With so many different types of market players on Wall Street these days, we’re always curious about how they go about executing various strategies. Las Vegas-based volatility trader Robert Blau, the founder of RABCO, spoke with Business Insider about his strategy and outlook for the markets.
This is especially timely because volatility is at multi-year lows.
We’ve transcribed our interview below. (Note: It has been lightly edited for clarity).
JL: I see you have a “collateralized options trading strategy,” could you explain what that means?
RB: Sure. What I started doing about fifteen years ago is trading options, primarily selling options, selling volatility. So I’m what you would call a volatility trader. And the collateral part is basically when you’re selling options you need to post collateral, generally in the form of cash, Treasury bills, could be municipal bonds. They just want to see that you have the way to pay off if the options sale doesn’t work out. That’s why we call it ‘collateralized options trading strategy.’
JL: Why is it that options markets are so inefficient compared to the S&P?
RB: Well, I don’t know if I would say that they’re ‘inefficient.’ I think that the options strategy that I employ is selling options on the S&P 500 index. Primarily, what I’m doing on the put side is selling disaster insurance. So if a hedge fund, for example, is concerned about some kind of macro event that is going to occur and they want to reduce their exposure they are buying this type of insurance to hedge their portfolio rather than just sell their stock and sell their position.
And so generally there’s more demand for this product that there are sellers and what happens is that premium that kind of gets built into the pricing due to the fact that most people really don’t want to sell the insurance. So the people who would be critics of this strategy would say that ‘theoretically you’re selling this insurance, but you could blow yourself up.’
My answer to them would be that over long periods of time that natural, historical volatility in the market is less than the implied volatility that these hedge fund managers end up paying to buy it.
And so, again, it has been considered a risk strategy, you know it’s certainly not a conservative strategy, but the management of the options is really the key to my success and that comes from many years of battle wounds living through you name it—September 11th, Flash Crash, and all the crazy stuff that’s happened over the last 15 years. The list is very long.
JL: Would you say this is analogous to how some insurance companies make their money?
RB: Absolutely. It’s analogous to insurance. The best way to describe it is when people ask me to put it into plain English for non-Wall Street people, it’s definitely like selling insurance.
It’s kind of like you live in New York and you hear that the hurricane is forming out in the Caribbean and someone comes up to you and says, ‘Do you want to buy hurricane insurance?’ and you’re saying, ”Nah, I don’t really think so,’ and they’re saying, ‘c’mon, it’s only a $1,000’ and you’re like, ‘Nah, forget it.’ And then the hurricane starts moving up and now it’s in Florida and they come back to you again and say, ‘do you want to buy hurricane insurance?’ and you start to think about it a little bit more, but now the price is $2,000. And then eventually when the hurricane gets to Washington, D.C., the price is $5,000 and you’re ready to buy it.
So it is analagous to that. The other side of the coin is when you think of it like car insurance, and you say ‘Well, I need a policy for the year for my family.’ It’s a $12,000 policy and three months goes by and you turn around to your insurance agent and you say, ‘I’m cancelling. I want my premium back.’ What happens to those three months? They earn premium.
They keep your money and at the end of the day that’s how they make money. So yes these types of puts and insurance premiums are very often done. Warren Buffett sells puts on the S&P. Basically, they used options, not my S&P options, but it was all these options that were being sold you know basically that’s what the CDS was—they were options on these bonds that no one ever thought would collapse.
So people thought they were collecting free premiums, but ended up getting blown out. So there’s a fairly ugly side to options. I think that’s why people tend to shun them. But I think if it’s done with experience and with a good degree of fear, you have to be scared of it and understand what you’re dealing with, I think there are crumbs that can be made you know from people who are paying up very often what’s overpriced.
JL: OK. So when I look at your returns from your performance it looks like, it kind of looks like how when the casino has to pay out the jackpot. There are some months in here that are volatile like April 2007, October 2008, August 2011 would that be analagous…?
RB: Yes. The nature of the strategy and the nature of the “bets” so to speak if you want to call them that what I make is that 80 to 90% of the time they work in my favour—I’m like the house. But upon occasion…the snakeyes comes up and the casino loses. So yes, that’s exactly, you hit it right on the head, that’s exactly analagous to kind of being the house in a casino.
JL: But I also see a lot of really consistent returns. Why do you think you manage to generate such consistent returns and you know what is it about options that produces this sort of opportunity?
RB: Well, like I said the nature of the strategy is that…The way I do it is I sell very low probability bets meaning low probability for the buyer and high probability for me. So the majority of times I’m going to win. Usually you have some kind of event once every twelve months and that event may be a very large one like August of 11 with the downgrade of the credit rating, which kind of caught me by surprise.
Once they raised the debt ceiling I thought the waters were clear only to get turned around on the downgrade, which affected me badly. But with that being said, the majority of times I win so the majority of times I do get that consistent return. The trick is to manage you know the September 11th event or the downgrade event. When those events happen, you have to manage it.
You can’t be a deer in headlights. You have to work and that’s probably the biggest dilemma that people have had doing this is that if they don’t manage effectively and those certain moments they can really lose a lot of money. I think the consistency there is because the nature of the bets I’m selling have a very low probability of success of the buyer of the options and a high probability of success for me.
And why I think that would exist is because you know is when you think about insurance — car insurance companies, hurricane, all kinds of insurance that someone would buy — overtime… What happens if there’s a Hurricane Sandy? You know yes they take a loss. But what happens for the next three years in that region? Everyone’s premiums are going to go up to reflect it.
So the insurance business as a business in general has been a huge successful cash flow type of business for you know lots of companies…all making money basically selling a degree of risk and if there is an issue the premiums come up to follow it. If you kind of look a little deeper into the returns, you’ll see when I have two kind of bad months so to speak the following three to six months thereafter are usually pretty strong because the options in market place are trading much higher and people are willing to pay much more when they’re coming off a scary event.
So you do take a loss, but you do also then get the opportunity to sell you know future months a much higher implied volatility.
JL: Is this a strategy that most people could execute, or does it take a lot of experience?
RB: You could read about it in a book. It’s not that I’ve invented anything new as far as selling options, but the experience yes. The experience is going through staring at the market, watching how the market behaves and knowing how to manage when the problems occur.
And that’s something someone could talk to you about, but until you’re in the middle of one of those types of events when you have a 500 point swing day, a 1,000 point swing day and these option prices are starting to scream. That experience is irreplaceable, so yeah I would say the experience and the management of the strategy is really more of the key than anything else.
JL: So where do most people who execute this type of strategy makes mistakes?
RB: They make mistakes in not cutting losses and managing positions in a timely and effective manner.
Just one little side note, back to your last question…I had a mentor who was doing this who kind of took me under his wing. That’s kind of where you know I learned on the job, but going back fifteen years when I first started it wasn’t that I was all on my own. I had someone who was doing this for many years prior. He absolutely was one of the largest retail accounts at Goldman Sachs who was doing this strategy and he kind of took me under his wing and looked over my shoulder and coached me, so maybe that gives you a little better explanation.
JL: OK. The biggest mistakes would be not cutting losses, not managing positions…
RB: Right. When you’re a trader, you have to have trading discipline and I think the biggest mistake that people make is not adhering to their trading plan and their trading discipline.
JL: So you’ve been doing this for fifteen years. What did you do before that?
RB: Prior to starting this strategy, which really I started for myself, friends and family and really I run it as a small business. It’s not a huge, big hedge fund. But prior to that I was very involved in many different entrepreneurial ventures in and around the Tri state area when we lived in New York. Some of them were entertainment related. So it’s kind of interesting that Justin got involved in show business. (Note: Blau’s son Justin is DJ 3LAU) …As you’ve heard his story. My hope would have been that he went into finance at least initially, but now I’m thrilled about what he’s doing.
JL: What’s your outlook for the market this year and are there any big themes that you’re looking at?
RB: “For me, the decisions that I make primarily are based on technical analysis more than fundamental analysis although when you have these Greek votes and these debt ceiling dates and all these kind of timelines certainly have to get factored in. For me, I’m looking more at volatility so you know right now the volatility is multi-multi-year low.
JL: Right, the VIX.
RB: You’ve got the VIX and the VIX is very low. The VIX is very low because, you know, yes it’s directly related to central banks printing money and this general sense that government’s will interfere with the markets in anyway that they can to kind of stabilise things and that has kind of eliminated a lot of the fear prospect. But that will change.
Over 15 years there have been these kind of periods. And if you look back kind of at a chart of the VIX over extended periods of time you’ll see that when you start getting down to these 12, 13, 10 kind of levels, at least over the last 15 years, look what happens next on the chart. You know the chart is, the VIX is shooting up. So something is going to happen.
We don’t know what it is if it’s going to be a war, if it’s going to be Bernanke when they stop printing $85 billion a month of money maybe that’s…Something’s going to happen and the volatility will increase. It won’t stay at this level and that’s really what I’m looking at…
JL: Since volatility has compressed recently, is it more difficult to execute they type of strategy?
RB: Well I would say that through the course of the year as volatility moves up and down there are better times and worse times… So yeah it’s a little tougher right now, but you never know what’s right around the corner. Usually you get enough cycles through the year…There’s enough opportunities throughout the year cycle where I will be able to achieve my desired goals.
JL: Thank you so much.
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