Investors flock to high Sharpe ratio managers on sites like IASG.com for a good reason. They display an uncanny ability to put up positive numbers almost every month. Option sellers seem to do this better than anyone, and they stand out when looking through hundreds of managers. If this one marker told the whole story, choosing winners would be simple, but that is not the case. So, what should investors look at if they want this return profile? In his bestselling book The Black Swan, Nassim Taleb describes the best characteristics of the best ones. In short, they create and execute solid plans for the unexpected. The extremely unexpected.
The phrase Black Swan can be traced back to a Latin expression from the 2nd century that translates to, “A rare bird in the lands and very much like a black swan.” Of course, the belief was that a black swan did not exist at that time. This belief persisted as a common expression in London in the 16th century until 1697, when Dutch explorers discovered black swans in Western Australia. Thus, a millennium of thought evaporated instantly. Often, we look at these events in hindsight and determine that we should have seen them coming. Famous examples include Tulip Mania in the Netherlands, where a speculative bubble burst in 1637, the Dot-com era, the mortgage crisis, and the Beanie Baby craze of the mid-’90s (hopefully just in the United States).
Taleb posits that extreme events happen more frequently than we think, so we should expect the unexpected and prepare accordingly. Things that have never happened before seem to occur with regularity. Most recently, shutting down entire economies, spiking inflation, and a large country being exiled from world trade are a few that caught me off-guard. Therefore, his preferred investing strategy was the opposite of an option seller who often depends on predictability. Instead, he was an option buyer. Specifically, way out-of-the-money options that were thought to be worthless. I spoke with one of his traders, who described the daily grind as being quite horrible. They lost money all the time until the market crashed, and they made it all back and more over a concise period. The problem was that investors could not stand to lose money all the time while they waited for a crash. The portfolio managers did not enjoy it much either.
Enter an option seller. Their strategy does the opposite; it sells put and call options as far from the market as possible while earning a premium. This creates a profile that makes money almost all the time but with the potential to lose a lot quickly. Demand in this space is heavily skewed to the put side as portfolio managers want to hedge downside risk by purchasing these contracts. Since markets tend to rise slowly and fall quickly, these options can be sold further away than call options. Call volume stays in a tighter range closer to the market. An unexpected spike or a massive drop can catch a manager off guard with extreme changes in value. If, for example, one sold 100 options for $10 each, a rapid swing could change the value to $200 each. This happens when everyone is looking for protection, and few are willing to sell it. As a result, they are subjected to unlimited losses if they do not re-purchase in time. Looking at track records for these strategies of significant length will often show a few months of these outsized declines.
Ultimately, the best-of-breed programs control this risk effectively. They do so in a variety of ways. Hedging can be done with a mix of long and short options positions. These can define risk tightly with equally balanced positions or a ratio of options sold and owned. Avoiding volatile events and limiting the length of holding periods is another tactic to limit risk. Recently, VIX futures have replaced some of these options as they tend to spike along with panic in the market. Special care should be taken if a CTA shows a short track record, has not traded through volatility, or cannot explain their risk management. A few that we use as benchmarks include Tianyou Asset Management, Global Sigma AGSF, and Crediton Hill. Each shows a long history through multiple market cycles and “Black Swan” events.
Despite these risks, option sellers can provide a stabilizing force in a portfolio. Consistent earnings paired with programs that may lose more often but profit in directional markets can potentially offer the best of all worlds. This includes a stable equity curve and diversification. Working with a professional who can point out the benefits and drawbacks of each strategy is perhaps more important here than with any manager group on our site. Please get in touch with any IASG representative if you think one might fit you.