Capping risk brings profits

Joe Reynoso, principal of Reynoso Asset Management (RAM) and the investment manager for the Reynoso Options Arbitrage Fund, says the institutional world is scared by triple-digit returns.

“If you’re earning 100% or more per year, they’re assuming correctly that you’re taking significant risks, which they may not want to pass on to their clients. In the long run, it’s better for us to be gaining a nice double-digit return on a much larger pie than a triple-digit return on a smaller pie,” Reynoso says.

This is one of the goals RAM tries to achieve by trading S&P option spreads. In 1997 Reynoso teamed up with Randy Hanebutt, a principal at RAM, who Reynoso met at the University of Chicago Graduate School of Business. Their options program has earned 15.47% in 2004, and it had a return of 16.62% in 2003. The largest drawdown was 9.5% in the summer of 2002. They now have $50 million under management.

RAM trades the relationship between historical volatility and the implied volatility of the option.

“Most of the time, maybe 80% of the time, the best stance to take is a short options strategy, dynamically hedged,” Reynoso says.

This strategy is based on the relationship of historical and implied volatility.

“Say that for $10 million we want to target 3% per month in options time decay,” Reynoso says. “The level of implied options volatility is higher than the level of the actual historical volatility of the product.... There are a number of ways you can do that. You can sell x number of at-the-money straddles, or x number of tight strangles.”

RAM typically employs a base strategy of simultaneously writing out-of-the-money put and call spreads on the same underlying instrument. The object in all of RAM’s tactical strategies is to identify pricing and volatility deviations from historical norms. RAM is never naked short options on the downside. Reynoso says they work with spreads to avoid liquidity crisis that can occur and they keep the delta neutral.

“You can put on the same profile by selling five spreads as you can by selling two outright options — you get the same Greek profile, the same time decay. What that does is it caps your risk,” Reynoso says. “Investors like to see the risk managed and capped at lower levels. So it turns out we have to put on a lot more options to achieve the same profile that we need.”

Reynoso says he chose options because it’s what he’s always traded and it’s what he knows best. Reynoso has been trading listed options 20 years and he says that makes him somewhat of a veteran. Reynoso worked at Chicago Research and Trading (CRT) during and after graduate school. At the time CRT was one of the preeminent options firms. He traded currency options there for about two-and-a-half years. Then he ran a small group of options traders as a proprietary trader at the Chicago Mercantile Exchange.

“Options are still enigmatic. A lot of people don’t understand them. There are not a lot of managed options strategies out there,” Reynoso says. “We thought it was a good niche.”

S&P options are the contract of choice for RAM because of their high volatility and liquidity. Reynoso and Hanebutt have lined up options on 10-year Treasury notes to trade next because of their liquidity. When adding contracts to their program, they focus more on liquidity than diversification.

Hanebutt says there are both positives and negatives to their strategy: “It’s positive because we have a unique product and the negative is that we often have to educate our investors along the way.”

With RAM, all orders are entered manually. There is no computer program telling Reynoso and Hanebutt to execute trades, but they do have a proprietary algorithm that tells them at what price levels to trade and how much size to put on.

“The program recognizes that having a short exposure to options is the most profitable stance most of the time. Of course, sometimes it pays to be long, and there’s nothing more fun than being long options and right, but that doesn’t happen that often,” Reynoso says.

For Reynoso, the summer of 2002 had extreme intraday volatility in the S&P. Reynoso said they studied their strategy and decided they could not have changed anything to avoid a drawdown, but their subsequently developed delta hedging algorithm would have reduced the loss.

“The program will make money most of the time, but nothing makes money all of the time,” Reynoso says. “This is what we do. We’re paid also to manage losses.”

RAM still made a profit in 2002 with a return of about 4%. They say one of main challenges in managing money is to have good returns but low volatility and lack of catastrophic risk.

“When you reduce your risk, you’re going to reduce your return. So you want to find the most optimal way to get the most bang out of the buck,” Hanebutt says.

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