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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.
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