MacroDozer Investment Philosophy
MacroDozer Investment Philosophy
My Favourite Tools in The Box.
Table of Contents
1. Executive Summary
2. What Is Going on Here?
3. MacroDozer Investment Strategies
3.1 Go Long / Buy Premium via LEAPS
3.2 Go Short / Sell Premium via Short-Dated Options
4. Relevant Short Premium Strategies
4.1 Short Straddle - Risk Defined
4.2 Short Strangle - Risk Defined (Iron Condor)
4.3 Call Credit Spread
4.4 Put Credit Spread
5. Position Sizing & Risk Management
5.1 Long Premium via LEAPS
5.2 Short Premium
5.3 Target Capital Allocation
5.4 Portfolio Risk Measures
6. Final Comments
1. Executive Summary
Data and probabilities are the only truths in the ζoo.
Tedious execution and methodical management may not sound sexy.
Options as the key to success: Long premium maybe, short premium, oh yes!
Implied volatility and time to expiration as silver bullets and edge.
LEAPS: The only long premium strategy that made it to the finals.
Short Premium: Risk-defined straddles, strangles and credit spreads are the backbones of MacroDozer's Investment Philosophy.
Each position must not exceed 5% of total equity; liquidity is king.
2. What Is Going on Here?
I don't know what's going on, you tell me. I am amazed and slightly confused by how savvy money investors play the markets and communicate what they think and do. Go to Twitter and watch what former suits, now t-shirts with webcams, post day in and day out.
Markets are random, especially in short to medium term, driven by emotions, arbitrary politics, and waves of over- and undershooting. Pick your interval; pick your poison. Corporate or macro data rarely serve as additional drivers; they may do so in the long run.
If you step away from all the noise, you'll find that financial analysts use current trends to justify their future tales. They move somewhere in the middle of the herd, repeating what you should know because it is happening. Their predictions are as good as the odds at roulette. More ethical analysts remain vague or predict various outcomes, but even a broken clock is right twice a day.
Who can predict the future and pick a multi-decade winner? Someone who just won that lottery maybe, once in a lifetime, and not sustainably. Successful investors are rare, and these people are right perhaps 50-60% of the time. Their real secret is a good process and precise mechanics. And the rest, well, the rest are trying to make money selling services while underperforming the broader market - what a show.
So how can you consistently make money in a wiggly world in arbitrary markets - at least Alan Watts gives the question of what's going on here a fair shot.
In a world with unlimited data and endless variables, you could try to collect as much data as possible, analyze it, and apply probabilities to future outcomes. Combine that with a solid process and tedious mechanics, and call yourself a MacroDozer.
Let’s go.
3. MacroDozer Investment Strategies
MacroDozer is all about data and derivatives. We call it the ζeta Way of Investing. One of the few Greek letters that have neither been used in the options world nor corrupted by WHO. We claim it.
Options are a fascinating financial instrument that allows you to structure investment products that can bet on upward, downward or sideways movements or a combination of the three, using leverage while hedging, on almost all types of assets, all at the same time.
The basics of options theory can be found in my favourite options courses for beginners. These basics are not covered in detail in the weekly BrainDozer articles or performance updates and are essential for understanding!
When trading options contracts, there are two main overarching strategies: (3.1) go long / buy premium and (3.2) go short / sell premium. It is as simple as that.
(3.1) Go long options is not the most sustainable strategy due to the options’ premium (de)valuation. Options have an element of time value that decreases daily, also called theta decay or theta burn. Theta burn is higher the shorter the contract and the closer the time to expiration.
The only viable strategy for long options is to buy long-dated contracts, called LEAPS (Long-Term Equity Anticipation Securities). At least nine months to expiration; the sweet spot is two years. The further away the expiration date is, the less theta is burned daily.
(3.2) Go short options is statistically and probabilistically the most promising strategy. Subject to sound structuring and laborious execution, the odds are in your favour.
3.1 Go Long / Buy Premium via LEAPS
Buying premiums is a good strategy when using LEAPS option contracts with a long maturity, a sweet spot of two years, and a strike price closest to the stock price. LEAPS mirror the stock price behaviour, with the critical differentiator showing some convexity. The option value increases exponentially when the stock price increases and behaves logarithmically when the stock price decreases. In addition, only a fraction of the capital is employed compared to the purchase of the underlying. Capital efficiency, leverage and hedging in one fell swoop.
Please look at the price behaviour chart below, which is as close to magic as possible.
In the QQQ example above, one could lose a maximum of 4.8k on a long position in Call 290 Jan 2024, regardless of how much the NASDAQ would fall. However, if the NASDAQ were about to start an uptrend, the initial investment of 4.8k would grow exponentially.
This strategy is best suited for long-term strategic and up-trend investing. The basic idea is to have a solid long-term conviction before getting in. Then you pull the trigger when the right moment comes, preferably during or after a correction, and have the patience to follow.
To reduce premium costs and theta burn, or to combat potential counter asset movements, selling shorter-dated 15-30 delta call options against the LEAPS position is icing on the cake.
By clever rolling activities in terms of strikes and the expiration of the LEAPS, the short calls will make you invincible. For instance, if the underlying asset goes against you, the LEAPS can be rolled down, as well as the short calls. On the other hand, if the underlying asset goes too quickly in your favour, the short calls can be rolled up and out in time, preferably for additional credit.
3.2 Go Short / Sell Premium via Short-Dated Options
Selling option premiums is the most promising and sustainable strategy if the trades are risk-defined, systematically executed, and managed.
Here is some brief information on option pricing. Six variables determine the price of an option. You don't need sophisticated formulas. The following table shows everything you need to know. If the stock price goes up, the call option price goes up and the put option price goes down, and vice versa. The same logic applies to all residual five variables.
Why is selling option premiums by far the most promising and sustainable strategy?
There is no natural edge in speculating on 1) Stock Price movements or choosing a specific 2) Strike Price when selling premiums. While these are essential aspects to consider, probabilistically, there is little to no edge. 5) Interest Rates, and 6) Dividends are taken as given and known; again, there is no edge.
The real opportunity in selling option premiums lies in the 3) Implied Volatility of the underlying and the 4) Time to Expiration of the selected contract.
3) Implied Volatility is the most critical value driver for option premiums. The higher the implied volatility of the underlying, the more expensive the premium will be. The following chart shows the implied volatility of the S&P 5001 over the last ten years compared to its actual historical volatility.2
The implied volatility is mostly significantly higher than the actual historical volatility. On average, implied volatility is 50% higher. At peak times, it can be double or triple that. In other words, option premiums for the S&P 500 have, on average, priced in 50% more volatility than has occurred. Consequently, an overpriced option premium due to overstated implied volatility is a clear edge.
Moreover, high implied volatility per se is not necessarily the decisive factor. Relative implied volatility, i.e. current implied volatility relative to historical implied volatility (not to be confused with actual historical volatility), is much more decisive. Some brokers refer to it as implied volatility ranking, others as implied volatility percentile. The idea is to sell premiums when relative implied volatility is high. If implied volatility declines and reverts to the mean, the option's value will decline even faster.
4) Time to Expiration is the options’ premium second most important driver. The longer the option contract has to run, the more expensive the premium. The goal is to sell expensively today and buy back cheaper tomorrow. It is advantageous if the premium is relatively high, but even more important is how quickly it loses its value. In technical terms, how fast the time value or theta decays. It is not the maximum time to maturity but the optimal time of daily theta decay that matters.
MacroDozer's sweet spot for selling premiums is exactly between day 60 and day 30, at about 45 days to maturity. Here the daily theta decay starts to accelerate just enough, and the return due to the fast premium decline outweighs the risk - another clear edge.
Proactive management of trades is the key to any short premium strategy. It is advisable to close trades when a 30-50% return on capital has been achieved about 20 days before maturity and move on to the next situation. An early exit maximizes the chances of success and minimizes last-minute surprises. For example, if the underlying has moved out of the profit zone, one could exit in time and move up or down toward the underlying price. If possible, all for credit.
4. Relevant Short Premium Strategies
This section is intended to be brief and to the point. The primary purpose is to present the main strategies without going into detail.
Assets with high implied volatility compared to actual historical volatility and assets with high relative implied volatility compared to past implied volatility will be the winners. The odds are that the premium will be overvalued, and implied volatility will decline as it reverts to the mean.
The optimal contract length for all short premium strategies is about 45 days. Here, the daily theta decay starts to accelerate just enough, and the return due to the rapid premium decline outweighs the risk.
4.1 Short Straddle - Risk Defined
The risk-defined short straddle is usually a neutral strategy. We want the underlying to move sideways without a clear trend. There are several ways to enter this trade. The simplest is to sell the at-the-money call and put (306) and buy the out-of-the-money 5-10 delta call (351) and put (261) to define the risk.
The maximum loss should be equal to the maximum profit. In other words, the risk-return target of this trade is 1:1.
4.2 Short Strangle - Risk-Defined (Iron Condor)
The risk-defined short strangle, or Iron Condor, is a neutral strategy. We want the underlying to move sideways with no clear direction or trend. There are several ways to enter this trade. For example, sell the out-of-the-money 30-delta call (322) and put (292) and define the risk by buying the further out-of-the-money 5-10 delta call (351) and put (261).
The maximum loss should be 2x the maximum profit. In other words, the risk-return target of this trade is 2:1.
4.3 Call Credit Spread
The Call Credit Spread is a neutral to bearish strategy. We want the underlying asset to remain unchanged or decrease in value. In the following graph, the asset's spot price is given as 306. There are several ways to enter this trade. To define the risk, one way is to sell the at-the-money call (306) and buy the further out-of-the-money 40-delta call (316).
The maximum loss should be equal to the maximum profit. In other words, the risk-reward target for this trade is 1:1.
4.4 Put Credit Spread
The Put Credit Spread is a neutral to bullish strategy. We want the underlying asset to remain unchanged or increase in value. In the following graph, the asset's spot price is given as 306. There are several ways to enter this trade. One way is to sell the at the money put (306) and buy the out of the money 40 delta put (296) to define the risk.
The maximum loss should be equal to the maximum profit. However, since out-of-the-money put options are generally more expensive than out-of-the-money call options3, it isn't easy to find an underlying with a target risk-return ratio of 1:1 for this strategy.
5. Position Sizing & Risk Management
Position sizing and risk management are critical to a successful investment strategy that employs options, contracts and premiums. Because they are contracts that give you the right, but not the obligation, to buy or sell an underlying asset at a specific strike price, option values can change quickly depending on the underlying asset's movement and changes in implied volatility.
The capital employed per investment or trade is real risk capital, and one must expect it to go to zero occasionally. In some short-premium strategies, losses could be unlimited if risks are not hedged. For long-term success, keeping position sizes small and risk-defined is critical.
5.1 Long Premium via LEAPS
An investment via LEAPS comes closest to a direct purchase of the underlying. The capital used for a LEAPS position should not exceed 5% of the total equity.
5.2 Short Premium
The capital for a short premium position should not exceed 5% of total equity.
5.3 Target Capital Allocation
For example, with five LEAPS positions and five short premium positions, each set at 5% of total equity, you will not touch more than 50% of total equity at any time. The other 50% remains as a cash buffer.
5 LEAPS x 5% = 25%
5 Short Premium x 5% = 25%
Total Capital Employed: 50%
Total Cash: 50%
A minimum of 50% cash is insurance against unforeseen events. In addition, the ability to quickly access liquidity in the event of market crashes can be advantageous.
5.4 Portfolio Risk Measures
Conventional risk and relative return measures, such as beta, alpha, sharp ratio, etc., are not entirely practical when constructing trades and portfolios with derivatives. Semi-well-constructed portfolios and unhedged trades have fantastic conventional metrics, so don't be fooled.
The real risk in the world of options lies in what is known as left-tail risk, or black swan or liquidity-type events. This is when derivatives and volatility funds can explode. They usually trade too boldly and confidently, without a liquidity buffer and possibly even without hedging. The long-term sustainable solution is, therefore, to always maintain a comfortable cash position and try to be as market-neutral as possible while entering trades in a disciplined and risk-defined manner.
Below is an illustration of a short straddle strategy (with defined risk) on the S&P 500 / SPY maturing on August 15, 2022.4 This particular trade has a risk-reward profile of 1:1. At current levels of implied volatility if the SPY were to fall by, say suddenly, 25%, this trade would result in a total loss at a SPY price of 275.
Advanced contract rolling techniques can shift the thresholds for maximum losses. As a result, even during a sudden liquidity event, it is possible to bring trades with maximum losses back into the break-even range.
So again, conventional risk and relative return measures are not necessarily helpful when dealing with derivative-constructed products or portfolios. It all comes down to how trades are entered, managed and exited and how well the overall portfolio is structured to protect against volatility, black swans or liquidity-like events. Betas and alphas can be exceptional for one, two or a few years in a row, but what good is that if you lose everything in year five?
6. Final Comments
This article is intended to provide a brief and concise overview of MacroDozer's Investment Philosophy. However, suppose you don't fully understand all the strategies or terminologies. In that case, I recommend you to take a light and easy options course for beginners offered by tastylive, a trusted source of MacroDozer.
Calculated as the standard deviation of SPX’s next 30 days’ futures daily moves, shown as an annualized percentage.
Calculated as the standard deviation of SPX’s last 30 days’ daily moves, shown as an annualized percentage.
There is generally more demand for equity out-of-the-money put options than out-of-the-money call options due to higher liquidity risk to the downside.
Check section 4.1 for a sample pay-out graph.