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Consider your Options: Avoiding the Fate of the Thanksgiving Turkey

November 20, 2012

 

This Thursday, homes across America will be inundated with the succulent scent of roasting turkey, whipped mashed potatoes and fresh pumpkin pie. Though we look forward to celebrating with family and friends, the Attain office is thinking about a different kind of turkey at the moment- a hypothetical turkey, complacent in his well-fed routine and ineligible for a Presidential pardon, as imagined by none other than Nassim Taleb.

Taleb describes the comfort a turkey finds in consistent feeding, and the confidence that arises from reliable care. Of course, the turkey has no idea that his comfort is merely preparation for the comfort of a home cooked meal in which he will be the not-so-comfortable guest of honor. Because we're nerds, every year we get a chuckle out of recreating a graphic from The Black Swan, depicting 1000 and 1 days in the life of the fowl, getting a bit of a  morbid laugh from the fate of the poor turkey in question.

 

 

This metaphor isn't just an exercise is geek humor, though; there is an important lesson to be derived from the untimely end of the well-fed bird. Whether the chart here runs an uneasy parallel to your equity portfolio in 2008 or seems to mimic the trajectory of your Netflix stock holdings, it serves as a reminder that the unthinkable can and will happen. The investor most likely to be familiar with such an equity curve, however, is the investor in an options program. They've feasted on the bird, and they've been in its shoes on the cutting block, but, still, most don't go vegan... and here's why.

What does an Options Program Do?

There are two types of options (puts and calls), and there are two things you can do with each (purchase or sell/write). For the sake of clarity, let's look at puts. Think about a put as an insurance policy (maybe flood insurance in the spirit of Superstorm Sandy) where small amounts are paid on a regular basis in order to ensure coverage in the event of a rare flood damaging your property.

Using this analogy, put option buyers are just like the homeowners buying flood insurance. They are willing to put up a small amount of money month after month in order to receive a large sum if the unthinkable should happen. On the other side, the put option seller is just like the insurance company. They will take your small amount of money, and in return promise to pay you a large sum if the unthinkable happens. Of course, the flood isn’t likely to happen tomorrow, so the insurance buyer loses that small amount of money each year while the insurance company gets to keep it.

This is a simplified example, of course, but the premise is good enough for our purposes here, which is that the options market is comprised of two entities, the buyers (insured) and the sellers (insurers). The buyers are betting that price action will move a certain amount, in a certain direction, before a certain date (betting that the "flood" they are insuring against will happen this year), while the sellers are betting that the price action will not move a certain amount, in a certain direction, before a certain date (The "flood" doesn’t happen this year). If the market moves that certain amount, in a certain direction, by a certain date - then the buyers will make out; if it doesn't - then the sellers will keep the premium the buyer paid.

You may have noticed the string of qualifiers in the example above, saying the price had to move a certain amount, in a certain direction, by a certain date. These three qualifiers are really what makes options trading difficult. You must be right on all three accounts, not merely one as you would when buying a stock (direction). As the saying goes, almost only counts in horseshoes and hand grenades.

How do we get these numbers?

The daily pricing of sold options is something which can confuse a lot of investors utilizing an option selling CTA. And the clearing firm's often cryptic statements don't help much either. So, we'll break it down step by step for you.

First, when the manager first sells the option, that amount is credited to your account's cash balance. So, if you started with $10,000, and the manager sold an option to receive $500 in premium - your account's cash balance would be $10,500. Don't get too excited, though; the sold option simultaneously creates an open trade loss equal to the amount of premium received (in this case -$500). So while your account's cash balance increases, the account's marked to market value remains exactly the same. In fact, once considering commissions and fees on the trade, the net effect would actually be a slight loss.

The profitability of this trade will shift according to the qualifiers we discussed earlier. For instance, the closer you get to the date in question without movement in the indicated direction, the more profitable the trade becomes. If the price is moving in the indicated direction, the profitability of the trade would drop. Even then, the extent to which the profitability would fluctuate would also be dependent on the size of the move in one direction or another.

Essentially, option prices are a reflection of anticipated volatility in a given market. The prices provide an imperfect measure of the perceived probability of a major swing in the near future. When the market is swinging around all over the place and option prices are high, they are reflecting an increased probability that the market could drop 10% in two weeks, for example.

Option sellers are basically saying that they think the probability of the market moving that certain amount over that certain time is zero, and they are therefore happy to be able to sell the volatility at a level above zero with their assumption that it will soon be worth zero.

The SOV, or Short Option Value,  for investors utilizing short option selling CTAs statements is the amount above zero (or the total "liabilities") you have outstanding on the open positions. The goal of an option seller's strategy is to get that value to 0, and thus book the entire premium received as an asset.

For investors seeing any open trade losses in their option selling CTA accounts, a quick look at the SOV can tell you how much of that loss you can earn back due simply to time value decay if the market stays where it is by the option expiration. That is of course, a very big IF, but the SOV can act as a guide.

Why invest?

In our experience, while most novice investors flock to buying options as a sort of lottery ticket type investment, most professionals are option sellers. Why is this? All of these advisors are attempting to profit from this time decay property of options in one manner or another, whether it be selling naked call or puts, selling bear credit spreads, or selling bull and bear credit spreads simultaneously - an "Iron Condor".

This is where investors tend to raise an eyebrow. As one of our clients said, "anyone can sell options." This is true, but there is a nuance to the situation that many overlook. Yes, these managers are all using a similar tool (options selling), but it's how they use it that matters most. Just because you have a tool does not mean you can effectively use it. You can stand at home plate, bat in hand, and stare down a 95 mph curveball, but your ability to hit it is not necessarily going to be on par with a pro.

These advisors are akin to the pros referenced above. They're all using the same bat, but their results depend on when and where they swing (read: sell).  Some sell them much closer to the market than others, and, in doing so, can generate higher profit at a higher risk level. Some have theoretically unlimited risk with naked writing of options, while others prefer spreads which insure the loss is no more than the difference between strike prices.

We often hear investors asking the same questions. Why are these option sellers primarily trading S&P 500 options? Are there any out there participating in different markets?

Well, the answer to the first question is that most CTAs use the S&P 500 futures options because it is where they find the best volume and liquidity. With tens of thousands options trading hands each day, there is plenty of room for advisor to get in and out of their positions. Compare that to a market like coffee, where just a thousand or so options may trade all month. That liquidity has helped CTAs like Bluenose Capital, Newport Capital and Crescent Bay  make a name for themselves in the options selling world.

As far as options sellers working outside the S&P 500 realm, there are certainly a handful out there. For instance, HB Capital Management Diversified is fairly diversified, trading bonds, currencies, and commodities. White River Group Diversified Option Writing Program trades gold, oil, bonds, Euro currency, and corn.

What's the catch? 

If all this sounds too good to be true, you're asking the right sorts of questions. While option programs can play a role in your portfolio, there is always risk involved. In exchange for small, typically consistent gains, these programs can experience very large losses at a moment's notice. Much like the turkey that feeds in leisure until the day he unexpectedly meets his maker, options program investors will frequently bask in the comfort of a streak of gains, only to be caught off-guard by a sharp drawdown. These programs are technically short volatility plays, which, on the whole, make a living by risking a large amount to make a small amount. They can get away with this (in theory), because they have a large winning percentage where the large losses are very rare. 

But the problem as we see it is two-fold. For one, those losses aren’t quite as rare as we would hope. As we've written about in the past, volatility spikes happen at a frequency far greater than one would statistically anticipate, which means that option programs must be good at calculating the true probability of these supposedly rare events, not just the perceived probability based on past market action. Second, it doesn’t really matter how rare the large loss is if it is completely debilitating to your portfolio when it happens. Would you play a game of Russian roulette with a hundred chamber gun (resulting in a 1 in 100 chance of being killed)? No way.  A 1% chance is too great a risk when something as significant as your life is at risk.

Similarly, even if the chance of an option selling portfolio blowing up is only 5% or so, is that really worth the chance of losing 75% of your investment?  We say no. But does that mean we don’t recommend option selling managers for your portfolio? Not necessarily. 

We still do recommend option selling managers if it fits with what an investor is looking for. What we do not recommend is getting started with managed futures through an option selling manager. For one, they won’t track the managed futures performance which likely piqued your interest in managed futures, and are more likely going to be correlated to the stock market.  But for those with portfolios of managers, option selling can provide a nice balance to the portfolio, as it will no doubt include a good portion of long volatility programs which will be flat or struggle during times of decreasing volatility. The trick is to not let the option selling program, and its potential for a big downside surprise in the future – dominate the portfolio.

The Catch Part II - FCI

We would be remiss in talking about options without talking about the FCI program which was on the Attain recommended list before the program closed this summer. FCI was an option program that had delivered a performance profile comparable to that of most in their category, and with a lower minimum investment than some and diversification between multiple markets, was an attractive option to investors.

Why did we recommend something which went on to lose money and close to investors? And why didn’t we recommend investors get out of FCI sooner? And what can we learn from FCI?

As for recommending something which goes on to lose money, that happens to individual investors. It happens to professionals like Attain. It will happen again. This is a risky business and there are no sure things. The bigger concern for us was not sounding the “stop trade” alarm on FCI sooner. What kept us from doing so?

Part of it was trying to be patient and not falling for the “in at the top, out at the bottom” negative feedback loop we have talked about. FCI lost a lot in 2007/2008, and then earned most of that back for those investors who stuck with the program. Fast forward to 2011 and they again had a big loss (the kind typical for option sellers and the type they had just come back from over the last three years) and it seemed prudent to apply the same patient approach.

But this time was different, as it so often is, with FCI failing to recoup the losses due in part to their market diversification risk control failing in the face of increased correlations between markets in the new “risk on/risk off” world. They suffered further losses until the final months saw changes to the program and management team before shutting down altogether. 

The lesson for us from FCI is first and foremost that option selling CTAs have unique risks which can be tamed for a time, but are unlikely to be tamed forever.  They exhibited a classic option seller profile of rare but large losses outweighing years of positive performance and gains, and investors need to be aware of those risks (part of the reason for newsletters such as this).

The bigger lesson was to make our recommended list more automated and based on our ranking algorithm; versus qualitative input and the desire to stick with a program through losses to see the gains on the other side. We already do such in talking with clients, telling them to set a line in the sand at which point they should cease trading a program (and indeed some clients having such stop points saved them from further losses in FCI), and our new ranking system launched this year was done in part to create a ranking “line in the sand” which removes a program from our recommended list.

Finally, there were two lessons which apply to the rest of the option space:

Two Steps to Smart Option Program Inclusion

#1- Limit Your Portfolio Exposure

While option sellers can provide a balance in your portfolio, that doesn't meant they should make up the bulk of it. This can be a difficult temptation to resist during periods that are friendly for option sellers, as these can be periods where trend followers. For instance, during times like 2004-2007, option sellers provided an attractive performance profile, but in 2008 and 2009, this blew up in the faces of those who had loaded up on option program allocations. Even today, as options programs display strength and start to crawl back into the narrative, it's crucial to resist the urge to over allocate to the strategy; potential volatility spikes as a result of the fiscal cliff or deteriorating circumstances in Europe simply present too much risk of a 2008-2009 repeat.

#2- Book Your Option Selling Gains

One option that option sellers have (pun intended) which the poor turkey does not is that they can change the rules of the game. The turkey is at the mercy of the farmer, and has no choice really but to risk it all each day by eating his fill and packing on the pounds until his time is up. 

An investor in an option selling program, by contrast, doesn’t have to put everything on the line every day. Most option selling programs out there manage investors’ money by increasing position size as the account grows. This is great if the account keeps going up and up, but can be devastating when there is a big downside surprise.

After witnessing several major spikes in volatility sucker punch a whole host of option selling strategies, it occurred to us that perhaps there may be a better way of investing in an options selling program than letting an option selling manager continuously compound your investment with them.

We first thought, "Why not just have the manager trade a fixed amount of money (the initial investment), and not allow them to compound and add risk at all? If 75% of your account is always at risk, the absolute value of the amount at risk grows as your account grows.  Why not try and keep the absolute value of the risk a constant, thereby treating the option selling investment as an income producer rather than something which will grow your assets?"

This sure would protect against a big downside surprise, as you could only lose an amount equal to the drawdown times the initial investment, but it also curtails profits in a big way. One of the tenets of successful investing is to let your money work for you through compounding, and trying to not be the turkey by completely eliminating compounding seems to hurt more than it helps.  

The ideal scenario, of course, would be to let the investment compound, but then take all your winnings off of the table just before volatility spikes and you suffer a large loss. In reality, that is impossible without a crystal ball which tells you when the volatility spike is coming (and if you had one of those, you probably wouldn’t be reading this).

So, we needed a way in which we could participate in the compounding effect, but at the same time, take profits off the table with some regularity, so that when there is a double digit loss, it isn’t on the initial investment plus all of the gains to that point- only on the initial plus some fraction of the profits.

To test whether we could protect option selling profits without sacrificing too much return, we came up with the simple idea of letting the investment compound for 12 months at a time, taking the profits off the table at the end of each year.

For example, if an investor started an option selling investment with $100,000 in January of 2011, and made $35,000 (after fees) during the year as the advisor saw success and increased position size as the account grew (compounding), this plan would entail having his broker move the $35,000 out of the account on Jan. 1, 2012 and instruct the advisor to trade the account at the $100,000 level. The advisor would then position size based off the $100,000 and any profits made during that year. This has the added benefit of reducing your management fee annually, as you would be paying on the new level, not the continuing balance.

We tested this strategy across an averaged track record of 93 option programs in our database, including programs that are currently trading and programs which are no longer active to avoid any survivorship bias. We simply took the monthly performance of all option programs in our database for each month and averaged those to arrive at the average option program return for each month back to 2000, and then did our analysis on that average performance. But, before we go any further, it's important to note that the results we're about to discuss are hypothetical in nature. This is real results of the CTA programs, but we’re doing weird things like taking out any profits annually, so best to consider them hypothetical. Please take the time to read the full disclaimer on hypothetical results below*.

With that, the results of our Hypothetical run looking at on the option programs as they operate normally, versus booking profits every December.

DISCLAIMER: Hypothetical Performance. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. Average Option Program Performance when allowing for compounding of any profits, as compared to booking profits annually and resetting to the minimum amount.

 Taking Option Profits off the Table

Now, some of you may jump to that final column in the table above and say this playing it safe stuff isn’t for me, with the normal operation across all the programs earning a total return about twice as high. But before jumping to that conclusion, notice the drawdown is nearly 3 times higher, and notice that in the past five years that relationship is not nearly as pronounced.

This is where the turkey really has to look in the mirror and ask himself (itself? – not sure who a turkey asks) whether they want to accept the higher risk in return for the higher reward, and more importantly, whether they would have the staying power through the 3x higher risk. It’s easy to sit here and look at averaged numbers and think you want the higher total return, it’s quite another to be staring a -40% drawdown in the face and knowing you need to stick through it and risk perhaps twice as much in losses to get to those higher returns.

If we put a probability on your ability to withstand the losses, the math starts to favor booking profits. Just doing a simple calculation to say you would be three times more likely to live through a risk three times smaller, and assuming you have a 75% chance of sticking with the investment at the lower risk level, we can surmise that there is a 60% chance of seeing the smaller 210% total return, and 1/3 of that chance, or just a 20% chance, of seeing the larger 532% total return. For those counting at home, that’s an expected return of 126% (60% * 210%) for the booking profits strategy, and 106% (20% * 532%) for the compounding strategy.

Of course, the likelihood of an investor sticking through a drawdown is a highly personal and dynamic level unique to each investor, but you get the idea. It isn’t as black and white as simply picking the highest return. It’s about what you can live with and reducing the risk to avoid being the Turkey on the 1001st day.

In conclusion, no matter the math and now matter how good your option selling manager is, or has been to date, there is no denying that they have a greater than zero chance of a large negative surprise akin to the turkey’s 1001st day at some point in the future.  It seems wise to us, to protect against that small, but still present, chance by taking some of your option selling gains off of the table.

Whether you do it annually as outlined above, or devise some alternative method, the goal should be to capture as much of the compounding effect as possible while getting money out of harm’s way from time to time. You could even take some of those profits off of the table and put them into something which is currently underperforming, becoming one of those rare investors who actually gets out (of a portion) at the top, and in at the bottom instead of the less successful, but more common, profit chasers.

In the meantime, Happy Thanksgiving to you and yours from the Attain team!

-   -   -   -   -   -   -

Regarding Hypothetical Results

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 participation (whether or not all signals are taken) in the specified system, and money management techniques.

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.

THESE PERFORMANCE TABLES AND RESULTS ARE HYPOTHETICAL IN NATURE AND DO NOT REPRESENT TRADING IN ACTUAL ACCOUNTS. 

 

 

IMPORTANT RISK DISCLOSURE


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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.