Divestor

John Hempton at Bronte Capital writes another high-quality piece about how having superior information doesn’t necessarily translate into stock market returns. It is just like people that shorted the stock market in 1999 because of insanely high valuations (or shorting Amazon in 2009 at $100/share!) – even though they might be correct, the market can remain irrational longer than your ability to remain solvent.

It is always frustrating in markets to be right, but to get the timing incorrect. This is why option markets are always so brutal to those don’t get the element of market timing to be correct. It is also an indication that even when betting against the majority, you will only be able to win if some of that majority decides to see the world your own way – this process can take years, just like it did for the former Dow Jones Industrial stock Eastman Kodak, or for the poor fellow (Alfred Wegener) that developed most of the geological theory on plate tectonics – he was completely correct, but ridiculed in his own scientific community and died before he was proven correct about 40 years after he proposed the theory.

You can also see other stocks that are on their death throes, such as nearly anything involved in newspaper or paper-based publishing. It also makes you wonder what industries today that aren’t visibly dead will be on their deathbed in the next 20 years – look around you and see what you use today, and wonder if it will be replaced with some substantial technology innovation that is just in its infancy today. Maybe this is why Amazon is trading so highly – maybe they will be exterminating conventional retail shopping?

I remember back in the late 90’s, back in the days when I started investing and didn’t know too much other than technology companies, that I did a lot of research on flat panel displays. Back then, 17″ CRT monitors were still about $500, but it was imminently clear to me that flat panel displays would be the way of the future – if anybody tried lifting up a 21″ CRT monitor you would end up breaking your back trying to move the thing. It lead me to two companies, Genesis Microchip, which did semiconductors in FPDs, and Photon Dynamics, which made diagnostic and factory equipment for the manufacturing of FPDs.

Both of these companies didn’t skyrocket like I anticipated them to and I never even invested in them, but it was worth noting that despite the fact that flat panel displays became the future of computer displays, I never was able to financially capitalize on it in the marketplace.

I am noticing that the implied volatility of the S&P 100 is below 20% right now, which is the lowest it has been since when the financial crisis really picked up steam (September 2008). At the peak of the economic crisis this was around 80%.

The concept of portfolio insurance is simple – buying put options represents a form of insurance. You can play with these options and come up with some concepts that can be translated into English for less financially sophisticated people.

Let’s pretend you owned $100 of the S&P 500. If you wanted to insure your portfolio against any further downside for the rest of 2010 (i.e. you wanted to guarantee that you could sell your $100 of S&P 500 for $100 at the end of 2010), how much would it cost you? The answer is about $9.89 given closing option prices on December 24, 2009. This sort of insurance is good if you anticipate a possibility of the market declining, but you still want some “skin in the game” in the event the S&P 500 goes up between now and the end of the year.

We can repeat the same thought experiment, except asking ourselves if we wanted the right to sell your $100 of S&P500 for $90 by the end of 2010, a 10% loss. This insurance will cost you $6.14 to purchase.

The difference between these two values are $3.75.

What this practically means is you can bet the following ways (again, note I am indexing the value of the S&P 500 right now to 100 for the purposes of this post):

1. You can bet that the S&P 500 will not drop at the end of 2010. Reward for getting this right: $9.89 for $100 notional risk. Punishment for getting it wrong: $9.89 minus $1 for every $1 that the S&P goes below $100 at the end of 2010.

2. You can bet that the S&P 500 will not drop more than 10% at the end of 2010. Reward for getting this right: $6.14 for $100 notional risk. Punishment for getting it wrong: $1 for every $1 that the S&P goes below $90 at the end of 2010.

The “bets” to describe the results of predicting an S&P 500 level of 90 to 100 are a little more complicated to explain, but they can be done with portfolio insurance as well. Essentially you can feed any probability distribution into a model and have it crank out the optimal purchases/sales of options to correspond with your crystal ball forecasting.

Since I can’t forecast indexes, I’ll leave this to the gamblers. That’s what most option markets end up being. Right now, the option markets are saying that they expect volatility to be low, which keeps option prices low. This generally favours people that have strong beliefs that the markets will go rapidly in one direction or another.