Friday, February 24, 2006

Options Trading: Premium Selling and Diversification

Placidity continues. Flatlining indices aren't presenting much of an exciting landscape for net delta types. However, time keeps running forward at its inexorable pace and continues to reward premium sellers.

Part of me wants the market to make a big move but at the same time, through diversification of strategies employed at Cadence Capital, profits get generated in any market conditions.
Granted, I like delta moves because that's where serious rate of returns are attained (strongly augmented by long gamma strategies). However, time decay-type returns are nothing to sneer at either - even if they don't give you the same ROI.

It's really a matter of capital allocation. For fund managers the game isn't about just timing the market from vol/direcitonal perspectives. It's also (and more so as fund assets grow larger) the game of picking the strategy with the right payoff profile for a particular stretch of time and allocating appropriate portion of assets to it.

Currently, we're still 70% in cash, but our short premium strategy is by far the most prevalent on the books. As the market keeps on churning we'll get shorter while fully realising that an ensuing directional move can (and likely will) challenge our short premium positions. A big part of our short strategy is to collect enough profit from time decay to offset forthcoming losses due to delta exposure.

Does this work?

It does as long as the move does not come too quickly. Mainly the bulk of this sort of risk is contained by a short time window (7-10 trading days) after premium is sold. This assumes sales in the front month premium as we want the exponential theta to "outrun" delta exposure in the short term. While this works well, often we witness convergence of theta profits and delta losses netting a zero. That being so, it's a small price to pay for a potential (and highly probable) profit.

Of course then there is the issue with outliers.

Assuming that a strategy takes on a reasonable amount of risk (so that a reasonable amount of profits stand a chance of being generated) outliers will inevitably happen. That's why diversification within a strategy plays such a crucial role. If we want to employ a premium selling strategy, we'll sell premium in a large number of issues. While this may be counterintuitive, this has a "self-hedging" effect where the probability of all (or a very substantial part) of the portfolio blowing up is very small.

And how does one hedge that "very small" probability?

Through diversification across strategies. For example, our short premium strategy will get us to sell puts on issue A. At the same time we'll be long issue B through our delta long strategy. Naturally, A and B by themselves aren't enough to offset overall risk, but when there are many A's and B's in several uncorrelated "buckets", this risk gets closer to zero.

But, it's never really zero, is it? That's why we are traders and that's why "past performance is not a guarantee of future results." :)

Cheers,
/Dmitry

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