The Creation of Bubbles

The word bubble is used to describe an excessive irrationality that leads to abnormal mis-prising of assets. Financial history reveals that bubbles are not specific to region, race or religion. Under the right circumstances, they can happen anywhere.

What are the ingredients of a typical bubble:

1) Low interest rate for a prolonged period of time (12-18 months). Easy access to cheap money eventually creates an excess money supply that leads to investment in projects with low and even negative return. Liquidity trumps fundamentals.

2) A new industry that most people don’t understand and therefore don’t know how to price. In late 1990’s investors were throwing money at every company with “.com” in its name disregarding the lack of revenues, profit and sound business model. Many realized that the companies they were buying would never make it to a green bottom line, but believed in the theory of a greater fool. As long as there was someone else to pay higher price, it was perceived as a “safe speculation”. In early 2000s, 3com sold 5% of its shares in Palm via IPO. The new issue took off so fast that its market capitalization became twice as much as that of 3com. But remember that 3com still owned 95% of Palm. It turned out that the value of 95% of Palm was worth $25 billion more than the entire market value of 3com, which essentially meant that market was pricing the value of all other 3com’s businesses and assets at negative $25 billion.  Greed trumps fundamentals.

3) A large number of people suddenly start to feel rich. When they feel rich, they start to behave as such. The source of newly realized wealth could come from excessive savings or sudden increase in the value of equity (home or stocks). Suddenly people realize that they have access to a lot of money, which means that they can afford to spend more or/and they could work much less if they find a way to make their money work for them. The appetite for risk rises and the hunt for return starts. Money goes into the asset class that has performed best in the recent past. Price growth becomes exponential and it continues until Wall Street’s printing press manages to catch up with the demand for the desired securities. Warnings about massive mis-pricing are massively ignored. Confirmation bias is deeply wired in the human brain. We tend to search and find only information that proves and confirms our beliefs. Arrogance trumps fundamentals.

There were dozens of bubbles in our financial history and the frequency of their appearance has recently accelerated. It is safe to assume that as long as human beings take investment decisions, there will be other bubbles. They can’t be prevented, but their impact could be softened with a proper regulation.

To spot a bubble is easy, to profit from it is the hard part – because no one knows how big a bubble will become and how long it will continue. Many spotted the housing bubble in the USA in 2004-2005 and started shorting housing stocks. Needless to say, most took big losses as housing stocks quadrupled before they reversed course. Many speculators were right, but they were early and over-leveraged.

Nothing lasts forever. As Howard Lindzon would say “Find trends, ride them and get off.”

Good to Great

I’ve found over the years that much of what separates  the excellent traders form the average ones is not so much their ideas ,but what they do with those ideas. Two traders will have positions go their way and then pull back a bit. The first trader, anticipating punishment, fears losing his gain and takes a quick small profit. The second trader, anticipating reward, adds to the position on the pull back and reaps large gains. Same idea, different outcomes, all as result of conditioned patterns of thinking.”

Dr. Brett Steenbarger

Being in the Prediction Business

“After studying forecasting day and night for 30 years, I realized that I don’t know what the market is going to do, and I’ve yet to find anyone who can consistently and reliably forecast an uncertain future” – Ned Davis

“My financial success stands in stark contrast with my ability to forecast events… all my forecasts are extremely tentative and subject to constant revision in the light of market developments” – George Soros

“The art of prophecy is difficult, especially with respect to the future” – Mark Twain

Some Trading Wisdoms

“Never let the fear of striking out get in your way” – Babe Ruth

“If you can’t take a small loss, sooner or later you will have to take the mother of all losses” – Ed Seykota

“Don’t think about what the market is going to do. You have absosutely no control over that. Think about what you are going to do if it gets there.” – William Eckhardt

“I turned from a loser to a winner when I was able to separate my ego needs from making money. When I was able to accept being wrong. Before that, admitting I was wrong was more upsetting than losing money” – Marty Schwartz

“The worst mistake a trader can make is to miss a major profit opportunity. 95% of the profits come from only 5% of the trades” – Richard Dennis

Thoughts on Short Selling and its Alternatives

James Altucher, a managing partner of Formula Capital, has an interesting post on the nature of short-selling.

  • Never short based on price action. A stock that is going straight up can continue at least until you are bankrupt before falling to the ground.
  • Never short based on valuation. A stock might be expensive at 100 times earnings and it will be even more expensive at 200 times earnings.
  • Unless you are hedging, your short positions should be 1/3 the size of your long positions.
  • Believe it or not, short stocks that have high short interest. In general, short squeezes are a myth and stocks that have high short interest are usually shorted for a reason.

It might not makes sense to go long a stock that is up substantially in a short period of time, but not being a buyer doesn’t mean that you should be a short seller.

When selling short, paying attention to risk management is essential. Initiating smaller than usual positions for short ideas helps, but it is not sufficient to prevent a disaster if a stock gaps up substantially above your stop loss. There are alternatives to simple equity short selling. Alternatives that allow for more precise risk control:

1) buying puts – you know exactly how much you could lose if your thesis turns wrong. The maximum loss is the whole premium, which means that if you risk 0.5% of your capital on short ideas, 0.5% is the amount that you would lose in the worse case scenario. In general, implied volatility tends to rise as the price of the underlying asset declines; therefore if your trading thesis turns right, your option position is likely to benefit from rise in IV. There is one major exception to the rule of high negative correlation between the price of the underlying stock and the IV of its derivative contracts – it is called volatility crash, which occurs after the expiration of a major event such as earnings’ day or FDA approval day. IV is highly elevated before such major events due to the higher uncertainty about the potential impact of those events on the stock price. Once the news from such an event is known, the IV quickly retraces back to its  long-term mean disregarding the price action in the underlying stock. With two words, under the above explained conditions, IV  of options could drop despite a drop in price in the stock.

For example, instead of shorting SPY at 115.45 where it is currently trading, you could buy SPY $115 April PUTS at $2.35. The maximum loss that you can incur is the paid premium if you decide not to offset your position before it potentially expires worthless on the third Friday of April. If your trading capital is 100k and your maximum risk for short ideas is 0.5%, you would be able to afford buying only two contracts. (100k*.5% = 500 and 500/2.35 = 2.12).

The current delta is (-0.4916); gamma is 0.0683; IV = 16.19%; vega = 0.1439; tetha = -0.0307. Let see what is likely to happen with this position if SPY drops to 110 in the next 15 days and the IV of the option rises 3% points. Due to the drop in SPY’s price, delta and gamma will contribute to the option’s premium with approximately 5*0.4916+4*0.0683 = $2.73; the 3% increase in IV will boost the premium by 3*0.1439 = $04317; For 15 days, theta is expected to erode the premium by 15*(-.0307) = -$0.4605. The total impact on the option premium would be +$2.72 or 115% increase from the current base.

You could also sell OTM SPY March calls in order to take advantage of time depreciation, but with this approach it is much harder to manage risk. In a post I made last weekend, I mentioned that back then SPY $117 March calls were traded for $0.47 and SPY was offered for 114.30. 4 days later SPY is up to 115.45 and the SPY $117 March Calls are traded for .34 – a decline of 0.13. This is the power of time depreciation 10 days before option expiration.

2) buying put spreads- if you are concerned about risk and time premium, you might go with this approach. It will limit the potential reward, but decrease the negative impact of volatility and time depreciation. Another alternative is selling call spreads if you have an intention to take advantage of time depreciation and potential drop in IV. Currently the SPY 115/113 April Put spread is traded for about $0.75; SPY 115/117 April Call spread for about $0.97.

Certainly applying the above suggested tactics requires that the underlying stock is optionable and its contracts are liquid enough, so slippage is not an issue.