As one of the world’s largest databases of futures traders, we see more strategies and talk to more managers in the asset class than almost anyone. We also speak with thousands of investors each year looking to improve their portfolios. These conversations over the past two decades give us great insight into what investors say they want for their investments and, oftentimes, what they really want in their choices. Frequently, they are different. Consistently, they choose programs with the highest returns but find that they dislike the erratic nature of those gains. In fact, many of those positive periods come in more extreme environments, creating a “lumpy” profile. Option-selling programs look quite the opposite, with predictable returns for most months and losses coming in the most turbulent times. Both types have their place in a portfolio if they are used correctly. Is an option trading investment right for your goals?
Option selling explained
While statistics vary by market, approximately 94% of S&P e-mini puts expire worthless, and the majority of call options do as well. This makes selling puts (and, to a lesser degree, calls) a potentially lucrative and reliable source of returns. The basic concept is that a trader can write a put (meaning to sell) outside of the range of the market for a premium. If and when the option expires, the CTA keeps the money from the sale and can perform the same operation again. We cover the basics of this in our article Options Made Simple. With option expirations every day of the week, some of these positions might be held for as little as a day or even a couple of hours. If S&P stays out of the strike price range, it will expire worthless. Much like farmers might willingly lose money on corn puts to protect their downside, hedge funds and banks use long S&P puts to offset risk, hoping not to need the protection. The natural supply and demand characteristics keep both sides happy. When the market drops quickly, option sellers can take large hits if they do not respond rapidly.
Dangers of Strategy
Consistent returns can disguise some of the dangers of option selling. Unlike a traditional futures contract or stock, the value of an option does not move linearly. A relatively cheap put sold for $10 can jump to $100 and then $400 if fear explodes in a short period. We describe this phenomenon in our article on so-called “Black Swan” events. The VIX, also known as the “Fear Index,” measures the willingness of option writers to sell puts, which can be a good barometer for these prices. A high VIX means fewer sellers and higher prices, and a low VIX means that volatility is low and expected to remain so. At the beginning of February 2020, this index was at approximately 14 and stayed below 15 through mid-month, which is near the bottom of its range. Once COVID hit, this index spiked to an all-time high of 82.67 on March 16th, an astounding 550% increase. Buying options back to exit in this situation can be very expensive. This makes the reaction to key events critical to the success of option sellers.
Mitigating Risk
Approaches to reducing this potential for serious losses take many forms. We see shorter duration holding periods the most. If an option expires within a couple of days, the trader is often selling into known market scenarios. If, for example, a pandemic hit, they might get through their current expirations in a day or two and then be able to sell further and further from the current market price or simply stop selling protection to others entirely until they know what is happening. Using a combination of long puts to hedge their short puts can create defined risk scenarios where losses can be managed more easily. This also reduces upside, but a large loss can take months to recover. Diversification is another useful technique. By adding directional strategies that do well during a market crash, potential losses can be offset. Funds like Hyperion, which mix option writers with additional CTAs that capitalize on S&P stress, are an example of using natural strengths to offset weaknesses in other areas. Since it may be difficult to specialize in multiple areas, using strategy-specific traders for each role can be a good route.
Portfolio Fit
We find that every investor likes predictable returns. Option writing programs often provide exactly that but with the potential for sudden losses. A balanced portfolio that also utilizes directional futures managers, equities, and bonds can provide an “all-weather” approach to the market. Much like bonds historically, the predictable gains of these programs can add consistency to a portfolio, particularly through range-bound or slowly declining equity markets. This can help with investor patience, which can be limited even with a long-term mindset. Unlike choppy markets that option writers thrive in, directional futures traders often shine in crisis situations—the systematic nature of these programs benefits from longer trends and consistent moves. Equity holdings struggle during turbulent periods as well but grow slowly in normal conditions. Thus, the combination of all these strategies.
Deep knowledge of the benefits and risks of various traders is vital to assessing if one of these programs is a fit for your portfolio. The right option strategy can add consistent returns through most normal conditions and, properly balanced, can help risk-adjusted performance over long periods. If you do see a program that looks interesting, please reach out to see if the daily trading and benefits can work in your portfolio. With over 300 commodity trading advisors on our site, we offer choices for everyone.
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