Sun, Apr 19, 2015
A A A
Welcome Guest
Free Trial RSS
Get FREE trial access to our award winning publications
Opalesque Futures Intelligence

Manager profile: Alex Khalil explains the mindset that underlies his options trading strategy.

Tuesday, July 27, 2010

How Option Selling Works

The previous article is by the head of a business that specializes in option selling. Here, we have another perspective on option selling, from Alex Khalil of Vantage Capital Management.

Mr. Khalil started his financial career at Oppenheimer & Co. He picked up technical skills during a stint at AT&T's database development and migration business and was an assistant trader at the hedge fund Millennium Partners. He has worked as a securities trader at ETG LLC and Assent LLC.

He founded Vantage in December 2008 and started to manage client money the next November. His return from proprietary trading was 54% in 2009.

Mr. Khalil's commentary reveals the mindset underlying the strategy.

Many short sellers and option traders got hurt in 2008 by relying on their systems.

I traded for myself for about a decade, primarily equities with some options. That taught me true risk management; when you trade your own money, protecting your capital base becomes the priority. After all, that's what enables you to trade and supports your earnings. So you look very carefully at the impact of leverage and other risks. This experience made me a defensive trader. I worry a lot about losing money.

Over the years I became a proficient short trader. Traders tend to develop a bias to going long, but I developed a bias to go short and would make most of my money on the short side. In 2001, when the dotcom bubble burst, short selling was relatively easy. But even after that I did well on the short side.

Short selling stocks laid the foundation for my current strategy of selling put and call options on the S&P 500 index.

After I'd been trading for a while, I went to the NYU Stern School of Business to get an MBA. While finishing the MBA I developed a new trading strategy. At that time, I did not have a futures account, so I used the SPY, an exchange-traded fund, as the surrogate for the S&P 500 to test my theory. I traded options on the SPY.

This went on through 2008, which was a very turbulent year and not ideal for selling options, especially puts. I knew in 2008 that the strategy would work if I could implement it well. It is easier to execute in a less volatile environment, but the strategy did well in 2008. By the end of the year I was convinced it would work and established a futures account.

Tail Events

Being short a stock is similar to selling naked calls. But with the option, you have more breathing room. When you sell a naked call, you're in essence going short the stock, but selling OEM calls is easier than shorting the stock because you're further out of the money.

With calls I have an edge because I can be selling it out of the money but remain just as defensive as with the underlying stock. By contrast, when you short an equity you could be immediately under water if the price ticks one penny higher than your entry price.

In the past I wrote trading algorithms that were fully automated. This strategy is not, but it relies on rules and parameters that determine the trades mechanically about 70% of the time. I allow myself 30% discretion to look at what's going on. I worry about tail events.
Many short sellers and option traders got hurt in 2008 by relying on their systems or models. The model told them that the market was coming back up after losing heavily by the middle of the year, but those models did not factor in the credit crisis!

If you put on blinders, the model can fail you when something unusual happens. Yes, you need to stick to the methodology, but there are conditions you can monitor and intervene as necessary. You do need to look at the global picture and its implications for markets. There were warning signs the market was unraveling while the credit crisis was in the making.

My biggest fear is another September 11, when the market closes and then reopens 20% lower without any opportunity to adjust your position. I was trading at the time. It is a day I'll never forget. By contrast, in 2008 the market dropped sharply but it was orderly in the second half of the year. You had an opportunity every day to adjust your position.

Time Decay

When you sell a naked put, the risk and return are not different from selling a covered call option, where you are long the stock and meanwhile collect a little premium.

A lot of the premium revenue from selling calls and puts is driven by Theta, the “time decay” feature of options. An option has an intrinsic value if it is in the money. But if is out of the money, the price depends on time value.

Time decay is the mechanism by which the price of options depreciates. The longer it takes before the option expires, the more time value is built into the premium of the option. As the days tick by, the option becomes worth less as the chance that it will go into the money declines.

I look to collect time decay. If you sell options you want the time value to depreciate as you want the price to be lower when you buy the option than when you sold it. Time decay is how I generate revenue.

This strategy is scalable, at least up to $200 million. The S&P 500 is a very deep and liquid market. I could also implement the same strategy for other indexes, like the FTSE. It can be used for any index with a liquid market that is actively traded.

I think these kinds of strategies have a promising future. Investors may have thought that equity mutual funds carry less risk than CTAs or hedge funds, but the fact is mutual funds lost around 50% annually twice in the past decade, in 2001 and then again in 2008. Many hedge fund managers who are also CTAs do much better than mutual funds.
 



 
This article was published in Opalesque Futures Intelligence.
Opalesque Futures Intelligence
Opalesque Futures Intelligence
Opalesque Futures Intelligence
Today's Exclusives Today's Other Voices More Exclusives
Previous Opalesque Exclusives                                  
More Other Voices
Previous Other Voices                                               
Access Alternative Market Briefing


  • Top Forwarded
  • Top Tracked
  • Top Searched
  1. Studies - Fund managers bullish on equities, alternative asset classes, Hedge funds starting to spurn emerging markets, Insurance companies take aggressive approach to hedge funds despite restricted exposure[more]

    Fund managers bullish on equities, alternative asset classes From Benefitnews.co: Asset allocation and risk continue to be the top issues for institutional investors in 2015 and, while nobody is sure what the economy will do in 2015, investment fund managers remain positive about investm

  2. Investing - New hedge fund strategy: Dispute the patent, short the stock, David Einhorn bets on AerCap as leasing company avoids turbulence, Top hedge funds reveal these best investing ideas, Hedge funds bet big on PetSmart price bump, Victory Park Capital increases investment in upstart to $500m[more]

    New hedge fund strategy: Dispute the patent, short the stock From WSJ.com: A well-known hedge-fund manager is taking a novel approach to making money: filing and publicizing patent challenges against pharmaceutical companies while also betting against their shares. Kyle Bass, head of Hay

  3. Tiger Global falls 2.9% in March, down 5.3% in Q1[more]

    From Reuters.com: Investment firm Tiger Global Management, one of the hedge fund industry's most closely watched players, told clients that its hedge fund lost 5.3 percent during the first quarter, an investor said on Wednesday. Much of the decline came in March when the fund lost 2.9 percent,

  4. It’s not just hedge funds—IMF study finds stability risks from ‘vanilla’ funds[more]

    From MarketWatch.com: Leveraged hedge funds and banklike money-market funds are the parts of the asset-management industry most associated with risks to financial stability. But a report from the International Monetary Fund suggests that “plain-vanilla” mutual funds and exchange-traded funds also ca

  5. Hedge funds gain 2.4% in Q1 driven by currency and commodity markets[more]

    Komfie Manalo, Opalesque Asia: Hedge funds posted positive results last March to conclude a strong first quarter, with performance driven by strong macro trends in currency and commodity markets, complemented by broad-based gains and positioning in event driven, equity hedge and fixed income-b

banner