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My name is Andrew Jarmon and I'm a consultant in Los Angeles. I am a long term investor that waits for very specific opportunities to arise for the 3+ year timeframe. I also really enjoy trying to spot bubbles and market inefficiencies. Questions or comments? E-mail me at:... More
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  • 2 Long Strategies For Annaly Investors Concerned With A Falling Stock Price

    Last week, investors saw the stock price for Annaly Capital Management (NYSE:NLY) mint new 52-week lows, reaching an intraday low point of $12.46 on Thursday before rallying to close at $12.66 on Friday.

    This new low marked a 30% fall in the stock price since the 52-week high of $17.75 and a 23% fall since the close of $16.13 on March 22nd. Annaly is now solidly below its 50, 200 and 400 day moving averages.

    (click to enlarge)Annaly Three Year Chart

    On a book value basis, NLY was trading with discounts as low as 18% to March 31st book value of $15.19 and 10% to the book value David White estimates of $13.82 given the recent jump in long-dated interest rates.

    If you're an investor wondering if you should be buying at these prices but afraid of subsequent price falls, there are two strategies involving writing options that I would like to bring to your attention.

    Covered Calls - Collect Dividends With Some Downside Insurance and an Upside Ceiling

    As an alternative to simply buying the stock and holding it, an investor could turn around and additionally write covered call options on the holding. This entitles the purchaser of these options to buy your shares at a certain price (the strike price) if they decide to exercise the option.

    In exchange for capping potential stock price appreciation, the investor receives a premium. Additionally, presuming that the options either aren't called until expiry or aren't called at all, the investor will receive all of the dividends in the interim.

    You can think of the premium you receive on selling the covered call options as a bit of downside insurance. To help illustrate how this might look in practice, I've looked at the October 2013, January 2014 and January 2015 call options based on the average between the bid and ask price at the close of Friday relative to the closing stock price.

    (click to enlarge)

    If you're comfortable with the returns and capping potential stock price appreciation, the premiums from the covered calls can absorb declines in stock price of 1-3% depending on the option you write.

    This could be an effective strategy for an investor looking for income but concerned with additional deterioration in stock price. Additionally, if you set up a DRIP (dividend reinvestment plan) with the dividends that are paid out, even if your options get exercised you will still have shares left over.

    Put Options Covered by Cash - Set The Price You'd Like to Buy at and Earn "Interest" If It's Unexercised

    As an alternative to buying the stock and writing covered calls, investors can write put options covered by the cash they could have used to buy the shares at today's price.

    By selling the option to sell you shares of NLY at a certain price, you receive a premium (what I've referred to as "interest") and can stipulate exactly what price you'd be interested in acquiring the stock at.

    To demonstrate how this could look in practice, I've looked at the October 2013, January 2014 and January 2015 put options.

    (click to enlarge)

    As you can see, if you're already holding on to cash waiting for a price you'd like to get in at, you could write some put options and get paid to wait.

    As an important caveat, you would not be receiving dividends while your written put options were outstanding. That being said, if you're holding cash, you're not getting paid dividends either.

    Disclosure: I am long NLY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

    Tags: NLY, options
    Jun 24 1:40 PM | Link | Comment!
  • The Role of Investor Selection Bias In Volatility Levels
    To read this article in its original format, please click here

    This article is the second in a series of three articles investigating volatility as "the" measure of risk.  To read the first article, "A Thought Exercise: Is Volatility Really an Asset's Risk?", please click here.


    In Richard Thaler and Cass Sunstein's Nudge: Improving Decisions About Health, Wealth, and Happiness, one of the most valuable parts of the book is the authors' separation of humans as they behave in economic models and as they behave in real life. TL;DR: quite differently.

    In the realm of investments, financial scholars have largely described investors in their models as being essentially the same while retaining varying inherent risk appetites.  In a world where more risk is rewarded with more return (an issue I will address in the third article), this makes sense: some people are willing to risk more to make more, and vice versa.

    This is where the "Econ" (human as they behave in economic models) vs. "Human" (human as they actually behave) dynamic that Thaler et. al. introduce becomes relevant.  The first important difference between the financial model human and the actual human is the tendency to benchmark with assets, leading to a world where payoffs are expressed as relative to a basket of securities such as the S&P 500 (this is exactly how the Motley Fool ranks their participants).  In a paradigm where indexing is rampant, perceptions of risk are strongly different than what modern financial theory would lead us to believe.

    The second difference is a strong preference for relative wealth: i.e. a level that places one ordinally higher than others.  This has been seen in game theory experiments where participants preferred lower absolute payouts that were higher relative to other participant's payouts (i.e. $40 and everyone else getting $20 versus $70 where everyone else gets $80).  This further leads to a logarithmic preference scale as you compare the 1st to 2nd, 50th to 51st and 99th to 100th percentiles of wealth.  The change in the number of people you are now better off than in the first interval is much higher than the third interval, suggesting that the risk you'd be willing to take in the first instance (i.e. to jump from the 1st percentile to 2nd percentile in terms of wealth) would be much higher than in the third interval. 

    To change the interval size, and now look at the change from 1st to 75th percentile in relative wealth demonstrates why lottery payouts are so popular, even though from a high level perspective they're effectively like throwing money away (your probability adjusted return is less than the initial capital outlay). They represent the greatest possible delta in relative wealth for the least cost.

    High Volatility Stocks: Another Form Of Lottery

    This translates to a preference for assets with high volatility, which in conventional terms are seen as the riskiest/most lottery-like.  Authors such as Eric Falkenstein have covered this relationship rather extensively, but as it pertains to volatility as a measure of intrinsic risk I would like to go a step further.  In our market, investors searching for these lottery-like payouts are going to go in search of assets with already high volatility.  In this scenario, volatility is going to beget more volatility, as more lottery seekers pile in.  The lottery seeker, by preference for the highest relative wealth delta for the lowest cost, is going to prefer the assets with the highest ordinal ranking in terms of potential payout.  This would lead these investors to dramatically favor, say, the 10th decile of assets in terms of volatility over all other assets.

    Why is this a problem for volatility's connection to risk?  The key is the self-selection going on when picking assets.  If the lottery payout seekers had a slope to their preference, this might still plausibly lead to an efficient market where volatility measures intrinsic risk of an asset, as the lottery seekers become more concentrated in higher risk assets.  But the preference for the highest risk stock in ordinal rank is going to lead to a disproportionate asset allocation, leading to a breakdown in volatility in its connection with risk.

    The final article in this series will serve as an exploration in to the problems with the risk/return correlation
    Dec 19 3:53 PM | Link | Comment!
  • A Thought Exercise: Is Volatility Really An Asset's Risk?
     To read this article in its original format, please click here

    Over the next three articles (this article being one of them), I will be covering why I believe volatility comes up wanting as a proxy for risk.

    Throughout a classic education in finance and economics, one core concept that became an assumption of my daily life was that volatility was risk.  To a certain degree this intuitively makes sense: if I'm buying an asset, and I have little sense what its value is going to be in an hour or two days from now, I should buckle up because it's going to be one hell of a ride.

    In a relatively preset environment, volatility would certainly approximate risk.  For example, if we were to live on Mount Kenya as a subsistence farmer, where mean daily fluctuations of temperature equate to 11.5 degrees Celsius (20.7 degrees Fahrenheit), this could surely be seen as one approximation of the risk of being able to generate a successful crop, although another might be seasonal weather fluctuation, such as that seen over a year.  Still another would be fluctuation in weather over several years.  Thus these three time spans (daily, seasonal and yearly) of weather fluctuation could probably closely approximate your risk of survival (of course there would be others: see bears).

    So why might a security's volatility not closely approximate its risk?  One answer would be the failure to translate observed volatility to actual volatility, although we would certainly run in to this problem when observing weather.  The other problem would come with what this volatility actually represents.  In the case of weather, it is the state of our atmosphere, something far beyond our control (although the aggregation of humans is doing a pretty good job: see climate change)

    Is An Individual Investor Equivalent to a Subsistence Farmer?

    In an asset market, for volatility to approximate "risk of survival" like it does in the natural world, it would have to retain some key characteristics:

    • Unchangeable by one or several individuals
    • Relatively constant over time
     
    With the first item, we find little support that a small subsection of the population cannot move prices and ergo influence volatility.  By its nature, asset markets are a wealth adjusted voting machine, so were one to be so inclined, with the proper amount of money one could dramatically influence the price environment of one particular asset.  This further topples the second characteristic as big money moving in and out of trades can dramatically affect the volatility of individual assets.
     
    Because volatility is easily manipulated and not an inherent characteristic of an asset, its value as an accurate predictor of risk is severely diminished if not totally obliterated.  Thus, while volatility might be high for an asset currently, there is no inherent dynamic that suggests that it might or should stay at this level for any amount of time going forward.
     
    The next article in this series will look at sticky volatility induced by selection bias followed by an article exploring problems with the risk/return correlation.
    Tags: Risk, Volatility
    Dec 18 2:22 PM | Link | Comment!
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