures spread, which is a popular proxy bet on in winter gas being in short supply.
The OTM calls are extremely expensive because if we see gas for March delivery trades for $10, then it’s safe to assume that we have a severe shortage — volatility will explode as the market tries to find a clearing price.
But this possibility remains unlikely.
The call price is balancing 2 opposing forces.
1) It’s not clear how high the price can go in a true squeeze or shortage
2) The MOST likely scenario is the price collapses back to $3 or $4.This is a gnarly situation — The price has an unbounded upside, but it will most likely end up in the $3-$4 range. Even though the calls are expensive, the vertical spreads all point right back to that terminal expected price of $3 or $4.
In other words, the market is making a distinction between probability (via vertical spreads) and expected value (via outright option premiums).
Loved this writing, sang to me
"Principal-agent conflicts in asset management lead to perverse incentives where an investor will actively try to avoid path risks to preserve a sense of return stability.
A cynic following the incentives may notice a fiduciary's preference for private assets that are less volatile simply because their marks are stale. This is like avoiding bloodwork because you don’t want to find out your cholesterol is too high.
Of course the slow-to-mark investments are still volatile. The fundamentals of the private business are correlated with the public market volatility. A private fund that is slow to mark its assets down is not going to let you redeem at the optimistic mark. This costs you the opportunity to sell the private shares and rebalance into heavily discounted public markets.
A less cynical framing of such investors is they are giving up liquidity because it will behaviorally “save them from their own fearful trading”. We would frame this as “selling the option to rebalance at zero”.
Path blindness has innocent causes as well. You may hear some investors argue in favor of individual bonds instead of a bond fund. They worry that bond fund prices move around and have no real expiration, so when interest rates rise your losses are somehow more real. But if you buy a bond and hold it to maturity you can put your head in the sand, and never lose.
This is a misunderstanding."