Base values for derivatives in my Top-5 list?

I have compiled a “Top 5” list of c2 systems to suggest to friends with medium-sized hedging accounts. (People with larger accounts who can afford higher fees may have other good choices.)



A major consideration was “baseline value.” For example, B1GLOBAL has twice the average returns of S&P ETF TIMER, along with an equally suave performance. However, I am not qualified to determine to what extent B1Global may be what I call “freebasing” (pun intended). The base value is especially important for my #1 ranking. This means, if I were forced to depend on ONE c2 system, which would I choose? If my grandmother were in a gambling mood, which would I suggest? For a hedge account, I will take risks and I want strong gains–but “if possible” also a strong liklihood that I will not suffer huge losses.



I.e., I assign US treasury bonds a base value of 100%. As for long-only index investing, it is unlikely to underperform the market, which at most drops 40%, and ultimately increases in value. So I assign a long-term base value of 80% for most long-only ETFs, especially concerning index funds. However, I average-down S&P ETF TIMER because it is 1/2 involved in short ETF’s and all in leveraged derivatives, holding no actual stocks. My net result is a 60% base value for S&P ETF TIMER.



For forex, options, and futures, which I do not understand well, I turn to the following median maximum drawdowns for 500-day histories on the c2 Grid. This is based on eyeballing only. Nonetheless this gives me ‘base values’ which seem appropriate.



Forex: -75% median max DD. Base value: 25%.

Futures: -60% median max DD. Base value: 40%.

Options: -40% median max DD. Base value: 60%.

Long on Stocks: -20% median max DD. Base value: 80%.



However, there are many types of forex, futures, or options strategies. Perhaps I am being unfair to these particular strategies? Someone who is more familiar with forex, futures or options, please let me know! Thank you.



#1. S&P ETF Timer

Stocks. CAGR 42%. Max DD -14%. Monthly fee about $43. Base value 60%.



#2. B1Global

Forex. CAGR 89%. Max DD -12%. Monthly fee about $50. Base value 25%.



#3. sp500-trading.com

Futures. CAGR 66%. Max DD -31%. Monthly fee $50. Base value 40%.



#4. Shorting Options

Options. CAGR 37%. Max DD -21%. Monthly fee $10. Base value 60%.



#5. Rebound Solo

Stocks. CAGR 39%. Max DD -20%. Monthly fee about $20. Base value 80%.

In your profile your state quote - "I know very little about options, futures or derivatives" but you rate shorting options as the #4 system your gambling grandmother should trade, and that your advising your friends on medium-sized hedging accounts. What on earth are you talking about ? or better still why dont you explain what a medium-sized hedging account is ?

“”"“you rate shorting options as the #4 system your gambling grandmother should trade”""“

No. I rate S&P ETF Timer as the only system toward which I would steer my grandmother if I was unable to dissuade her from gambling. Also this was intended to be somewhat humorous, not literal. Both of my grandmothers passed away before I was 10. Sorry if it did not go over.



”""“or better still why dont you explain what a medium-sized hedging account is ?”""""

Because my message was already rather long and this would have been a tangential digression. This discussion is about assigning relative base values to give some general idea of relative risk of different forms of derivatives. Not about my personal preferences for top picks.



Nonetheless I am happy to explain. I did not specify what makes a medium-sized account, because this is somewhat subjective. I assume people know whether they want to pay $100 monthly for systems, or prefer to seek out systems costing less than $50. And you can see that my top picks all cost $50 or less. I might be willing to put $100 systems on this list, if the returns and length of history warrented this. However I doubt that you can find a $100 system with a better profile than the ones I list here for $50. Or if you think you can, feel free to mention it, I’d be interested.



Here is my personal perspective. If a system fee is $100 monthly, that is $1,200 per year. That is 10% of $12,000. This means that if you allocate $12,000 per system, then whatever the $100 system ends up winning (or losing) per year, you will make -10% less. That’s pretty intolerable–my personal opinion. Ideally I would want $60k in such a system. A lot of people have that for their total life savings, but you should not gamble with more than 50% of your life savings on a high risk system–and almost every c2 system is high risk–my personal opinion.



So generally, I personally compromise with 5% overhead target. And just hope that the systems I pick will pay that overhead.



Summarizing my personal opinions concerning what constitutes a medium-sized autotraded hedging account:



– I do not think anyone should consider autotrading with less than $60,000. Because the software alone is $1,200 yearly. Ideally, pitch in with relatives and do $120,000. But everyone had better feel comfortable with possibly losing what part they put in.

– On the other hand, these are high gain systems. They work or they don’t. We have hopes they will work, or we wouldn’t be doing this. And if we don’t pick correctly, we will lose no matter what. So perhaps it’s only necessary to put in $60,000 and hope the account will grow so fast the overhead won’t matter. I can dig that thinking. But I would not want to put in less than $60k.

– It is not feasible to reduce overhead by only subscribing to one system, in my opinion. I strongly believe it is very, very important in a hedging portfolio to have diversity and to rebalance monthly or bi-monthly. Take most of your winnings from the winners and decide whether you dare to prop up the losers or try something else. Rebalancing between diverse systems cuts the risk in half.

– (When I say my #1 pick must be something I would subscribe if “forced” to do only one system, that is being rhetorical. It is just the way to think before giving something a #1 rating, not something I would suggest to do.)

– In my opinion, you’d want at least $12,000 per system. If you only have $60k, and if every system costs $50 monthly, then with $12k per system, you need to add 5% subscription fee overhead to the 5% system fee. And be careful to choose systems with low churn. Fortunately, two of my picks cost only $10-$20. This lowers average system cost.

– I think 3 systems give enough diversity. More diversity is better but not if they are mediocre systems. Do not choose 4-5 systems just for diversity. But do choose 4-5 systems if you can find 4-5 that you really like.

– If you can raise $120,000 for high risk, then you can afford a few $100 systems, or perhaps one that is even more expensive. However you would not want all $100 systems or you are back to square one in terms of overhead. Capiche?



In conclusion, a medium-sized hedging account, means $60,000 to $120,000 in my opinion. But possibly $12,000 in other opinions. In either case, it seems to me that most c2 subscribers should want to find several systems that only cost $50 or less. (Maybe I am wrong and all you folks have $250,000 and if so I stand corrected.)



Please note that the intended topic of this discussion is “base values.” If this does not interest you, or you do not understand it, or if you disagree with my personal preferences for best picks–please say so. I would be happy to discuss whatever you like. I do hope that a few people will be interested in the intended topic. But if not, c’est la vie.

Correction. Software system fee over head on $60,000 is 2%, not 5%. So with $12,000 per system and $50 subscritption fee you would pay 7% overhead. Not including trading fees. So I do suggest possibly increasing to 15k-20k per system or else picking systems with a mix of around $20 and $50 monthly fees.

Hi Krystof,

I don’t want to divert your thread too much but just a short interjection: Shorting Options is labelled as an options system by C2 because most of the trades are option trades. But the core holding consists of stocks (ETFs in this case) so it is actually more of a stock system than options.



The same is true of Isonomy Plus for that matter. The stock trades are all adjustments to the main positions. No stock holding is ever closed entirely which is why those trades never appear in the closed trades list.



Dean.

Hi Dean,



I was counting on you to answer this thread because I know you’re an expert on options. What took so long?



Your Isonomies are an outstanding line of systems, especially the Turbo. But 1. above the preferred price range for my list and 2. I know little about options. If I could be more clear about about the options, then I could be more clear about how appropriate Isonomy might be for large accounts.



I bought PUT OPTIONS by Jeffrey Cohen, but only browsed it quickly, and am doubtful I can judge how far he might be correct. And I have been unable to find people able to discuss it. This is a conservative investment method. Cohen suggests never buying stocks but only options, in such a pattern that you limit gain to 20%, but also limit downside.



Before I spend a year learning all the math needed to understand and verify Cohen’s method–I want to know what is the fundamental value of options?



For example, I own some of a platinum ETN. It’s much more efficient than platinum mining which has political and labor problems. However I can’t put much in it. Because if Barclay’s ever declares bankruptcy, the ETN is -100% worthless. Definitely not the same as owning bars of platinum. And such things happen. In 2008, one major mutual fund family went bankrupt. It was discovered their treasury bond fund did not have the required number of bonds. After the lawyers were done feeding, the investors probably got back about 93%. So it was not a huge disaster but please note–we are talking about treasury bonds.



If you can lose 7% in a treasury fund bankruptcy, imagine what you might lose in the bankruptcy of an inverse ETF, or a leveraged 2x ETF. I don’t know, and neither do my advisors at TD Ameritrade.



Similarly, an option may be “tied” to a stock value, but presumably your broker or some institution is underwriting that “tie.” Suppose you own $1,000,000 in put options as recommended by Jeffrey Cohen, and then 2008 happens again, which is exactly the reason for following the Cohen strategy… But… suppose some key institution goes bankrupt… Is it possible that your $1,000,000 in options becomes nothing but 1,000,000 I.O.U.'s from a bankrupt institution? Or do YOU actually own direct liens or titles on real stocks (similar to the treasury fund investors being entitled to the treasury bonds in the event of bankruptcy)? If so to what percent?



Similarly, one of the c2 reviews of Isonomy Turbo criticizes it for holding “naked puts.” I am not totally clear about how a “naked put” works, and I think this is what Cohen recommends, and the performance chart shows clearly that you know what you are doing…



However I would like to know, assuming that you continue to do everything correctly, is there substantial hidden risk in “naked puts” similar to an ETN? I.e., suppose someone has 10 million dollars and you will continue to make winning decisions. Is there something else that might go wrong?



Until I understand this better, then all else being equal, I cannot imply that having $1 million in options is equal to having $1 million in stocks.



Nonetheless, I would like to point out that my tentative rating of 60% base value for options is much higher than for all other derivatives. This is based primarily on looking at the median max DD’s of C2 options strategies. Nonetheless this speaks well for options as relatively more safe than other derivative strategies.



Unless I am mistaken, Forex in particular is not only “freebasing” (no baseline value) but according to my understanding, whatever you hold in a Forex market is very similar to holding an ETN. I thus suspect that someday one of these popular forex brokers will go pop and those few who made millions (instead of losing millions) will be unhappily taken by surprise. But anyone feel free to correct me, because I really don’t know. (?)

Hi Krystof,

Options are pretty complicated derivatives due to the non-linear response of the price to a multitude of factors. Add to that the fact that different contracts linked by the same underlying asset can be combined to produce a truly perplexing risk/reward profile…



Used carefully they can be very effective tools for risk control, but it is also easy to introduce large risks without even being aware of it!



I will try to address your specific points here:



“PUT OPTIONS by Jeffrey Cohen"

Yes that book was one of the things that spurred me on to start learning about options. His basic premise is a good one: combine a stock picking method with options to smooth returns and hedge downside risk. As to whether it really works as advertised over the long term, if I had to guess I’d say yes but I don’t know; I haven’t traded that strategy in that particular form.



There are several potential flaws to do with his method of renewing positions over the long term but again, I don’t know how serious they are in reality. He could have filled extra pages discussing these and other issues instead of padding out the rest of the book with the useless recap of every company in the DJ30.



…what is the fundamental value of options?

I see where your caution comes from. Any derivative contract relies on counterparts remaining solvent enough to honour obligations. So in that sense yes they carry an added element of risk on top of the ‘normal’ risk affecting any traded security or asset. However, this does not trouble me too much as in well regulated markets there are safeguards built in which, although not 100% safe, are still pretty good.



Take an example: XYZ stock is trading at $50 per share. I buy a call option on XYZ with a $45 strike for, say, $8 per share = $800 per contract.

Now let’s say XYZ shoots up to $100 at expiration and I exercise. The writer (the person who wrote the option contract to sell to me) must sell me 100 shares at $45. If they hold the shares already, they simply sell me those. But they could have also sold me a naked option; i.e. they don’t hold the shares. In that case they must now buy 100 shares of XYZ at $100 to sell to me at $45.



The question is, what if they cannot afford to do that? The writer goes bust and I get fewer than 100 shares.



Here is where the regulations come in. Any exchange traded contracts have margin requirements that reduce the chance of a counterpart being unable to honour obligations.



To illustrate this I’ll switch the example round:



I write a $45 strike call contract on XYZ (trading at $50) and sell it to person B for $8. Lets say I do not hold any shares of XYZ. I am required to keep the $8 per share cash in my account as collateral as long as I am bound by the contract plus I must have an extra amount of collateral, say $10 per share for the sake of argument, which is my margin requirement as I do not own any XYZ stock. Effectively I owe $500 but I have $1,800 collateral locked by the authorities so I cannot spend it!



Then XYZ goes up to $60. I now owe $1,500 and still have $1,800 collateral. The margin requirement rule kicks-in saying that I no longer have enough of a collateral cushion so I receive a margin call from my broker. I must deposit more cash as collateral or I must close my position; i.e. buy a $45 call from someone else who either has the shares or has more collateral available than me. If I deposit more cash I can keep the position going but if I close at this point I end up with a big loss. Either way the buyer, person B, is still relatively secure in that they can get their 100 shares if they choose to exercise. If I do not meet the margin call then the broker closes my position without my consent, just to be on the safe side.



Now what if instead of just going up to $60, there comes an extreme event: XYZ shoots up to $100 overnight. The broker does not have time to close my position and I now find that I owe $5,500 with only $1,800 collateral. If I cannot deposit more money I cannot buy 100 shares and I cannot close the position because I cannot afford to buy that call off of someone else as it’s price will have risen to at least $5,500. I am broke and cannot honour my obligation.



What happens to person B now, the buyer of my call?



1. Well, for a start this sort of scenario would happen very very seldom. As volatility increases so do margin requirements so that if such a move is remotely likely I would have to hold more collateral.



2. Most of the time I would hedge myself, for example by buying stock as the price rises so the severity of getting caught out like that would be lower and I would not be racking up losses. This is what market makers do most of the time and, especially with an illiquid contract, the chances are that your counterpart will be a market maker rather than ‘end user’. They usually hedge themselves completely so they make no profit under any scenario but they get to pocket the risk-free bid-ask spread.



3. If I cannot honour the contract the law would come after me to liquidate any other assets I may have to pay my debts.



4. I believe, and this is where my knowledge is fuzzy, that these fully regulated contracts come with broker guarantees, and ultimately government mandated insurance, such as the FDIC or similar. So if 1-3 all fail to recoup the money then 4 does. But as I say, I am not clear on this point.



5. If all the above fail, person B ends up $800 down on what was a $5,000 position. He should have been $4,700 up.



Something that may be similar in a way:

Suppose you own XYZ stock and hold it in a nominee account with a broker. Your broker lends it out to someone who want so sell short. Price rockets, short seller goes bust and cannot buy those shares back any more… hmm, what guarantee do you have now of getting your shares back?



Anyway, in summary, strict rules lessen the counterparty risk but of course it cannot be eliminated. As you mentioned with the mutual fund that, essentially, had been cooking the books.



Over The Counter or bespoke contracts are more dangerous. I do not know much about those but I believe they are less regulated and you really do have to watch out for the credit worthiness of your counterpart as you are much more on your own. However, as a retail investor or trader those are not so easily available.



”…is there substantial hidden risk in “naked puts”…"



Not really. Not for me at any rate, but maybe for my counterparty, the buyer of the option. Again, best illustrated with an example:



XYZ is at $50, I write a put at $45 strike and sell it to person B for $3 per share. It is “naked” because I do not hedge my risk by, for example, simultaneously selling stock short.

1. If XYZ stays above $45 then the contract expires worthless - no counterparty risk for anyone.

2. If XYZ goes down below $45 then person B has the right to sell me the shares at $45 so I am the one liable, not them. Therefore no extra counterparty risk for me but there may be some for them if I go bust.



There is still the ‘normal’ risk to me of writing a naked put. If XYZ falls to $30, I still have to buy it at $45 when the contract is exercised. I have lost $12 per share ($15 minus the $3 premium which I received for selling the contract) but that is the same risk as if I had simply bought the stock at $42.



Where naked puts become dangerous (again under ‘normal’ circumstances where all counterparties remain solvent) is if I write 5, therefore being exposed to 500 shares, but I have only enough capital to buy 100 shares; i.e. a case of over-leverage. As the price of XYZ falls I start getting margin calls and am forced to close positions at a loss until eventually I may end up with an account at zero with all of my positions closed - no way to recover from that, even if XYZ turns around dramatically!



Okay, I have waffled on for long enough now. Must go put my two year old in the bath :slight_smile:



Dean.

Hi Dean,



Did you not forget the role of the Option Clearing Corporation?



As far as I know, when you are buying or selling regulated options you, through your broker, are dealing with the OCC and not with the counter party directly, in other words you don’t have to worry about the credit worthiness of your counter party, the OCC in effect guarantees performance.



I don’t trade options, so please anyone correct me if I am wrong.



Karl

Hi Karl,

Yes I did forget about the OCC; thanks for the reminder! I remembered there was someting of the sort there, hence "…such as the FDIC or similar…" in point 4. But I am still unclear about what would happen if there were a major collapse in the financial system that causes the OCC to go bust. Can it go bust and still guarantee cleared transactions?



P.S. I noticed point 5 is not quite right: person B would not be $800 down as there is $1,800 collateral available. So worst case scenario is that person B would be $1,000 up instead of $4,700. This is fine - worst case is less profit instead of more profit! - unless person B was relying on that position to hedge something else, for example a short stock position.



Dean.

Thank you very much Karl and Dean! Finally some straight answers about options. I was afraid my message was over-detailed, but you have addressed every detail. I will try to summarize my resulting understanding…



1. ““Options are pretty complicated derivatives due to the non-linear response of the price to a multitude of factors. Add to that the fact that different contracts linked by the same underlying asset can be combined to produce a truly perplexing risk/reward profile…”” Very well said. I am glad to hear that maybe I am not suffering from over-imagination and paranoia concerning options.



2. Re: PUT OPTIONS by Jeffrey Cohen. ““There are several potential flaws to do with his method of renewing positions over the long term…”” I am glad you reminded me of this aspect of Cohen’s book. Traditional “value investing” generally involves holding a stock for more than one year, easily qualifying for discounted “long term” tax rates. But Cohen’s Put Options expire in one year. And meanwhile, you could be “in the money” in one month but “out of the money” at the end of the year. So I would want to do significant backtesting before deciding when exactly to close a position.



Perhaps the most obvious criticism of Jeffrey Cohen’s book is its name: “Put Options.” The title should instead be something like, “Safer Investing With Put Options.” This is not a general book about Put Options. Options have a lot of options, and many of them unsafe. Of course, a clumsy name does not discredit a book. However, I do think this choice of title implies a certain lack of perspective.



3. It seems best to ignore “underlying” risk factors for options. The Options Clearing Corporation insurance is presumably something like SIPC–not as solid as FDIC perhaps. But this might only be an issue in the type of market situation in which multiple major corporations are plummeting in value. In such a situation, any added “underlying” risk from options strategies could be more than compensated by the hedging potential for options as pioneered by Jeffrey Cohen.



I.e., the “overlying” risk level for all options strategies can vary greatly, from more risky to less risky than for blue chip equity investing. It seems best to focus on these “overlying” factors. Doing otherwise may become confusing and put the cart before the horse.



4. However, there is also an added “overlying” risk factor with most options strategies: in that it seems especially important to know what one is doing. "“Used carefully they can be very effective tools for risk control, but it is also easy to introduce large risks without even being aware of it!”"



In the 1920’s and 1990’s, any monkey could buy stocks and feel he was a genius. Even in bad times, so long as you avoid OTC or pink sheet stocks, it is actually difficult to lose much in the long run. In contrast, I suspect that someone might have a good Options strategy, but walk home wearing a barrel if he does not apply it with significant competence.



Q. In plain English, what is being done and what are the risks with “Shorting Options” and also “[LINKSYSTEM_36590219]”?



These systems are not clearly described. One of them has a link to a video which does not seem to play.



Q. Is this a fair assessment of Isonomy Turbo?



Isonomy Turbo is well described, including backtesting which shows a significant gain for 2008. Isonomy Turbo seems basically a conservative system, similar to Jeffrey Cohen’s. ““Simplified result: we profit if the stock price rises or even just stays the same. If the price falls, insurance is in place to limit losses.””



–But if Isonomy Turbo is as “cautious” as I suspect, why would anyone want to bother with Isonomy or Isonomy Plus?



–Does the success of Isonomy Turbo rely somewhat on the value of silver?



I happen to be backtesting my own new system from Jan. 2007 through Aug. 2011. It is taking me a week longer than expected to publish, because I have decided to combine my “low risk” and “medium risk” strategies. Backtests show about 30% CAGR for 2007-2011, for both my system and for Isonomy Turbo. Also if I understand correctly, Isonomy Turbo may be a bit more cautious than mine, with its Cohen-style loss limits. I might like to subscribe to Isonomy Turbo, as an excellent diversification to also using my own system which does not involve options or silver. My only problem is that after the 6-month discount period, Isonomy Turbo costs $1,200, which is 10% of $12,000. I would feel far more comfortable with a permanent fee of $600.