One of the fastest growing managed futures strategies is also the one that comes under the most suspicion: option writing. The reason for its popularity is simple: it works. The reason for suspicion is equally easy to understand: there often are periodic blow-ups for option writers. The strategy seems to be getting greater respect these days but it still has its doubters.
It is this dichotomy that led us to ask more than a year ago: “Are option writers due for a fall?” June 2006. The answer was “yes,” but only for those who don’t use the proper risk management. While that sentence could be used to describe any trading strategy, the boom and bust cycle has been more closely related to the option writing strategy. Perhaps it is because of the large survivorship bias or the fact that there have been some famous managers who have gone down in flames. Either way, the strategy continues to grow, but this February there was an event that while inevitable, was one we haven’t seen in quite some time — a huge volatility spike in equities.
This is the scenario all option writing naysayers point to when criticizing the strategy. On Feb. 27 the Dow Jones Industrial Average dropped more than 400 points in one day. More important, the S&P 500 dropped more than 57 points. Because we discussed this possibility a year ago and seeing Futures has profiled some very profitable option writers in recent years, we though it would be a good idea to see how option writers weathered this storm.
OPTION WRITING
The concept is simple. Sell out of the money puts and calls (usually in the S&P 500), collect the premium and wait for the options to expire worthless. This is what happens more than 75% of the time according to a study done by the Chicago Mercantile Exchange in the late 1990s (see “Play the edge,” below). Of course, it is the other 25% of the time you must worry about and the reason why there are so few old option writing programs. There are as many varieties to option writing as trend following, but that is the basic concept. Some traders insist on being market-neutral, some write naked options while others insist on protection through credit spreads. While for the vast majority of option writers the worst-case scenario is when an option moves into-the-money. Futures just profiled a manager whose goal is to both collect premium and select options that will move into the money (see “Hansen: Being right even when wrong,” July 2007).
While there is this great variety, nearly all option managers had a difficult time with the volatility spike in February and March. The average return for option programs in February in the Barclay database was -3.91%, for February and March it was -4.52, with the majority of managers losing money and 16 with double-digit drawdowns.
One of the oldest and most successful option writing commodity trading advisors (CTA) is Ansbacher Investment Management. Founded by Max Ansbacher, the program has a track record dating back to 1996, encompassing numerous volatile periods. Maruf H. Khan Noorpuri, principal at Ansbacher, initiated a market neutral strategy in 2003. While the February-March period was rough for many options writers, Ansbacher got through that period relatively unscathed (-2.1% in February and flat in March). Khan Noorpuri attributes the program’s ability to navigate February’s rough waters and overall success to its methodology and low levels of leverage.
K4 Capital Management handled the February spike well, dropping -3.75% for the month, its first monthly drawdown since launching the program in May 2004. K4 President Barry Kosoris says “We had some options that came very close to- the-money and when it gets that close, I will buy them back and roll them out. The real problem was that it happened right at the end of the month so the drawdown was [worse] because we had to take that snapshot of options value right at the end of February. At the end of the month there is no time to moderate; you just have to move out of the way to more distant strike prices.”
After the spike K4 closed out 1385 puts in the S&Ps and moved them down to about 1320 for the following month’s (April) expiration. “It is generally true that the worst time to have to buy those options are also the best time to be selling them. If you wait in anticipation of the market dropping further you can end up just eating those losses and not having any way to recover them,” Kosoris says.
While rolling options further out of the money is a common practice for option writers when the market is moving against them, it can be dangerous. Raithel Investments Inc. prefers to take its lumps immediately rather than risking further losses. Raithel dropped 7% in February and 2.3% in March but is up year-to-date, after returning 35.73% in 2006.
“You want to make sure you can play another day,” says Raithel Vice President Bryan Raithel. The program uses stops and when their options get too close, they will exercise those stops instead of rolling them further out and risk additional losses.
“You have to have your get out strategy and you have to maintain it. You can’t let emotion take over. If you don’t stick with what you have and keep your emotions in tact, if you are doubling up, you are going to get whipsawed all over the place,” Raithel says. Kosoris acknowledges the risk to rolling out but prefers it to adding new calls in a downward market. “There is certainly a risk to rolling and its what the risk managers at the major brokerages are looking at. But when you roll out you gain quite a bit of margin and quite a bit of distance to the next put strike and you buy time to react,” Kosoris says, adding, “It is more dangerous to try and sell calls if the market is dropping hard, and [to] try and get your money back because there is a lot higher probability that it is going to whipsaw back and get your calls in trouble than it is going to drop another two standard deviations and get further out puts in trouble.”
Kosoris made some changes despite his moderate drawdown. “There is a certain point that I just won’t come closer-to-the-money regardless of what my formulas say. It has made me a little bit more cautious and [February] was a good wake-up call for anybody in the options-selling business.”
K4 could safely rollout and trade more options because it executes its trades electronically at fees of less than $5 per roundturn. “That really helped because our cost to roll in and out of options is low. I am not sweating and the clients don’t have to worry about paying an $8 commission and losing that on top of the option value.”
K4’s low cost structure helps two ways: it can afford to be further out-of-the-money and thus buy safety, and the low cost allows it to be more flexible when the strikes become too close for comfort. “It doesn’t bother me to sell calls that I am only gong to get $20 or $25 for because I am not paying much of a commission on them. And it does let me go farther out.”
RISK MANAGEMENT
Risk management is the key to any trading program and with option writing that may be more acute. Daniel J. Bennett is a long-time successful option writer. His basic strategy is to sell naked options, but after several years of lower volatility, Bennett Principal Daniel (Joe) Bennett began writing credit spreads a couple of years ago. Instead of writing naked strangles 30 to 35 days out, he would write credit spreads 45 days out. That way his risk was locked in. Bennett warned that managers who attempted to earn the same returns in low volatility environments that they were able to earn in higher volatility periods were taking on additional risk. “As the volatility waned they didn’t adjust. They are driven to make these returns by their clients and instead of using jurisprudence, they used bad judgment.”
Raithel also made adjustments. Their program has an algorithm that detects volatility and when it kicks in it puts on an additional hedge. “We call it the sniffer,” Raithel says. “If the alarm sounds we will put on the hedge. We do not predict, we react, if it says to do it we do it and that is part of the system.” The sniffer helped hold down losses after the February spike, he adds.
Khan Noorpuri says there is greater variety in option strategies than other styles.
“There is no restriction on selling an option, anyone can sell an option, but the profile of your risk will vary dramatically depending on which strike you sell, which month you sell, how many you sell, what you do after you sell it, what induces you to go from strike A to strike B, what kind of execution are you able to get [and] how are you managing your execution risk. The variations are dramatic so you could be a put writer and I could be a put writer but because we do it in slightly different ways, our risk profile and are results will be dramatically different.”
BAD NEWS/GOOD NEWS
When we examined option writing a year ago the market obliged us in May and June with a significant volatility spike (see “A tale of two spikes,” below). But instead of handing option writers their lunch, because the spike was relatively mild, it increased premiums and allowed option writers to earn better returns. While February’s spike was sharper and created more pain, the end result was good as premiums went up.
“We definitely got some money from people that were burnt in other places. We have some clients now who we know were licking their wounds and looking for either a safer haven or different program,” Raithel says.
Bennett notes: I don’t think things like that are good for anybody but as long as the ranges expand on the S&P because of uncertainty, that is what creates the volatility. He adds that the higher volatility allowed him to post returns of 8.8%, 3.4% and 3.75% in the three months following his 6.8% drop in February. “A good shock to the system gets the heart going again, that is all it was, like a couple of well-greased up paddles on someone’s chest and it woke everyone up,” Bennett says.
Kosoris agrees, “I have been trading options since October 2002 and client accounts since May 2004 and this (February) is the first time I have had a monthly drawdown. That week was no fun at all but looking back on it, it was definitely [a learning experience]. If you are going to sell options you need to go through something like that and know how your system and you are going to react to it.”
WATER IS FINE
One criticism of the current crop of option writers is that they have not been tested. For the most part volatility has been shrinking since 2002. In that same period the number of option programs have grown exponentially (see “The more, the merrier,” below). And for the most part it has been due to a relatively benign environment for option writers. That came to an end in February — at least temporarily — and managers who weathered the storm will use that to distinguish themselves.
“Now is the time to put money with option writers. If these people are sitting on the sidelines waiting for volatility to increase, here it is,” Bennett says.
Raithel says: We had a lot of [introducing brokers] tell us a lot of people got hit a lot worse. We are still in the top 10 [of our sector] in CTA performance. There were actually people waiting to see what a bad month for us was because we had 43 straight months of no losses. One investor in particular said ‘I was too afraid to get in, I was waiting for you guys to have a down month,’ that person got in after the February loss.
Khan Noorpuri doesn’t agree that the last few years have been relatively easy. He points out that volatility, as measured by the VIX, does not capture the risk of upside moves. “We are in the market, in our case, for short periods, selling short dated options.
If in a short period, like two days or two weeks, the market swings 5%, that is a very big move and if the underlying price of the option is not anticipating that, it is a very tough situation.” He adds that with option premium on the low side whenever the market swings quickly in either direction there is danger. “Up is equally painful as down.”
He adds that options are unique because of their versatility. “Most products don’t change in character; buy a bond, it doesn’t change except the fact that it is going to maturity; buy an individual stock, it doesn’t change; the option when you sell it, it changes continuously because the implied volatility can change. What the underlying does obviously changes and that affects the gamma and the other thing which is sort of a constant is the decay. It is a multi-dimensional product.
“The reason why option writers tend to make money is that the implied volatility, which is the price of the option, tends to be — not always — greater than the actual volatility, which is the change of what the underlying is doing. But there are periods, and this in when the problems occur, the spread between the implied and actual volatility gets compressed making the life of an option writer harder,” Noorpuri says.
Will volatility continue? To what extent the past few years has been easy or difficult for option writers aside, eventually there will be greater volatility and the spike in February gave potential investors a peek at how various managers may handle it.
This is important because many people see volatility on the rise.
“This thing can get very volatile in October,” says Bennett, whose proprietary analysis points to higher volatility in the fall. “My volatility model shows that on a longer term basis the volatility is going to pick up in the fall. That’s all you can say. You can’t say whether it is going to go up or down.”
Jon Hansen, principal of Censura Futures management, recalls a story of his mom making boysenberry jam. The boysenberry bushes would be covered in thorns and he would have to collect them. “You put your hand in there and just get hammered in order to get the berries and yet my mom had been doing it for so long that she would put her hand in there and come out of there with a stack of berries no problem. Option writing is a lot like that. You can really get stung, you can really get hit if you don’t know how to handle your risk but there is some great fruit there. If you can do it properly, don’t get greedy and manage your margin and your risk, then it is one of the best ways to generate consistent returns,” Hansen says.
Correction:
In “Commodity Indexes getting more complex,” July 2007, we misidentified Michael Magers’ company. He is with Barclays Global Investors. Futures regrets the error.
