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Option selling CTAs: 13 months after the volatility spike
April 21, 2008
For many stock index option selling CTAs, February 26th, 2007 is a day they won’t soon forget. Option selling CTAs were extremely popular in 2004, 2005 and 2006 as historically low volatility fed right into their short volatility strategies, creating consistent strings of small profitable months, with nearly no losing months. Zenith Resources, for example, had 40 consecutive winning months between September, 2003 and January 2007. Another, Diamond Capital, had just three losing months in as many years between 2004 and the end of 2006.
What’s not to like about that? Well, as they say, past performance is not necessarily indicative of future results. And Feb 26th, ’07 was the day “not necessarily” became a reality. Volatility spiked over 80% as markets around the globe sold off heavily with the Dow down over 400 points, or -4.2% and other markets following suit: with the Nasdaq down -6.2%, and S&P 500 down -4.4%. That spike in volatility sent the prices of Put options which the option selling CTAs had sold soaring, causing large losses.
When the dust had settled, there were losses nearly across the board for option selling CTAs. That type of quick, substantial move to the downside was just what the option selling CTAs had been betting against, and they caught got with their hand in the cookie jar, as the saying goes.
The Feb 26th spike has been marked with a yellow circle below.
What Happened Next?:
It’s always fun to look back and talk about a big up or down day, but what we’re more concerned with is what happened the next day, and the day after that, and so on. If this was a “shot across the bow”, so to speak for option sellers, how have they done since then?
As we said in our March 5th, 2007 newsletter: the lesson to be learned from Feb. 26th is that there is a option selling strategies - to the tune of one week losses equal to a few months of gains. And, that diversification into programs not involved with the stock market is always a good thing.
We also said it was a good thing these types of moves don’t happen very often, and that there was a silver lining in that the item the option sellers are selling - option premiums - had nearly doubled in price. The conventional wisdom holds that an option seller can do well during periods of higher volatility, as long as they survive the initial spike in volatility (Feb 26th).
We wanted to put this wisdom to the test by seeing how several of the popular option sellers have done since that fateful day, and you can find the results in the chart of the week below.
The results were encouraging, with an average gain across all 14 programs of nearly 10%. Compare this with an average loss of -5.87% in February ’07 for our sample group, and you can see that on average, the option sellers were able to recoup their losses.
We counted 14 option selling CTAs in our database who encountered losses in February 26th, many of whom also hit new maximum drawdowns at that time. Of those 14, 8 have been profitable since then (Mar 07 through Mar 08), while 6 have seen losses in the 13 months since Feb 26, ’07. Four of those six have seen losses of under 10%, while two of the six encountered larger, double digit losses and shut down completely.
What Lessons were learned?
- Lesson #1 – Option sellers survived. When looking at what volatility has done since Feb 26, 2007, it can safely be said that investors in option selling programs have pretty much been in the wrong place at the wrong time. The past 1.5 years has seen a spike in volatility not seen in many, many years - which was exactly what option selling programs were betting against. So it is to be expected that there would be losses in that environment, if not complete losses of capital (remember short options have theoretically unlimited risk). And we have seen losses, closed programs, and new drawdowns for option sellers. But we have also seen winners, and gains in spite of the tough option selling environment, which supports the idea that if you can survive the spike, you’ll be better on the other side.
Lesson #2 – It takes a while to gain back option selling losses. While there have been some programs which have bounced back very quickly, on average it took nearly a whole year for these programs to recoup the February losses and get comfortably back into the black. This makes sense, as option sellers are set up to risk large but rare losses in exchange for small but frequent gains. It can take quite a few of the small gains to make up for the large loss, and given that option sellers must rely on the time decay factor (which usually lasts at least a month), that can mean quite a few months. Often times, being successful over the long term with an option selling strategy means taking in as much premium as possible between those periods when a spike takes some of what you've been "paid" away from you.
- Lesson #3 - Not all option selling CTAs are created equal. While nearly all option selling CTAs were hit in Feb ’07, their performance since has varied quite a bit. Some have closed, some have gotten back in the black several times only to see more volatility bring them back down, and some have thrived in the higher volatility. The common theme among those programs which have not been able to get back in the black since Feb 07 is that they generally sell their options closer to the current market price than their peers.
Option sellers are essentially saying that they think the probability of the market moving a certain amount over a certain time is zero, and they are therefore happy to be able to sell that probability (which can be quoted in terms of volatility) at a level above zero with their assumption that it will soon be worth nothing.
The problem is, the actual possibility of the market moving that certain distance over that certain time is technically greater than zero. You’ve heard the old saying, anything’s possible. Well, we saw that first hand on February 26, 2007, as volatility doubled in just a few short days.
- Lesson #4 - The final lesson we can take from that “option seller scare” and subsequent year and a month of trading, therefore; is to expect the unexpected with option selling programs. The grand majority of investors are attracted to the allure of option selling strategies and their supposedly more consistent and smooth return stream. Statistically, short volatility programs are the obvious choice time and time again, with their higher monthly winning percentage, low volatility, and low drawdowns.
However - as we saw in real time with these 14 option selling CTAs in Feb ’07 (and more recently with the Ascendant program), that smooth pattern masks the hidden risk of a volatility spike. These short volatility programs have the possibility of high negative kurtosis, which doesn't show up in normal statistical measures like averages or standard deviations. In layman's terms, they have the chance (say a 10% probability) of large negative losses, while it appears beforehand from a normal bell curve analysis that the chance of a large negative loss would be something on the magnitude of 1/100 of 1%.
So, the last lesson to be taken from the volatility spike is to incorporate these possible “shocks” into your numbers. Add a losing month of -20% into the averages for an option selling program you’re looking at, for example, and see if the numbers still impress. They likely still will, and you’ll have added a healthy dose of reality in the meantime. For those programs who survived the volatility spike of Feb ’07 and the following 13 months, this exercise has already been completed. The “shock” has already been inserted into the numbers of the bulk of the popular option selling CTAs, making their averages and standard deviations more representative of what to expect in the future.
- Jeff Eizenberg
IMPORTANT RISK DISCLOSURE
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Feature | Week In Review: Stock Index Futures Stage Big Rally; Crude Hits a New Record High (Again) | Chart of the Week
US Stock futures had a big week on the heels of great earnings from tech heavyweights Google and Intel. Both corporations beat the street on the earnings side, while also upping their sales forecasts for the remainder of 2008. Not surprisingly, NASDAQ futures led the charge gaining +5.36% last week. SP futures also had a nice week posting gains of +3.92%, while Dow Jones futures lagged just behind at +1.67%. Smallcaps also had a nice week of trading posting gains of +4.26% in the Russell 2000 futures and +3.72% in the SP Midcap 400 futures.
The street’s other big story continues to be crude oil and another round of record prices. Last week May Crude Oil futures hit a new record high of 116.97 per barrel before closing just lower at 116.69 on Friday for a weekly gain of +5.88%. RBOB Gasoline futures also charge higher posting gains of +6.34% and with summer fast approaching it seems like drivers should get used to paying at least $3.50 per gallon in the US. Natural Gas prices are shooting higher as well with May futures gaining +7.29% last week, meanwhile Heating Oil futures continue to climb higher as well finishing up +3.23% for the week.
Other commodities on the move last week included the grains which saw Corn futures -3.10%, Wheat futures -2.86%, and Soybean futures -2.06% all move lower. Metals finished the week mixed with Gold futures -1.27% and Copper futures -1.32% moving lower, while Silver futures +0.73% and Platinum futures +2.13% climbed higher. In the softs Coffee futures +3.15% and Sugar futures +2.70% traded higher, while Cotton -2.59% moved lower. Finally in the meats Lean Hog futures +4.42% and Live Cattle futures +2.84% both posted nice gains.
Elsewhere, US Bond trading continues to be volatile. Treasury futures moved lower on the heels of the stock market rally with 10 Year Note futures losing -1.74% and 30 year bond futures dropping -2.18%. In currency trading Swiss Franc futures fell -1.88% and Japanese Yen futures lost -2.89% for the week. The Euro & Dollar Index remained steady
With a little over 1/2 of the month on the books, we are starting to get a feel for how April is shaping up for many of the CTA's we track. Here are few snapshots into the various sectors.
Option Traders - As discussed in last week's review, we believe Index option mangers have a great deal of potential upside over the next few months; and last week’s Index option expiration gave a taste of that potential. Here ere are few estimates thus far in April: Ace Investment Strategists +1.84%, Ascendant S1 +1.59%, Zenith Diversified +0.67%, Diamond +0.44%, Cervino Diversified +0.4%, Zenith Index +0.31%, and Rathiel +0.10%. Those that are down for the month include Crescent Bay -0.93%, Zephyr Aggressive -0.82%, Zephyr Moderate -0.59%, and Crescent Bay BVP -0.43% In the Commodity options FCI is ahead an estimated +1.53% for the month.
Trend Following and Multi Strategy- In the trend following and multi strategy space Crude Oil has been the hot topic with it rising close to 15% for the MTD. Mangers capitalizing on the trend include Longtermtrading.com (newly registered) +7.71%, Vision Capital +6.27%, Dighton +3.85%, Attain Modified +0.93%, and Attain Strategic Diversification +0.11%.
Agriculture mangers - As noted above volatility is not scare in this sector; however with most mangers playing the spread markets the volatility has been less. Here are few estimates- NDX Shadrach +3.53%, NDX Abednego +0.62%, and Rosetta -1.44%.
Finally, Forex markets have seen the greatest gyrations and lack of consistency recently. The most noteworthy has been PFG K3, which is down approximately 15% for the month and has surpassed its February drawdown. In speaking with the manger he noted the recent performance has been highly correlated to the equity markets, which has in turn affected the shorter term strategy's ability to identify the daily trends. Historically he has seen 6 month stretches where currency market fluctuations "trade sideways" and can affect the program. As such he has been working on an additional shorter term model for the past 8-9 months that he plans to put into play in the months ahead. We recommend knowing your line in the sand on this program and continuing to monitor this program closely over the days and weeks ahead.
***Day & Swing***
It was another slow week of trading as equities crept higher and bonds continued their slide. Overall the swing trading systems fared better than their day trading counterparts as intraday reversals were plentiful throughout the week.
Signum EBL was the top performer last week with open and closed trade profits of +$5,820. The system entered the week short two units of the Eurex Bund and took profits on half of the position. Following closely was Tzar ES, which is holding long and gained +$2,945 in open trade profits on its current position. Bounce eRL profited +$2,130 on a trade that it held from Wednesday to Friday. Mesa Notes has been holding short for just over a month and tacked on another +$2,046.87 in open trade profits.
Tzar NQ came into the week with a long position and tacked on +$1,935 in open trade profits. The PGA system profited +$1,705 in open and closed trade profits for the week after shifting its bias from short to long early in the week. AG Mechwarrior ES had four consecutive winning trades last week for profits of +$1,117.50 and seems to be on the comeback trail after a rough start to the year. Ultramini ES profited +$677.50 for the week on two trades. Seasonal ST ES lost -$42.50 after exiting its long trade just a day before the ensuing rally late in the week. Tzar eRL lost -$2,930 for the week on its short trade after just missing a long reversal mid-week. Finally, Signum TY lost -$5,975 for the week in open and closed trade equity but reversed its position to short.
On the day trading front, BounceMOC eRL was the top performer with profits of +$1,445.91. Rayo Plus Dax was next in line with gains of +$849.19 on three trades. AK47 ES had two trades for a net gain of +$615. Waugh eRL was quiet because of the smaller trading ranges and profited +$349 on one trade. BetaCon 4/1 ESX made +$144.04 on two trades. Compass SP was the only day trading system to finish in the red down -$625 on three trades.
Long term traders have basically headed to the sidelines during the past few weeks as high volatility coupled with choppy market action has taken over many sectors.
Rate futures experienced a sharp sell-off last week with price activity taking 30-year Bonds to levels not seen since mid-February. The pressure stemmed from growing ideas the Fed may have made their final rate cuts due to the ever heating inflationary gauges especially in the food and energy sector. Aberration exited the long TY position with a gain of $7,402.25. Both Aberration and Relativity are Short the U.S. Dollar Index making +$2,225.00 (open trade) and making +$115.00 (open trade). Relativity is also long MP making +$525.00 (open trade)
Food and grain sectors were again a mixed bag during the past week as grains fell on ideas that spring plantings may not be delayed as previously thought due to drying conditions for most of the Midwest last week. The meat sector posted decent gains last week on stronger than expected foreign demand as both the dressed pork cut-out and boxed beef cut-out posted sharp increases, which is very impressive considering the current U.S. hog slaughter is running 10% over year ago levels. Relativity is currently long corn making +$987.50 (open trade).
IMPORTANT RISK DISCLOSURE
Futures based investments are often complex and can carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading losses are material points which can adversely affect investor returns.
Past performance is not necessarily indicative of future results. The performance data for the various Commodity Trading Advisor ("CTA") and Managed Forex programs listed above are compiled from various sources, including Barclay Hedge, Attain Capital Management, LLC's ("Attain") own estimates of performance based on account managed by advisors on its books, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.
The dollar based performance data for the various trading systems listed above represent the actual profits and losses achieved on a single contract basis in client accounts, and are inclusive of a $50 per round turn commission ($30 per e-mini contracts). Except where noted, the gains/losses are for closed out trades. The actual percentage gains/losses experienced by investors will vary depending on many factors, including, but not limited to: starting account balances, market behavior, the duration and extent of investor's participation (whether or not all signals are taken) in the specified system and money management techniques. Because of this, actual percentage gains/losses experienced by investors may be materially different than the percentage gains/losses as presented on this website.
Please read carefully the CFTC required disclaimer regarding hypothetical results below.
HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN; IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK OF ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL WHICH CAN ADVERSELY AFFECT TRADING RESULTS.