He began a study of volatility and decided to move away from pure premium collection. “If you are strictly a premium collector, you have a couple of issues. If you collect $2, then $2 is the best you can make if everything goes right. Second, if that is the only way you can make money, then you often are tempted into doing a collection trade when the edge is not with you,” Walczak says.
What he discovered was a volatility trading strategy that could exploit rising volatility. “A simple example is you sell a front-month option and buy a back-month option. If you do that at a credit, you have the opportunity for the front-month option to decay in value or go away entirely and the back-month option still has value,” he says. “The secret sauce for us is in the placement. If you are correct with where you place these things, then you get the best of both worlds. You don’t just have residual value in that long option, the long option actually could explode in value while the short option goes away.”
The February 2007 wakeup call came enough in advance of 2008 for Walczak to complete his adjustments and earn 50% in 2008, a year that completely wiped out a number of option writers.
“We found that rather than trying to trend-follow price to the downside, it is better with options to trend-follow volatility to the upside,” Walczak says. “Usually those are two conditions that go hand in hand.”
While the volatility trading strategy helped diversify the program and turn 2008 from a potential disaster to a home run, Walczak still was having problems in sharply uptrending markets. “Those really caused us a lot of problems with the techniques we were using, so I spent a lot of time [on that] and in 2010, we [began] to do some trend-following price wise.”
They still were using only options and found they could exploit trends more safely this way. The strategy uses a wide variety of ratio spreads, butterflies and offset butterflies. “It is basically 1 x 2s, 1 x 3s, 1 x 2 x 1s, where you are buying one, selling two, buying one,” he says. “That allows us to put trades on for little or no cost, so if the market tanks we are not long the market. We don’t lose money, the trade just goes away.”
Walczak says, “It is not that we changed so much as we evolved: Premium collection, to premium collection plus volatility trading, to premium collection plus volatility trading plus upside trend-following price-wise.”
Walczak uses all three approaches but emphasizes the one appropriate to market conditions. “I can construct a spread that gives me the exposure I want. It is not a make-it-up-as-you-go-along [approach], we have established position templates for different types of market environments. If I want to go long volatility, I don’t scratch my head and say, ‘What do I do now?’ We go into our tool box and pull out the long volatility spread and do some analysis around where to put that on.”
It is a combination of a discretionary and systematic approach that has produced solid returns in different market environments. Harbor has had no losing years and has produced a compound annual return of 22.07% with a 1.22 Sharpe ratio, and Walczak is still making improvements.