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Does the recent volatility spike mean the end for options selling?

October 13, 2008


With all of the volatility that has been seen in financial markets over the past two months (and especially last week), the option selling programs which effectively bet against such volatile moves have seen quite a tough time of it. With many seeing double digit monthly losses, and others losing more than half of their accounts value, we estimate that roughly one half of all option selling CTAs will likely to be out of business by the end of the year.

Option selling has often been referred to as picking up pennies in front of a freight train, which obviously involves catastrophic risk if you are not nimble enough; and the painful losses among many option sellers begs the question of whether the penny pickers have indeed been bowled over by this fast moving freight train of a market.

It is indisputable that many have been run over. But there have been some, such as Cervino Capital Management who have survived the volatility extremely well, and for those contrarians out there who zig when others zag, there sure are a lot of pennies now back on the track begging to be picked back up.

The question for those involved in option selling, and for those contrarians who aren’t spooked by what has just happened, and instead are looking at what may come… is:  Will it ever be safe to go back on the track?

Mack Frankfurter, one of the principals of Cervino Capital Management, gives his thoughts below on the current high volatility market and where this leaves option sellers now. 

(Walter Gallwas)

Has the Freight Train  Run Over Option Trading Programs?

By Mack Frankfurter

“To fly an airplane it must fly ‘in the zone.’ Too slow and you stall and lose control; too fast and the wings come off.”

This is what Captain Dan Ryder, a former Navy fighter pilot, explained to me shortly before the “bailout” vote a few weeks ago, and it has stuck with me ever since.

Since then world equity markets have plunged in a dive that hasn’t been seen since the Great Crash of 1929 stoking fears that we may be headed for the worst recession since the 1930s. Amid mounting fears that the frozen credit markets pose an imminent danger, the pressure for a coordinated rescue by the world’s economic policymakers has become acute. As stated in this weekend’s Financial Times in a telling quote, “Five years ago central bankers seemed almost omnipotent; now they seem scared.”

No doubt sentiment has materially changed since October 2006 when equity markets were in the midst of an extended bull run and the VIX, also known as the fear gauge, was hovering in a range between 10 and 12. For comparison, on Friday October 10th, the VIX hit an all time record intraday high of 76.94—that is 7 times higher than 2 years ago, and almost 3.5 times greater than levels for the VIX just a month ago.

The importance that this volatility plays in options trading should not be underestimated. In fact, it is the key factor which drives how much premium can be charged/received when purchasing/writing options.

Low volatility appears to be a good environment to sell options in, but in reality it is outside the option selling comfort “zone,” just like the plane flying too slow and at risk of stalling. Just like a calm before the storm—the risk during a low volatility environment is that volatility will spike much, much higher.

Along these lines,  volatility during much of 2006 and through February 2007 was too low. This became apparent on February 27, 2007 when the VIX spiked nearly 100% and several option writing programs collapsed, giving back two or three years of accrued profits in a day.

Since that date, volatility began to rise with the VIX trending higher. But this presented another problem for many CTA option writing programs—the transition from low volatility to higher volatility can be treacherous. Nonetheless, a group of these programs managed the transition, and arrived at what could be considered the “sweet spot” or “zone” for premium capture—a VIX ranging between 20 and 30.

This “zone” level was the average range for the VIX from 1997 through 2003, but even during that time there were several volatility spikes. The first event was during the summer of 1998 with the implosion of Long Term Capital Management when the VIX reached 45. The second event was after 9/11/2001 when the VIX spiked to 44. This was followed by a VIX high of 45 during the 2002 bottom. Each of these readings is far below a VIX of 70+ reached this past Friday.

More recently, since February 2007 the VIX has spike above 30 several times: first on 8/16/2007 when it closed at 30.83, then on 11/12/2007 at 31.09, followed by a spike on 1/22/2008 with a reading of 31.01.

But the most memorable day was March 17, 2008 when the Federal Reserve Bank financed JP Morgan’s takeover of Bear Stearns in a controversial deal. The VIX spiked to 32.24 and market pundits debated on whether the Fed overreacted, or had helped us narrowly avert a crisis due to systemic counterparty risk.

We got our answer in September. Merrill Lynch agreed to sell itself to Bank of America, Lehman Brothers filed for bankruptcy, and the Federal Reserve provided AIG with an $85 billion loan.

It’s been downhill ever since with the largest financial “bailout” in United States history causing an existential crisis in a classic case of the road to hell paved with good intentions. Every action that central banks, the treasury or governments have taken so far to try and stem the bleeding has been dismissed by the markets.

As of the end of last week,  it had seemed that Capt. Ryder’s airplane was now out of the “zone” and flying way too fast as the metaphorical wings of market volatility finally came off. With the VIX above 50, much less given its rise above 70, we are definitely out of the zone for option selling, and at Cervino we decided market conditions had become extremely imprudent to trade.

Has the options trading model blown up?

But does the fact we’re now out of the “zone” mean the options trading strategy is no longer valid? I, for one, don’t think so and believe that the opposite may be the case.

Consider that investor interest is options programs is a study in contrarian behavior. During the 1990s (shortly after the crash of 1987) there was a great deal of aversion to the strategy of writing options. This began to change after the triple bottom in 2002 when the bull market in the S&P 500 and the bear market in the VIX provided a ‘goldilocks’ environment for naked option writing. The result was a proliferation of CTAs offering such programs by the end of 2006.

The irony is that low volatility going into 2006 created increasingly dangerous conditions to engage in option writing. CTAs who write options can only capture as much premium as volatility will allow (that’s what they gain when they write options). So in order to maintain return expectations from prior years, a CTA had to increase risk by either moving the strike price closer to the underlying price, and/or increase the number of positions.

Yet conventional wisdom at the time was that these programs were uncorrelated to the underlying market. As a result, there was a flood of investor interest in option programs seeking 20+ percent returns. The subsequent transition to higher volatility since February 2007 has chastened many investors once again.

There is an old saying when it comes to options trading—it is like picking up pennies in front of a freight train. It turns out many players offering option programs in 2005 and 2006 were relatively new to the space, untutored in the violence of short “gamma” as happened during 1998, 2001 and 2002.

So what distinguishes one option program from another, or risky option trading from less risky trading? The answer is qualitative, but the trick is to produce “risk-adjusted returns,” in which positive returns are generated while mitigating volatility and exposure to risk. In options trading, this is a difficult feat.

First, investors need to recognize that there is a direct correlation between leverage and return with any managed futures program. A program which produces a 30% return is not necessarily better than a program which produced a 15% return. In fact, these returns could be produced by exactly the same trading programs with one using twice the leverage as the other for the same size account. Risk adjusted returns are a much better measure of manager skill.

One of the crucial factors which provides for consistent absolute returns in option writing/premium capture strategies is “theta,” or time decay. Consequently, the most important responsibility for a trader to manage is the risk of positions in his/her book, which should be considered liabilities until expiration.

A standard strategy is to write options far out-of-the-money, with the idea that the probability such options will go into-the-money by expiration represents a low probability event. In this strategy, traders will “white knuckle” their positions with expiration the only true stop loss. Investors are required to suffer high intra-month equity volatility in their accounts with the expectation that if the options eventually expire out-of-the-money, any unrealized losses plus premium written will be earned.

Risk of ruin is high with this kind of approach, and there is a tendency for the “deer in the headlight” syndrome. If traders do cover such positions, thereby booking large “painful” losses, they will often “roll” the contract to another strike price in the hope that the market won’t reach that subsequent level.

This kind of strategy has worked reasonably well for many option programs, with some using variations of the strategy to mitigate risk and equity volatility by utilizing bull spreads and/or calendar spreads.

The key question in this current environment is if implementing routine trading strategies is still viable or more importantly, is it prudent? There are rumors that certain CTA option programs have utilized more margin than the agreed-to account size. This situation, in my opinion, represents irresponsible trading.

The bulk of investment performance is typically a function of strategy and risk taken. Yet the complexity of human behavior can never be fully modeled. Therefore, a discretionary common sense approach is needed—one which balances the qualitative with the quantitative in order to manage cycles of volatility.

Traders often like to talk about how they provide “alpha” or skill-based returns. Alpha is a byproduct of “beta,” which is often referred to as a benchmark. In alternative investments, one can think of beta as the core strategy and alpha as tactical overlay in response to changing market conditions.

This is the strength of discretionary trading—the ability to tactically adapt to changing conditions.

Unfortunately, the ‘quality of returns’ is a difficult concept to quantify. My recommendation is not to analyze how well traders have performed in normal market conditions, but how they have performed under stressful market conditions such as February 2007, March 2008 and now during October 2008.

Where does option trading go from here?

The G-7 has pledged to do everything in their power to prevent any more Lehman Brothers-style failures of systemically important financial institutions, but nevertheless, there will be more dislocations to come. Concern now is focusing on insurance companies and automakers. Notably, the cost of protecting Dubai’s debt surged last week as concerns mounted about potential investment losses in the emirate and the refinancing of up to $22 billion of debt.

Meanwhile, Standard and Poor stated that GM and Ford may go bankrupt, which is just one indication that substantial damage has been done to the “real economy.” Further, expectation is that unemployment will increase causing a feedback loop into lower consumer spending and reduced earnings for companies.

All this leads to the idea that the US stock market is susceptible to a long malaise where the predominant trend will be wide ranging sideways action. Yet, after we turn this page in market history, systemic risk will also hav.e been greatly reduced, and it is unlikely we will see the VIX at 60+ again for a generation

Current volatility makes any attempt at establishing option positions as of today very risky/expensive. However, once the market finds technical support, the setup is one where there will be greater implied volatility than the actual volatility as exhibited by the market. This is a perfect environment for arbitrage.

So for the option programs who survived this period and proved their mettle in managing risk, investors should recognize that markets over the next few years will likely be “in the zone” for these programs. In the parlance of our previous metaphor, there are now nickels or even dimes on the track (not just pennies). Further, three or four huge freight trains have just come screaming down the track, with little to no warning, making it less likely, though still possible, that any more trains will be coming for a long time.

- Mack Frankfurter, Cervino Capital Management


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Feature | Week In Review: A histrically volatile week leaves its mark on many | Chart of the Week


A worldwide fear that the next Great Depression was upon us sparked one of the worst market declines in at least 75 years during the past week. The now linked commodity markets (on big global demand bet) also sold off heavily as the CRB index moved down to levels not seen since January 2007.  The break in the CRB from the July highs has seen the index shed 38% with the majority of the declines coming during the past couple of weeks. Energy was the biggest losing component in the CRB index led by RBOB Gas -17.22%, Heating Oil -16.67%, Crude Oil -16.25% and Natural Gas -10.13%

The stock index sector was the hardest hit led by S&P 500 futures losing -23.86%, Dow Futures down -19.34% and NASDAQ futures -19.34% lower. The small cap arena was not much better with the Mid-Cap -17.49% and the Russell -15.57% also down double digits. (remember these are weekly numbers)     

The tone in the metals was firmer than anywhere else as the precious metals such as Platinum +3.92% and Gold +3.11% found support from safe haven buying. The industrial metals was a little different, meanwhile,  as worries of economic slowdowns in developing nations sparked selling as Copper lost -20.38%, Silver fell -6.47% and Palladium fell -2.26%. 

The U.S. Dollar +3.38% was also a beneficiary of safe haven investing  as ideas loom that  European rate yields would be drastically reduced in upcoming months to help revive market confidence.  The British Pound lost -3.56%, Euro -2.66% and Swiss Franc -1.12%. U.S. rate futures also ended with loses as nervousness about the credit sector and a possible rescue plan kept the sector on edge. The rate sector freeze was fairly evident in Europe as LIBOR rates spiked 2%-3% last week, this in turn sent rate futures down with U.S. 30-year Bonds losing -2.62% and 10-year notes down -2.54%.

The commodity and food sectors remained in a tailspin as the likelihood of a worldwide economic slowdown sent investors fleeing. The grains also felt added pressure from news that the USDA had raised current U.S. production figures in a late week release. Loses were led by Wheat -11.92%, Corn -10.24% and Soybeans -8.37%. Livestock saw Live Cattle -6.84% and Lean Hogs down -1.69%. Cotton -13.99% led the soft sector down trailed by Sugar -10.95%, Cocoa -9.22%, OJ -7.47% and Coffee -5.59%.


With stock prices around the world plummeting (ahead of today’s big rally) many investors are beginning to take a serious look at multi-market trend following CTA’s again.  Trend followers typically do best when the markets are experiencing large moves on either side of the market, higher or lower.  Not surprisingly, the recent volatility seen across not only stocks, but commodities, bond and currency futures has been good for these models.  

Through Friday, managers who have been actively trading and finding profits include the Attain Portfolio Advisors Modified Program +15.64% est and the APA Strategic Diversification Program at +9.05% est for the month.   Robinson – Langley has also posted nice returns in October at +6.00%, Long Term Capital is up +5.70% est and Hoffman Asset Management isn’t too far behind with returns of +4.14% est.

Dighton USA, meanwhile; was looking at a steep drawdown before today’s action – as they had entered long at various points on the way last week. But Dighton was one of the biggest beneficiaries of today’s hue rally, as they exited long positions on the way up to mostly erase any losing open trade equity.

Elsewhere, other multi-market managers are taking a step away from the markets as volatility as measured by the $VIX.X shatters record highs.  The VIX is an index designed by the CBOE and is used to gauge the level of “investor fear” in the market place.   Any time the VIX is over 40 it is worth noting as this rarely occurs and Fridays’ record close at 76.94 was absolutely crazy.  Because of this record “vol”, some managers have elected to play it closer to the vest and not trade as much.   Multi-Market managers included in this group include Clarke Capital Management, DMH, and Northside Trading.

As the title of this week’s newsletter alluded to – it was a very bad week to be in option selling. The record volatility has caused steep losses among option selling CTAs, unfortunately. Some managers have managed to keep the losses within manageable levels, which is remarkable given the sharpest (and most continuous) down move in many, many years. Cervino Diversified (whose principal Mack Frankfurter guest authored for our newsletter topic above), Raithel, and Zenith have all exercised excellent discretion to get out of the way of last week's falling knife...Cervino Diversified is down a mere -4.6% (2x is down -9.35%), Zenith Index is down -7.39% while Zenith Diversified id sown -13.23%, and Raithel -7.92%. Not what we want to see form an absolute return vehicle, but not catastrophic losses, either.

On the other side of the spectrum are managers who have seen sharper falls, after losses last month as well. Current October estimates are as follows: Ace Investment Strategists -12%, Crescent Bay PSI -9.24%, Crescent Bay BVP -11.8%, FCI -25%, and LJM -63%. 

Finally, in the agriculture and grain markets, not all mangers were able to escape the volatility but they were able to manage the risks.  Current October estimates Chicago Capital +0.19%, NDX Abednego -1.33%, NDX Shadrach -3.07%, and Rosetta -4%.

***Trading Systems***

While trading systems generally have a long volatility profile, last week’s historical sell-off in global equities and corresponding rise in the VIX actually kept most systems on the sidelines. Those that did participate found it difficult to stay in trades with expanded daily trading ranges like 100 pts in the S&P, 1000 points in the Dow, resulting in minute by minute swings of 10-20 points in the SP. It’s hard for a 7 point stop not to get hit when the market “noise” is up to 15 points.

Swing programs that were holding short in stock index futures cheered on the slide throughout the week while programs holding long bonds were hit pretty hard after bonds didn’t take on their usual inverse relationship to stocks. Tzar NQ came into the week holding short and held its position for the duration of the week.  Signum TY reversed short mid-week and tacked on some open trade equity after taking a loss on the closed out long trade. Signum EBL continues to hold long and saw some open trade equity disappear after bond markets fell globally. Ultramini ES had two trades last week for a net gain of $5.

Moving on the day trading programs, only two systems were active due to the previously mentioned volatility. Many of the day trading programs that stayed on the sidelines have filters that prevent them from trading when the market moves X percent, daily trading ranges exceed certain levels, etc… Of the two systems that traded last week, Rayo Plus Dax fared much better +$2,727.35 for the week on three trades. Waugh eRL was not able to stay above water -$594 on four trades.

In long-term trading, the U.S. Dollar and Japanese Yen continued to rally against the major foreign currencies. Of particular interest to trend following programs were the Aussie Dollar and Mexican Peso, which were down ~15 % each against the Dollar. Grain markets also signaled new short entries in Soybean Oil and Soybeans after taking a long time to flip over from the huge run-up earlier in the year.

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.