By Jay Pestrichelli
HiPOS Conservative is now in cash.
We exited the iron condor today around 10am ET after the market gapped open up nearly 6%. Without going through blow-by-blow of the trading day (and what a crazy day it was), we closed the position at about a net 10% loss including all the rolls and trades we’ve made since the market volatility kicked in late Feb. Results will vary slightly depending on your individual account. Despite the unprecedented market moves and volatility, we continued to manage the position through it all and took risk off at a loss less than the stock market or our benchmark.
So, what next?
HiPOS will remain in cash until we see a more normal environment conducive for our entry rules. The Primary two reasons are as follows:
The first has to do with the market volatility and the inversion of the risk curve. More to come on that.
The second, and this is really the main reason, is that the Chicago Board of Options Exchange is (Cboe) will be closing the Options trading floor in Chicago effective Monday, March 16, 2020 until further notice. All trading will essentially be restricted to the electronic market. To be clear, this does not mean that trading is halted. But our normal course of executing trades involves using our relationships and expertise to work to get the best prices we can for your clients
With the pits closed and no open outcry, we believe it will be way too difficult for us to execute the strategy with normal efficiency.
Back to dislocated volatility. What we mean by this, and what HiPOS has always followed, is that right now, the return of our HiPOS positions is less than the risk we are taking. The reason HiPOS has such a strong track record is that it enters positions that have a higher return than the risk taken. Well right now, the dramatic highs and lows every day are not fully reflected in option prices.
Technically speaking for a moment, what we get paid when we enter a trade is based on the implied volatility of the options. That is just a complicated way to say what the options predict the market will move each day. What we experience is known as historical volatility. It’s the actual statistical data point that shows what happened.
Let me use an example we can all relate to. When you use Google maps to plot out a drive, it gives you a time of arrival. That takes into consideration lots of things and implies how much traffic you’ll experience and your average speed. However, when you get there, it’s the actual arrival time and now that trip is history so to speak. Sometimes the estimated time of arrival (ETA) Google predicts is spot on and sometimes you actually arrive sooner than the ETA. In those situations, Google implied a time at the beginning of your trip, but you actually beat it.
Google was implying that the speed would be slower, but your results were better than expected. However, if Google fails to imply enough time and you hit unexpected traffic the actual time turns out to be worse than what Google thought. In those situations, your results were worse than what Google calculated before you started your trip. You should have started earlier to make it on time.
This is exactly what is going on in the options market right now. The actual daily movement is no where near what the option prices are implying. This means that the HiPOS strategy is not getting paid fairly for the risk it is taking. Below is a chart that shows how the implied volatility (like Google’s ETA projection) is way lower than the volatility actually experienced.
This is not a metric we discuss very often, but over the last week you can see how the implied one day move (option pricing) has dramatically underestimated what actually happened. As such, we find it prudent for this relationship to start to even out before going back into an environment that is mis-pricing risk.
A few other items:
While we don’t know how long this hiatus will last, we think this is a great opportunity to assess if the risk of HiPOS is still something you want in your or your client’s portfolio. We’ve always recommended that HiPOS not to exceed a 15-20% allocation and what we just experienced is the reason why. I’ll be setting up time with advisors and clients to review.
And finally, we thought it was worth mentioning that a handful of clients have decided to take the cash position of HiPOS and roll it in to an equity style strategy like Buy & Hedge or ZBIG. While that isn’t something we’re specifically recommending, it can be an appropriate rotation for those that believe a hedged equity product with exposure to stocks will rebound faster than HiPOS.
As always, feel free to reach out to us for further clarification.