“We found that by reducing our risk exposure a [little], we could decrease our overall risk a lot,” Black says. The new approach evened out their returns and even allowed them to earn profits in dangerously volatile months for pure option writers.
“We didn’t have any 6% to 7% months; however, we didn’t have any down months [in 2012]. There were a couple [of] months that we might have had a loss, but with our long positions we ended up making 0.5% or 1%,” Black says.
“Most of our profit comes from collecting premium,” Dean adds. “The long side is overlaid for risk management and incremental [profit]; some months it might be quite a substantial portion of our profit.”
The other change involved ITB reporting returns based on the monthly option expiration cycle instead of the calendar month.
“We were finding that between options expiration day and the end of that calendar period, we were making trades to protect our profits for the month,” Black says. “If we had a good month going into expiration and volatility picked up between expiration and the end of the month, we found that we were making short-sided trades only looking out to the end of the month to protect profits or reduce losses.”
Those trades hurt the program, increased the program’s trading frequency and, subsequently, its costs.
ITB has decreased its trade frequency by 50% since moving to the option expiration cycle. The reporting change also dampens the volatility of the program by allowing it to not be subject to frequent erroneous settlement prices, according to Black.
The changes produced the best performance in the seven-year history of ITB, which now manages $170 million in three pools and a managed account program, which all trade in a similar fashion.
“We are not trying to hit home runs every month; we are just trying to make a decent profit,” Dean says. “We just dialed down the program somewhat; part of that has been through less aggressive selling and a little more aggressive buying to hedge risk.”