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Managed Futures Strategy Focus: Option Selling

August 13, 2007


With most of the popular CTAs available to investors with $250,000 or less to invest focusing on option selling strategies, and those strategies being put to the test with the recent increase in market volatility - we thought it was important to shed some light on the ins and outs of this popular trading strategy.

Option Basics:

First, some very basic background on option trading. There are two types of options, puts and calls. And there are two things you can do with each, 1. purchase the option, or 2. sell the option (also referred to as writing the option). Instead of the normal text here which tries to explain how buying and selling the different options works, I'll ask you to consider only the Put options for now, and think of them as a life insurance policy, with the buyer of the option similar to a person who buys life insurance, and the seller of the option similar to the insurance company.

So, using our insurance example - Put option buyers are just like life insurance buyers. They are willing to put up a small amount of money in order to receive a large sum if they die. 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 you die. Of course, you probably aren't going to die 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 "person" they are insuring will die 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 "person" that was insured will be alive and well after this year ends). 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.

Price, Direction, and Time

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 - as you must be right on all three accounts, not merely one as you would when buying a stock (direction).

Take the example of Zenith Resource's sale of two August 1305 Puts on last Monday. By selling these Puts, Zenith is saying that they don't believe the S&P 500 futures, which had opened at roughly 1450 that day, would fall over 10% and go below the price of 1305 by August 17th (by exchange rule, the August options expire on the third Friday of each month). That would be a 10% drop in two full weeks, and while that may seem extremely unlikely - there were people out there who bought the insurance from Zenith, for 2.50 per contract - or $625. There are complex formulas for figuring out what the implied probability of that move happening is, based off the price received - but for the purposes of this example we can assume it priced in a roughly 2% chance

So Zenith, the seller, was betting against the S&P 500 futures moving a certain amount (145 points), in a certain direction (down), by a certain date (Aug. 17th); while the buyer was looking for prices to go below that price by the 17th. In practice - looking at the strike prices of the sold options, whether its a call or put (market up or down), and the date of the options gives the investor utilizing an option selling manager something to cheer for (or against) while watching the markets.

Options Pricing, marking to market:

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. But before you say, wow - free money; 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.

For example, as noted above the venerable Zenith Resources sold two August 1305 Puts on last Monday for 2.50 per Put. That resulted in a total of $1,250 being credited to the account. But while the cash balance went up, the open trade equity in the account went down by a similar amount (assuming the option closed at the same price). So, on day 1, the net effect of selling the option was zero, with $1,250 booked as an asset, and negative ($1,250) booked as a liability. The net effect would actually be a slight loss equal to the amount of commissions and fees on the trade.

Fast forward to the end of the day on Friday, Aug. 10th, and we can see on the account statements that the option in our example above (the Aug. 1305 Put) was worth only 1.10, or $275 per contract. So, the account still had the $1,250 in extra assets it booked last week, but now the liability against those assets was only worth negative ($550), meaning the trade had made $700 thus far in open trade profits. ($680 after commissions) This gain was despite the market closing on Friday at nearly the same place it was on Monday morning, 1450. The gain therefore was due to the fact that we were 5 days further along without the market any closer to the 1305 level. The chances of the market going there by the 17th were now being priced in at about 1/2 of what they had been just 4 days earlier.

Selling Volatility

This chance, or the probability we spoke of above that is "priced in" to the option's prices is what we refer to as volatility. 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. Thus volatility and options prices are essentially one in the same thing, reflecting the probability of a certain move happening in a certain amount of time.

Option sellers are essentially 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 on investors utilizing short option selling CTAs statements, or Short Option Value, 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 enduring the current spike in volatility and 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 Option Selling?

In our experience, while most novice investors flock to buying options, 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". The question of how these advisors and their strategies differ seems to come up more with different option selling strategies than anything else, and it is important to note that these are merely using option selling as their investment vehicle, and the different strategies and methods of getting into and out of positions (and when to get in and out) are what really add value and create the performance.

As one of our clients said, "anyone can sell options", and this difference may seem small, between the tool (options selling) and the method (where and when to sell them). But just imagine yourself at the plate trying to hit a 95 mph fastball, versus what Hank Aaron or Mickey Mantle could do in the same situation, and you can see that the tool (the bat) is not as important as the skill using it.

These advisors skill in using the "bat" is based on where and when they sell their options. Some sell them much closer to the market than others, and in doing so can generate higher profit, but with higher risk. 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.

Two questions we get a lot when talking about option selling CTAs, especially from investors who are already employing a few option sellers operating on the S&P 500, are 1. why are most option selling CTAs using the S&P 500 market, and 2. Are there any option selling CTAs who utilize similar strategies on markets besides the S&P 500.

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 over 40,000 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.

The answer to the second question is Yes, there are two CTAs we recommend who utilize option selling on other markets: Financial Commodity Investments and CKP Lomax. Click on the name to see the track record.


There is of course risk in this type of strategy - to the tune of one week losses equal to a few months of gains. And we have seen that risk come to the forefront in the past month as volatility has spiked higher thanks to this subprime mortgage fiasco in the US.

But there are also a few silver linings here. One, these types of moves don't happen every day. Technically, they can't, or the market would go to zero over the course of a few months. A similar volatility spike was of course back in 2001 following the 9/11 tragedy. Take the Zenith Index program as an example - and you can see that Zenith lost -3.1% in September of 2001 - then went on to make 155% over the next 51 months until losing -2.9% this February. Past performance is not necessarily indicative of future results - but option selling is a strategy in which you get "paid" to take on the risk of events like these happening.

Being successful over the long term with an option selling strategy means taking in as much premium as possible between periods when a spike takes some of what you've been "paid" away from you. The past few weeks have been one of these periods, and quitting now would be similar to an insurance company paying for your car repairs - and then firing you as a client and not taking in anymore premiums to offset the expenditure they just made. That wouldn't be a good way to run an insurance company, and it isn't a good way to approach the losses for option selling CTAs either, in our opinion.

The second silver lining, and one more important for recouping the recent losses - is that the item the option sellers are selling - option premiums - have nearly doubled in price. While that causes pain in the short term, it means the advisor can sell the same positions for about twice what he or she used to moving forward. Imagine an oil producer like Exxon Mobil, who sees the price of Oil double. There may be short term pain while people cut back on consumption - but eventually people will need oil and Exxon Mobil is now receiving twice what they used to without any additional cost. No wonder they made $113 Billion in profits last year.


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Feature | Week In Review: Volatility again the Name of the game


Volatility was the name of the game last week as the stock and energy markets felt the effects of the recent credit market crisis. Stock futures saw the most trading activity as e-mini futures had daily trading volume of at least 2.5 million contracts during each day last week. Thursday and Friday where even more active with 3.2 million and 3.6 million contracts traded respectfully as the VIX (CBOE Volatility Index) hit 29.84, it’s highest level since March of 2003.

Once again the credit crisis that has affected everyone from the billion dollar hedge fund, to the owner of a $100,000 single family home, was to blame as liquidity for high risk mortgages and other loans simply dried up. For the week SP futures actually gained ground (+0.55%) due to bullish corporate earnings. Russell 2000 futures remained the most volatile index of all as well finishing +3.63% higher for the week. Elsewhere Nasdaq futures lost -1.24%, DOW futures were down -0.22% and SP Midcap 400 futures were up +0.47%.

The other big story last week was the volatility in the world energy markets as prices for crude oil, gasoline, and heating oil came crashing down while Natural Gas prices skyrocketed. Crude futures were down -5.31% for the week as analysts predicted that the recent stock market turmoil would cause Americans to cut back on their energy use. RBOB Gasoline futures followed suit falling -3.66% and Heating Oil futures were down -3.09%. Natural Gas futures were up big at +11.88% perhaps just in time for the prime Gulf of Mexico hurricane months of August and September.

Elsewhere in commodity trading metals prices were down across the board with Silver futures falling -2.19%, Copper down -3.43%, Palladium off l -2.41% and Platinum dropping -1.44%. Grain prices were mixed with Wheat climbing +2.32%, Soybeans up +1.25%, while Corn fell -2.19%. Meats had a wild ride with Lean Hogs falling -8.76% and Live Cattle moving -3.50% lower. Finally in the Softs, Sugar was down -6.93%, Cotton fell -5.62%, and Coffee moved +2.47% higher.

***Day & Swing Trading***

Despite some large moves in both directions last week, most of the day trading programs and a handful of the swing systems fell victim to the wild intraday swings that have been happening more often than not in recent weeks. A large daily move in the S&P 500 used to be 15 points, while recently we have seen the market swing in 15 point increments in a matter of minutes.

One system that picked its battles wisely last week was Compass SP which made +$5,100 on two trades from Monday and Wednesday. Both trades were roughly equal in profitability, but Wednesday’s trade was an emotional lift for Compass traders after the system reached its profit objective and then sat back and watched as the S&Ps sold off 25 handles from the highs. BounceMOC eRL finished the week in the black with profits of +$425.60 on two trades. Finally, Rayo Plus Dax made +$360.28 on one short trade from Thursday.

On the other side of the ledger, BetaCon 4/1 ESX got caught up entering on breakouts that didn’t pan out and lost -$142.72. Keystone eRL lost -$375 but had luck on its side on several different occasions when the market made late reversals in the system’s favor to trim the losses considerably. OPXP eRL lost -$380 on three trades Tues, Thurs and Fri. Impetus eRL had one trade on Tues for a loss of -$404. BounceMOC eMD had one trade on Wednesday that lost -$695 after the Midcap quickly sold off late in the afternoon only to rebound and go back after the highs. Waugh eRL lost -$2K exactly on three trades.

Among the swing traders, Adaptive US and Adaptive Euro regained some lost ground after it continued to buy the various indices at a discount. On the week, the US Index made +$4,330 and the Euro made +$1,963. Bounce eRL made +$1,077.50 after taking profits on Wednesday and getting stopped out just above breakeven on Fri.

SeasonalST ES and eRL had small losses of -$125 and -$213.33 respectively. Ultramini YM and EMD were down -$265 and -$2,362.75. Mosaic eRL had a tough week with losses of -$2,443.50 on six trades, far more active than the average swing trading system.

***Long Term***

Activity for the soft commodities was again a mixed bag last week, although underlying support in soybeans due to a bullishly construed USDA report sparked a firm tone in most grains and oilseeds. Despite last weeks support corn and cotton continued to be capped by improving weather conditions in the U.S. The wheat market continues to be the star of the other sectors and scored 11+ year highs due to worldwide supply issues. The livestock and meat sectors traded lower on weaker than expected cash and product markets and ideas that a pick up in slaughter activity could become overbearing especially if foreign demand does not pick up as expected. Aberration is currently long BOZ making +$2030.00 (open trade), long CTZ losing -$1790.00 (open trade), long KWU making $4387.50(open trade) and short CZ at breakeven (open trade).

The U.S. dollar and Japanese Yen posted gains last week versus the major European currencies due mostly to global stock market uneasiness on worries of increased credit risks. News emanating out of Europe that some banks on that continent could be subjected to the U.S. Sub-prime problem seemed to ease recent inflationary fears that has kept the continentals in a steep uptrend. The news also seemed to spark some unwinding of the Yen carry trade that had been en vogue in recent months due to extremely low interest rates in Japan. Economic releases in the U.S. this week are on the heavy side with a test of each sector being represented, which should give the markets a good key on whether or not the recent turns in direction could be a precursor to the recent long established trends. Long term trend followers remain mostly on the sidelines due to choppiness and volatile swings, although Aberration is short the DXU currently showing a -$95.00 loss (open trade).

Rate futures posted moderate losses during the past week on worries that recent credit risks could worsen and force yields higher, although an infusion of liquidity from major central banks eased some concern late week. Despite the weakness most sectors of the rate complex remained near 11+ week highs as underlying support continues to stem from ideas that the shaky sub-prime mortgage industry have began to infiltrate the corporate finance area. News that some recent leveraged buy-outs could be on shaky ground due to the recent surge corporate rates did sparked some underlying safe haven of buying bonds. The upcoming week’s economic releases could be a strong indication for near term guidance as all sections of the economy will have a report cover their sphere. Currently long term trend followers have a neutral bias.

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.