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Mark Spitznagel – How This Hedge Fund Manager Nullifies Market Crashes

http://www.option-price.com/ -- Calculate option prices We tend to think of insurance as a necessary cost: the price tag on some peace of mind. This analogy has been the orthodoxy in the world of investing, as well, but Mark Spitznagel’s track record – boasting annualized returns of over 100% between 2008 and 2020 – paints a very different picture. For Spitznagel and his hedge fund Universa, risk mitigation should actually improve the CAGR (Compound Annual Growth Rate), rather than reduce it. The combination of an instrument tracking the S&P 500 index (75%) and bonds (25%) provides a better CAGR than the index alone. Unfortunately, this is only a 0.1 percentage point improvement, which therefore fails to offer enough protection in the case of a steep market decline like in the fall of 2008 and spring of 2020. Parking one’s money with the average hedge fund isn’t an option either: in fact, the average hedge fund detracted from CAGR, as the overall industry has failed to beat the indices and generate alpha over the past two decades or so. The answer, according to Mark Spitznagel and to his mentor and author of the influential book “The Black Swan” - Nassim Taleb – lies in put options with a highly asymmetric payoff. The actual strategies used by veteran practitioners like Spitznagel are most certainly many orders of magnitude more complex than this, but he lays out a basic framework in his book and in several articles. Spitznagel’s simplified strategy calls for the purchase of 2-month, 30% out-of-the-money puts on the SPY, which are then sold at 30 days to expiration. Former hedge fund manager Jesse Felder actually tested this strategy back in August 2016, and found out it worked surprising well. In this simulation, Felder purchased put options with a strike price of $155 (30% OTM) with the underlying SPY trading at $219.40. Spitznagel’s strategy seeks to offset losses of 20% or greater in an equity portfolio, the value of which Felder sets at $100,000 in this exercise. Felder’s puts would therefore have to earn him around $20,000 in order to nullify these losses, with a monthly investment corresponding to 0.5% of the portfolio he's trying to insure. He would therefore be buying $100,000 * 0.5% = $500 in October 2016 155 put options, with a price tag of $9 per contract. Assuming a 20% drop in the SPY and an implied volatility level of 55% (consistent with previous stock market crashes), Felder’s options would skyrocket to $328.10 per contract, for a total portfolio protection of $18,046. ($9 * 55 = $495) (55 * $328.10 = $18,046) This assumes the worst case scenario where the puts only rise in value at the eleventh hour, i.e., with only 30 days to expiration. At 40 days to expiration the puts would have not just offset all losses, but actually have posted a profit of close to $5,000. This strategy, while extremely powerful, is not without its flaws, as the puts require cheap prices (low volatility) at the time of purchase. Following the 2020 stock market crash, volatility – measured using the CBOE VIX – has remained at consistently elevated levels, double and sometimes even triple the volatility levels seen throughout 2016. In fact, I recently ran this strategy and the results were rather abysmal. SPY: $375.70 (Date: 01/15/2021) Exercise Price: $263 (30% OTM) 20% drop level: $300.56 Price per contract: $75 (March 19, 2021 puts) Number of contracts: 7 Predicted return simulation: (30d to expiration) 7 * $488.88 = $3,422 -$20,000 + $3,422 = -$16,578 (40d to expiration) 7 * $688.00 = $4,816 -$20,000 + $4,816 = -$15,184 (50d to expiration) 7 * $875.80 = $6,131 -$20,000 + $6,131 = -$13,869 This indicates investors seeking to use this strategy now have to figure out ways to insure against a large stock market decline using roundabout means, perhaps through the purchase of puts on correlated assets.