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Practitioner View: Craig Kendall argues that the risks of option selling are manageable.

Tuesday, July 27, 2010

Option Selling for the Long Haul

Many investors regard option selling as a very risky strategy. Here Craig Kendall, founder and president of Financial Investments Inc., argues that the risk is manageable and the strategy has long-term potential.

Financial Investments' Option Selling Strategy returned 38.9% in 2009 and 21% for the first six months of this year. However, it had a drawdown in 2008, with a 23% loss. By contrast, the more recently launched Credit Premium Program made money in 2008 as well as in 2009. Both programs are among this issue's Top Ten.

Mr. Kendall also manages a hedge fund that applies the same strategy to equities and equity indexes.

 For investors who think outside the box, there are opportunities to generate absolute returns in these uncommon markets.

I searched for an alternative investment strategy after certain experiences in the stock and real estate markets. During the dotcom heyday I helped some companies go public. It was an exciting time but I noticed the disconnect between valuations and future cash flows. You could see there was a bubble and it was going to burst. In the early 2000s I helped with real estate deals, but there too values were increasingly not supported by cash flows.

Meanwhile, I learnt about option selling. This sounded like a viable long-term strategy. True, it is not for the faint of heart. But having implemented the strategy for almost six years, we understand the risks very well.

The basic investment idea is to write options with the expectation that we will retain the premiums as the options expire worthless. We make money as the options' value decays over time, rather than from market direction. That's what I love about selling options. I'm not a betting man-I'm a businessman .We can be 100% wrong about equity and commodity markets and still generate a commendable rate of return.

It happened in 2009. Our team looks at a lot of research, but we never anticipated that equity markets would rebound as strongly as they did in 2009. Our forecast for equity markets was totally wrong. But our results were fine and it worked out perfectly well for the clients.

Insurance Analogy

Selling options on futures contracts and collecting premiums is similar to selling insurance. Like insurance companies, the option seller has probability on his side. With the amount of capital a client has allocated to us, we execute trades based on predefined risk parameters for that amount of capital. We manage the risks every day and have never had a margin call for any of our clients.

This is not a black box strategy, though we do use proprietary programs for signals as to the next opportunity. But that's just the starting point. Based on volatility signals, we find which market offers opportunity, then do the research to decide what is the derivative option for getting the best rate of return. In other words, we do a systematic search to find opportunity but use a discretionary approach to finalize the best trades.

We trade liquid commodity markets, including crude oil, natural gas, wheat, corn, and currencies. Often we manage to sell at high and buy at low. When gold was very expensive about two-and-a-half months ago, we sold gold calls. Since then gold dropped and is now at support level, so we look to sell gold puts. When crude oil runs up, we sell crude calls; when crude oil runs down, we sell crude puts. The same thing happened with the euro/dollar and bond markets. We just have to be careful not to be whipsawed.

Right now wheat is a good opportunity. It's hitting six year high prices, with lots of volatility.

Hedging

Our Option Selling Strategy (OSS), which has a track record of five and a half years, sells far-out-of-the-money contracts. About three years we started the Credit Premium Program, which executes closer-to-the-money contracts with higher yields and larger capital requirements. For CPP, we hedge every contract we enter into and we know not only our predefined gain but also our predefined loss for every trade. Going closer to the money enhances returns; the downside is a little more volatility. Everything is hedged to control losses.

In 2009, volatility stayed within a good range for us. By contrast, in October of 2008 volatility exploded. In that situation, the CPP program did much better than the OSS because we rolled out of contracts much quicker. The 2008 black swan put quite a few of our competitors out of business.

We worked to improve risk management to address future black swan events and are very conscious of the potential impact of a big equity market drop on our positions. We're not doing S&P 500 contracts.

This year so far has been great for us, even as commodity and equity markets went down for most of the year. A lot of up and down movements and uneasiness create a perfect environment for our strategy. I credit our team for managing so well.

We do not target outstanding returns. Our object is to manage the risk and generate commendable returns for clients. And our business model is set up for the long haul.

Looking forward I think there will continue to be uneasiness in equity and commodity markets, certain sectors will continue to deflate and economic recovery will be difficult. But for investors who think outside the box, there are opportunities to generate absolute returns in these uncommon markets.
 



 
This article was published in Opalesque Futures Intelligence.
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