Kawaller & Company LLC : Long Option Convergence Trading

Summary

Understanding our approach requires an appreciation of the difference between the spot price (relevant for imminent delivery) for any good or commodity and a futures price (relevant for delivery at some prescribed time in the future) for that same good. Ultimately, when futures contracts expire, these two prices must necessarily converge. While this price convergence may be either a cost or benefit to futures traders, we restrict our activities to buying options on futures contracts – but only when this convergence effect works in our favor to a greater extent than option time decay works against us. While purchasing options has the attribute of offering the potential of unlimited gain with limited risk, these options have the added benefit of necessarily appreciating if held to their expirations when underlying spot prices are stable. This is a condition that can be determined at the point of purchase, and we believe it to be an edge that is available only in connection with the market for options on futures contracts.

Investment Strategy

While the above philosophy dictates the allowable portfolio holdings, the size of our positioning is discretionary. We employ a systematic process of adding to our positions when eligible options become cheaper and reducing our holdings when these same options become more expensive. This process enforces a discipline of buying low and selling high. Most funds achieve leverage through debt.

Risk Management

A purchased option offers the prospect of unlimited gains and limited losses, equal to the original price paid for the option. Thus, given that our portfolio is restricted to long options, the amount at risk at any point in time is the value of the options held. Our “value at risk” is truly the amount of option premium we have expended. This is a concrete, real number, as opposed to a theoretical abstraction that changes with each and every adjustment to the portfolio. We necessarily conserve the vast majority of our capital at any point in time, to assure (a) that the magnitude of those losses will be contained and (b) that we’ll maintain sufficient capital to continue trading after these current losses are realized.