Thursday, 7 April 2011

Consulting Two - No Explicit Cost v Negative Carry Option Strategies

In my consultancy work I have been surprised by the frequency with which I have come across zero-cost strategies in options. Traders and portfolio managers find them more alluring than they should. It is as if these strategies intrinsically have more merit and deserve more attention. They don't.

To take on an options strategy, in say an equity index, the trader or PM must have a view on the underlying. To have an informed view the trader must follow the instrument closely – this allows them to attach probabilities to the possible broad scenarios behind taking a view via options. So the thinking may be that the index has had a good run and is beginning to act tired; that is there is limited upside from the current level. Or it could be that a particular share has formed a double bottom, there is good value in them and selling might begin to dry up. The first scenario is one that might suit an over-writing of call options. The second might fit an underwriting near current levels by selling put options.

To simplify market activity there are three broad outcomes possible – a trading range, a further significant rise, or a significant fall. Lesser directional movements are captured in the trading range scenario. The money manager or trader will have views on the likelihood of each of these, or to put it another way, if pressed most money managers could attach probabilities to the three broad outcomes. The money manager might have a view that the odds of a significant decline are small, say 10%, but having had a good run the odds of a trading range to consolidate the rise is quite high, say 60%. And the chances of further significant upside are greater than the chances of a significant fall, given the evidence of new buyers – so the odds of a significant rise are 30%. Whatever the exact percentages, the trader will have his own take on what the probabilities are of the three possible outcomes. It is his own probabilities which need to be fed into the construction of an option strategy to make it a fit of his view.

Of course the further significant rise might follow an intermediate pause for refreshment in the price of the shares or index. The extent of time taken to consolidate or pause is a key point. This is the time frame factor, and all managers have a time frame in which they add most value. This is the period over which they generate alpha. If they are a scalper, they shouldn't be taking a view over the next quarter, and a fundamentally-driven stock selector should not be looking to implement a view over the next couple of days. If a manager has a variant perception on earnings, for example, that would normally emerge over several quarters rather than over a week. All option strategies have a time frame, fixed around the months of the option maturities. To be a good fit for the trader the option strategy has to take place over the right forecasting horizon for them.

In a commodity market traders will know the price level at which industrial users will be highly likely to come in to buy. They may know the price zone when commercial hedgers have historically increased their open interest. In the world of equities a manager will have a clear idea of where value is emerging in a particular stock, and where companies buy-in their own stock. In fixed income traders will know at what interest rate funding becomes attractive to a particular category of market participant. So the portfolio manager or trader will have his own mental map of the significant levels of the markets they follow as they see them. In contrast, traded options are bought and sold for strike prices set at intervals by the rules of the exchange on which they trade.

The currency of option trading is volatility. So it might be said that the vol on a class of options is at least a couple of points rich compared to its recent history. Or that the smile of the volatility curve is particularly skewed because of a recent freefall in prices, meaning that out-the-money puts are expensive relative to those with strike prices near-the-money. The 3-D volatility surface is what the options market maker takes his view on.

The users of options may or may not have a view on volatility per se. The users may have opinions on levels and how long it might take for moves to develop and mature, and what probabilities they attach to scenarios for their markets. Professional traders will have a view on vol. Portfolio managers who read a lot of fundamental research and meet company managements are unlikely to have a strong or well-informed view on option volatility by class, never mind by strike. So having done option training, PMs will know what implied and realised volatility are, but it is not the element on which they are typically able to take a well informed view. It is not their currency.

So it is that option strategies are often expressed in the language of levels – strike prices plus or minus net premium. For simplicity pay-off graphs tend to illustrate possible outcomes at maturity. This makes the marketing of strategies more straight forward, and expresses strategies in terms closer to those most readily understood by the widest number of portfolio managers. It does little for suitability or fitting with a manager's market view. And so we come to "zero cost" option strategies.

Zero-Cost Strategies
Zero-cost strategies would not matter much were it not for the frequency with which they are implemented. After all the PMs are all grown-ups and they can always say no to an options strategy proposal. But the allure of the cachet of no explicit cost seems to be very strong with the buy side. So a disproportionate number of strategies are created, sold and implemented based on the appeal of no up-front premium outlay.

The typical circumstances are that, for a give maturity, the premium attached to a near-the-money strike option happens to be twice the premium for an out-the-money strike option. This means that, taking account of one side being on the bid and the other on the offer, an investor can receive as much premium for selling two lots of options O-T-M as they pay for buying one lot of A-T-M options. The payoff profile is rising profit through to the OTM strike, and from that level out a declining profit.

Sometimes the ratio between the strikes dealt in is not 2:1, but say 5:2, but overwhelmingly in reality the zero cost collar or put protection is sold and implemented using a ratio of 2:1. The outcomes are then much more intuitive to comprehend (and pitch).

In the process of putting the strategy together the strike levels and maturity of options are selected to fit the template that the purchased premium outlay should be offset by the premium received from the options sold. Occasionally, when the term sheet is put together by a less experienced sell-sider, the O-T-M option is struck further out in time than the near the money option. This diagonal call spread/put spread is less elegant to sell and understand, and utilises two time horizons.

Now going back to the portfolio manager's use of options, he or she should use traded options when they efficiently implement their views on markets, and within their style of investing/trading. Their views come in several aspects: their own take on what the probabilities are of the (three) possible outcomes in the specific market; their own mental map of the significant levels of the markets;  and they should take views via option positions over a time-frame that has a resonance with their own horizon for adding value.

Explicitly stating the elements going into the views on markets makes plain how specific they are to the trader or portfolio manager. It may well be possible to express the market view of a portfolio manager using options – so the time frame, probabilities and significant levels match what can be achieved and structured in the options market. That can be guaranteed to happen using over the counter options; that is, using bespoke instruments. To a degree using pre-existing strikes, dates and a given volatility surface of traded options will always be a compromise versus that ideal fit.

Lay on top of that that zero-cost strategies are put together when there is a conjunction of option maturities, skewness and strikes that just happens to give a ratio of 2:1 in premiums, and the impartial observe can see that zero cost strategies are a very artificial construct. Further it is plain that in order to put them on portfolio managers or traders are quite conceivably having to compromise their own market view in some dimension to accommodate the implied view of the zero-cost option strategy. So the real cost of the zero-cost strategy is not the premium expended, which by definition is nil, but the potential for a significant compromise with the actual market view of the risk taker. This mis-match is too often the cost of the zero-cost option strategy.

Using Negative Carry Strategies
Parenthetically, the inverse of the driver of the zero-cost options strategy, has produced great returns in some hedge funds. Rather than be a net seller of gamma (through being short one unit of O-T-M delta) some of the most successful trades of all time have been long long-dated optionality. Being net long of option premium comes at a cost – there is time-value erosion to cope with. But for some patient investors there is a big attraction in having a negative carry trade which gives well defined upside/downside parameters.

The "greatest trade of all time" is the definitive example of the successful negative carry trade. Mortgage backed securities have embedded optionality in pre-payment risk, but through derivatives on MBS specific tranches and indices it was possible to construct trades that would benefit from no payment risk – when mortgagees hand back the keys on their houses. So it is that the likes of John Paulson and Kyle Bass made billions on the subprime meltdown. There was an explicit cost to the trade, but the downside was known from the outset, and at least in the mind of the originator of the trade the real risks were in rolling over the positions – the collapse was going to happen at some point, though its exact timing was not foreseeable.

A similar set up was seen by Mark Hart of Corriente Capital of Fort Worth Texas. Like Paulson he created a dedicated vehicle to run a long long-dated option strategy to play one specific investment idea for the medium term. In the case of Hart, the fund he created in 2007 with the founders of GavKal, the European Divergence Fund LP, owned credit default swaps on European sovereign risk. Hugh Hendry of Eclectica is hoping for a similar payoff (7:1 and better) from using CDSs for taking negative views on China-related plays.

Another successful manager that uses negative carry options is Jerry Haworth of 36 South Investment Managers of London. 36 South has a diversified fund, the Kohinoor Fund, that only uses long-dated options and which has a 10 year track record. Haworth has also set up funds to benefit from specific tail risk events that use the same approach – for example the Black Sawn Fund that made 234% in 2008.

For each of these managers the use of negative carry option strategies gives a very useful attribute - the left side of the distribution of returns is truncated. That is the range of possible outcomes is limited on one side, which is the classic desirable skewed distribution of hedge funds.

Finally, some successful managers will not engage in negative carry trades with optionality on a structural basis in their fund. Rather for some long established and successful managers they see themselves as earning the right to start to use these strategies once they have passed a return threshold for the year. So once they have earned 8 or 10% (and therefore have every chance of producing a double digit year as a minimum) they will invest some of their profits to give a shot at making a banner year.

When I was Head of Derivatives at Clerical Medical I used to tell the investment professionals there that derivatives should be used to implement their views on markets when the instruments allowed that to be done economically. So in specific circumstances, for a particular money manager, a zero-cost collar may exactly fit their market/stock view. But the investment concept invested in, and the fit of the option tactic with the view is more important than the explicit cost, as the successful examples of the use of negative carry option strategies show. 

The first article in this series on consulting in the hedge fund business can be found at Consulting One

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