My little blog here may be mostly known for the Safe Withdrawal Rate Series. But I’m surprised how many people share my other passion: options trading. Both here on the blog and at FinCon last weekend lots of fans of the blog asked me when I’m going to write something about derivatives again. Wait no more! I have been thinking about this one for a while; it’s another cautionary tale about markets going haywire and unsuspecting and unsophisticated investors are caught in between. And then they realize the “safe” and “conservative” strategy marketed by their financial adviser can blow up in their face!
The Wall Street Journal came out with a pretty detailed article (subscribers only) a few weeks ago, but the story has been around for a while. See, for example, on WealthManagement.com or SeekingAlpha.com. And this time it’s not some obscure small shop in Florida that got into trouble. No, it’s one of the big fish: UBS! Their so-called “Yield Enhancement Strategy (YES),” marketed as a conservative and low-risk strategy to risk-averse investors with mostly bonds in their portfolio, racked up heavy losses late last year. Well, at least people weren’t completely wiped out like the poor sobs in the OptionSellers mess. But a purported 20% loss (about $1b) is still a hard pill to swallow for investors that were told that this is completely safe. Sure, if you were 100% invested in the S&P500 last year and lost 20%, then yeah at least you knew what you’re getting into. But for the average mom-and-pop muni bond investor, a 20% loss is pretty epic. And not in a good way!
Of course, looking at the low-yield environment right now – in some places we even have a negative-yield environment – I don’t blame investors for shopping around for higher yields. But be aware of the charlatans. If they tell you that higher yields come with no side effects run away! There is always a catch with a higher yield! Even if it’s your trusted personal wealth advisor at a shop as famous as UBS!!! This yield enhancement strategy involved a risky options trading strategy. With 5x leverage! And most of the investors didn’t even know what they were getting into unless they had read the pages with the fine print! So, let’s do a post-mortem for this strategy. What were they doing and how and why did this go so horribly wrong?
What were they doing?
The UBS Yield Enhancement Strategy involved a so-called Iron Condor strategy. Sounds like a heavy metal band from the 1980s but it’s a pretty common strategy in option trading circles. This strategy involves trading four options, two short and two long positions. Here would be a simple example. The underlying is at $100. You sell a put at 90 and a call at 110. And then buy a put at 85 and a call at 115. The four options create the four kink points in the payoff diagram, see below.
- We achieve the maximum gain in between the two inner option strikes (90 & 110) when all four options expire worthlessly and we’re left with the net option premium, $1.06 in this case.
- If you go past the inner two option strikes, losses start piling up because the short option position is now in the money and we’re losing $1 for each $1 we go beyond the inner strikes. The breakeven points are at $88.94 and $111.06 where the loss from the short put or call option exactly wipes out the net option premium.
- But once we go beyond the outer option strikes, our long option (both on the put and call side) kicks in and limits our losses. The maximum loss is the $5 gap between the two option strikes minus the $1.06 option premium, so a net loss of around $3.94. (Side note: Yes, I know, all these numbers are multiplied by 100 because that’s often the size of one option contract for both individual stocks and the SPX index options. 50x for e-mini futures options!)
In other words, the iron condor strategy is a bet on markets staying calm, i.e., we’re hoping for the underlying asset neither gaining nor losing too much. You make your maximum gain in that middle region and you normally set your inner two strikes to cover at least 70% probability (often +/-1 standard deviation). Even as high as 90 or 95% probability. Think of yourself as selling insurance against rare tail events. In other words…
It’s like “picking up nickels in front of a steamroller!”
I love this analogy! It accurately describes the payoff profile of a lot of options trading strategies (for example my put selling approach). Most of the time, you generate modest income but be aware of the occasional steep losses. Again, to really drive it home, there are the 4 ingredients:
- Gains are modest
- There is a high probability of gains
- There is a low probability of losses (= the flipside of the item above!)
- The losses can be substantial
By the way, there is nothing fundamentally wrong with this payoff profile. Quite the opposite, it’s likely the reason why this strategy works so well and generates profits on average. Exactly because it sounds unattractive to the average Joe and Jane who are chasing after the big payoffs, e.g. lottery wins, playing in the casino, etc.! But being the casino is always more profitable than playing in the casino.
“In the casino, the cardinal rule is to keep them playing and keep them coming back. The longer they play, the more they lose. In the end, we get it all.” Sam Rothstein (Robert DeNiro) in the 1995 movie Casino
Payoff profiles with this negative skewness (iron condor, naked puts) often have better average returns than those with positive skewness (long options, lottery, casino). So, again, don’t get me wrong. I’m generally a fan of this type of strategy (though I’d never personally touch an Iron Condor, more on that below). In fact, I’m using my put selling strategy to fund the majority of our retirement cash flow needs. I’m just saying that UBS’ marketing was dubious and the execution and risk management were poor!
Which brings us to the first problem with the UBS strategy:
The marketing lie: No, you’re not picking up Benjamins in front of a baby stroller!
The way it was marketed seems like UBS was stretching the truth a little bit, to say it diplomatically. WealthManagement.com posted a piece of the UBS marketing material, displayed below. Do you notice anything?
- Gains are substantial (two arrows up)
- There is a high probability of gains (in the central three columns)
- Losses occur only during rare, low-probability tail events.
- The losses are modest (one arrow down)
It sounds like UBS was claiming that their strategy is equivalent to picking up Benjamins (large payoffs most of the time) in front of a baby stroller (small loss with a small probability). Positive skewness! In a short-volatility strategy!
So, did UBS square the circle here? Of course not! The payoff diagram is a total lie! It should look like the one below. This Iron Condor should always involve moderate profits in the central region and (relatively) substantial losses if you get to or past the outer strike prices during rare outlier events. It is a mathematical certainty! This is the exact “Picking up nickels in front of the steamroller” analogy. Of course, that would have looked a bit less impressive than the actual UBS marketing materials where they wanted to create the impression of picking up Benjamins in front of something a lot less scary than a steamroller!
How the hell this nonsense could have made it through the legal and compliance review is anyone’s guess. When I worked in the industry I also talked in front of clients and prospects and our materials were always scrutinized ad nauseam! And we were presenting in front of highly educated counterparts: the fellow-PhDs, the fellow CFA-charterholders running the pension fund or endowment or sovereign wealth fund. You’d think that legal disclosures should be even more stringent when talking to retail investors (even if they are high net worth clients with seven-figure portfolios). If you’re the researcher/portfolio manager behind this product you should have complained about this table! Were you overruled by the salespeople?
Side note: As my buddies in the options trading community will no doubt point out, there is, of course, one way to reverse the maximum profit vs. loss relationship with the Iron Condor. If you were to set the strikes very close to each other, say, for example, a 98$ and $99 for the put strikes and $101 and $102 for the call strikes! The maximum gains would then be smaller than the maximum loss. But the probability of the maximum gain would be very small, the opposite of what you’d normally try to accomplish with the Iron Condor!
How you can lose lots of money with an Iron Condor in a choppy market (e.g. 2018 Q4!!!)
Before we understand how you can pile up heavy losses with this strategy, let’s first go through a best-case scenario, see the chart below. Assume the underlying is at 100 and we sell at strikes +/-10 points (green lines) and buy at strikes +/-15 points (red lines). You make the maximum profit if your index stays within the green lines and you lose the maximum amount if go beyond the red lines (on either side, up or down!). And also somewhere between the red and green line would be the breakeven point but I don’t include this here to not clutter this even more.
The first set of options expires at date 2 (doesn’t matter whether this is 2 days or 2 weeks or 2 months, it’s just for illustration). After 2 periods we set up another iron condor with the same range of strikes expiring at date 4. It looks like the underlying was at 102, so the inner strikes were at 92/102 and the other strikes at 87/117. Same at time t=4 for options expiring on date t=6. In this best-case scenario, we made the maximum profit because the index stayed within the two green lines at the expiration dates 2, 4 and 6:
How about the worst-case? Same setup as above, but a slightly different path for the index. The index was volatile enough to end up outside of the red lines at the expiration dates. You lost the maximum amount of money on all three options! What I found particularly scary about this scenario is that the index recovered all the initial losses on t=4 but you lost money twice already. (And this is one of the reasons why I don’t normally touch Iron Condors. I don’t want to get whipsawed like this!) And you get hammered on the way down again on t=6.
And if you remember the fourth quarter of 2018, there have been plenty of occasions where you could have gotten “whipsawed” like that with your Iron Condor. By the end of November, you had three down-moves of 6% and more and two up-drafts of 6% and more. If that didn’t destroy your Iron Condor, then certainly the -15.7% in December and the +15% recovery that followed the trough on December 24!
What is still a mystery to me, though, is that the UBS-YES was ostensibly backtested over almost 20 years and supposedly never racked up the kind of losses as in 2018. Seriously? Not even in 2008/9 when we had much bigger moves? Strange!
The “we will just ‘manage’ our positions” lie
Maybe a smart asset manager can avoid those heavy losses by closing out the losing positions before they become a problem, right? It sounded like the UBS clients were told a similar story, too. It certainly sounds like a great idea! Wouldn’t that mean that I can achieve a payoff like this one here, see the chart below? We get to keep all that sweet profit between the two inner strikes (90-110) and then chop off the losing side of the trade, say around 88 and 112. Maybe that’s how they came up with their return diagram with the positive skewness?
But that’s not so easy! Let’s look at a concrete example of what might happen if the market were to move against you. Imagine that after only 1/10 of the time to the option expiration, the index dropped to 90 already, i.e., up to the point where you’d start losing money with the Iron Condor. OK, let’s manage the position, get out while we can still get the $1.06 profit, right? Wrong! That drop to 90 has already caused a loss of about $1.00 in your Iron Condor position, see the chart below. Remember, the blue line is the payoff at the expiration date! Before the expiration, we’re at the mercy of the Option Greeks! And thanks to Delta and Gamma (likely Vega as well), you’re on the red line. And deep in the red! (Side note: this exact problem, namely, that the P&L before the expiration looks very different from the one at expiration also killed the OptionSellers.com strategy, as I outlined in my post last year. Most of their short-call strikes weren’t even breached and they still collapsed under heavy losses!)
So, managing the positions is not as trivial and not the panacea that people always want to make it. Because you face the following conundrum: Do you cut your losses and lock in a $1.00 loss or stick with the position? Sticking with the position might still work out after all. If the index simply stays at 90 you’ll not just make back the loss, you’ll even earn that maximum premium you hoped for. You can still get to the blue line! But it can also backfire if the index drops another few points and you lose the maximum possible amount. Cutting your losses can also backfire, especially with an Iron Condor strategy; if you get out too early and initiate a new Iron Condor with $90 in the center and the index snaps back to 100 and beyond you lose again on the way up. You should have just stayed put in that case!
There were at least three warning signs that something wasn’t quite right with this UBS Yield Enhancement Strategy:
- You can’t market an Iron Condor strategy with equity index options as a “non-directional” investment to conservative, risk-averse investors who prefer to have no equity exposure. It stays non-directional until – well – until it does become directional! Sure, at inception, you may have a zero delta (equity exposure) but you are still at the mercy of the equity index as the market moves over time (gamma, delta and vega).
- The clearly incorrect return diagram that claimed this strategy has positively(!) skewed returns, as opposed to the negative skewness in all the other income-focused option strategies.
- Annual management fees of 1.75%. You’ll have to generate a lot of upside potential to make this worthwhile. But if you generate, say, 4-5% returns (before fees) during good times and returns are negatively skewed so that tail event losses can reach 4x or so of your gains then you’re looking at around 20% losses if the crap hits the fan. Which, ironically, is exactly the loss in the UBS product. Astonishing how the folks at UBS were surprised by a loss of that size. Maybe they thought that they can “manage” their positions and get out before losses get too large? But that’s no easy task!
But don’t get me wrong: I’m a huge fan of options strategies. Especially the income-focus strategies are a great fit for folks like us in early retirement. About 35% of our financial net worth is in my naked put strategy. To avoid the three problems of the UBS-YES, though, I heed the following three principles:
- I sell naked puts and they have equity correlation. Thus, I would only run this with money that would have otherwise been invested in equities anyway.
- Be aware of the negative skewness! It means that you’ll have to budget for rare losses that are many times higher than the gains you target. So, I don’t go overboard with my return expectations!
- I do this strategy myself and save the 1.75% management fee!
Hope you enjoyed the post! Sorry if this wandered off into option-math la-la-land! Please leave your comments and suggestions below!
Title image source: Pixabay.com