Core Strategies of an Options Portfolio Manager
Over the last few years have I witnessed an entire army of traders writing articles describing ways to exploit options for income generation via premium short selling. Curiously enough, the prevalence of this sort of trading took strong hold just as the VIX levels hit the low teens, and, for the most part, stayed there. After all, wouldn’t one think that premium selling is far more lucrative with implied volatility trading at higher levels, and, in contrast, less rewarding and more risky with the vol (volatility) being “cheap”? In short (no pun intended), yes.
Before we continue, let me state that the purpose of this article isn’t to educate you, the reader, how to sell options. While that topic is interesting, it has been covered in much detail by other contributors. So, I will offer only a brief overview of how we sell options in our fund – with the sole purpose of defining a proper context. After all, in order to sell premium successfully, you don’t have to be sophisticated and “right” about the behavior of the underlier. Rather, your success depends much more on you being dead “right” on handling the risk. Consequently, I’d like to dedicate this space to the issue of risk — a topic grossly misunderstood and discussed far too rarely in proper detail — especially given the increased popularity of this strategy.
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The Basic Idea
Our basic idea behind selling options is fairly simple. We look for options with relatively high implied vol levels on assets that satisfy certain technical criteria. Such criteria are: a high volume breakout or a breakdown, an extremely oversold or overbought condition, or a proximity to a significant level. At least one of these criteria must be met to qualify a sell, which is usually implemented via a short OTM credit spread with a maturity of 3-8 weeks.
At all times the portfolio of short options is diversified across 30-70 positions and is hedged with a number of index puts (this is where low index vol comes in very handy). In essence, we’re short rich vol on individual issues and long cheap vol on the index. Options veterans will recognize this as a quasi-dispersion play.
Understanding Risk
Now the reasons why we sell options are by far less important than the involved risks. i.e., your success as a premium seller has a lot more to do with understanding and managing these risks rather than coming up with a sophisticated selling strategy.
So, here is our list:
1. Implied volatility risk. With options trading, this type of risk is the one overlooked the most (or often just blatantly ignored!) Here we must understand that when we sell an option we are short vega, which means we are short vol. An explosion in implied volatility has an adverse effect on our short holdings.
2. Directional risk. This is usually an obvious and never (one should hope!) ignored sort of risk. In technical terms, a short option will have some delta exposure that will work against us when the stock moves towards the sold strike.
3. Sabotage risk. After you stop laughing (if you aren’t, that’s a good sign) realize that there is no Greek letter for this (ok, fine, vega isn’t exactly a Greek letter either : ) ). After all, quantifying someone’s emotional state is pretty hard, but even so, we have to be aware of the very real risk of sabotaging a perfectly good trade. In my personal experience, this is by far the worst type of risk. This is the sort of risk that makes you think in retrospect (after the loss has been realized) “I should’ve just left it alone.” Eight times out of ten, had you indeed “left it alone,” things would have worked out just fine.
4. Delusional risk. A cousin of the above, this sort of risk is extremely prevalent among option sellers. In simple words, short sellers often make money. Often that happens for long periods of time. However, that in itself does not validate most short sellers as good traders. Just the opposite — prolonged success mixes brains with luck, and, as human nature would have it, we’d rather consider ourselves lucky than smart.
Having identified them, let’s now go through the risks in more detail.
Implied volatility risk (henceforth I’ll just call it “vol risk” — a much more accepted term among traders) needs to be carefully evaluated as follows: If we’re short an option and the vol explodes, what happens to our P&L? Well, that depends on how we’re short. If we’re short a spread (we should be in most cases) our vol risk is lower than in an outright naked short position. Both legs will increase in value due to the vol effect and the long leg will offset some of the vol-induced losses of the short one. If we’re short a naked option the losses will be worse because our position is “unhedged”. However, here is an important point to keep in mind: these “losses” are unrealized. As the option gets closer to expiration its price will decline, regardless of the implied vol. Our only real risk is that the vol will increase along with the underlying asset moving to the strike.
Dealing With Risk So, how do we deal with this?
1. Sell options with vol trading at its upper historical bound. That is, if an asset’s ATM vol is 30% on average (for example, over the last 12 months), look for it to hit 45-50% before considering a sell.
2. Be aware of vol’s behavior. We know that vol is generally mean-reverting. However, there are cases where vol explodes and instead of reversing, it continues to explode. This often happens when vol sharply breaks out to new levels. So, selling vol spikes is OK as long as the spike is hitting an old “high”, not a new one.
3. When vol goes against you, consider where the underlying is and the time remaining before expiration. With the underlying sufficiently far away from the strike and theta becoming exponential (< 2 weeks away), the increased vol is likely to give you some temporary headache but no actual realized loss. When this happens, sell even more options instead of running for cover.
4. Directional risk has its own surprises but I tend to view it as the sort of risk that’s much more easily quantified and controlled than any other. Let’s take an example: an asset is trading at $50 and we decided to sell $45 puts one month out. To hedge our risk we bought $40 puts and thus limited our loss to $500 per contract.
What’s our real risk and how do we treat it?
Define an outlier and compute the probability of its occurrence. In this case an outlier is an asset that runs through both strikes (45 and 40) by the expiration. Another qualification for an outlier is that we as traders have no control over it. In other words, we wake up in the morning and see our asset trading at $36.74 on 5 x normal trading volume. That’s never a nice thing to wake up to, but the consolation is that once you realize that this sort of outlier only occurs once out of every 30 trades, it shouldn’t be a problem to absorb the loss. And if you haven’t quantified this to be the case, then don’t sell the options.
A more common occurrence is that of the asset gradually moving towards the short strike and then through it. What will save us here are two things:
Strategy with respect to the underlying’s technical position. Why did we sell the 45 strike? Was it (for example) because 45 is an extremely oversold level? If so, what’s the likelihood of the asset reversing at or below 45 and rallying to some higher level? Quantify this (derive a mathematical expectation) and depend on the result accordingly.
Discipline with respect to forced liquidation. Define your criteria for the inevitable cases where liquidation is a must. One of them could be “liquidate if the asset reaches the short strike”. Again, quantify the validity of this rule and execute it consistently.
Diversification over maximally uncorrelated assets. Now, this is a hard but necessary requirement. We must own short premium in such a way that several blowups can not wipe out our portfolio. In fact, we are always positioned in such a way that several blowups will only make a dent in the profit and never in the invested assets. If this sounds impossible, it nearly is. That’s why our biggest challenge is to build a sizable portfolio quickly enough (that is, find enough opportunities) before we get “hit”.
Basically, directional risk has little to do with options being, well…options. It’s all about the underlying. So, make sure you are very comfortable with the asset’s behavior from a strategic standpoint before selling its options. A good rule of thumb is, if you are a decent (not necessarily good) stock trader (by decent I simply mean not a losing one) you are very likely to have reached the required level of this sort of comfort.
Sabotage risk. Let’s face it – we are human (as much as we’d like to be machines when it comes to trading) and thus are fallible by our very human-ness. While being short options makes it easy to “stay” in most trades (you can be horrible at it and still turn a profit from a lot of your trades) the crucial factor is the ability to stay in those trades that are painful. I am convinced that the ability to handle painful trades is the actual, nearly quantifiable edge that separates long-term winners from temporary ones. We will all stay in our trades when assets move away from our short strikes and as a result we will all make money (this can happen for quite a long time) — regardless of our actual abilities as traders. However, how many of us will walk away with a profit or a well-managed loss when the opposite happens?
Quantify and Test
So, what to do?
Simple: Quantify, Quantify. Quantify. Make sure that your strategy considers all the possibilities and has defined mathematical expectations for every outcome. Only then will you know what to do when you’re in pain. From my own experience I’ve discovered (or rather, validated) the notion that pain is good as most of the time pain spells opportunity.
Delusional risk. Funny as it may sound, admit that we are all extremely susceptible to our own beliefs. We like to think ourselves successful and we like to attribute our successes to our unique abilities. The reason this human trait is a serious risk is that in many trending or flat markets the large majority of premium sellers will make money without realizing (or admitting) that their ostensible success came from pure luck. Think about it: selling options up to year 2000 was a pretty sure way to make money — and for quite a long time. So, you did this for a year and racked up a 60% return. Now try to tell yourself that it was just luck — especially after looking at 150 trades that you’ve made. Had to be brains, right?
Well, since success alone isn’t good enough to isolate ability from luck, what else is there?
Again, very simple: Test. Test. Test. Try to make money in any market. Can you do well by selling calls in a bear market just as you have by selling puts in a bull one? Can you handle forced exits when things go awry? Can you handle a broad collapse when all assets trade with a beta of 1? Realize that it is not important that you answer yes to all of the above. The important part is to have the ability to avoid those situations that you marked with either “no” or “don’t know”. Because by the time you’ve actually learned to do that, you’re guaranteed to be completely disillusioned in the truest sense of the word.
And so, there you have it. Whether you’re been successful in your options selling or not, learn these risks and learn to respect them. This will help you keep those premium proceeds you see piling up in your account every day — the very ones you’ve got “used” to counting as part of your equity — all the way to expiration and then, all the way to the bank.
Dmitry Babayev is a portfolio manager and derivatives strategist at Cadence Capital Group, LLC, a Manhattan based money management firm. His main focus at the firm is on premium selling, aggressive long/short and delta-neutral strategies. He also maintains a blog, Live Options Trading (with corresponding coverage of stocks, ETFs and futures) reflecting the actual activities of Cadence Capital Group.