Category Archives: Portfolio Principles

Run your own fixed income annuity

June 7, 2019Bull Directional, Bull Put Vertical, Early Retirement, Portfolio Principles, ProductsTLT30DayTrading

Sometimes you just want to make the guaranteed risk return with the possibility of some upside, but with a guaranteed return of principal. This is typically where fixed annuities come in, however they can be expensive with up front load or annual management fees. Fixed annuities can also be structured in an opaque way where it is not clear exactly what investments the product has bought and how they are managed (e.g. trade turnover etc) – in short they are not very transparent.

Please note: A fixed income annuity is a very complex contract between you and the insurance company. Therefore it is not perfectly compared with the actual investments described in this blog – but this is a starting point to see if the flexibility of doing it yourself might give you some more transparency.

So … is it even possible to run your own fixed income annuity style investment ? Preferably with minimal management, without all the fees and long lock up periods. This blog post is a look back at an annuity style strategy that has been executed for the last few months.

Lets assume we’d like to do this with a lump sum principal of $100,000 USD. It is pretty easy to create medium term US treasury portfolio which is close to the risk free return – lets assume we can construct an equal weighted multi year duration portfolio of treasuries up to 5 years out. Technically there is some duration risk on the longer dated treasuries, but it’s decent proxy for a stable risk free return portfolio. A few months ago in Feb 2019 this had a blended rate of approximately 2.5% – yielding about $2500 a year in interest. See this table for the basic treasury portfolio construction:

Price Date	US Treasury Duration	US Treasury Yield (annualised)	Principal Amount	Yield Amount (annualised)
13th-Feb-2019	6 months	2.51	$20,000	$502
13th-Feb-2019	1 year	2.55	$20,000	$510
13th-Feb-2019	2 years	2.53	$20,000	$506
13th-Feb-2019	3 years	2.52	$20,000	$504
13th-Feb-2019	5 years	2.53	$20,000	$506
TOTALS			$100,000	$2,528

See prices from US Government Treasury website

Managing interest rate risk

However over the next few years, rates might go up or they could be cut. Ideally when each treasury expires we’d like to be able to roll into a new treasury bond with a similar or higher interest rate. However by the time that happens the interest rate market could have moved. So how to manage that interest rate risk without risking any principal?

Since Bond prices will increase when interest rates go down some hedge needs to be provided against falling rates. More simply – something that makes money when rates go down.

In March 2019 we started adding to the above treasury portfolio, by using limited risk bullish short put spread in TLT options. In theory TLT should go up if FED was to cut interest rates and go down if rates rise. TLT contains bonds that have an approximate 17.8 year bond duration, so it is not a perfect proxy for own mini fixed income portfolio that has an average duration of about 2.5 years – however it should be correlated at least. Plus TLT does have very liquid options market that is a couple of pennies wide and can often get filled at mid price, so we can be confident of getting liquid fills on the option trades.

This TLT “short interest rates” trade can be done fairly simply using an ATM bullish put spread, with a slight time decay in your favour on trade entry. There appears to nearly always be a small amount of extrinsic value in an ATM put spread appears to be consistently available, because TLT itself has an actual yield – so you would expect to get paid something for holding it for 90 days even if (all other things being equal) the price never moved. For example if the market is $125, you can sell 5 contracts of $126 put and buy 5 contracts $124 put 90 days out for a credit of $1.05. That would give approximately $0.05 of extrinsic value with $1.00 of instrinic value. If TLT rallies over $126 by expiration can make $550 for that quarter, if it closes below $124 lose $450 for that quarter. Obviously if rolling the put options is considered this becomes way more complex, but waiting to close until near expiration is the simplest case.

If you want to replicate a true fixed annuity with no risk to principal, you’d have to be careful size each trade to not risk too much on each TLT put spread. Lets assume we will do one put spread per quarter, and risk $500 per quarter per spread – that would mean in theory we could lose $2000 ($500 x 4 quarters) on the spreads. However since we gain $2500 in treasury interest, so we’d still be $500 ahead for the year. Not great obviously, but that is the theoretical worse case scenario and if we want guarantee to maintain principal then we have to be cautious with the risk. This is an annuity strategy where aim is to take some market risk but only with money gained from interest payments, never from the principal.
If you wanted to take equity risk as well, this could be applied using SPY option spreads, but recognize that is obviously not as tightly correlated to US treasury rates as TLT.
If you did lose money on the TLT spread, that would be an advantage to you when you come to re-invest any expiring fixed income, because the treasury rates would be higher.

To clarify the idea here are a couple of actual trades to show the principal. One is a simple bullish put spread. The second one was a combination of bullish put spread with a bearish short call spread sold against it.

TLT bullish put spread

This trade was entered into in March 2019, then exited closer to May 2019 expiration on 1st May. There was a $369 profit as TLT had traded up slightly. This took approximately 50% of available profit.

Trade Date

TLT bullish put spread with bearish call spread

A couple of days later on 3rd May a similar bullish put spread trade was opened June options, but this had an overwrite with a call spread to give the trade some option premium to sell. Normally trades would be rolled the same day, but there was a couple days in between trades because the earlier trade was trigger by a limit order (and didn't notice position was exited).

Trade Date

Fixed Income Annuity - Summary

This blog post showed how it is possible to take small profits out of TLT to increase yield, but with limited risk if TLT goes down. In this real life example TLT went up, so the May and June spread trades added a few hundred dollars in yield. However if TLT did go down that would be an advantage to the main US treasury principal because new bonds could be bought with higher yield to expiration. This might need some tweaking to make into a better results, but it demonstrates the idea. There is approximately 30mins monthly effort required to analysis, enter, monitor and roll the TLT spreads. Running your own "annuity" product is potentially a lot cheaper than an traditional annuity that charges upfront load fees and annual fees.

Portfolio Principles

February 19, 2018Portfolio Principles, Products30DayTrading

Portfolio Principles – Risk Management

Risk management is arguably more important than any actual trading strategy. Multiple traders can run the same strategy, but could get widely different results because of their risk management rules and whether or not they actually apply their rules properly under market stress.

Take risky positions with small amounts of capital that limit downside on trade entry

Use capital efficiently – for example use ETF option spreads or deep ITM ETF call options instead of buying ETFs outright.
Where possible with exchange listed products use option spreads on trade entry to limit downside risk.

For risky positions in small cap or alternative investments the stop loss is zero, so only enter with what can afford to lose (e.g. use maximum $10k per idea).
Visualise what to do if that $10k position is down 90% – should be nothing because the risk was sized on trade entry.

Risk is always sized on trade entry and never increased through the lifetime of the trade

Don’t reestablish the same trade immediately after exiting for a loss. That is effectively the same not having any stop loss risk management.

Everyone has their maximum risk limit tolerance, except for some very rare investors like some institutional traders who don’t feel emotion or pain on losses.

Investment Themes

Cash is a really bad long term investment, and should be thought of as a constantly decreasing asset due to inflation. However cash is very useful to have for short or medium term opportunity. 100% invested is likely missed opportunity cost for an investment theme not thought of yet. 100% invested all the time is only suggested by the fee based investment management so they can get paid.

Recognise the difference between “themed generation investments” and just a trade. Long SPY call spread $250/$255 for next month, is just a trade (so don’t leave one leg on and treat it like an investment). Long bitcoin or 3D printing stocks can be a multi year trade.

Trading and long term holding are both ok in a portfolio – just be clear which positions fit each category.

In volatile markets like crypto currency a month can feel like a year. Global stock markets are not truly as volatile because they are very mature market – the perceived volatility is often due to investors position sizing traditionally makes it a large part of their net worth.

Don’t attempt to follow investment theme advice from too many sources because it clouds your vision. but read as much as you can on different investment opinions and perspective. If you read something you don’t agree with – decide why you don’t agree with it and see if there is any thing it could add to your own rules. Always stay with your own rules. Importantly investment is about what you believe other market participants will do, not your personal opinion. Your personal opinion on market direction isn’t worth that much. e.g. if you think S & P 500 is on the biggest bubble since Dutch tulips, but you have noticed that many other people are comfortable with it – might be getting limited long exposure.

House Money

“A stock operator has to fight a lot of expensive enemies within himself.” Reminiscences of a Stock Operator by Edwin Lefèvre

After a large profit take the original risk out of the position, then let the rest run as “house money”. Always try and play long term with “house money” if you can because it removes some of the original fear of loss from the trade.

You are probably limited by what you believe is a lot of money. This type of scenario is directly applicable to the crypto market for the last year. Assume you invested $10k, then exited original $10k from position – so still have a position but no risk – and over time the “house money” position goes to $100k. If ultimately lose $100k of “house money” from the peak valuation of that investment – is that an acceptable risk ? If you make have unrealised gains of $100k do you want to exit immeadiately because you cant stand to give it back ? What if the unrealised $100k profit goes to $50k but they goes to $200k afterwards ? Can you handle the swings – even with house money ?

Do you assess the trade based on how much money you have in it ? Or it is based on the investment idea still being valid ?

If you lose on the trade do you anchor to that loss ? Or do you believe that opportunity always come along ?

There are never optimal trades in financial markets, only “good enough”. You will always leave something on the table. Does this achieve initial trade targets ? Whether is was a winner or a loser – was it a well managed trade ? Loser management is as important as winners.

The legendary investor Bernard Baruch who came through the 1929 crash mostly in tact was asked what made him such a successful investor. He replied: “I always buy ‘too late,’ and sell ‘too early.’”

Managing position trades through big swings

“It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight! It is no trick at all to be right on the market. You always find lots of early bulls in bull markets and early bears in bear markets. I’ve known many men who were right at exactly the right time, and began buying or selling stocks when prices were at the very level which should show the greatest profit. And their experience invariably matched mine–that is, they made no real money out of it. Men who can both be right and sit tight are uncommon.” Reminiscences of a Stock Operator by Edwin Lefèvre

“Old man Partridge’s insistence on the vital importance of being continuously bullish in a bull market doubtless made my mind dwell on the need above all other things of determining the kind of market a man is trading in. I began to realize that the big money must necessarily be in the big swing. Whatever might seem to give a big swing, initial impulse, the fact is that its continuance is not the result of manipulation by pools or artifice by financiers, but depends upon basic conditions. And no matter who opposes it, the swing must inevitably run as far and as fast and as long as the impelling forces determine.” Reminiscences of a Stock Operator by Edwin Lefèvre

“Bill Gates got his money because he owned a stock, Microsoft, and it went up eight hundred times, and he stayed with the trend. He sat through one of the greatest bull runs in the history of civilization. He understood the pain of gain.”
Paul Tudor Jones (Tudor Investment Corporation) in Tony Robbins “Money: Master the Game”

Personally I believe it is physiologically easier for me to trade a limited risk option spread strategy because I know how much I can lose every month – but the expected return is only 5% to 10% a year. However handling huge swings in a wild crypto bull market is much harder – yet infinitely more profitable – and after taking out the original stake to play with house money there is no money at risk. It is way more profitable to simply hold positions in a bull market, than trade around them.

Position Entry

This quote is from Paul Tudor Jones (Tudor Investment Corporation) in Tony Robbins “Money: Master the Game” – after showing a picture of rapidly sloping up chart with a “You are here” arrow at the top of it, this is the quote:

“How many people want to be long and stay long this chart?” And about 60% will raise their hands. And how many want to get off this investment and sell it ? Then 40% or so will say get out. And I say “You 40% should never ever invest your own money in your entire life! Because you’ve got this contrarian bug, and this the greatest way to ruin that there possibly is. It means you’re going to buy every brand – you’re going to buy things that go to zero and sell things that go to infinity.”

Do you have a temptation to buy cheap on the way down? Buying cheaper is good, but better done when potential is not yet released in new issues that have no overhead supply. Will make more money buying into a market rising off a low base, than trying to pick a bottom in a “race to the bottom”in multi month decline.

Which of these are you tempted to buy ?

Option 1 – uptrending market that is already 20% for the year moving to recent multi year highs, off a 1 year flat base
Option 2 – downtrending market that is already down 60%, and heading steadily lower over a number of months with some -10% months along the way

Its really hard for me to do 1 & very easy for me to 2, because of personality type. Don’t like to overpay for anything & like the idea of getting a “bargain” (cheapskate). Plus the implication that you are smarter than the market because you picked close to the bottom (ego).

Final quote from Paul Tudor Jones “Don’t be a hero. Don’t have an ego. Always question yourself and your ability. Don’t ever feel that you are very good. The second you do, you are dead.”

Download Portfolio Principles eBook for Kindle

New York Traders Expo 2016 review

February 28, 2016Portfolio Principles30DayTrading

Went to New York Traders Expo 2016 last week, as have done for last 3 years. We have two main aims to get ideas for the 30 Day Trading strategy back tester and keep up with option product trends in the market. You can still view all the recorded New York Traders Expo events here until 12th March 2016, including some of the one’s discussed below.

Its given great direct access to either the owner or developers who write the products and generally brainstorming ideas. Can quite happily spend a few hours just chatting away to various product owners about option strategies, and everyone is generally interested and helpful.

First impressions are that there are now a lot more products with options, options on futures and futures – would estimate about one third this year, versus about 10% in 2012 (unscientific estimate/guess).

Secondly the cross over between what is a developer, quant or product owner is becoming more blurred. For example there are CEOs who programmed the original code base for their system or developers who can articulate option strategy and market risk like a quantitative analyst. Having a cross over skillset understanding IT, trading strategies and product marketing is really important for a lot of people creating these products.

These are some high level ideas we took away from the daily presentations. They are deliberately high level so as not to take away from the presenters proprietary ideas (just to give a flavour of what was discussed).

New York Traders Expo – Fintech trends

The following were not really related directly to any of our 30 Day Trading option strategy ideas, but just interesting Fintech industry trends. “Fintech” definition is broadly speaking usually Silicon Valley startup firms in the last 5 years that trying to disrupt the heavily regulated financial industry. Why has it taken so long for this time of innovation to come to financial industry ? If it has been done in travel by Expedia, or book selling by Amazon, why not finance? Simple answer regulation is so high in the financial industry so has taken long to disrupt in the last 30 years. Plus a number of entrenched players like exchanges and traditional asset gatherer have no motivation to change the profitable status quo. These are some trends we found from various presentations:

The algos are coming, and thats a good thing!

One company presenting at New York Traders Expo was Motif, that enables customers to re-use existing or customize a “motif” list of up to 30 stocks that can be purchased as a basket with one click. User can have fractional shares owned by themselves, so algorithm can buy exact dollar amount $500 of a stock basket (the “motif”) in real time. Motif algorithm handles the fractional share distribution among users, transparently to the user. Motif can actually make money on transaction costs because their fractional share algorithm is so efficient, unlike traditional brokerages that find it harder to make money from transaction fess because their model require a lot of legacy inefficient behind scenes processing. Their CEO made the point that Fintech companies can start with a clean slate from the technical design without years of software development layered on top of legacy platforms.

Process automation for financial overload

One big New York Traders Expo theme was using process automation to deal with financial information overload and handle complex tasks for you. For example, Motif is looking at automating tax harvesting strategies. This year they are planning to provide a service where you get an alert on your phone saying “It’s year end, do you want to tax loss harvest?”. If you pick “yes”, then the algorithm will sell your losers at year end, go to cash, then auto buy back your stocks after 31 days to avoid the IRS wash rule (without you need to do anything else).

Constantly reducing transaction costs

What is the long term term in trading transaction fees ? Likely heading towards zero.
Traditional brokers make money from holding customer cash and fees. Costs an average broker about $600 to inboard a customer. Fintech companies new investment from the ground up in custom technology ultimately reduces transaction fees for users.

There is a lot of friction (transaction costs) moving USD around the banking system (bank fees) and trading securities (trading fees). Can bitcoin transactions on the block chain help reduce transaction fees towards zero?
Bitcoin transaction costs are cheaper than USD and bank transfers in the US (using ACH) are generally inefficient.

Forbes also offered some ideas on how blockchain technology could be used to improve this. The distributed ledger technology, has potential, however people are starting to create multiple block chain technologies, with no consolidated system. For example if broker A is using block chain technology X and broker B using block chain technology Y, then they need to use a 3rd system to settle transactions – that’s not scalable or desirable. As was pointed out – “That’s the great thing about standards, if you don’t like the existing standard you can always invent your own!”

Automation cannot solve everything (yet)

Transaction costs might go to close to zero in future, but these ideas will survive because they are hard to replicate. These investment ideas will still require non automated human effort:
1) insight – the idea of better strategies and risk management
2) relationship – a human to manage emotions in market stress and check market risk tolerance
3) hard to do tailored financial advice – hard to get good advice if you are not generic “401K” style allocation.

Market Place Execution “Fairness”

Iex exchange aims to increase transparency after you press “Go” on the trade, the idea made famous for Micheal Lewis’ book Flash Boys.

Currently IEX is applying to become an exchange, so what would that mean. Iex is currently dark pool, due to regulations very hard. applied to become a us exchange, received about 400 public comment letters. There are were about 15 public letters for all other us exchanges.

Everyone trading at Iex has the same info make a decision. Iex aim to not charge for market data if they become an exchange. IEX has a “speed bump” which slows down order speed 350micro seconds of delay (1/100th of time taken to blink your eyes). Nasdaq has a 40 pipe (used to be 10 pipe) now is 10 micro seconds faster. That means if you have the money you pay for faster market access, you can get trading info faster. That is essentially what IEX is offering is slightly slowed down known playing field for a All market players, not just those with the cash to play.

Customer now the designer, not just the consumer

Another New York Traders Expo theme was that customers are becoming more important for idea development, and large numbers of engaged users drives improvements and ideas with Fintech company products. More companies use social crowd sourcing to gather ideas and allow customers to customize their own solutions. Traditional finance managers have a list of products to choose from and you pick the one you like best – if its not on the list you cannot do it. For example, if you didn’t want to invest in tobacco companies, and the only mutual funds included tobacco companies – your historical choice was invest or dont.
Fintech companies are saying here is the basic template, but now how would you like to customise it ? This can get very specific to sub sector themes with ideas that people see around them or have job expertise in (e.g. cancer related biotech startups).

Self directed investing

Tasty Trade believe that self directed investing is becoming the new finance model, because of inherent conflict of interest in the existing model. Current finance providers have no vested interest in investor results because there are not penalized for bad performance and still take a greater than 1% fee. Fees add up over time, and fees remove any return over standard market performance. Today there are better finance education, lower trading fees and better mentoring resources available, so everyone can get better (no excuses!).

Using options to hedge long term portfolio

Saw an interesting Buy and Hedge book similar to our portfolio principles ebook of using options to hedge ETFs. This is unusual because do not often see a similar approach in main stream financial books, so thought we’d review it at some point. I believe it involved using long term put options to completely hedge downside risk on the entire portfolio (totally cut off tail risk), which could get very expensive in the long run, so curious to see their criteria for managing the put options.

Market outlook 2016

Went to a market outlook presentation by Larry MacMillian Options as a strategic investment. Basic view is that 2016 would be a bear market, but there could be a bounce into April/May, then rolling over into the rest of the year. But not 2008 disaster scenario, just a typical bear market. Recommended various short delta hedges on indexes or trying to go long volatility via the VIX. Without going into too much detail on their proprietary criteria, essentially this was a VIX futures calendar, involving buying VXX futures front month (eg April 2016) and selling back month (eg may 2016). A couple of traders I discussed this with actually discounted this trade because of the possibility of large differences in VIX front month and back month spreads – basically too dangerous because potential differences in VIX term structure (most of the time it would be fine, unless the differences between front month and back month become too pronounced).

Summary

This was a really quick overview of the New York Traders Expo. There was lots of content in 2016 as usual, but definitely worth attending if you are in New York in February next year.