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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.
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