This is the market environment where a short volatility trading manager proves their worth. Two recent Pinnacle Award winners in this regard are of note. Short volatility players LJM Partners and Global Sigma, both a run with obsessive mathematical backgrounds, were put to the test this past week.
As the stock market closed down over 500 points in the past few trading sessions, volatility soared but perhaps most important – and least understood – is the importance of the distance of the downside path traveled relative to the standard deviation market probability models.
That might sound like a mouthful, but there is an easy explanation. And once you understand this explanation you will start to grasp the risk management variables that go into a strategy that has a win percentage consistently above 70%, based on studies of the averages in the BarclayHedge CTA database.
How the Strategy Works
Short volatility Commodity Trading Advisors (CTAs) engage in a strategy in the options markets. They typically sell options and collect a premium over the immediate value of the underlying asset. Here is a basic example: If an S&P option has an immediate cash value of $500, if the underlying asset was sold at that moment in time, the option could sell for $5,250. The $250 premium is collected by the option seller and for accepting the time risk of the option, which is an obligation that can be executed in the future.
And there is one key problem many investors have with derivatives in general – conceptually understanding that contract structure is often based on delivering something in the future and accepting the risk for doing so. Said another way, one key characteristic of the short volatility strategy is that it operates similar to an insurance company. An insurance company assesses risk, considers past behavior and then makes probability assumptions break even payout for a payout structure. If an insurance company determined that the actual “cost” of insuring something was $5,000 over the average of a sample coverage base, they might assign a $250 premium.
This is the mathematical fundamental behind the strategy, with strategy variations on risk management making the difference between success or failure.
Understanding the Risk Relative To Market Environment
Like an insurance company (and many of the Credit Default Swaps the underlie the US and European economy), most of the time the strategy is very lucrative with a low losing % — but it is loss size that really matters. The problem with the strategy occurs when probability diverts from standard deviation and the markets traded explode with significant volatility and sharp consistent price persistence, as has been the case the past few days. Which brings us back to LJM and Global Sigma and why watching their risk management now is more important than ever.
These players are known to sell S&P put options. The key to consider in this strategy is the distance they sell from the market. For instance, if the market is S&P market is hypothetically trading at 1,500 and the CTA sells a put near 1,200, the trade is a winner so long as the market does not breach significantly below 1,200. The location to sell the put is typically determined based on probability tables that, like an insurance company, attempt to determine the likelihood of the market going below 1,200. It is the point at which the market explodes lower, breaching the 1,200 level, that the CTA’s risk management regime – a core value – comes in to play.
In Due Diligence Recognize Risk Management Regimes, Look for Rules
Investors should have ideally determined upfront the basic method the CTA manages risk – particularly during a negative market environment. Now is the time to watch that strategy in action.
Potential CTA Risk Mitigation Strategies:
In the case of a short volatility CTA, the strategy can most basically manage risk by purchasing back the option they sold. However, this could also be the most costly of all potential risk management moves, as rising volatility might dramatically increase the price of the option as probability tables determine a higher likelihood of the outlier event occurring. With the price of options dramatically higher, this is typically the time risk managers might investigate selling options, not buying them. Thus, another option is to hedge the short option contract with a futures contract. Futures contracts don’t have the same time premium variables as do options. While potentially more cost effective, sometimes this hedging method is considered “imperfect” with the option premium – and related margin requirements – not recognizing the futures hedge the same as a direct option offset. Another strategy is to hedge and roll the option position into the next month or down the option ladder. Again, there are pros and cons to this strategy depending on what the market does in the future.
Whatever the outcome, this is the time the high win percentage short volatility strategy is tested – and where investors will learn that managers who control loss size in this strategy are most valuable.
DISCLOSURE: These are the opinions of the author and may not have considered all risk factors. Nothing on this web site should be construed as an individual recommendation, talk to your independent advisor. The author and Opalesque may have relationships with those people they cover in the publication. Mr. Melin provides a full disclosure of his business relationships to regulators and certain eligible participants who engage him in consulting projects. Managed futures investing involves risk and there are no guarantees of safety or future performance being implied. Managed futures can be a risky investment. This web site and its content is subject to the terms of the web site. Risk Disclosure and terms of web site are available here: http://www.uncorrelatedinvestments.com/templates/Disclaimer.html Performance information received on this site is provided by third parties and deemed reliable but there is no guarantee relative to same. Performance reporting sources and quality assurance techniques may include, but are not limited to: disclosure document, CTA self reporting, brokerage firm reporting, consultant reporting, spot checking other reporting databases; nonetheless no guarantee of accuracy or implication performance verification or auditing is being made by the publishers. The CTA Database is a project separately managed from www.uncorrelatedinvestments.com.