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Has the Steamroller Rolled Over Options Trading Programs?

"In days of old, seers entered a trance state and then informed anxious seekers what kind of mood the gods were in, and whether this was an auspicious time to begin a journey, get married, or start a war. The prophets of Israel repaired to the desert and then returned to announce whether Yahweh was feeling benevolent or wrathful. Today The Market's fickle will is clarified by daily reports from Wall Street and other sensory organs of finance. Thus we can learn on a day-to-day basis that The Market is "apprehensive," "relieved," "nervous," or even at times "jubilant." On the basis of this revelation awed adepts make critical decisions about whether to buy or sell. Like one of the devouring gods of old, The Market -- aptly embodied in a bull or a bear -- must be fed and kept happy under all circumstances. True, at times its appetite may seem excessive -- a $35 billion bailout here, a $50 billion one there -- but the alternative to assuaging its hunger is too terrible to contemplate." -- Dr. Harvey Cox, Atlantic Monthly (1999)

"To fly an airplane it must fly 'in the zone.'
Too slow and you stall and lose control; too fast and the wings come off."

This is what Captain Dan Ryder, a former Navy fighter pilot who also served as Underway Command Duty Officer on U.S.S. Nimitz, explained as we sailed around Santa Cruz Island in a 37' Tartan. That conversation took place the weekend before the "bailout" vote, and it has stuck with me ever since.

Since then world equity markets have plunged in a dive that hasn't been seen since the Great Crash of 1929 stoking fears that we may be headed for the worst recession since the 1930s. Amid mounting fears that the frozen credit markets pose an imminent danger, the pressure for a coordinated rescue by the world's economic policymakers has become acute. As stated in this weekend's Financial Times in a telling quote, "Five years ago central bankers seemed almost omnipotent; now they seem scared."

No doubt sentiment has materially changed since October 2006 when equity markets were in the midst of an extended bull run and the VIX, also known as the fear gauge, was hovering in a range between 10 and 12. For comparison, on Friday October 10th, the VIX hit an all time record intraday high of 76.94--that is 7 times higher than 2 years ago, and almost 3.5 times greater than levels for the VIX just a month ago.

The importance that volatility plays in options trading should not be underestimated. In fact, it is the key factor which drives how much premium can be charged/received when purchasing/writing options.

Low volatility makes for a difficult environment to write options and capture premium in a risk adverse manner. Like an airplane flying too slow, volatility during much of 2006 and through February 2007 was too low. This became apparent on February 27, 2007 when the VIX spiked nearly 100% and several option writing programs collapsed, giving back two or three years of accrued profits in a day.

Since that date volatility began to rise with the VIX trending higher. But this presented another problem for many CTA option writing programs--the transition from low volatility to higher volatility can be treacherous. Nonetheless, a group of these programs managed the transition, and arrived at what could be considered the "sweet spot" or "zone" for premium capture--a VIX ranging between 20 and 30.

This is the average range for the VIX from 1997 through 2003. But to gain insight into volatility spikes during this time period one must look back to three events. The first event was during the summer of 1998 with the implosion of Long Term Capital Management when the VIX reached 45. The second event was after 9/11/2001 when the VIX spiked to 44. This was followed by a VIX high of 45 during the 2002 bottom. However, each of these readings is far below a VIX of 70+ reached this past Friday.

More recently, since February 2007 the VIX has spike above 30 several times: first on 8/16/2007 when it closed at 30.83, then on 11/12/2007 at 31.09, followed by a spike on 1/22/2008 with a reading of 31.01.

But the most memorable day was March 17, 2008 when the Federal Reserve Bank financed JP Morgan's takeover of Bear Stearns in a controversial deal. The VIX spiked to 32.24 and market pundits debated on whether the Fed overreacted, or had helped us narrowly avert a crisis due to systemic counterparty risk.

We got our answer on September 14, 2008, when in one of the most dramatic days in Wall Street's history, Merrill Lynch agreed to sell itself to Bank of America, while Lehman Brothers filed for bankruptcy protection and hurtled toward liquidation after it failed to find a buyer. That event set off the domino effect when on September 18th, the Federal Reserve provided AIG with an $85 billion loan in return for a government stake of 79.9 percent and effective control of the company--an extraordinary step meant to stave off a collapse of the giant insurer that plays a crucial role in the global financial system.

It's been downhill ever since with the largest financial "bailout" in United States history causing an existential crisis amongst those who hold to purest free market ideology. Yet, even with its passage--noting that financial market "rescues" have precedence in U.S. history dating back to Alexander Hamilton--the deterioration in the markets has not stopped (yet, as of this writing).

It is a classic case of the road to hell paved with good intentions. Every action that central banks, the treasury or governments have taken so far to try and stem the bleeding has been dismissed by the markets.

And last week it seemed that the metaphorical wings of market volatility finally came off.

With the VIX above 50, much less given its rise above 70, market conditions have become extremely imprudent to trade. This is the conclusion that we came to, resulting in our liquidating positions.

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Has the options trading model blown up?

Investor interest is options programs is a study in contrarian behavior. During the 1990s there was a great deal of aversion to the strategy of writing options. This began to change after 2003 when the bull market in the S&P 500 and the bear market in the VIX provided a 'goldilocks' environment for naked option writing. The result was a proliferation of CTAs offering such programs by the end of 2006.

The irony is that low volatility going into 2006 created increasingly dangerous conditions to engage in option writing. In order to maintain return expectations from prior years, a CTA had to increase risk by either moving the strike price closer to the underlying price, and/or increase the number of positions.

Conventional wisdom at the time was that these programs were uncorrelated to the underlying market. As a result, there was a flood of investor interest in option programs seeking 20+ percent returns. Then came the subsequent transition to higher volatility since February 2007 which has yet again chastened many investors.

There is an old saying when it comes to options trading--it is like picking up nickels and dimes in front of a steamroller. It turns out many players offering option programs in 2005 and 2006 were relatively new to the space, untutored in the violence of short "gamma" as happened during 1998, 2001 and 2002.

So what distinguishes one option program from another, as well as risky trading from less risky trading? The answer is qualitative, but the trick is to produce "risk-adjusted returns," in which positive returns are generated while mitigating volatility and exposure to risk. In options trading, this is a difficult feat.

First, investors need to recognize that there is a direct correlation between leverage and return with any managed futures program. A program which produces a 30% return is not necessarily better than a program which produced a 15% return. In fact, these returns could be produced by exactly the same trading programs with one using twice the leverage as the other for the same size account. The key is risk-adjusted returns.

One of the crucial factors which provides for consistent absolute returns in option writing/premium capture strategies is "theta," or time decay. Consequently, the most important responsibility for a trader to manage is the risk of positions in his/her book, which should be considered liabilities until expiration.

A standard strategy is to write options far out-of-the-money, with the idea that the probability such options will go into-the-money by expiration represents a low probability event. In this strategy, traders will "white knuckle" their positions with expiration the only true stop loss. Investors are required to suffer high intra-month equity volatility in their accounts with the expectation that if the options eventually expire out-of-the-money, any unrealized losses plus premium written will be earned.

Risk of ruin is high with this kind of approach, and there is a tendency for the "deer in the headlight" syndrome. If traders do cover such positions, thereby booking large "painful" losses, they will often "roll" the contract to another strike price in the hope that the market won't reach that subsequent level.

This kind of strategy has worked reasonably well for many option programs, with some using variations of the strategy to mitigate risk and equity volatility by utilizing bull spreads and/or calendar spreads.

The critical question in this current environment is if implementing routine trading strategies is still viable or more importantly, is it prudent? There are rumors that certain CTA option programs have utilized more margin than the agreed-to account size. This situation, in my opinion, represents irresponsible trading.

The bulk of investment performance is typically a function of strategy and risk taken. Yet the complexity of human behavior can never be fully modeled. Therefore, a discretionary common sense approach is needed--one which balances the quantitative with the qualitative in order to manage cycles of volatility.

Traders like to talk about how they provide "alpha" or skill-based returns. Alpha is a byproduct of "beta," which is often referred to as a benchmark. In alternative investments, one can think of beta as the core strategy and alpha as the tactical overlay in response to changing market conditions.

This is the strength of discretionary trading--the ability to tactically adapt to changing conditions.

Unfortunately, the 'quality of returns' is a difficult concept to quantify. My recommendation is not to analyze how well traders have performed in normal market conditions, but how they have performed under stressful market conditions such as February 2007, March 2008 and now during October 2008.

Where does option trading go from here?

The seeds of the economic crisis we currently find ourselves is founded on the 'forward contract exclusion' from Section 2(a)(1)(A) of the Commodity Exchange Act of 1936. From this loophole in the Act, and various court cases since 1936, as well as the CFTC's 1992 exemptive order issued under then-chairperson Wendy Gramm, evolved the unregulated over-the-counter (OTC) derivatives market.

It is this history, along with deregulatory aspects built into the Commodity Futures Modernization Act of 2000, which allowed for the exponential growth of the $50-$60 trillion credit default swaps (CDS) market.

But for the ISDA and its former CEO, Robert Pickle, previous market crises such as the Orange County and Metalgesellschaft derivatives debacles in 1994, as well as the implosion of Long-Term Capital Management in 1998, should have long ago forced OTC derivatives onto exchanges such as the CME.

The persistency of frozen credit market conditions in the face of multiple central bank, treasury and government actions/interventions is cause for great alarm. Meanwhile, the Sword of Damocles overhanging this crisis has always been the CDS market. Draconian as it may be, some are calling for international action to declare credit default swaps null and void. But could this fear be overblown?

Fear culminated in panic last week as the market eyed Friday's Lehman Brothers CDS auction in New York. The average price at the auction was below 10 cents, and worry was that financial institutions worldwide would have to face a bill of as much as $400 billion leading to significant writedowns.

It turns out, however, that the net payouts that CDS sellers have to make on defaulted Lehman Brothers debt is only a small fraction of the amount of insurance that was written. According to the DTCC, the "multilateral" calculations it performed on swaps tied to Lehman "indicate that net funds transfers from net sellers of protection to net buyers of protection are expected to be in the $6 billion range."

This is excellent news as it proves to the market that net exposure on CDS transactions is substantially less than the $50-$60 trillion nominal figure often cited, which in fact references the "underlying" bonds and loans being protected. In other words, contract offsets greatly reduced overall market exposure.

Meanwhile, there has been an announcement that the CME Group will launch by the end of November the first electronic trading platform that is fully integrated with a central counterparty clearing facility for the CDS market. At the same time, the G-7 has pledged to do everything in their power to prevent any more Lehman Brothers-style failures of systemically important financial institutions.

Nevertheless, there will be more dislocations to come. Concern now is focusing on insurance companies and automakers. At the same time, the cost of protecting Dubai's debt surged last week as concerns mounted about potential investment losses in the Emirate and the refinancing of up to $22 billion of debt.

Meanwhile, Standard & Poor's stated that GM and Ford may go bankrupt, which is just one indication that substantial damage has been done to the "real economy." Further, expectation is that unemployment will increase causing a feedback loop into lower consumer spending and reduced earnings for companies.

All this leads to the idea that the US stock market is susceptible to a long malaise where the predominant trend will be wide ranging sideways action. Yet, after we turn this page in market history, systemic risk will also have been greatly reduced, and it is unlikely we will see the VIX at 60+ again for a generation.

Current volatility as of today makes any attempt at establishing option positions very risky/expensive. However, once the market finds technical support, the setup is one where there will be greater implied volatility than the actual volatility as exhibited by the market. This is a perfect environment for arbitrage.

So for the option programs who survived this period and proved their mettle in managing risk, investors should recognize that markets over the next few years will likely be "in the zone" for these programs.


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