DeepState
Multi-Strategy, Quant and Fundamental
- Joined
- 30 March 2014
- Posts
- 1,615
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- 81
Yeah, good discussion. Many roads to Rome.
Glad you raised the house and car insurance example. Let's run with it. You want to insure your house and car. You want to be able to live in your house and drive your car, restoring it to workable condition if you encountered a mishap. For TinSoldier, the longer his investment horizon, the insurance should simply be over the return not being well below say, cash, over that horizon. That's his house and car. Return over investment horizon. What happens along the journey is actually irrelevant. All that matters is the end result. He can be insured, for this example. The longer the return horizon, the lower cost of the put until it almost vanishes. Compare that with insuring every quarter which is certainly not zero. That difference is over-insurance.
Expected outcome is important. You must be a fan of it because you are acting in a way to get higher expected returns or you probably wouldn't do it unless you regard this as just entertainment or something like it. But, I think you mean that volatility is important too and the pain of the journey. Absolutely no argument there. Warren Buffett has said that you don't need any more IQ points than 130 to do well in the market. Anything more than that, trade them in for temperament.
My view is that, for the most part - particularly for a newbie - if you can't hack the heat cut back your position size until you can. The longer you are prepared to think about, the more you can hack.. What are you doing in equities if you can't think out quite a few years? Yours is to enter full position size with insured stops. I have outlined why married puts are likely to underperform full sized buy-hold. That gap is the price for temperament. So there's no answer...it depends on your temperament. But that's the cost. You will increase the chances of losing money against cash for the benefit of placing a floor under your returns for an ASX 200 ETF. But you might sleep better along the way. It's true, that's not to be underestimated. But you can either insure at net expensive, or reduce position size. Both become more comfortable the longer your horizon is and actually become closer and closer to the same thing.
As for cashing chips in if you can't handle the heat (moving to a Corolla!! love it)....I just ran some figures based on the ASX ETF assumptions and allowing for skew that would be priced in for a 3 month option. The option is for a loss protected at 5% downside relative to current price (allowing for 1% to be earned from dividends). The option does not 'cost' much at about $2 per $100 face value protected. But by buying protection, the way options work, it actually takes you out of the market. In this case, delta is -0.23. Roughly, buying married puts is akin to turning up at the casino, putting 100 chips down and then putting your arms around 25 or them before any play takes place at all. You cashed in before you started. This is why protecting costs you as well. It holds you out of the market, and you pay negative odds for the privilege.
Overall, I know I couldn't handle a monster draw down and survive it without a lot of insomnia. I ensure that I can handle the losses via adjustment to position size and do take additional steps to defend the extreme edges. But these are truly extreme. Some of these steps include taking synthetic option like protection with weird pay-offs that suit my purposes. So...TinSoldier...this is not black and white and it is clear that Minwa has made great points. Hopefully this playful contest of ideas has helped to add to your state of confusion, analytical paralysis and so on. It helps to appreciate there are, indeed, may roads to Rome. When the fog clears a bit, hopefully you'll discover a path that is right for you.....like most of us, find that it isn't...learn and keep looking/learning.
Good trading Minwa
