Friday, October 05, 2007

Future Planning: Hedging the Solution Space

NOTICE: The following is not financial advice, and is solely my opinion. If you follow the plan laid out below you will probably lose money. In fact, by following this plan, I hope to lose money. By the end of this post, hopefully, you will understand why.


I tend to think that we are on the verge of a global economic and societal collapse driven by diminishing marginal returns on civilization’s investment in complexity—especially by the declining availability of surplus energy. I don’t think that this will result in a single, catastrophic collapse event, but rather in a slow, grinding decline that is masked by epiphenomena and the confusion of symptoms and causes, effectively negating our ability, as a society, to muster the will to take effective mitigation measures. I also think that there is a reasonably high probability that I am dead wrong. I don’t have a crystal ball—all I can do is attempt to project trends into the future, and guess at the outcomes of our massively non-linear planetary-societal system. Humans tend to have a very poor track record at predicting the long-term future—why should I not be subject to the same limitations? After all, conventional wisdom says that things will keep on much as they always have, that we will find a way to overcome. Here’s the grand challenge: if individual or societal plans for the future focus only on collapse, or only on continuation of the status quo, then the high probability that the alternative occurs will be catastrophic. Further complicating matters, there are certainly more than two possible future scenarios. How does one hedge against the multi-dimensional future solution space?

I am beginning this discussion with the assumption that none of us know what the future holds. We can, however, identify possible future scenarios. Not all of them, of course. Rather, I am proposing a “future solution space” methodology that uses current trends or indicators as dimensions. Then, based on my belief that risk is mispriced (based largely on continued reliance on variations of the Gaussian-derived Sharpe Ratio for portfolio risk management and Black-Scholes method of option pricing) and that returns for options on extreme price movements are highly scalable, it should be possible to hedge against movement in any vector in the future solution space simultaneously. Let me offer a simplified illustration:

Oil/Dollar/Dow solution space:

Here is a solution space with three dimensions: dimension 1: NYMEX Crude Oil rise/fall, dimension 2: US Dollar rise/fall, dimension 3: Dow Jones Industrial Average rise/fall.

These three dimensions are an extreme simplification of the possible sets of future scenarios, but are useful as an example and because it is relatively simple to hedge against extreme movements in any direction from the status quo through out of the money options on established futures exchanges. In fact, I think that a multi-dimensional hedge can effectively address this solution space with only 3 options: crude oil call option (betting on extreme rise in price), dollar put option (betting on extreme loss of value), and DJIA put option (betting on extreme loss of value). As a hedge, this set seems to address most of the risk scenarios where a “conventional” investment in a career and home won’t pay off. Can you describe a scenario where one of these three options doesn’t pay, but the economic status quo doesn’t continue? This simplification isn’t meant to address sudden collapse scenarios where the markets simply cease functioning (an identified weakness, which we can also hedge against). But I have a difficult time explaining in advance how the economy could collapse while none of the following—spike in crude oil, drop in the dollar, OR drop in the Dow—occurs. Under most scenarios, at least one, probably two of the options pays off (e.g. Dollar drops causing a spike in the price of dollar-denominated oil but a rise in the numerical value of the Dow).


Sudden Peak: Oil prices will spike. IF they spike sufficient to cause enough demand destruction to actually fall, that will cause the Dow to collapse. It will likely be accompanies by either high inflation (dollar collapses) or deflation. While deflation is also possible, that would cause the numerical value of the Dow to collapse. Not perfect, but nothing is…

Now expand this multi-dimensional hedge beyond purely financial market considerations. Accept for a moment that the above hedge system is a perfect hedge against any movements in the financial markets (it is not). What could still cause it to fail? Two thoughts immediately come to mind: 1) collapse/conflict is so sudden that markets shut down completely, or 2) popularist laws are enacted that negate the hedge, say by penalizing people who “exploited” the dramatic market swings through options. Under scenario 1, the classic survivalist advice along the lines of “beans, bullets, and gold” may suddenly prove extremely valuable. Under scenario 2, hedges that operate outside the purview of established exchanges may suffice—again, perhaps gold or silver coins. Moving beyond the fixed game-rules of financial markets makes defining and addressing the future solution-space far more difficult, but no less necessary.

Of course, these are intended as hedges AGAINST the continuation of the status quo. You still need a viable plan if things continue as conventional wisdom suggests they will. So, here is a potential outline of a “complete” future plan. It also happens to be what I am presently doing. It is certainly imperfect, but its imperfections should be illustrative:

1. Job for the Status Quo: invest in/prepare for a job that will pay well under the status quo. Personally, I’m studying law, even though I already have a “good job.” I find it fascinating and actually enjoy the area that I hope to be working in—litigation/appellate work with a subject matter focus on energy law. That said, law is probably a terrible choice for most people, but I have been very fortunate thus far in that things are working out according to my master plan:) —as general advice nursing or engineering seem the most prudent. I already have an engineering degree, but I want to be involved at the nexus of anthropology, politics, and the future of energy (an odd combination, isn’t it?), so I have chosen law.

2. Plan for a resilient and flexible “End Game”: I hope to continue to practice law in a capacity that I enjoy for the rest of my life, but I certainly want to be in the position that this is a choice, not a requirement. Therefore I plan to invest some of my income in creating a flexible and resilient “end game”—for me, this is a sustainable, self-sufficient home for my family that will excel in future roles as disparate as a vacation home, retirement location, or a survival retreat. This will be my principal investment, as I think that it will most effectively hedge against the vast majority of scenarios for which there is no effective market hedge.

3. Financial hedge: If the economic status quo continues, the home described above will become my version of a 401(k). If not, my financial hedges are intended to ensure that I can still complete that plan. I plan to follow a variant of the oil-dollar-dow hedge described above—at least until I can think of a better system. I currently have long-term call options on oil and short term puts on the dollar. I think that an investment of roughly 5% of my income will be able to effectively hedge against most financial catastrophe.**

4. The Black Swan: While I think that this future plan effectively hedges against many possible future scenarios, and will increase the probability that I achieve my goals under a variety of scenarios, it is important to recognize that there is always the possibility of something totally unexpected happening that will derail all of these plans. That probability is likely much greater than most people anticipate. Some investment in stored food and water, gold, etc. is probably a prudent way to hedge against at least some unanticipated dimensions of the future solution space. Like a far out of the money option, investment in a few gold or siver coins or a shotgun is a small price, probably won’t be necessary, but has a highly scalable value in certain possible futures. A broad base of knowledge, fitness, and health may be even more valuable.

My intent here is not to slide into self-help or prophecy. Rather it is to suggest that, if you think you know exactly what the future holds, you are probably deluding yourself. If you are not preparing for multiple contradictory future scenarios, then you are not preparing but gambling. What is the optimal hedge—the simplest, cheapest, and most complete coverage against radical departures from the status quo? I’ve proposed the following set: crude call options, dollar put options, Dow put options, 30 days food and water and a shotgun. Call it a future first-aid kit. My proposal is only a starting point, and certainly imperfect. How can it be improved?

It is also worth pointing out that such a hedge is only viable if it helps to achieve a future end-game vision that functions under both the status quo and collapse. In some Mad Max future, 30 days of food and a shotgun is a start, a broad base of knowledge is even better, but the point of the hedge is to get ensure existing plans come to fruition. Taking out a loan now to create that end-game vision in the near future, and then hedging against scenarios that would make you unable to repay that loan over the long term might be (contrary to “conventional wisdom”) more prudent than saving to get there some day…

**This financial hedge is, unfortunately, a bit more complex than simply buying one of each of these three options. For now I’m not going to delve into the intricacies of coordinating the strike prices and expiration dates of multiple options necessary to create a smooth hedge against risk through time. The general advice, though trite, is that if you don’t understand how to invest in options, you shouldn’t invest in options.

Parting question: I think this is a viable methodology for creating an individual plan of action. Can it be extended to a broader, societal plan? Financial hedges tend to be zero-sum in nature, so can't serve as the basis for a societal hedge--would any societal hedges necessarily pay "fair value" for risk, and therefore make hedging against multiple, contradictory future scenarios impracticable??


james said...

How far out are the expiration dates on these crude call options you are buying? It seems they are rather thinly traded more than 3 years out ... ideally I would like to buy ones that expire something like 5 years out. I've been looking for quotes here:

but feel free to let me know if there is a better place to find quotes for these.

Tom Konrad said...

I totally agree that the essence of preparing for the future lies in acknowledging that we don't know anything for certain. Knowing this, the best hedge against the future is to have flexible skills and an adapable mind... and to minimize fixed obligations susch as debt. This gives the felixibility to react to novel situations productively.

However, the derivatives that you are choosing to hedge your financial risk have an essential weakness that the last commenter hinted at... they all expire. If the housing bubble and the internet bubble have taught us anything, it is that the markets always do what they should, but never when (I was about 3 years too early predicting the demise of both.)

Hence, relying on financial hedges with expiration dates has a serious weakness. My chosen hedge is always the stocks of companies that I feel will profit from the various sort s of adveristy I think might happen. Rather than oil futures, you can buy a portfolios of companies that will profit as oil prices rise: public transit, batteries for hybrids, etc. (for more ideas, see my website

Other risks can be dealt with similarly, and without an expiration date.

The other advantage of stocks over futures as a hedge is that it is not a zero sum game: investing in profitable businesses which will profit more if the disaters we forsee come about helps everyone, not just the investors, by helping to prepare society for those same disasters.

Jeff Vail said...

I think the expiration problem is an excellent point. My preference for options is that the return is more scalable to the degree that it is realistic to take opposing bets on the same position--something I may end up doing with the Dow and dollar.

For now, oil options trade 5 to 6 years into the future (depending on time of year) with sufficient liquidity. I have a variety of oil calls ranging out to 2011, and (assuming I stick with this strategy) the plan is to continue to purchase these on a rolling basis. Other futures, and hence options on them, seem to be much shorter term, so my plan is to roll much more frequent and further out of the money options on the Dow and dollar. We'll see how it works out.

My concern with investing in stocks as a hedge against these future events is that I have yet to find a company that I like for its ability to grow profits in what I envision as the worst case: a rapidly contracting economy where no alternative energy solutions provide sufficient EROEI to buoy against the general collapse. I think that under such circumstances betting on a dropping dollar or Dow and rising oil will be more effective. In any scenario where enough companies (of the alt-energy type, for example) thrive to prevent my hedge-set from paying off, I think my career will provide well. That said, I think that an investment in alternative energy stocks is an excellent investment as part of the planning for what I now consider the status quo (I just don't like it as a hedge as much).

Of course, none of that addresses the zero-sum game issue of options on futures. I'm thinking of these hedges from an individual perspective at this point--much like a life insurance policy that is admittedly zero-sum. I don't think that it prevents "investment" in building community, working to mitigate the effects of peak oil, conservation, etc. For the time being I am not optimistic about the ability of humanity to actually take the actions necessary to prevent serious problems--localization, conservation, a fundamental shift away from growth-based consumer economy, etc. Maybe it will all just work out, I just doubt it...

james said...

What I especially like about crude call options is that they are a hedge against both a spike in oil prices and a fall in the dollar. In fact I am a bit puzzled by why one might buy both crude calls and dollar puts, since to my mind the crude calls allows you to place one bet on two horses.

That said, who knows when a dollar crash will happen - whereas the writing seams to be on the wall re oil IMHO. So I also intend to buy (more) stocks in companies that will "grow profits in what [Jeff] envisions as the worst case: a rapidly contracting economy where no alternative energy solutions provide sufficient EROEI to buoy against the general collapse" - namely, those of Schlumberger and other oil&gas services companies.

My research leads me to believe SLB/RIG/etc are the most leveraged against the price of oil and thus will see their stock prices rise the most. Secondly, I think they will be less at risk for nationalization or windfall tax expropriation than will Chevron/Devon/etc. They also provide a hedge against a fall in the dollar, albeit a less leveraged hedge than call options.

Tom Konrad said...

Here are a couple secotrs which should benefit from a massive oil price rise:

1. Rail transport
2. bicycles

These also have the benefit from not being subject to regulatory rick associated with greenhouse gas emissions, nor do they have problems of the zero-sum game type.

Anonymous said...

Wonderful stuff, Jeff.
I really appreciate your take on things; your parting question is a good one, and I respond with a "middle way" proposition:

Investment in community.

I think that 21st century Americans are fatally lacking in one of the most fundamental attributes to the human condition that has been integral in our development and survival over the millennia:

Close-knit, mutually beneficial relationships and common ground with a tribe / group of friends and family.

I think that while online blog groups of like-minded individuals is great, it is paltry in comparison in every way with actual flesh and blood, sweat, and tears relationships with folks you can trust and depend on.

Thus, I would posit that the ultimate hedge is investing not only in individual safety nets and resiliency plans, but also in community, here and now, with a discerning and strategic eye to the many possible nefarious outcomes we all face.

We're all in this together...we should make the best of it, for ourselves and for all others, that we can.

Peace and best wishes.

Eric said...

Because this is a personal solution and not a societal one, this strategy could be extremely damaging. The worst contributors to our energy woes (say, investors in major oil and gas companies who lobby tirelessly against alternative energy sources) are also the most likely to be hedging against the economic collapse, using this strategy or another one. So, they're not in the sinking ship with us, even as they drill holes in the bottom.

If we assume there's an escape hatch (and I'm sure there are countless ones that ordinary folks don't have access to) we can logically expect the existence of anti-social economic actors.

Ryan said...

The best test for if a solution could be feasible if adopted on a grand scale is this simple test:

"What if everyone did what you are proposing?"

What if everyone (or at least a large amount of people) decided to buy a call option on oil? One effect would be the increase in price of those call options, (basic supply and demand), so it can become a self-fulfilling expectation, at least to the early adopters of the strategy.

Would such actions hasten the very crash that we all hope doesn't happen? If markets are built upon expectation, I can't help but think that the quickening would occur.

Jeff Vail said...

I think that if everyone bought oil call options to hedge their personal exposure, then, because of the ability to arbitrage oil today to meet future obligations, today's price would rise. Dramatically. That would force the issue of "alternative" energy sources in the immediate-term, so we would quickly find out that either a) renewables are viable, or b) we're going to crash, so we had better make the tough preparations now. Well, at least that's the optimistic way to look at it. The pessimistic way is that it would force a rush to coal and coal-to-liquid in the near term, exacerbate global warming, and accelerate the upcoming resource war schedule. Not so nice. Fortunately, if there is one thing I'm quite sure of, it's that everyone won't follow my advice!

Joel said...

My ultimate hedge: Neighbors I know, and can rely on.

Isn't there some old Jewish proverb about a good name being worth more than silver?
(edit: it's 22:1, according to Google)

A vigilant neighborhood is also worth its weight in hot lead. And a few of them are much better at growing food than I am.

Lastly, it isn't a zero-sum proposition: I can offer a lot to them, too. And this mutual benefit will accrue in any scenario I can imagine.

Tom Konrad said...

I just went into more detail on my own peak oil hedging strategy on AltEnergyStocks. I started thinking about it because of this article... Thanks Jeff.

Anonymous said...

Oh yeah, you might want to hedge on getting your appendix removed before the fall.


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