Option Trader BOOM
January 11, 2018
Option traders are a booming business in the CTA space, at least that is the recent trend. It seems like every day we meet a new manager who incorporates some type of option selling or volatility trading. When measured by assets, most CTAs in the industry use some type of trend-following approach, so this development is a unique subset in our industry. Why the boom? What risks and opportunities are available?
As you can see from our graphic, the number of CTAs who engage in some type of option selling has increased over time.
There are logical reasons for this growth if we consider recent market trends. Even though it was nine years ago, the Great Recession made a lasting impression on how market participants contemplate risk. Because of this, there is a great hedge risk especially with put options. Yet someone has to take the risk of selling those options as insurance. Enter this select group of CTAs (Please note that these CTAs are not the only risk takers).
Not only is there ample supply for the demand of options but there have been favorable market conditions since March of 2009 with perhaps the greatest bull market in modern history. With the exception of several retracements, options sellers have had an overwhelming advantage. Said another way, the purchasers of insurance seldom filed a claim. See image below of CBOE’s VIX courtesy of Trading View:
The boom isn’t limited to option-selling CTAs either. Money has flowed directly to VIX futures as well as ETFs that specialize in volatility trading. For example, see Bloomberg’s Businessweek report on the inflows to ProShares Short VIX Short-Term Futures ETF.
A lot of money is excited about the idea of selling volatility through a variety of means. But how has this strategy type faired compared to others?
Autumn Gold has conveniently constructed two indices to help track option writing CTAs (AG Option Writer EW and AG option Writer AW). These non-investible indices aren’t perfectly correlated to their components but they function as a good proxy for our purposes of a general comparison. See table below.
A few things stand out when comparing the option writing strategies to other asset classes. Their recent performance compares very well with both domestic and international stock indices. As measured by the AG option writer indicies, option-writing strategies have out performed foreign stocks and more or less kept pace with US stocks in the past three years. Even more appealing, option-writing strategies have significantly outpaced their big trend-following brothers in the CTA space – see the Societe Generale CTA Index. While other CTA strategies have languished in a low volatility environment, option-writing strategies hit their stride.
Yet all is not roses. There is no free lunch, and option-writing is certainly no exception. Look again at the table above. Notice the differences between gain and loss deviation. These percentages measure the variance of positive and negative months. A higher percentage means greater variance. Notice that managed futures as a whole is the only group with a Gain Deviation significantly greater than the Loss Deviation (see AG and SocGen CTA indices). Yet option-writers as a subset are the opposite. This means their returns are skewed to the downside.
Anyone familiar with selling option premium understands why this is. We’ve written about the unique risks of this strategy before. See our blog post Pennies on a Train Track.
What option writers may gain in probability of returns they give up in depth of losses. This is why it’s common to see very steady, modest returns punctuated by short-lived but deep drawdowns.
Case in point, notice how option writers lost in 2008. The calendar year performance doesn’t necessarily show the entire depth of drawdown during the Great Recession, but it helps demonstrate how susceptible these strategies are to volatility in particular. And as with any index, some components even imploded due to losses.
Selling option premium remains a very attractive strategy but it’s not without significant risk. These risks can even be over looked when you’ve had a few years of low volatility, which makes for prime option selling conditions. It is great to out perform other managed futures strategies, but knowing the specifics of your trading method is important. If a CTA who sells option premium is currently managing your account, congrats, you’ve probably had a good experience recently. But do you have a thorough understanding of their risk management?
This is where Foremost can provide excellent service. If you’re not certain about the trades on a statement or wording in a disclosure document, we are here to help explain.
Give us a call! 888-818-0880, we look forward to speaking with you!