Volatility as an Asset Class

The history of managed money in the futures world since its early days in the 1980s has been about one thing: Trend following. However, a niche strategy that dates to the first options on futures contracts has been option writing. Prudent traders since the launch of options have used the product to mitigate risk, but there had to be someone on the other side of those defined risk long options positions. 

Soon strategies were developed to earn consistent returns by selling option premium. For a majority of the trading community, options were a one-way tool, so options sellers had the advantage of setting their own price. 

When founder of Warrington Asset Management Scott Kimple started trading options more than 20 years ago, most options managers were pure premium sellers. “Back then before tech homogenized a lot of trading and got everyone on the same valuation models, you did have some pretty extreme options mispricings,” Kimple says. “My mentor was a pretty aggressive premium seller and [earned] amazing returns taking advantage of those mispricings.” 

Option selling strategies had a reputation for producing strong returns for several years before a volatility spike came and wiped many of them out. As soon as it was over there were people to take their place, or the same strategies rebranded to avoid meeting a high-water mark following deep drawdowns. 

“They were either long-term sellers or short-term [sellers] trying to get within the inflection point of time decay,” Kimple says. “Now you have some fairly sophisticated players in multi-billion dollar shops and there has been more sophistication that has come into it.”

That sophistication, and the broader acceptance of selling premium as a strategy (see “Options on ETFs & ETFs on options”), has made things tougher for premium sellers. More traders are willing to take the other side of option trades. “People didn’t really understand options; the technology that we have today in terms of rapidly being able to adjust option prices based on models didn’t exist,” Kimple says. “You did see wide markets. Back then you would get into a fast market, the few market makers would blow the spreads up $5, $10, $15 wide and would make their month on a couple of fast markets. Efficiency has been added that has minimized the number of fast market conditions.”

There was still risk. “It might have been easy for the real good ones but with that extreme volatility in those mispricings, it was more like the Wild West,” Kimple says. “The business had become more institutionalized, technology has probably leveled the playing field, there is more advanced work on options and options pricing, and there are more option specialists.”

The Year 2008

As noted above, premium collection strategies have come in and out of fashion, but the 2008 credit crisis meltdown knocked many out of the game. Even the best practitioners of the strategy realized that they would never move to the next level of money management until they dealt with the inherent risk associated with pure naked options writing. One firm that earned outside returns for several years — LJM Partners — decided to alter their approach following the crisis. Actually, LJM had already offered more measured strategies with lower risk and less dependence on pure premium writing, but after 2008 it incorporated some of those methods into all of their strategies. It involved adding long options positions that reduced risk and its reliance on premium collection. 

“Our Aggressive strategy, which was a pure option writing strategy now shares a lot of the characteristics of our more conservative programs; this is because we have found that that is a much more efficient way to avoid those steep drawdowns like we had in the Aggressive Program in 2008,” says Lauren Savino, managing director, LJM Partners. 

LJM’s Aggressive program earned 68.10% in 2003, 53.76% in 2004, 42.21% in 2005, 37.71% in 2006 and 21.25% in 2007 before dropping 48.05% in 2008. Its Moderately Aggressive strategy also gained more than 20% in each of those years before losing 18.69% in 2008. Its Preservation and Growth Strategy earned 12.12% in 2008. “We added some long put positions in the portfolio that would offset some of that true options writing exposure, that is how that strategy was positive in 2008,” Savino says. “The philosophy was that pure option writing wasn’t for everyone so we wanted to create a risk/reward profile that was more appropriate for an investor that has a lower risk tolerance.”

LJM’s performance during that period was superior to most similarly geared options strategies — even the Aggressive. 

LJM was not alone. The industry produced a wrath of innovative options strategies after 2008 that sought to harness underpriced options in addition to simply collecting premium. This trend grew so noticeable that we dubbed this group “volatility value traders.” They were not all the same, but each utilized long option positions to hedge exposure to pure naked option writing and, in some cases, sought returns from underpriced premiums. 

An added bonus for these managers was that institutional investors were all of a sudden picking up the phone. Once they were volatility value traders instead of simply naked option writers, there was more institutional interest. The growth and growing validation of the CBOE Volatility Index (VIX) helped legitimize volatility as an asset class. It also gave tools to hedge volatility exposure. 

Instead of being ignored by institutions, some option managers are being actively courted. “Today, even when you talk to pension endowments some of the big institutional investors, they put out RFPs for option writing strategies to bring in a certain amount of income,” Savino says. “That is a big shift from my first few years working at LJM.”

LJM has even launched a 40-Act version of their Preservation and Growth Strategy and are managing about $650 million in it. “That is actually where most of our assets are today. It is a very different space from when we were just a CTA,” she adds. 

“Liquidity, volatility, open outcry and technology are the four big significant changes in [the space],” Kimple says. “Liquidity used to be kind of thin in the short options space, that has been somewhat democratized.”

He adds that the advent of weekly options has improved liquidity. “When I started there was one options expiration per month. Now you have got multiple expirations. You see these big banks come in and participate in Weeklys.” 

LJM still earns money through collecting premium, but is better protected in the case of a volatility spike and can earn positive returns from long option positions. “We are always net short [volatility] whether volatility is high or volatility is low,” Savino says. “The majority of the time there is still going to be a positive spread between the implied volatility and realized volatility. That is what we have seen for the last 18 months. So even though we have seen volatility trending lower — when you look at VIX as a measure of volatility — the realized volatility has also been significantly depressed for a long period of time.” 

That said, LJM includes long volatility positions in their portfolio to offset risk. “We always try to stay neutral when it comes to the market but there is a short [directional] bias just based on the fact that we want to offset some volatility risk,” Savino says. 

Robb Ross began trading options in the late 1990s when volatility was high. He saw S&P options providing a premium of 12% on at-the-money options 30 days out. “That was the price of fear in the market for what people are willing to risk to sell you safety,” Ross says. “I [thought at the time], there is a way to take advantage of this without just being a straight option seller.” 

He developed his Alternative Hedge Program, initially dubbed Scantily Clad straddles (see: Options naked straddles: A more modest approach,” Futures, January 2011), which is a Delta covered premium strategy. While unique, the strategy followed the trend of accessing the value of option premium while maintaining solid risk management models. 

Back to the future 

While firms like Warrington and LJM have survived and thrived through multiple market cycles by including prudent use of long option positions and not being completely exposed to the forces of volatility; pure premium selling appears to be on the rise. 

“The big story is this untried untested central bank activity has caused volatility to be abnormally low. It has caused an interest in the space, especially in short volatility,” Kimple says. “The only way to make money the last couple of years has been in the short volatility space. It has caused a dramatic increase in structured product related to getting short volatility. You have volatility tourists; people who are relatively new to the space who have come in – realizing the only way to make money is selling volatility — doing it in a highly risky fashion.” 

Kimple says the trade may last for a while but warns that it is crowded. “Recently when volatility has picked up [traders have] come in and smashed it back down. However, at some point when it comes unhinged, like it did in January and February in 2016 – the last time we had an extended period of higher volatility —these guys are going to get creamed.”

Volatility has contracted so much that many traders are asking if the VIX is broken. Kimple points out that of the 26 instanced where VIX closed below 10; 17 of those have occurred this year (see “Shrinking vol,” left).

“We think the markets will regress to more normalized volatility patterns at some point,” Kimple says. 

The question is, if prepared, will all these managers and traders trading volatility short? Folks like Kimple and LJM have navigated numerous volatility cycles. 

“My competition is an option trading program that has a track record from 2012; if they have got double-digit returns, they are selling volatility,” Kimple says. 

He worries that managers who have maintained those strong returns during the low volatility period between 2013-2017, they are taking on too much risk. “The only way they have been able to do that is by ramping up their risk and when — not if — volatility increases; these are going to be the guys taken out on a stretcher. That is always the case (see Volatility cycles,” below).”

Kimple adds, “People say to us, ‘Your returns aren’t what they [used to be],’ We say that is because we are good risk managers. You have options traders that have made strong returns over the last few years because they have been taking excess risk. The canary in the coal mine for these guys is if you look at their intermonth returns for January/February 2016, August 2015 and October 2014.Their intermonth drawdowns would be very instructive and would be a bit scary.”

The options-writing strategy is more accepted by both institutional and retail, and it could be happening at the wrong time. 

“My concern is if that acceptance is based on people who know what they are doing and who are able to sustain the next volatility spike?” Kimple asks. “It is frustrating that every time we’ve gotten a volatility spike it is a matter of hours or days before it is fully retraced. That is not normal, it is a direct result of central bank activity [and it] is something that can’t last forever.” 

Kimple may sound like Chicken Little, but at some point the market will have an extended volatility spike, and there are more people short volatility than ever before. 

“That is what is going to test the current generation of volatility traders,” Kimple says. “What happens when you have a Dow that drops 1000 points and doesn’t bounce back and take out the all-time high, a day, a week, a month later? What happens when the market goes down and stays down?” 

If we know anything about the markets, it is that it will happen. The question is when and how prepared you are for it.