Animal Spirits Podcast - Talk Your Book: I Need To Do Some Hedging Trades

Episode Date: September 26, 2022

On today's show, we spoke with Eric Metz, President and CIO of SpiderRock Advisors about tax-loss harvesting, replicating exchange funds, and de-concentrating portfolios using managed option strategies.   Find complete shownotes on our blogs...  Ben Carlson’s A Wealth of Common Sense  Michael Batnick’s The Irrelevant Investor  Like us on Facebook  And feel free to shoot us an email at [e-mail] with any feedback, questions, recommendations, or ideas for future topics of conversation.  Learn more about your ad choices. Visit megaphone.fm/adchoices

Today's Animal Spirits Talk Your Book is brought to you by Spider Rock Advisors. Go to spider rock advisors.com to learn more how you can use options overlay strategies to help with concentrated positions for clients, tax loss harvesting, exchange fund replication. Did I say that right, Michael? You did. You know that. All right. This is a very interesting conversation. So if you're an advisor, go to spiderrockadvisors.com or alternatively reach out to your Black Rock advisor. They can bring it right into them because They both have a rock in the name.

Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnik and Ben Carlson as they talk about what they're reading, writing, and watching. Michael Battenick and Ben Carlson work for Ritt Holt's Wealth Management. All opinions expressed by Michael and Ben or any podcast guests are solely their own opinions and do not reflect the opinion of Ritt Holt's Wealth Management. This podcast is for informational purposes only and should not be relied upon for investment decisions. clients of Ritthold's wealth management may maintain positions in the securities discussed in this podcast. Welcome to Annal Spirits with Michael and Ben.

Michael, I have something to admit to you. I've never traded an option in my life. No. It's never happened. Does that really surprise you? I feel like I ran out of Ben Carlson's surprises and here I am. Yet again, surprise one more time. I've never traded an option.

How is it possible? You never were like, eh, just want to roll the dice. Never? Here's the thing. Before Robin Hood existed, how did you do it? How did you trade options back in the day when you had your trading journal and you were losing money every day? Not every day.

It was very simple. I went to my trust of custodian, TD Ameritrade, and it's right there. Stocks, ETFs, options, buy sell, call put, maturity, strike. I mean, come on, very easy. I know in theory, like, they're easy to understand. It's like, I'm not putting a bunch of money up, and maybe I can multiply my money in a very short amount of time. But I think with the way that they're priced and everything, understanding that market, when you hear people talk about it who actually understand it,

it's a very complicated market. When I was trading options, I was in it for the love of the game. I was doing it for the fun, the YOLA, so to speak. I was all right. I'm going to lose 100% or I'm going to make 1,400% in the next 30 minutes. And that's that. Short-term options are the parlays of investing. 100%. You almost always lose. I bought calls or puts before earnings. That was it. It's exactly like your gambling strategy with sports now. tell me all these 10 to 1 parlays you do? How many of you ever won? Well, yesterday I was getting to the end zone until the Jets. Jets were down 13 points of two minutes left and they busted my parlay. I was feeling good. Anyway, blaming the Jets is like blaming the Fed. No, it's not. My option strategy would have been fine if wasn't for the Fed.

Not even close. But unlike my shenanigans, there are real professional, sophisticated ways to use options to do a few things. to hedge the downside, to exchange one risk in a single security for a diverse set of stocks. So we spoke with Eric about this. And that was new to me. I didn't realize that they were able to do that. Exchange funds, exchange funds have been around for a long time. And an exchange fund is basically, not basically, it's when you pledge a security. And in exchange for pledging this, and they're all sort of tax implications and nuance here,

you get a diverse basket of security. So you're swapping a single risk for. a diversified basket. We get into this a little bit in our talk with Eric, but it's essentially essentially going from a single stock, if you want a bunch of shares in Google, you can transfer that risk from a single share, single stock ownership to a concentrated risk into owning like the SP 500 or Russell 3000, whatever it is, and have more diversity that way, which is really an interesting way to look at options. And so Spider Rock works with advisors to come up with bespoke solutions for their clients. And we get into all of that and much more on today's episode with

Eric Metz. We are joined today by Eric Metz. Eric is the president and CIO at Spider-Rock Advisors. Eric, thanks for coming on today. Appreciate it, Ben. So Michael and I talk a lot about options trading strategies as it pertains to retail investors on our show every week. And you guys are offering these options strategies to all sorts of investors.

Who are you working with at Spider-Rock? It's a good question. We saw a void in the marketplace, really for what we call the intermediary, which is the financial advisor or CIO or consultant. who sits between the end investor and the markets. Options tend to be somewhat sophisticated and complicated and assuming you even understand them to the max, the workflows and the technology to facilitate the trading and analytics

is somewhat fragmented across the industry. So we decided to consolidate all of the, what I'll call investment components and then marry them with an infrastructure and technology to deliver them. So predominantly financial advisors is our target user base. Can you talk a little bit about the history of Spider-Rock? I know, coincidentally, maybe not coincidentally, but you got an infusion of, or there's some sort of professional relationship between Spider Rock and Black Rock, but you were Spider Rock before

you met Black Rock, right? Sure, yeah. So we founded the business probably 2013 era, really to solve that void that I just alluded to, built out a whole host of workflows and use cases into the major channels of private wealth. So think Fidelity, TD, Schwab, UBS, Pershing, Bank, New York, Mellon, Northern Trust, etc. Those are the back offices of where our client's assets reside and grew that business. And then as BlackRock was entertaining different potential partners to fulfill their

SMA and UMA needs, we were the chosen group to partner with them. So that deal was consummated in July of 2021. When you say the deal, are you now wholly owned or did they invest a small, like what does that look like? So they're a minority investor and they're our exclusive distribution partner. So all of those intermediaries or financial advisors are clients of both BlackRock and Spider-Rock advisors. And as their scale brand equity and product breadth was trafficking the marketplace daily were one pillar of that now. You mentioned that options are hard to understand. And I'll admit, for me, sometimes they're hard to understand. What was your background that got you into this

space? Sure. It began in academia at University of Michigan in financial engineering and started some work on derivatives and then quickly pivoted into industry and joined a firm in Chicago called Chicago Trading Company, which cut its teeth on the floors of the CBOE and the Board of Trade. And and really learned my craft from them in the early 2000s. And then as the world kind of went digital and technology took hold of the industry, pivoted into a more upstairs electronic-based trade and did that for about 15 years. And then had a stint and asset management. And the genesis of Spider-Rock Advisors was born just really out of the perpetual request from our now clients asking for the hub and spoke offering with all the investment solutions curated to their needs.

When you're working with advisors and their clients, are you guys recommending certain strategies or are you talking to advisors asking what they're trying to accomplish and then showing a whole host of different potential strategies? Michael, it's a great question. It's really a function of the advisor's background and expertise in the asset class itself. If they're a novice, we will definitely take the lead and kind of position one or two strategies or solutions that we think hits the zip code of what they're looking for. vice versa groups that are very equipped in the asset class will say here's what I'm trying to

solve. Here's what I think. Can you validate that or disprove it or recommend something better? And so there's both a push and a pull dynamic, but it's really a function of our clients that dictate that. The use case that I think from our clients that makes most sense is you have someone who comes in with a huge amount of shares in a public company, say they work for Amazon and it's 90% of their net worth. And they say, I want some sort of option strategy to make sure that I can't lose my shirt for what I've already gained, but I also want to give myself some upside. So I want to use some sort of option strategy to pen me in a little bit and make me a little more range bound. That seems like one example. What other examples are there for financial advisors

that you're using for these types of strategies? That use case right there, Ben, is probably 20% of our business. So you identified it accurately. I would say the others are just thinking about the equations with an after-tax mindset. So yes, that 90% concentration is an eyesore and people's wealth was created upon that, so it's protected. But the other thing to think about is how do I change the risk reward profile of my current situation or my current positions without having a tax bill? So reshaping that Amazon position into a variety of different outcomes to not only profit but manage risk, but with a tax focus is largely a core or core use case. And then the other one that's been more recent is really hone in on your use case of

Amazon. I have this Amazon risk, but I really want S&P risk. And so how do I swap my Amazon risk into S&P risk without paying taxes? And so we went to the drawing board and built a solution we call Exchange Fund replication, which swapped your Amazon risk for an index of your choosing or the clients choosing, just using simple listed derivatives. And we manage that in an ongoing capacity. So really, taxes and risk transfer altering the risk reward of a portfolio. All right. So we want to dive deep into both of those. Let's start with the first one. You mentioned taxes, maybe here's a softball for you. Why wouldn't, if somebody's trying to do, let's just say a simple cover call strategy,

why would an advisor not just manage that on their own? What are you guys able to do above and beyond with the tax treatment that an advisor might not have the expertise to do on their own? So if you think about what covered calls are inherently doing, people are gravitated towards them for the concept of income. But simultaneously, the second you sell a covered call, you are reducing the risk in a portfolio or in that security. And so if you calibrate on that risk reduction, the only other way to reduce that risk is to sell shares.

And if they're sitting on embedded capital gains, we can kind of create an apples-to-apples comparison on that value proposition of just performing covered calls. Michael, you took it a layer deeper and said, all right, well, what if somebody's doing this upon themselves? Well, the markets are moving in real time. So that Amazon share price is ticking up and down every single minute. And therefore, the covered calls or the call options are commensurately tickering with that. And so that relationship's a known piece of information that we can monitor. And even intervening and trading needs in a manual capacity myself, knowing how we built everything, the machinery and the technology to reduce what I'll call slippage or the implementation cost to the market makers, think liquidity, we minimize that.

And so the outsourcing capacity, especially as you try to scale not only one covered call, but many, for one portfolio, let alone hundreds of clients, we sit in the cornerstone intersection of all those needs. You spoke about taxes, like in terms of if you want to start reducing your concentration manually just selling, how can you use option strategies in a tax-aware manner? Yeah, so everything we do at Spider-Rock Advisors is generating what we call like a total return profile, a risk-address return profile, and then third would be the after-tax. So thinking about things, really as folks have tax-managed equities and they're managing a household of assets, the concept of tax loss harvesting is not new, but the concept of doing this with options we call this strategic liquidation is somewhat novel in marrying the holistic approach. And so if there are gains or losses in an option, you can use them in your estate planning or your financial planning, no differently than if there are gains and losses in your equity portfolio. And so we devise scenario analysis to outline where there are after-tax benefits from utilizing options and contrast that without using options.

So that's the fulcrum to even use the strategy to begin with. And then once you are performing it, there's value propositions both on the timing and how you interface with capital markets to deliver these value propositions, if that makes sense. You mentioned that some people come to you and think that they're going to sell calls or puts in earn some income. what are some of the pros and cons of using options as an income strategy for people who just don't use them very often? Certainly.

It's the number one goal of me and my team that's just to manage the expectations of our advisors and their clients. And so there is no free lunch in capital markets. Most folks are drawn towards covered calls or selling puts for the quote unquote income. But understanding that there are risks associated with both is a key piece of the education. So we'll start with coverage calls is probably the most ubiquitous solution or strategy. out there. Selling your Amazon covered call, as simple as that sounds to collect 8% or 12% in call premium, well, what if the stock rallies 30% in a quarter? And in doing so, what are the risks

and what are the ramifications? That's where our proposals, that's where our communications with advisors and our educational federal come in. What we want to do there is say, okay, well, the total return of this outcome is actually the highest in the strategy, but we have to think about this tax piece. And so buying those calls back, albeit at a loss, if known in advance and using that strategically and your holistic planning is very powerful. So most folks think the stock's going to get called away. That's an issue. That's a problem. That's scary. We can preemptively manage that and then utilize those tax equations to the benefit of the advisor or the client. In other words, if the stock is getting close to being called away, you would what? You would take the loss on the

options and use that to potentially sell some of the underlying as like a tax neutral manner? You got it. Simple as that, Michael. What if somebody's okay with having their stock get called away because it's a programmatic way of doing it? Because oftentimes when we're talking to clients that have concentrated positions, the reason why the positions are concentrated is because they've generally done very well. If the stock has fallen 80% since they held it, it wouldn't be a concentrated position anymore. So people are generally, loathe to part ways with the stock, maybe this is like a behavioral way to programmatically get them to reduce their concentration. Totally. And so that behavioral element, whether it's emotionally

attached because the stock has done so well for them, they're loyal to it, whether they inherit it and it's a family heirloom of sorts that use cases arisen. We've seen a state and trust planning documents that state that they can't sell it. And so option strategies sit very, very uniquely in a solution set to solve a bunch of investment objectives, but also adhere to those emotional attachments or contractual attachments in the estate in the trust planning world. So preserving dividends, maintaining upside, putting a floor, putting a ceiling on it,

all of these things are, I'll call it, solution sets that only options can deliver. And so it's our team's job to navigate that conversation with the advisor, with the client about what their goals are. Coming back to one of your earlier questions, Like the more detailed with bespoke needs that you have, the more consultative it is, and the more our team will guide you to finding that recipe of the solution set. You mentioned earlier that you came from academia, and I think if you're looking at it from

that lens, you would think, well, everyone uses the same options pricing strategy. So how much differentiation can there be? And then you went from academia to the real world, and I'm sure that there's a ton of differentiation because volatility characteristics in the way people are positioned probably changes pricing. So what is the biggest difference there between the form? realize that people learn in their textbooks and how these options actually work in real life? That's a phenomenal question. And you mentioned behavioral finance. No matter how good a model is, all models will be broken in certain market conditions. And so retooling them and recalibrating them

is what I saw happen in practice much more regularly than academia, which is where you fit to a model and then you kind of let it run and then you tweak. I think machine learning in this day and age has brought forth that intersection in a more real-time feedback loop. But at the end of the day, like behavioral financial mistakes are made even with the most quantitative groups. And so where that rubber meets the road is just risk management. Having sound risk management practice, both in portfolio construction, but also in real-time modifications, why are you making changes? What variables are in the equation today that maybe weren't 90 days ago or 180 days ago when a model was devised and then understanding what ramifications there exist when you make those changes. So

that feedback loop, if it's only quantitatively driven, can sometimes be a recipe for disaster and vice versa. In practice with no model, then you're kind of flying blind. So you definitely both. So you said roughly one-fifth of the business that you do is on concentrated equity positions. Talk about the equity replication, I think, is what you called it. Trading one risk for another. How do you do that and what does that look like? Sure. So exchange fund replication. So exchange funds have been in the marketplace for quite some time. There's two prominent operators or portfolio managers of that in which you pledge a concentrated stock into an LP with other folks that are in a similar position. And then you gain diversification between your pro rata share of your

position within the fund. So we can make up a use case here. I have a million dollars of Amazon. They're a hundred million dollars in the fund. Everybody's got a million dollars of a variety of things, and so now I'm diversified because I have exposure into all of those other instruments. But at the end of seven years, which is an obligation to get the tax benefits, you're left with a whole host of securities that you may or may not want. But the real goal in incorporating this solution set out of the gate was, I have too much of Amazon and I want diversification. Well, if we can hedge your Amazon and gain you diversification to things that you want, not that you're subject to in an exchange fund, then all of a sudden you've solved your objective.

swapping by Amazon for what we'll call S&P 500 exposure and more so it's daily liquid and transparent but the most important thing here is you can control your tax outcomes through time and so giving the advisor or the client these tools was a novel concept that was really built from client demand and how it's performed is coloring an individual security in this case Amazon and doing the exact opposite with the risk that you've just freed up in indices or ETFs of your choosing. So in the example, I just gave you S&P 500. And then now I have a call on a put in Amazon.

You have a call on a put in the S&P 500 every single year. It's likely that one of those will have a quote unquote unrealized loss that you can realize. And then you can tax loss harvest no differently with those new instruments through time and then erode your concentration risk while maintaining exposure to the broad-based market. So I would say this is probably our largest concerted effort, new demand. product or solution here in the last 12 month. We talked a little bit about how your experience in

the options market has changed over time. One of the things Michael and I've talked about for the last few years is the sheer amount of retail trading in the space from places like Robin Hood. How much has that had an actual impact on the pricing, the structure of the markets? Has retail really changed things in the options market in a big way? A big way, no. It's definitely altered it. I think the professional community and the market at making community, and I would classify the professionals as institutions, hedge fund, proprietary traders, et cetera. It's forced a lot of folks to come onto the front or end of the maturity cycle. If you think of all of options in the list of marketplace as having weeklies and monthlies

and quarterly maturities, retail tends to traffic in the front part of the curve. There's a lot of reasons for that. But I think that has enabled a lot more liquidity. Sorry, explain the curve. So you're talking about retail just trades shorter dated options. because they want to see something happen right now as opposed to longer dated options. Is that the idea? It's like instant gratification. It's like if I know what I'm trying to solve for,

then I can make my bed and see what happens in two weeks. That's got the allure of the retail trader. I spent a lot of time early in my trading journey, trading those weekly calls on a Wednesday afternoon. Those are good times. There you go, and you know where you stand. You got a couple hours left, and you're going to make a lose in a couple of hours.

But what that's done is it's taken a lot of the performance, professional players, and it's forced them to move up to supply liquidity to those folks. And so it hasn't changed it. That's always occurred. It's just put more of a focus around, I'll call it, inside of the 60-day life cycle. And that goes for ETFs and single securities. I'm looking at Amazon right now as we speak. There's a September 30th maturity.

And what that's done is it's forced the technological capacity of all these groups to just sharpen their pencil even further as the latency requirements to maintain an edge just have gone up. Hey, Eric, while we have you, can you describe for the audience what gamma hedging is because that became a very buzzwordy buzzword, I guess in 20, late 20, 20, 2021? Could you explain what that is? Yeah, there was a big article. I think what you're referencing is kind of the meme stock movement and kind of when

call option buyers, especially retail, forced what you're describing as gamma hedging, which is a real thing. So liquidity suppliers, whether they be market makers or banks, are selling those call options to the people that are buying them, and they hedge it. So when they sell a call option, they buy stock. And if the stock keeps rallying, they have to buy more stock. That's what gamma hedging is. And so they try to maintain a market neutral position, so no directional bias on any given point in time. And when that, quote unquote, squeeze happens, then every supplier of liquidity who sold calls, they're just buying more and more stock to maintain their hedge. So that is what

gamma hedging is. And so when you get almost like a self-fulfilling prophecy when momentum traders start buying call options and the suppliers of those call options, the liquidity providers that have to hedge, and then the stock keeps rallying just on the sheer market structure of that trade. That's what gamma hedging is. As far as the meme stocks go, like Bedbath and Beyond in recent months, then GameStop for the last 18 months or so, how much of those moves can you ascribe to options trading them? It's hard to put an exact figure out. If you had to guess, how much are options responsible for some of the gains we've seen in these stocks? Listen, it's a security by security analysis.

But if the options trades are large enough, then the hedging of that trade has to be contrasted with the average daily volume of the stock. If the hedging requirements are two or three times the average daily volume of the stock, when the stock's going to rally. And so what happens is those folks have queried short interest and low average daily volume with good options liquidity, and they've tried to create the feeding frenzy, if you will, into these gamma hedging squeeze type trades. That's exactly what's happening. When your team is talking to advisors and they're trying to manage concentrated positions,

I know it's all over the place and it obviously depends on a million factors, but are people trying to collect income? Are they trying to limit the downside? What are some of the strategies that you offer look like? So we offer both. The third would be exchange from replication, which is just swapping your concentration risk for market risk. We'll call those the three categories. And the income desire is a function of the security. The income potential in Amazon is much higher than Coca-Cola. Why is that? Because the stock's more volatile? Exactly. And so simultaneously, the needs to hedge the downside risk in a more volatile stock often are higher as well. And so really,

coming back to behavioral finance, it's understanding the goals and objectives of the client advisor. And then we display in what we call a proposal, both the income, potential, but also the downside profile. And people contrast that to like what they think of is like an upside downside capture ratio. And you walk through and you define the pros and the cons of each. And sometimes people split them, meaning I need income in category A, but I need downside protection in category B. And so if that 90% net worth client is tied up in one stock, they'll want diversification in these solutions just because nobody has a crystal ball as to what the future holds. We've mentioned a few specific strategies.

that you employ with advisors and the people listening probably could come to you with those strategies because they have examples like that. But do you ever have financial advisors say, listen, we've never worked with options before. We don't really understand them very well. We're just going to sort of open a kimono for you to take a look at some of our client portfolios and you can kind of give us a proposal. Does it work like that as well where you kind of can come in as a consultant and say you have the ability to do A, B, and C with these types of clients? Is that how you work or are you more having advisors come to you just for specific use cases. Mix bag, we have had the former that you just outlined. The way I like to start most of those

conversations is without options, what are you trying to solve for? And in absence of tax, what would you do? And if I can ask those two questions, I very quickly can construct two or three thought-provoking value-ad ideas in which options can be embraced in a fiduciary capacity. So you mentioned income, you mentioned downside protection. Rebalancing is another one, the 80-20 client who, invested since 2010 or 2011 has received such tremendous gains, even with this year's, sell off, that when they think about rebalancing, what would you do? Well, I'd sell my equities to buy fixed income or I'd sell my large cap domestic growth to international value. Once you have that goal, you can instantaneously stand up two or three solutions sets that our team will

illustrate and discuss those pros and those cons. Can you talk about some of the costs involved both implicit and explicit. Obviously, there is a cost, a fee that you guys charge for your services, but then on the other hand, there is also a cost to option strategies like everything else. There is no free lunch, so maybe just on both of those. So we're an asset manager at the end of the day. So no differently than any other asset managed firm, whether you're managing an SMA or a mutual fund, we charge basis points on our overlay. So in that Amazon example of a million dollars, we're doing covered calls on a million dollars and we're charging somewhere between 50 and 85 basis points depending upon the strategy

of that million dollar amazon position the cost of implementation like market structure costs this is again a large value proposition that we work with our advisors on which is fit as spreads and options are larger than stocks meaning the call options in the amazon 130 strike calls are wider than yet stock itself and so navigating that given the fast moving markets is something that technology can aid somebody with and so the technologically advantage to minimize that cost is a key value proposition that we bring our clients. We tend to align our fees with the ability for our solution set to have cost savings relative to manual implementation. So we try to align our value proposition just on that alone. So you can save somewhere

between 30 and 150 basis points on just an implementation savings. I was wondering that on execution because let's say you have an advisor who says, I have my CFA and CFP. I pass a level three. I know what options are. I can do this myself. Could they potentially lose if they say, I can develop an option strategy, but because their trading system, they might not have the best handle on that you can really help there as well? Exactly. So I mentioned that volatility piece, Michael earlier, on like the income potential. That's a known variable that we as option professionals monitor.

That variable is in real time changing. And so monitoring that is, I won't say impossible from a manual construct, but it's very cost intensive if you were to try to do that. Once you even know that piece, then you actually have to transact. And so minimizing your transaction, slippage costs is what market making does and what our technology aids us in doing. If people want to learn more about your services, should they contact their Black Rock rep or reach out to Spider Rock directly?

Both will end up at the same spot. So if somebody already is working with a Black Rock market leader, that relationship will be able to aid these conversations and get them in the right spot with all the resources of BlackRock. Our website does a good job at navigating that down to one of my partners team who runs our sales and marketing. But again, if you have a relationship in place, lean on it. If you don't, our website, spiderwackadvisors.com, we'll aid that navigation as well. Hey, I got one last question for you. Is this, we spent the entire conversation today talking about equities.

Does this work across other asset classes or is it primarily slash only for stocks? It does work across other asset classes. The constraint is really who your back office is. So think Schwab, TD, or Fidelity and how they view risk in fixed income instruments or in even commodities. And so the idea here is to be very capital efficient. One of the best value propositions of option overlays is to be capital efficient. I mean, you don't have to post or fund the strategy, but those requirements are a regulatory piece that are governed by your back office or your custodian itself. So Fidelity governs that we don't.

We just operate within. So we sit kind of hub and spoke to all the major players. It's viable to go off of equities, but equities are the most ubiquitous. So that's a good one for back office stuff for the people who pay attention to the operations. If you're an advisor, you have a custodian, you work with all those major custodians. It's not like the advisor has to open up a different account somewhere else to work with you. Correct. Yep. We're plug and play at TD Fidelity Schwab, Pershing, UBS in some capacities,

and depending upon some of the bank trusts venues like Northern Trust or State Street or Bank of New York Mellon. We have operations plugged in as there as well. Eric, this was terrific. Thank you very much for coming on today. Appreciate it, Michael. Thanks, Ben. Okay, thanks to Eric. Thanks again to Spider Rock. Remember, it's Spider RockAdvisors.com. Send us an email, Annalspiritpod at gmail.com. Thank you.