Options strategies to consider after the latest hedge fund disaster
One of the more remarkable stories to emerge from the US in recent days has been the collapse of optionsellers.com, as it fell victim to the short squeeze in natural gas.
Given the strong reader response to my previous article on option selling, it might be worth discussing some of the fundamentals when it comes to option trading. I’m going to describe for you a range of strategies, and let you know which ones I think are the most reasonable.
This happened to the natural gas price:
At the same time, the implied volatility in natural gas options prices went through the roof (so options pricing got much more expensive, in addition to the move in the natural gas price itself).
What Went Wrong
Cordier’s fund was effectively short nat gas, and didn’t have the nat gas to deliver for these contracts. Also, since the positions were leveraged vs. the size of customer accounts, the adverse movement was enough to wipe out the strategy, and indeed to put many client accounts into the red. These clients are now facing large bills to restore their account value back up to zero!
Nobody has died, but it is clearly a financial tragedy of sorts. At the same time, the hedge fund’s counterparties (those who were long nat gas) will have profited from this event.
Naked Call Option Selling – Maximum Risk
If you read my previous article, you will note that I specifically discussed the cash-covered put strategy. This is a strategy which gives you a long exposure to the underlying asset.
When trading options, you have a long or short exposure to the underlying asset according to this table:
You have a long exposure if you buy calls or sell puts. You have a short exposure if you sell calls or buy puts.
Now let’s consider the maximum profit from these four possibilities:
Let’s look at the right-hand-side first. If you sell an option, your best-case scenario is simply that it expires worthless. Your maximum profit is whatever you sold the option for, i.e. the premium. This is the same as an insurance company hoping that nothing happens after it sells a policy to a customer.
On the other hand, if you buy an option, then your potential gains are much more exciting.
If you buy a call option, then you have a long exposure and since there is no limit to how high the price could go, your potential gains are uncapped.
If you buy a put option, you have a short exposure and you want the underlying to be worthless, as that would maximise your gains. Your potential profit is the entire notional value of the underlying asset.
Now let’s switch things around and see what the maximum losses for everyone are. All we have to do is switch around the values from the above table (since the profit for the person who buys an option equals the loss for the person who sells an option, and vice versa).
So if you buy options, your max loss is what you paid for them. In the same way, if you buy an insurance policy, the worst-case scenario with respect to that contract is that you don’t get to make any claim (most people will hope that they don’t make a claim, of course!).
If you sell call options, on the other hand, you face a potentially infinite loss, if the underlying price goes toward infinity. If you sell puts, your max loss is the entire notional value of the underlying assets.
Selling call options is therefore the most dangerous of the four strategies, in terms of maximum potential loss.
But note that if you already own the underlying asset, in sufficient size, then you don’t face an infinite loss. This is because your positions offset each other.
For example, if James Cordier’s fund owned sufficiently vast quantities of natural gas in the required specifications, then it would have been hedged and would not have suffered a catastrophic loss.
But not only did he not own any natural gas, but his position sizes were much bigger than the value of client accounts. For the purposes of illustration, let’s say he was short $400 million of natural gas, even though his client accounts were only worth $100 million in total.
A More Reasonable Approach
My approach to options is to look for strategies which will enhance portfolio returns while posing zero probability of portfolio destruction. I’m looking for strategies which are compatible with an investment programme to protect and enhance portfolio value, not trading strategies designed to speculate on short-term price movements.
This means that I favour strategies which are “hedged” or “covered”. Let’s consider a range of strategies in turn:
- Buying Calls. Out-of-the-money call options allow for highly leveraged exposure to a stock or index. Only very small portions of a portfolio should ever be allocated to this strategy, as there is a high probability of a 100% loss. In-the-money call options can be used for a less risky stock replacement strategy, but the leverage must be managed or this strategy can also produce serious losses.
- Buying Puts. Buying put options is a great way to gain short exposure. Unlike with regular short-selling, the potential losses from buying puts is capped (see the table above). However, they require even better timing, as the stock must fall prior to expiry for the put-buyer to make a net profit. Shorting is difficult and buying puts is difficult to do profitably for many of the same reasons. Puts can also be used to insure the risk of long-only portfolios.
- Selling Calls. This can make sense if I already own the stock or underlying asset, and want to generate some extra income while also accepting that I may be forced to sell the underlying asset at the agreed strike price. This is the covered call strategy. (If I don’t own the underlying asset, then this is a naked call and I face unlimited losses.)
- Selling Puts. Selling puts means agreeing to buy an asset at a particular price, regardless of the actual price it is trading at when it expires. As described in my previous article, I am interested in the cash-covered put strategy. This involves selling puts at a strike price where I would be both willing and able to buy the underlying asset in the required size on expiry day.
There are many other ways that options are used to take positions in the markets: spreads, straddles, collars and so on. While I’m sure these strategies are useful for some traders, they require very liquid markets (to keep trading costs down) and huge attention to detail. For my own purposes, I’m content with the cash-covered put. To avoid blow-up, I certainly won’t be selling any naked calls!