David R. Henderson  

Buying Puts for Years?

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In a response to, I think, me, although he doesn't make it clear whether he's responding to me, Robert P. Murphy writes:

I realized from Levi's comment that people are genuinely misunderstanding what I was trying to say in that op ed. I'm not going to try to go through it all right now, but check this out. Back in 2013, Ryan Murphy (no relation) was teasing me in the comments here, saying that I should be rich if I know the Fed is driving the stock market. I brought up that guys like Mark Spitznagel made a boatload of money from the two previous crashes, and Spitznagel is heavily guided by Austrian capital and business cycle theory. (Disclaimer: I was a consultant on that book.)

Ryan then said well let's see how he does in the future. OK, thanks to von Pepe, I see this WSJ story that Spitznagel's Universa Fund made a billion dollars on Monday (up 20% for the year). Does that count as "profiting from a prediction"? And no, if I understand his portfolio construction, he didn't give half of it back later in the week, because he didn't short the S&P, instead he bought deeply out of the money put options. (Click through to the article if you want more details.)

To be clear, I'm not saying, "The scientific validity of Austrian business cycle theory rests on the shoulders of Universa's 3q performance relative to a passive mutual fund." And yes, maybe Spitznagel just keeps getting lucky. My modest point is that if you think you can dismiss my perspective with a one-liner, you're really not even trying to appreciate what I've been saying.

I haven't put in all his links. If you want links, go to his post.

Before continuing, let me explain puts for those who don't know. You buy a put option that gives you the right to sell a stock at an agreed upon price. All other things equal, the lower the price, the less you have to pay for the option. Then, if the market price falls below the agreed-upon price, you make money. This is what Universa did.

Would I have loved to have invested with Universa on, say, August 1? Of course I would. Their puts made a lot of money.

But go back to the problem I stated originally with Bob Murphy's op/ed. I wrote:

Let's say that you warn people that a price will fall. It keeps rising. Finally, years after your warning, the price falls. But it falls to a level well above the level it was at when you made your warning. How useful, then, was your warning?

I think not very.

How does this apply here? Well, imagine that Universa, like Bob Murphy had "been warning for years that the Federal Reserve was setting us up for another crash." Given that Universa's recent strategy was to buy puts that were "deeply out of the money," isn't it likely that they would have followed the same strategy all those years? So they would have bought a lot of puts that expired without their ever exercising them. That's a lot of money over the years. How does it compare with the $1 billion gain? I don't know. But I would like to know. Otherwise it's hard to judge their strategy, even ex post.

True story: A fellow Ph.D. from UCLA, back in the late 1990s, looked at the dotcom stocks and just knew, based on fundamentals, that the stocks were overvalued. So he took some of his two daughters' college fund and bought puts. The stocks kept rising. The puts expired. So he bought more. The stocks kept rising. The puts expired. Eventually, in early 2000, he was right. But by then, he had spent all of his daughters' college fund and had nothing left to buy the puts that would have made him real money.

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COMMENTS (15 to date)
Kevin Dick writes:

"The market can remain irrational longer than you can remain solvent."

Often attributed to Keynes, but the provenance seems to be in doubt:


Kevin Erdmann writes:

Kevin Dick, a couple years ago I saw the corollary to that, which I think is generally more applicable:

"The market can remain solvent longer than you can remain irrational."


Bob Murphy writes:

I can't independently verify these numbers, but here's what Wikipedia says:

Spitznagel’s hedge fund Universa “made one of the biggest profits on Wall Street during the 2008 financial crisis” (according to CNBC),[39] scoring returns of over 100% as the Standard & Poor’s 500-stock index lost over a third of its value,[5][7][8][10][18][19][20][40][41] and making him “a fortune” according to The Wall Street Journal.[5] Despite being “one of Wall Street’s most bearish investors” (and even “the world’s most bearish investor”[42]), Spitznagel has “produced consistent gains since then, including a 30 percent return” in 2013 and 10 percent in 2014 (and has “been up every year since 2008”), according to The New York Times.[14] Spitznagel produced gains of 20% (or over $1 billion) in 2015 from the mini “Black Monday” (China) stock market crash.[43]

Two more things:

(1) Keep in mind that if the market is improperly assessing the risk of a crash (of a particular magnitude), then there exists a strategy with positive expected value where you lose small amounts on puts until it finally hits. E.g. suppose there was a fair coin being tossed repeatedly, and you could spend $1 on a ticket that would pay $1000 if 5 heads in a row came up, otherwise $0. If you kept buying those tickets with each new coin toss, in practice you would probably have a string of losses but eventually it would hit and you would make money.

(2) No matter what evidence I present, you are always going to be able to rescue (some version of) the EMH. So in a sense it's pointless for us to keep going back and forth. Ryan Murphy asked me in 2013 whether Spitznagel would be profitable going forward, and it seems like he was. But you guys can just say, "He got lucky, I bet in the next five years he'll fall behind an index fund strategy," or you could say, "He's taking on a lot of risk, and his return doesn't justify it." etc.

Outis writes:

Perhaps one can say that, to the extent that the ABCT is correct, the EMH suggests that its insight is already priced into the puts?

Michael Byrnes writes:

I thought that Universa's strategy was based on Nassim Taleb's approach of being in position to benefit from rare events when they happen. The idea being that the fund buys inexpensive "out of the money" put options, most of which expire because the price of the stock is above the option price. But, in the (rare) event that a stock has fallen greatly in value, the options are worth a lot.

In this way, the buyer of puts loses tiny amounts of money on most of its trades but its overall risk is limited because it is not taking on any downside exposure. And when rare events (stock or market crash) do happen, the buyer wins big time.

The entities that sell the puts are taking the opposite side of the bet. Usually, selling these puts are "free money" since most of the time the puts are worthless. But when the rare event happens, the puts become huge money losers for whoever sold them. (It strikes me that AIG-FP was doing something similar - with derivatives, not puts - in the runup to 2008 and we all saw how well that worked for them).

In any case, the Taleb strategy is not "I predict that the market will collapse within the next X months so I am going to start buying out of the money puts." It is more like, "I cannot predict when the next crash will happen, but I can be certain that one will happen eventually. So I am always going to buy out of the money puts (even though most of the time they will be worthless) so that I am always in position to profit when the rare event does occurs."

I don't know much of anything about Universa and Spitznagel, but if they are following a Taleb strategy then it is not about having any foresight about when a crash will occur - rather it is explicitly the opposite - it is about always being in position to benefit from the rare event because the timing of such events cannot be predicted.

I don't think it is particularly "Austrian" to believe that we will have more recessions. I would imagine that 99.99% of economists believe that.

David R. Henderson writes:

@Bob Murphy,
Thanks for the data. That helps.
Keep in mind that if the market is improperly assessing the risk of a crash (of a particular magnitude), then there exists a strategy with positive expected value where you lose small amounts on puts until it finally hits.
You’re right. I didn’t raise the issue because I knew that Universa just broke even on puts. I raised the issue because that’s a better way to judge its success, not just by looking at huge gains when the puts are in the money, but by looking at their performance over time.
No matter what evidence I present, you are always going to be able to rescue (some version of) the EMH. So in a sense it's pointless for us to keep going back and forth.
I don’t think it’s pointless. I have already granted, in response to an earlier question you asked me, that the EMH has problems. Are you sure, Bob, that you meant to argue with me on this point, not Scott? My post above was not about the EMH. It was about doing the accounting for gains and losses right. You did so in your comment above. You did not do so in your post that I linked to.

Bob Murphy writes:

Hi David,

You're right, I misunderstood the strength of your confidence in the EMH. I had missed your response to me in that older post, and so when you posted the Fama bio and linked to those posts, I thought you were affirming that it was smooth sailing for the EMH.

Also, the post on my blog wasn't directed at you. I realized when going back and forth with Levi that I hadn't spelled out why volatility (especially in the downward direction) would be something I expected, and so that's why I brought Spitznagel into the story.

@Michael Byrnes: Yes you've got Taleb right (in general), but not Spitznagel (right now). You should read the WSJ article if you want to see more discussion.

A writes:

Universa's AUM was described as $6 billion in a 2011 profile, and $6 billion in an article dated yesterday. They must have been returning a ton of client money despite exemplary hypothetical performance.

Shayne Cook writes:

David Henderson, Bob Murphy, et.al:

I've been reading, with more than a little amusement, the various posts, postulations and articles (Henderson, Murphy, Sumner) on the recent stock market volatility. Specifically, how it relates, if at all, to EMH and the Austrian business cycle theory. I find both the Austrian economic school of thought and the EMH very interesting and informative. Some of the banter about recent (or any) stock market volatility less so.

But I have a question for Bob Murphy that relates specifically to this post and his original article.
It is this:

How has Spitznagel's Universa Hedge fund performed over the long/medium term relative to say Warren Buffet's Berkeshire Hathaway?

Before you answer, I confess it's something of a 'trick' question. Spitznagel's is a trading strategy, versus Warren Buffet's investing strategy. It's rather like comparing the act of buying a coat off the rack at Wal Mart with the intent of re-selling it at a higher price later (Spitznagel), versus buying it with the intent of wearing it to keep yourself warm in the Winter - for a long time (Buffet).

(A Note here: I, personally, am an investor, not a trader. I don't buy 'stocks'. I buy 'companies', with the attendant stock certificates merely indicating my share of ownership of those companies.)

What I've found most amusing in the posts and articles over the past few days is that well educated and informed economists seem to be interpreting events - in the context of the merits of both the Austrian school and EMH - solely from a trading perspective. And a very cherry-picked and limited trading perspective at that. I'm not at all convinced that is valid. I'll try to explain.

In this post in particular, and cited post/articles by Robert Murphy, Sptiznagel (ostensibly applying Austrian school theory) is couched as the sole or at least notable 'winner' in an overall market of 'losers'. Nothing could be further from the truth. While it is perhaps true that some traders or more specifically some 'trading strategies' may have lost during the recent downturn (or 'crash', if you prefer), investors like myself didn't 'lose' a dime. Investors don't sell into down markets. They buy into down markets. I did.

Point being, Sptiznagel may have made a "Billion dollars" clearing his put options during the downturn. Good for him. But I would quickly add that investors who purchased the shares of companies at greatly reduced prices during the downturn have and will do far better than $1 Billion in gains going forward. Understand that for every 'trader' selling his/her positions during the recent downturn, there was a buyer. The buyers will collectively do quite well.

One final point - on part of the Wikipedia entry that Bob Murphy cited:

" ... Spitznagel has “produced consistent gains since then, including a 30 percent return” in 2013 and 10 percent in 2014 (and has “been up every year since 2008”), ..."

At the risk of being nitpicky, the S&P500 produced a 30% gain in 2013, an 11% gain in 2014 and has been "up" every year since 2008 as well. Not questioning the voracity of the Spitznagel claim, I merely find it's cited hedge fund performance completely unremarkable relative to the overall S&P500 index performance. (And that, only if you are applying a 'trader' perspective.)

Jeff writes:

The "true story" at the end is why I advocate "not if, but when" portfolio management. The essentials boil down to: long the market, and hold protective puts. That way the expiring puts are paid for from the profits of the long position.

I'm thinking the fellow in the example may have been taking very large bets though, because an option contract isn't that expensive.

Charlie writes:

I traced the Wikipedia article source back to the times, and I think someone should point out that the returns are hypothetical and not real. Also, the hypothetical returns apparently come unaudited from firm materials.


"The Universa strategy has produced gains of 10 percent this year, slightly less than the stock market overall. It’s been up every year since 2008, according to the materials.

The footnotes of the materials state that the performance numbers are hypothetical — and may differ from actual results."

Maybe the returns are real, but it's a pretty odd example to build your entire case on a track record that is unverifiable.

Just buying out of the money puts has and will continue to be studied. It is hard to study the "secret sauce" here. Usually, where there are returns there are bets. Ask Long Term Capital.


Shayne Cook writes:

To Jeff:

While your suggestion would appear to be a superior strategy, I would argue that it is merely an extension of the trader-centric mentality that is at the core of the problem here.

You say, "The essentials boil down to: long the market, and hold protective puts. That way the expiring puts are paid for from the profits of the long position."

My only "protective put" (hedging strategy) is to have the discipline to avoid selling into a down market. I don't have any need to find - and pay - a counter-party to effect my "hedging" strategy. It costs me nothing to apply that discipline. It only requires patience.

Jeff writes:


I'm not sure what you mean by "trader" centric, since I wouldn't advocate any more transactions than necessary. I do understand the point of buy & hold being a superior strategy, and that is true, as far as it goes. I mean that, if you are in charge of your own portfolio, and you can postpone selling at your own sole discretion, then yes, you can rely on the upward drift of the market as a whole. But I would recommend anyone pursuing this to remember that a stock market crash could occur right around your planned retirement date.

If we're talking about a managed fund, though, then it's a different story. We have to keep in mind that people might liquidate their positions after crashes and that turns paper losses into real losses if the fund doesn't maintain sufficient cash.

Ken P writes:

Shayne Cook writes:

Investors don't sell into down markets. They buy into down markets. I did.

That's pretty much how I view it and I bought into the down market, too. We hit some all time highs recently and I trimmed back to 40% - we are 7 years out from the last crash, why be heavy with stocks at all time highs? Now I'm at 70% again like I was when we hit the highs, but bought in on the two super down days. If nothing else, being able to buy on those down days relieves some of the stress of those days.

Shayne Cook writes:


Perhaps I wasn't clear. What I meant - and mean - by a "trader-centric" mentality and perspective is as follows:

To a Trader, stocks (or options, or bonds) are merely "inventory" - to be resold (converted to Federal Reserve Coupons) at the earliest possible opportunity. Optimally, the number and content of "sells" exactly matches the number and content of "buys". A "buy" always automatically implies a "sell".

Conversely, Investors consider stocks (company ownership rights) and bonds as an investment that provides its own returns over a long period of time. A "buy" never automatically implies a "sell", and certainly not within a short time period or even a constrained time period (e.g., Options expiration).

Again, the analogy is going to Wal-Mart and buying a winter coat - to wear in order to keep oneself warm in Winter (Investor), OR to try to re-sell at a profit as quickly as possible (Trader). Either is a legitimate reason for purchasing the coat. But those legitimate reasons derive from entirely different perspectives.

As an aside, I don't consider "buy and hold", or any of what I would call "Investing" strategies necessarily superior to trading strategies in general. They are merely different, and arrived at from vastly different market participant perspectives. I only consider an "investor" strategy superior for me and my circumstances. I'm a market participant, but I don't do trading.

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