Edward Walczak began his trading career after 25 years in business operations and supply chain management. It was Walczak’s experience running Chicago-based candy manufacturer Brach’s commodity hedging operation in the late 1990s that got him deeply involved in the markets.
At one point, Walczak’s boss asked him about position limits and he had no idea what he was talking about, Walczak says. “You only get embarrassed once and I spent a week with my trader [learning] the business and became intrigued by it.”
Walczak is a math guy with degrees in Physics and Economics from Middlebury College and an MBA from Harvard, so naturally he was drawn to options. By 2005 he was making more money trading than in his day job, so he began trading proprietary money full-time and set up a commodity pool for friends and family.
In 2006 his proprietary trading returned 52.68% and in 2007 he added customer accounts to the Madison, Wis. based Harbor Financial LLC.
Fortunate breaks come in all forms. For Walczak his biggest break may have been a painful February 2007 drawdown in his mainly option writing S&P 500 program. The drawdown was not fatal, 17.93% for the month, and the program was positive for the year, but it made Walczak rethink his overall approach.
“Back in ’07, VIX was trading around 10 and all of a sudden the S&Ps dropped 50 handles in a day,” Walczak says. “A 50-point drop at the time was a big deal but historically was not that bizarre. It could have been a lot worse and I could have been wiped out, so I had to do something different.”
He spent the next year researching. “How do I cover these other risks that are out there and how [do I] use options to have a better risk/return profile?” he asked himself.
He began a study of volatility and decided to move away from pure premium collection. “If you are strictly a premium collector, you have a couple of issues. If you collect $2, then $2 is the best you can make if everything goes right. Second, if that is the only way you can make money, then you often are tempted into doing a collection trade when the edge is not with you,” Walczak says.
What he discovered was a volatility trading strategy that could exploit rising volatility. “A simple example is you sell a front-month option and buy a back-month option. If you do that at a credit, you have the opportunity for the front-month option to decay in value or go away entirely and the back-month option still has value,” he says. “The secret sauce for us is in the placement. If you are correct with where you place these things, then you get the best of both worlds. You don’t just have residual value in that long option, the long option actually could explode in value while the short option goes away.”
The February 2007 wakeup call came enough in advance of 2008 for Walczak to complete his adjustments and earn 50% in 2008, a year that completely wiped out a number of option writers.
“We found that rather than trying to trend-follow price to the downside, it is better with options to trend-follow volatility to the upside,” Walczak says. “Usually those are two conditions that go hand in hand.”
While the volatility trading strategy helped diversify the program and turn 2008 from a potential disaster to a home run, Walczak still was having problems in sharply uptrending markets. “Those really caused us a lot of problems with the techniques we were using, so I spent a lot of time [on that] and in 2010, we [began] to do some trend-following price wise.”
They still were using only options and found they could exploit trends more safely this way. The strategy uses a wide variety of ratio spreads, butterflies and offset butterflies. “It is basically 1 x 2s, 1 x 3s, 1 x 2 x 1s, where you are buying one, selling two, buying one,” he says. “That allows us to put trades on for little or no cost, so if the market tanks we are not long the market. We don’t lose money, the trade just goes away.”
Walczak says, “It is not that we changed so much as we evolved: Premium collection, to premium collection plus volatility trading, to premium collection plus volatility trading plus upside trend-following price-wise.”
Walczak uses all three approaches but emphasizes the one appropriate to market conditions. “I can construct a spread that gives me the exposure I want. It is not a make-it-up-as-you-go-along [approach], we have established position templates for different types of market environments. If I want to go long volatility, I don’t scratch my head and say, ‘What do I do now?’ We go into our tool box and pull out the long volatility spread and do some analysis around where to put that on.”
It is a combination of a discretionary and systematic approach that has produced solid returns in different market environments. Harbor has had no losing years and has produced a compound annual return of 22.07% with a 1.22 Sharpe ratio, and Walczak is still making improvements.