Risk Over Rules: What Counts in Risk Mitigation Strategies
Cboe Guest Author: Devin Anderson, Chief Executive Officer and Cofounder, Convexitas, LLC
Managing risk mitigating strategies is a complicated profession. But it does not have to be for advisors and end investors. Unnecessary complication mostly comes down to misunderstanding or mischaracterizing risk: how to measure it, how to set expectations for its performance and how to deliver it. In this blog, we share a broad framework for what we believe comprises excellence in risk mitigating strategies.
In short, Convexitas views the following as essential:
1. Clearly defined goals that enable portfolio level decision making
2. Same day access to returns
3. Client/advisor sponsorship for reinvestment
Thinking Clearly About Risk and Time-Based Pitfalls
When we look back at the history of securities investing in the United States, it is easy to see the source of confusion. For decades, quantifying risk was simply about summing up price and quantity. There was a number of shares, and you multiplied them by the price for a market value. Then you assigned that value to an allocation bucket and found some software to give you the totals which reasonably represented how many dollars were at risk in each category.
However, when we start introducing derivatives, the picture can get cloudier. We lose this ability to simply multiply price and quantity together to find our risk. Premium or mark-to-market value of an option doesn't tell us how much risk we're taking in the same way that it does for $100 in an ETF! It doesn't help that many widely available advisor risk systems and Turnkey Asset Management Programs (TAMPs) either do not consider derivatives, or when they do, can only deal with the derivatives risk by matching it 1:1 to a share, such as one share or index unit to one option (ignoring multipliers for simplicity).
First generation answers to risk mitigation strategy design were of course influenced by the same linear thinking: long one put for one unit of the underlying, rolled or managed on a specified schedule. Maybe one lower strike put or one call are sold to help offset the cost. Investment managers and researchers have enumerated many versions of these strategies, but in the end, the risk and sizing came back to this linear thinking: one unit of stock or index for one unit of option strategy. It was easy to draw the hockey-stick payouts for a client to show how options added up to a risk reducing profile.
However, option risks are convex in many parameters, especially in spot, volatility and time. As put, put spread, and put spread collar variants risk age to their next roll date, they change, sometimes in ways not obvious to the end investor.
Investors are often told they have a certain percentage floor or cap, buffer or ceiling, then shown a payoff diagram similar to the example below.
Source: Convexitas Calculations
While that’s certainly the payout profile at maturity of the options, the actual risk day-to-day is quite different and far more variable. Consider the profile of a long asset position, combined with a simple collar—long put and short call— at different points in time:
Source: Convexitas Calculations
Let’s pretend we have an asset trading at $100. We own one unit and buy the $98 put to protect the downside and sell the $104.30 call to fund it. The total premium spent was zero because these strikes were intentionally chosen to offset each other exactly, as they often are in these products.
On the first day with three months left to maturity, we own $100 of the asset but have only $24.60 of market exposure – the collar is canceling out the other $75.40 of market exposure. The package would realize about 25% of the market upside on this very first day if the market rallied. Six weeks later, there is about $34.20 of market exposure. With 10 days to go, there is $63.50 of market exposure, which quickly rises to $97 in the final few days. What you own is now incredibly different simply due to the passage of time.
There’s no complexity here with respect to moving the level of the market or volatility here – this is just a very simple, stylized example of how much the risk may change throughout the three-month life of a collar, holding the other variables constant. The only thing driving these risk changes is the passage of time, but it still looks like $100 of the asset is in the account.
Now let’s say the market falls 3% to $97, what do the last 31 days look like?
Source: Convexitas Calculations
With one month to go, there is about $34 of market exposure. This is good considering the market has fallen – far preferable to owning the full $100. With one day to go, there is about $17 of market exposure, which again is great given that the market is lower. But if the market were to sell off below $97, you’d much rather it be the day of expiry when you have almost half the market exposure than you did at one the onset. The calendar is determining the risk here.
The clear conclusion is that in a market event, a drawdown, the responsiveness of the risk mitigating strategy would be determined by the point in time it fell on the calendar. In a real-life example, if your collar expired in March 2020, then you did really well as the market made its COVID-19 bottom just four days after expiry. If your collar expired in April or May, the result would have been quite different.
There is no shortage of techniques available to attempt to smooth out this risk. Most involve “averaging in” or utilizing multiple maturities of the same structure. But do these techniques solve the problem? At best they just spread the problem out into a series of smaller problems. We believe allowing the calendar to determine the risk of your portfolio is the fundamental problem. And if you’re an advisor, it is hard to know how much market risk you’re really taking for clients without having an in-house pricing system decomposing the strategy daily. These risks are just dynamic enough that professional, discretionary, non-static risk management is in order.
Managing to a more constant level of risk, instead of a trading structure with a time-dependent risk avoids allowing the calendar to determine a portfolio’s risk. However, this raises the question of how to communicate the level of risk with clients and advisors. If the investment manager cannot communicate by saying “one put spread for one unit of index risk”, then how are we going to communicate?
Option professionals can easily speak calculus to each other in the form option greeks: delta, gamma, vega, theta and the more esoteric volga, vanna, etc. But we simply can’t communicate with clients that way. So, we must bridge this communication gap.
The answer lies in clearly defined targets and risk guardrails. If the market sells off a certain percentage, then the strategy targets to be up a certain percentage, without respect to maturity dates. Then agree to some broad risk limits for minimum/maximum short market exposure and simulated shock scenario profit and loss (P&L) and now we have a framework to communicate with clients. Apply a Mandate Assets Under Management (AUM) or Trading Level and let the investment manager trade the options needed to deliver to the agreed target, leaving the linear tie of one unit to one option behind.
For example, in Convexitas’ Tail Liquidity product, the strategy aims for a 50% downside capture in exchange for a 20% upside drag as a risk target, which floats as the market moves. The specific targets don’t matter, it only matters that there are targets that reference the client’s agreed Mandate AUM.
This implies a few things for the investment manager. First, discretion is required to have a strategy which can deliver on those targets as the market evolves over time. Second, it implies more active trading to rebalance the strategy to support the target conditions agreed upon with the client. Remember we said this was a complicated profession; but it is what investment managers are getting paid to deliver.
The Importance of Reinvestment in Risk Mitigation
With clear strategy targets, an advisor now knows how much risk they can take in the underlying asset allocation. Those strategy returns are important, but they are only a fraction of the outcome. The full value of a risk mitigating strategy is the combination of the strategy’s direct proceeds and the opportunity created to reinvest those proceeds.
This implies that the Advisor/Client must have access to those proceeds quickly, and buy additional risk assets with those proceeds, ideally during the period of stress when prices potentially offer the best near-term entry.
In Convexitas’ estimation, as much as 2/3 of the long term compounded value of a risk mitigating strategy comes from the reinvestment, not from its direct proceeds. However, to access the reinvestment, the advisor/client must have access to the proceeds, which strongly implies that separate managed account delivery is critical to fully realizing the risk mitigating strategy ecosystem.
If our goal is to maximize the reinvestment activity from the strategy’s proceeds, the strategy needs to be collateralized by the assets the client already owns so that the risk mitigating strategy itself isn’t drawing capital away from the alpha/beta portfolio. The cash generated from the strategy needs to be instantly available without a delay caused by account transfer or fund redemption processes. Maintaining separate accounts solves both these challenges.
This is of course not to say that all derivatives strategies must be delivered this way. Short volatility/income strategies work well in a fund format because the collateral set aside for them acts no different than a bond. The client expects a positive return on that allocation and the collateral probably is better not at market risk, given that it might be needed to support the income strategy. However, risk mitigating strategies clearly benefit from his structure as they do not pull capital away from the rest of the portfolio and are stress-positive, allowing them to be more safely collateralized by existing assets.
Much like the requirement to target risk instead of maturities, this requires the investment manager to take on scaling separate accounts at multiple custodians. This is a complicated profession, but it is what managers are getting paid to deliver.
Unlocking Risk Mitigation’s Full Potential
The full potential of risk mitigation can be realized when risk targeting, same-day liquidity and advisor/client sponsored reinvestment in a separate account are combined. A more constant risk target smooths out time dependence and enables more consistent performance targeting, albeit with more trading. Same or next-day liquidity enables the opportunity for advisor/client-led reinvestment faster than a typical fund redemption cycle, while prices are likely still stressed. Taken together, these allow investors to extract the maximum value from risk mitigation.
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