Are option writers due for a fall?

Option writing has always been a professional’s game and every so often a spike in volatility could even wipe out a so called genius trader. Now not only are there dozens of smaller commodity trading advisors (CTA) using this strategy but more and more retail traders have discovered the benefits of option writing.

Whether it’s the simplicity of the strategy that makes it easier to understand than those based on complex computer algorithms or that investors simply like being on the side of the “smart money,” more and more investors have exposure to option writing.

Numerous studies show the vast majority of options expire out of the money, meaning sellers of options collect their premium and go home. But for those who take the leap from there to the idea that it is always better to sell options than to buy, they are making a mistake. Options sellers win more often because they are accepting unlimited risk; option buyers pay a premium for limiting their risk.

Trading programs based on collecting premium can be compared to selling insurance: it can be a lucrative business but you better have a good reinsurance plan when the hurricane hits.

Greg Jensen, vice president of Spread Trading Systems (STS), which provides options education to individual traders, has noticed more retail traders are writing options. “It is an easier concept to understand,” Jensen says.

He says having more people in the market is always helpful but notes some retail traders may be in over their heads. “Because it is an easy to grasp reward, people don’t look at both sides of the equation. It is a strategy that is much more difficult to apply in the real world.”

Despite its growing list of followers, many traders believe the next blow-up is always just around the corner with this strategy and prefer to avoid the strategy even when it proves successful through several years.

“Option writing is something I feel uncomfortable doing unless it is a covered call because you don’t have a measurement of your maximum loss,” says Jay Feuerstein, managing partner of Xenon Capital Management. Feuerstein acknowledges the success option writers have had throughout the past few years but he can’t get comfortable with the strategy. “It has been a great run but I don’t like strategies where I can lose more than I can make. I like having convexity in my favor.” He refers to the strategies’ tendency to provide a steady modest return stream until a spike in volatility causes a severe drawdown. See “One step forward, ten steps back?” below.

While some people will never be comfortable with the strategy, others say now is a very dangerous time. Option writers sell volatility. They have been successful because volatility in the equity markets (the vast majority of option programs trade S&P 500 options) has been shrinking for more than three years. While that provides a good environment for option writers, it also means that to gain the same premium, they must sell options that are closer to at-the-money.

There are various ways traders can seek more protection: credit spreads, stops, buying the underlying, rolling further out; but on a value basis, they are on the wrong side of the market.

Emil van Essen, president of Van Kar Trading Corp., also has reservations about the strategy despite managing an options program. “When I was at Prudential (15 years ago) we had software that would run options strategies. Pretty much all strategies in options didn’t work except for buying low volatility and selling high volatility. [When] you were continuously writing you would go through these periodic blowups,” van Essen says.

Volatility in the S&P 500 has plummeted in recent years. Value investors would compare premium collecting in this environment to selling soybeans below $5 per bushel or buying crude oil above $70 per barrel. You could be right but history is not on your side. “If guys are writing options during high volatility periods it is a very good strategy and it works well. The problem is when volatility gets low they don’t have the option of telling their investors, ‘hey I am going to be on the sidelines for the next 12 months, just hang with me.’ So they start writing options closer and closer and getting less and less premium and then boom the volatility reverts to the mean like it always does and they lose everything,” van Essen says.

Of the 52 options programs listed in the Barclay database, more than half of them were created in 2003 or later. Those managers have seen smooth sailing. Several programs were wiped out following spikes in volatility in 1987, 1997, 2000 and 2001.

One exception is Max Ansbacher who has run his option writing program since 1990. Ansbacher wouldn’t say it is a more dangerous time though he does say shrinking volatility makes it more challenging.

Ansbacher agrees that options writers need to write options closer in to earn the same premium as several years ago, but adds, “That is offset to a large degree by the fact that the market is less volatile. In 2000 you could sell an option 200 points out-of-the-money and the market could be there in two weeks; with the market we had recently it is very unlikely to move that far.”

He acknowledges that an event like 9/11 may be particularly challenging in today’s market but adds, “If some event like that occurs, it has to start wherever it is now and go up from there and maybe it won’t go as far as it would if the Vix (a volatility measure for the S&P 500) was 40 in the beginning.”

Event risk

One of the warnings being sounded about these strategies involves event risk. Any major event like what occurred on 9/11 has the potential to create a huge spike in volatility.

It happened on 9/11 and many option writers lost money, but the Vix on Sept. 7, 2001 was 30.99; at the end of April this year it stood at 11.59. Traders were in a much better position to handle volatility than they are today.

“When you have been writing options as overall volatility has come in, you look really smart. The problem is that things don’t go that way forever. Options writing tends to make you a lot [of money] for a lot of months, and all of a sudden you can give back everything in that one month when something unforeseen happens,” Feuerstein says. “The distribution of market returns is fat-tailed, and that doesn’t help option writers.”

He says in a benign market environment with the world in sync things would continue apace. “Look what is going on in the world, you have a scarcity of energy, you’ve got the Iranian nuclear issue, the continuing war in Iraq, you have a rebalance of global economics with the growth in China. I don’t know if this is going to be the time in the world where things go quietly along their merry way.”

Van Essen agrees there is more risk now. “My experience with options is that it is like a coil that gets coiled in, coiled in, coiled in; the tighter it gets the bigger the explosion.

The years 2000 and 2001 were extremely volatile. “If you look at the Vix, it was so high they could write options fairly far away and not worry that much, but now volatility is down,” van Essen says.

Defensive action

Shrinking volatility means less opportunity and option writers must accept that and not try to match their performance with more volatile times because that would mean taking on more risk.

Daniel J. Bennett, president of CTA Daniel J. Bennett, has altered his program for collecting premium in the S&P 500 options to today’s environment. In the past Bennett would write naked options 30 days out and write credit spreads further out. Now he will stretch his time horizon to 35 to 45 days but be covered. “Still short-term options but now with a little less risk; a little more protection because we are having to come in just a little bit closer,” Bennett says.

“The amount of margin you have to put up on the call side to collect any kind of reasonable premium is not worth doing. [In the S&P] a 1415 call with 30 days to go is 100 points out [and] going for $50 bucks. The margin on that call will probably run you $6,500. So you are going to margin $6,500 to make $50 less cost!”

Bennett wants to collect at least $300 on each option he writes. Today to collect $300 on a call he would have to write it 50 points out-of-the-money. “Could S&P move 50 points higher in 30 days? [It sure could],” Bennett says adding, “The margin will run you $12,000 to $15,000. You have a slightly more than 66% chance of winning. I wouldn’t do it. I want something with a 95% chance of winning. If the market is at 1315, I want to go out to the 1450s and there is nothing there.”

He adds, “We are having to do more credit spreads on the shorter term options. We modified. As the market has modified so have we.”

Although both Bennett and Ansbacher have produced double-digit returns the last few years, their returns have dropped and they are prepared to accept lower returns rather than increase risk.

“We are not going to increase our risk profile to chase returns. We made that decision. [Returns] may be somewhat lower but our clients are pretty happy with them,” Ansbacher says.

Bennett says a manager of an option program would be insane to try and match the returns that were possible a few years ago. “These people who are trying to match returns of four years ago are having to assume far more risk. If you are doing the same thing you were five years ago, there is an issue. They will get spanked.”

While option writers have had to make adjustments, and returns are down slightly, they say it would be a mistake to wait for a spike in volatility to get in. Michael Mullaney, president of Mullaney Investment Management, says depressed volatility levels can last for several more years.

“To proactively try and anticipate it is a mistake. This could occur for another seven years. The amount of profits you can make for the next seven years will dwarf the losses that would occur in year eight,” Mullaney says.

Bennett agrees that volatility can remain depressed for years but says managers shouldn’t overextend themselves. “We don’t push the envelope. When the market says we can push the envelope we do. Right now with volatility at 11%, it is damn tough.”

Ansbacher points out volatility doesn’t necessarily have to spike, it could move back up gradually. “The market has been calmer; now that will change at some point, and when it does option writers will have losses. But from there on you will be able to take advantage of the higher implied volatilities.”

Competition and capacity

It used to be that only market makers and a few highly sophisticated traders sold options. Ansbacher says, “We were virtually alone for many years and now we have a number of other people out there.” Bennett has also noticed. “Option writing has exploded. When we started there were not that many option writers, nine years later everyone is doing it,” he says.

Could the fact that there are more speculators competing to sell options have an effect on lower prices? Bennett says it could. “Volatility is based on markets but as far as depressed option pricing, yes, the depressed option pricing could be directly related to the number of participants,” Bennett says.

Jensen agrees the increased number of speculators competing on the short side of options is affecting the price. “I don’t think you will see the Vix at 50 again.”

Ansbacher is not so sure. “The primary driver of the option prices is the volatility of the market, that determines the implied volatility. The fact that there are a number of programs writing options, it is not an overwhelming size that it has affected the market.”

Nor does Ansbacher think the strategy is oversaturated as convertible arbitrage became last year. “We are not at the point of where convertible bond arbitrage was a few years ago. The biggest majority of convertible bonds were owned by hedge funds. The options are just a small add on to the volume of S&P futures. We are tied into the S&P futures market, which is huge.”

Measuring risk

One problem with analyzing this strategy is, because of its unique attributes, some of the common risk measures do not apply. Professional allocators and investors like to rely on Sharpe ratio as a measure of risk but the Sharpe ratio is particularly ineffectual when it comes to option writers. A Sharpe ratio above 1.00 is viewed as excellent and a sign of a low risk program.

Sharpe ratio measures return relative to the standard deviation (STD) of the program relative to the risk-free rate. Option programs that have been trading since 2003 routinely produce Sharpe ratios above 3.0. “These are measures which are going to look great as long as you remain in a narrow range.

In an option writing program, when it works, and you are just collecting premium, there is not a lot of up and down movement,” Feuerstein says.

Van Essen says, “Unless a guy has more than a five- or six-year track record, the Sharpe ratio is a little misleading. The model isn’t seeing the risk so we have to add that in. The survival bias in option writers is massive. How do you measure option writers when the database wiped out 80% of them?”

Sol Waksman, president of CTA database Barclay Trading Group, agrees that Sharpe ratio is not a reliable measure of risk for these types of managers. “The problem is that options writing can go long periods of time without being faced with significant volatility and then get it all at once.”

Volatility spikes occurred in 1987, 1997, 1998, 2000 and 2001. But at those times volatility was higher so option writers were not as vulnerable as they are today. Volatility has been shrinking since 2003, so any program started since then will not show, based on return, how it would handle a spike in volatility. “You cannot get a realistic picture of a manager’s ability to handle adverse conditions when all they have been exposed to is positive conditions,” Waksman says.

Feuerstein says confusion regarding real risk could add to a manager’s problem in a spike. “It is not just a matter of the trading strategy having a blowout but it is also investors with some pretty big losses saying, ‘get me out! I thought this was a low-volatility-consistent-go-to-sleep-at-night-money- under-the-pillow strategy. How can you have a drawdown like this?’ Then you have more problems because people are pulling out of the market and they have to buyback the shorts they have in the options even more.”

A better way?

The question then is how do you measure the risk of an option writer? Feuerstein says to look at value at risk. “Take current positions in a portfolio and stress test it for one, two and three STD movements away from the current mean and then you look at what the return would be on your current portfolio.”

Feuerstein explains the idea is to know what would happen in an extreme case. “Look at the past one-year and three-year movements in the portfolio. Look at what that range would be of the underlying security during that time period. Compute what a three STD move would be in the underlying and then compute what the option would be worth should that happen instantly.”

This is important because things change. “Know what you could possibly lose in a day should you have a hundred-year storm,” Feuerstein says, adding, “Every time somebody says ‘it will never happen again’ or ‘things have changed, this is a lower risk world;’ that is when they are due.”

A new tool to manage risk

Option writers have a risk management tool that was not available to them in any of the more recent volatile markets. Traders can actually trade volatility. The Chicago Board Options Exchange lists a futures and option contract on its volatility index (Vix).

Vix futures and options can offset the dreaded spike. “They still have to deal with gamma (price risk), but this gives them another tool. A tool for handling Vega,” says Dominic Salvino, a designated market maker for VIX futures and options at CBOE.

“This is a way to hedge some of that exposure,” Salvino says.

Bennett has not used the Vix futures but sees its potential. “I never considered buying a volatility index to offset risk in equity options but it seems like a natural thing.”

Feuerstein says option writers should use the Vix to hedge risk. “Absolutely buy some Vix options against it.”

Conclusion

Certain strategies perform better in certain environments. While the environment for option writers has been good, volatility has shrunk so much that managers must assume more risk to equal past returns. If an option writer’s returns have not shrunk in the past two years, that may be an indication he is taking on more risk and is more vulnerable if a spike in volatility occurs.

Even the strategy’s critics acknowledge its ability to produce solid returns in the right environment. “I am going to wait for implied volatility to get to more normal historic levels. Right now they are selling something cheap, that doesn’t make sense,” Feuerstein says.

Van Essen is also sitting out. “If some of these guys had a 40% to 50% drawdown, and it didn’t kill their psyche, I would definitely invest in them. Just wait for those blow-up markets like [in the] 1987 crash or the 1997 thing or periods like 2001, when the premiums where way up there. Wait for that and start writing options.”

If a qualified trend follower has earned extremely strong returns throughout a recent period, it is best to wait for a drawdown to make an allocation because the manager is holding a lot of open equity in his program.

Likewise it may be prudent to wait for an increase in volatility before giving an allocation to an option writer. Or perhaps look to option writers who diversify into other sectors. But as our option writers noted, the low volatility environment could last for a while and volatility could begin to rise gradually rather than with a huge spike. Volatility will increase and many of today’s option writers could face the type of blowups previous managers have. It is a strategy that has proven itself. But based on a pure value investing strategy, you would have to say that on a portfolio level you would reduce exposure to option writing in today’s current environment.

There are too many managers who have produced strong returns throughout several years to dismiss the option writing strategy out of hand. But it is a unique strategy that has unique risks that have to be understood. Options writers do tend to blow up. But as opposed to trend-following managers, their risk cannot be measured as easily. To truly measure a manager’s risk you have to see the program go through a spike in volatility. You must ask yourself what would happen to your position if there is a huge spike in volatility.

About the Author

Editor-in-Chief of Modern Trader, Daniel Collins is a 25-year veteran of the futures industry having worked on the trading floors of both the Chicago Board