Options Usage For CTAs Goes Beyond Risk Management
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The majority of CTAs are trend-followers. They do not try to anticipate market tops or bottoms, but rather look to find trends in motion and jump aboard. When these trend-followers use options, it is usually for purposes of risk management. However, there are other ways to utilize options that can provide the trader with the possibility of earning superior speculative returns.

Options on futures are a derivative of futures and thus are able to provide the buyer/seller with certain unique trading characteristics not found in futures, such as skewed exposure to directional price risk, exposure to volatility, and choices of various strike prices and expiration dates. An understanding of these characteristics can unlock the door to highly active areas of the options market. Volatility trading, with either a directional bias or with a market neutral bias is just such an area, one largely ignored by CTAs.

Concepts such as delta, gamma and market neutral are operands which combine to present the speculator with a tremendous array of trading opportunities that go far beyond long and short. In order to gain an understanding and an appreciation of the factors that must be considered for successful implementation of an options strategy, we've invited two expert options users to present their views.

Angelo A. Calvello, Ph D., Analytic TSA Global Asset Management. Mr. Calvello is the Director of Client Relations and Business Development for Analytic TSA. He is responsible for the development of the firm's products and business in the alternative investment area. Previously, he was Executive Vice-President at Credit Agricole Futures, Inc., Vice-President of Product Marketing at the Chicago Mercantile Exchange, and an independent floor trader at the Chicago Board of Trade and the Chicago Board Options Exchange.

[Name]. Mr. [Name] is the president of [Name] Asset Management, and is a former member of the Chicago Board of Trade. Currently, [Name] has managed futures, options and foreign exchange programs available with assets under management at $30 million.

Q: How do you use options in your trading? What advantages result from their inclusion?

Calvello: In our leveraged product line, we run five option-based strategies. Options are not simply a part of these strategies but rather are the foundation upon which the strategy is built. The returns generated by these strategies are the direct result of option valuation and trading. Specifically, these strategies seek to identify and sell mispriced listed cash options or options on futures. Typically, we sell a strangle while simultaneously replicating a fairly valued long position in the corresponding futures contract (establishing a "delta hedge"). We seek to arbitrage the persistent difference between implied and actual volatility in the global equity and fixed income markets--hence, the name of this group of strategies: volatility arbitrage. The major advantage gained from using options in our leveraged strategies is that the returns of these strategies are independent of market direction. This, of course, means that our return patterns are not correlated with the market or with other managers and that our inclusion in a pool or portfolio of managers can lower the overall volatility of the pool.

[Name]: We use options extensively in trading as a tool both to adjust position size and to manage risk. Under specific proprietary conditions, we purchase option premium and trade long gamma positions resulting in aggressive rates of return without a large increase in risk. Secondly, we substitute options for outright futures positions. Over time, we tend to meet our performance objectives with strong returns from a complex that explodes in volatility. An example of this occurred last April in the grain complex.

Q: How do you deal with the issue of volatility forecasting and its impact on pricing? Are you using a Black-Scholes or similar pricing model or have you developed a proprietary model?

Calvello: Our use of options reflects our commitment to developing and trading quantitative-based strategies. As a firm, we monitor over 80,000 optionable securities on a real-time basis and develop proprietary forecasts of volatility for each underlying asset. In our volatility arbitrage strategies, we take the relevant proprietary forecast of volatility and combine it with a valuation process we believe best identifies mispriced options and option combinations. By combining our volatility forecast with our valuation model, we believe we can enhance our strategies' performance by capitalizing on the mean reversion often found in implied volatilities.

We also trade options in our Active Currency II strategy. While the strategy is futures-based, we will use long options to hedge core positions in times of uncertainty, especially when a large position's profitability might depend on a binary outcome of a specific event (such as a political election). In this case, we will employ the same investment process in selecting and trading these options. In 1970, we developed our first option valuation model. We have continued our research and are currently working to expand our modeling to incorporate the stochastic nature of volatility.

[Name]: Volatility forecasting plays a minor role in our trading discipline. Our positions are accumulated over time and based upon our methods of pricing analysis. We trade market direction, not option volatility. Over the years my trading experience has been instrumental in the development of our proprietary discipline which isolates those situations when a market evolves into a structure having a high probability to become more volatile. We try to be positioned before volatility increases. One of our objectives is to capture high option returns as a market gains momentum and our gamma position grows.

Q: How do factors such as strike price, expiry and liquidity impact the decision-making process when implementing an options position?

Calvello: Our volatility forecasting capabilities and our valuation models allow us to add value by selecting the most over- or under-priced markets and options and choosing the optimal exercise price, expiry, and holding period. We have several screens that help guide the implementation of these strategies.

First, all things being equal, our preference is to trade the most liquid option markets available. Second, there must be a liquid futures contract on the same underlying. Third, we look at the liquidity of the individual options series. Liquidity is a key factor in that we can take positions of considerable size. We may be able to identify a mispriced option but if we cannot implement the trading decision, such identification is of little value.

Fourth, we consider the expiry of the option. An option with a long time to maturity can remain overpriced throughout our entire holding period; thus, there is no assurance of selling an overpriced option and purchasing it later at fair value (or better). The result is that we tend to sell options with a short time to expiration (approximately 30 days or less). Lastly, our valuation process has led us to focus on options that tend to be slightly near-the-money (about 2% out-of-the-money).

It is important to realize, however, that these are only guidelines. Our models often find mispricings across both strike and calendar skews; thus, we remain open to all possible strike and expiry combinations.

[Name]: We evaluate the option skew to isolate factors that determine our options strategy. When trading options one needs to understand how the skew affects different strategies. When we enter an option trade to reduce risk, we have a set of parameters that we like to see. When we enter an options trade as an aggressive strategy, the parameters are defined to meet that objective. The skew is an important ingredient in our analysis.

Q: Options, as a derivative of futures, provide exposure to volatility risk as well as to directional price risk. How do you manage this additional risk?

Calvello: In point of fact it is often the volatility risk that is of more interest to us than the directional risk. In our volatility arbitrage strategies, we take pains to neutralize the directional exposure of the position in order to focus on the volatility. As mentioned above, our volatility forecasts form the core of our search for mispriced options, and as such we rely on the long-run efficacy of our volatility models and our volatility research to help us maximize performance. We also manage risk overall by setting maximum notional sizes on our trades and monitoring all positions and position sensitivities on a real-time basis both on and off the trading desk.

[Name]: We do not view options trading as additional risk. Our firm is built around an options culture and options are part of how we think. If you use options properly, they should only enhance your performance, especially when a market turns volatile. We keep the logic simple and ask what is the potential gain from the options trade versus what is the exposure. Simple ideas will keep your exposure to the external factors to a minimum.

Q: Most trend-following CTAs who are reluctant to use options as a risk management tool argue that the increased costs of the options outweigh the benefits. Do you believe that this a valid argument?

Calvello: For trend-followers this might be true, since the cost of pure protection for many directional players eats into their returns significantly. Such managers may not have the capability, or desire, to develop the valuation tools required to identify mispriced options. However, Analytic TSA does not offer trend-following strategies. Indeed, our leveraged options strategies seek to mitigate all exposure to trend and to generate added value from the exploitation of option premium. From that perspective, options do not generate costs, they are the very source of our returns.

[Name]: We believe options are an important tool to manage risk. Options should only be used in specific circumstances and if used properly they will reduce risk significantly. We view options as an alternative trade. Of course there is exposure. However, when executed as an alternative to a futures position, options become a lower risk choice. It always boils down to one's philosophy, trading style and discipline and options play an important role in ours.

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