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Options Writing

Options Writing

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TRADER INTERVIEW

Ed Padon: Balancing risk and reward
After selling options for more than a decade, this fund manager knows how to generate consistent gains while avoiding drawdowns.
BY DAVID BUKEY

E

d Padon, fund manager of Zenith Resources, a managed futures program and commodity pool based near Dallas, Texas, has come full circle. Padon, 46, started trading far out-ofthe-money (OTM) options on gold and silver mining companies for small profits while in college. “I liked selling options for an eighth (0.125) and buying them back at a sixteenth (0.0625),” he says. “Or I’d buy at a sixteenth and sell at an eighth. That piqued my interest.” Despite his interest in trading, Padon entered the construction industry after graduating from Southern Adventist University with an accounting degree in 1982. In the mid-80s, he managed rental properties and two construction-related businesses. However, he found financing and developing residential and commercial construction projects frustrating. “It took longer than the actual construction,” he explains. After facing a third recession in the industry in 1989, Padon sold his businesses and began trading full time. Initially, he traded gold, silver, and copper futures, but soon began selling options on those contracts. He traded without charts for six months before changing brokers and discovering technical analysis. “I tried all the indicators — Relative Strength Index, stochastics, moving average convergence-divergence,” he
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I’m not trying to make a directional bet. I’m just trying to

the market’s not going to go.

determine where

says. At first, he was successful, but his winning streak only lasted a couple of months. “I took some drawdowns as I learned the technical indicators, and I was underwater for three years,” he says. Today, Padon stands firmly on dry ground. After trading his own account for a decade, he began managing funds in December 1999. Since then, his Zenith Resources index option program has gained at least 14 percent annually with a maximum monthly drawdown of just 3.12 percent (see Figures 1 and 2). His performance generated the top-ranked Sharpe ratio among CTAs over the past five years through May 2006. Padon’s success hasn’t gone unnoticed. Although Zenith no longer accepts new individual managed accounts, both strategies are still open through limited-liability funds, which Padon introduced last spring. He now manages $112 million and focuses on selling far out-of-the-money (OTM) puts on the S&P 500 (SP) futures as well as on currencies, treasuries, energy, and meats. His main index-option program sticks to the S&P 500 and is the most risk-averse, while the diversified program also sells puts and calls on other futures contracts and takes slightly more risk. Unlike many options fund managers who sell strangles (short puts + short calls) on the S&P 500, Padon’s approach is not market-neutral. Instead, he
December 2006 • OPTIONS TRADER

sells puts with strikes that have just a one-percent chance of being in the money at expiration. Because puts are sold so far below the market, the strategy offers a great deal of flexibility in terms of market direction. We spoke with Padon in late October about his strategy and recent trading experiences and the trade-off between risk and reward. OT: Are you selling both puts and calls — a short strangle — on the S&P 500? EP: No. We primarily sell naked puts in the index option program. We sell some above-market calls on the S&P 500 futures a couple of times a year, which might help accent our returns a little bit. In the diversified program, we take a bit more risk. We sell different-strike puts closer to the money. I wouldn’t want to sell the same strike in both programs. Here, we write put spreads (short put + long lower-strike put) and also sell naked calls about six times a year.

FIGURE 1 — INDEX OPTION PROGRAM VS. S&P 500 Zenith Resources’ index-option program sells puts on S&P 500 futures that are far enough OTM to have just a 1-percent risk of going into-the-money.

FIGURE 2 — DIVERSIFIED PROGRAM VS. S&P 500 The diversified program sells puts and calls on the S&P 500 and other futures contracts — currencies, treasuries, energies, and meats. Padon takes slightly more risk with this program, but it has gained more than the index-option program since January 2005.

OT: Is it a slightly bullish strategy, one that isn’t market neutral? EP: Right. You could call it a bullish strategy. But a slightly bearish or neutral market doesn’t hurt us either. In fact, a slightly bearish market is the best scenario. You could sell good premium the whole time, but you may have a few more heartaches. I’m not trying to make a directional bet. I’m just trying to determine where the market’s not going to go. OT: So your goal is to take advantage of time decay? EP: Absolutely. OT: Could you explain how your approach developed? Did any past experiences or mistakes when trading your own account in the 90s help form your put-selling strategy? EP: It was a process of trial and error that took 10 years. I realized there was a big difference between selling option premium and selling risk. OT: What do you mean?
OPTIONS TRADER • December 2006

EP: Many managed futures programs that sell options are based on selling premium. In other words, managers want to sell options for $1, $2, $3 — whatever their model says. But you have to understand what risk that premium [represents]. I first determine a trade’s statistical risk, and then I try to sell put strikes at that level or lower. For instance, I want to take a 1-percent risk. That risk [could yield] $0.20 premium or $2. But I’m worried about the risk, and I’m not trying to sell a certain amount of premium. That’s what I learned from past trades. If I go back and look at profitable trades, maybe it made sense to sell high premium. But if I consider the risk involved, I’ll think, “That was foolish.”
continued on p. 28 27

TRADER INTERVIEW continued
mium. For example, I can’t even start to sell strikes at a 1percent risk in bond futures. You might get 1/64th of premium, if that. OT: So what’s the answer? EP: I don’t trade those contracts. You might trade them directionally. Or to sell options, you’d have to take three or four times the risk. Right now, the T-bond’s implied volatility is just over 5 percent and the S&P 500’s implied volatility is 9 percent, which is historically low. That’s why we’re having trouble selling the put strikes I want to. OT: How has the drop in the VIX index affected your performance? Has it made your job harder? EP: Yes. Because of the low volatility, we’re not selling options for more than $1. When you’re selling options for less than $1, there’s a lot less flexibility between the bid and ask prices. If an option costs between $1 and $3, you don’t mind giving up $0.10 or $0.15 to execute the trade. But with $0.50 to $0.80 options, every nickel makes a big percentage difference in your returns. OT: So you’re placing sell orders at limit — higher than the bid — and not getting filled? EP: Only one of 15 orders I send gets filled. The lower the volatility, the worse it is. And I’m not seeing the strength of the bid as I had in the past. Previously, market makers would quote 0.40 (bid), 0.60 (ask), and you could bank on some $0.40 options there to sell. But now you might sell 100 contracts before the bid drops to $0.30. With low volatility, no one who fears the downside is buying options, and the quantity [of puts dries up]. OT: Would you consider changing your strategy to adapt? EP: I don’t know what changes I can make other than limiting the capital we manage. You can try to sell more contracts at a lower price, but I don’t see the advantage. I’d rather start trading S&P 500 index-based options at the CBOE. If the margins were the same at the CBOE as at the CME — dollar for dollar — I’d trade on both exchanges. I’d rather try to get more liquidity from another exchange than reduce the price of the puts we sell. I’ve heard the CBOE is considering lowering their margins in the fourth quarter. I don’t think our programs could hold more than $100 million at the CME. So it’d be good if the CBOE adjusts their margins. OT: Getting back to your strategy, do you create put spreads in addition to simply selling uncovered puts in the S&P 500 futures? In other words, buying a lower-strike put for protection? EP: We did a couple of times last year in our main index program, but not in 2006. OT: When you sell these spreads, do you buy and sell one
December 2006 • OPTIONS TRADER

OT: When you say risk, are you talking about the statistical risk of a put’s strike price going into the money — the market dropping to the strike by expiration? EP: Right. OT: How do you find put strikes that have just a 1-percent risk of loss? EP: I have custom formulas that use the S&P 500’s current implied and historical volatilities. The first formula uses the S&P 500’s historical volatility and shows the worst-case scenario (how far the market might fall). The second formula uses implied volatility to show what the marketplace is implying. To find a strike to sell, I assume the current month probably won’t be the worst (the largest loss) we’ve ever seen. And the implied volatility is probably wrong. Otherwise, there would be no option premium. The implied volatility [suggests] selling a higher strike than the historical volatility, because historical volatility shows the worst-case scenario. I sell the strike in between the statistical and implied volatilities.

of the prices that result surprise me.
OT: Is your formula for determining strike prices a probability calculator where you enter the S&P’s price, its expected future volatility, and time until expiration, and you’ll find a probability of the index ever touching that strike within a certain time period? EP: No, but it’s similar — the same basic situation. OT: So you think the S&P 500’s most probable move is somewhere between what its historical and implied volatilities suggest? EP: Well, it maximizes your return for the risk taken. Obviously, you could go out to the worst-case scenario (selling the lower strike). That’s the more conservative bet. But you’re not going to get any premium. This area — between implied volatility and historical volatility — helps me find the best risk-reward possibility. I’m just trying to find the optimum risk-reward ratio that makes sense to me. It has worked. Over the last several years, we’ve had the highest Sharpe ratio (risk-free return/standard deviation) of any CTA program. The problem is I can’t go the distance out-of-the-money that I’d like in most futures contracts. You can’t get any pre28

and traders become fearful, some

When the market starts falling,

option at a time or execute both trades simultaneously? EP: Simultaneously. Let’s say we sold a 1,200 put and the S&P trades at 1,300. If I sell it outright, I’m selling one contract for $10,000 of equity (margin). If the market gets within 75 points of the sold strike, margin will rise above $10,000. So if the S&P 500 drops to 1,275, I have to adjust the trade. At that point, I either need to exit or purchase a put below the one I’ve sold. That’s another way of creating a put spread and legging in. Here, the market can only drop 25 points before you have a problem. But if I enter a spread initially, the market can drop to 1,225 before the margin rises above $10,000, depending on the spread. If you’re selling puts 100 points out of the money, it makes a lot more sense to assume the S&P 500 will drop 75 points instead of just 25 points in the next 30 days. Because of the recent low volatility, a 1-percent risk is roughly 100 points below the market, whereas a few years ago, the same risk was 300 points out of the money. I’m trying to sell puts at the same risk distance below the market. But if I expect the S&P to drop 25 points this month, selling naked puts isn’t reasonable. I’ll try to sell a spread, so I can sell a put strike with a 1-percent risk and still have 75 points of flexibility. But my October options expired Oct. 20, and they were all naked puts.

OT: How do you determine your stop-loss point? EP: When we sell an uncovered put and we’re in danger of a margin call — the S&P 500 is within 75 points of its short strike — I’ll purchase a put 40 points or less below the one I sold. That ensures a margin call won’t occur if you’re using $10,000 margin. If the market drops near the short strike, I’ll buy back the short put and leave the long one in place. Then, I’ll consider reselling the put when the volatility is still high, but not necessarily that day or in the same contract. OT: How do you feel about repair strategies — buying or selling other options to get out of a losing position? EP: I don’t have a problem with it. If I were writing options 60 to 90 days before expiration, and there’s still 50 days to go, I’d be leery of trying to roll down (buy back a short put and sell a lower-strike one). But if you’re selling options that expire in 30 days or less, you can often roll down far enough to get out of harm’s way and get past the options’ expiration. OT: Why is that not a good idea with a longer time frame? EP: When you’re in trouble, you’re trying to fix the problem now. You’re probably not considering what will happen

Advertise in Active Trader Magazine
Contact Bob Dorman

HIT YOUR MARK!

continued on p. 30

Ad sales East Coast and Midwest bdorman@activetradermag.com (312) 775-5421 Ad sales West Coast and Southwest aellis@activetradermag.com (626) 497-9195 Account Executive mseger@activetradermag.com (312) 377-9435

Allison Ellis

Mark Seger

OPTIONS TRADER • December 2006

29

TRADER INTERVIEW continued

FIGURE 3 — S&P 500 FUTURES — SELLING PUTS In September, Padon’s more conservative strategy sold puts on S&P 500 futures that were at least 150 points (11.3 percent) below the market.

EP: No. I would use the same strategy and take the same risk every month. We can’t sell put strikes further out. The lower returns have to do with timing. For example, our last drawdown was in September 2003. That month ended on a Tuesday. We were profitable on the Monday and Wednesday surrounding our monthly report date. But on Tuesday, we lost ground. The S&P 500 [bounced around] and put us in negative territory for one day. OT: Could you describe a past trade in the S&P 500? EP: From Sept. 14 to 19, I sold a few October 1,180 puts and many 1,165and 1,175-strike puts in the index options program. Here, I didn’t sell calls (see Figure 3). But in the diversified program, I sold October 1,210 puts and bought 1,110 puts (credit put spread). Also, I sold 1,395 calls. The calls went against us, but I didn’t exit and they expired worthless. We sold the 1,395 calls for $0.45 and they rose to $0.80 at some point. That’s not bad, considering the market went straight up the whole time.

Source: eSignal

in the next 50 days. You often don’t establish a position you want. If you’re just walking in the door to establish a new trade, you’d probably never place that repair trade. If you’ve got just a few days left until it expires, time can heal it. But more time just gets you into more trouble. OT: Do you consider seasonal trends in the S&P 500? EP: Definitely. OT: Which seasonal trends stick out? EP: The September-October downtrend. And it was totally out of whack this year. That’s why we got caught off-guard a little bit last month. We sold October 1,395 and 1,400 calls, and they threatened us the entire time. September has been the worst month for our programs on a calendar basis. April has been the second-worst month, and I think it’s in line with some of the S&P 500’s seasonal trends. We’re not negative in those months, but they produce smaller gains. OT: So in September you try to sell puts even further below the market?
30

OT: In a typical month, do you tend to sell a couple of different strikes or do you focus on one strike? EP: I try to sell at least two strikes in each program. With the quantity of options we sell, I want to spread out over at least four strikes overall. OT: Why is that an advantage? EP: If the market goes against me, I only have to exit onefourth of the trades at a time. In the fund, I may sell 10 different strikes, because I take odd-lot fills (trades of less than 100 contracts). I can’t do this with the segregated accounts because I have to treat all accounts equitably. But if a deal comes along on a 50-lot (contract) trade, I’ll put it in the fund. OT: Do you sell options within 30 days of expiration to take advantage of an option’s increased time decay as expiration approaches? EP: Yes. And I’ve found the market is much more predictable in that time period. It becomes increasingly harder to predict beyond that point.
December 2006 • OPTIONS TRADER

FIGURE 4 — CRUDE OIL — SELLING PUTS AND CALLS

OT: In your diversified program, you sell options on other futures contracts in addition to the S&P 500, right? EP: Yes — currencies, treasuries, energies, and meats.

In August, Padon’s diversified program sold $64 October puts and $100 October calls. The puts went into the money on Sept. 12, and he exited and sold $62 puts. Despite this loss, the strategy gained 1.5 percent overall.

OT: Do you use the same strategy — selling far OTM puts within a month of expiration? EP: It’s similar, but we have to risk more to get any premium in these instruments. I may sell options with a 4-percent chance of going in-themoney. But the higher-risk trades are weighted less. I don’t take a 1-percent risk in one trade and a 4-percent risk in two other trades that each represent one-third of the account. A higher-risk trade will have more problems, but the overall effect isn’t as large. Last month, we were hurt in crude oil futures. I sold $64-strike October puts when crude oil closed at $73.19 on Aug. 16 (see Figure 4). I also sold October calls with a strike of $100. The short calls were four times further out of the money than the puts, but I received approximately the same premium for them. It’s the opposite Source: eSignal situation in the S&P — you can sell close-to-the-money calls for $0.40, while you can sell puts 150 points below the market for the same price. When crude oil dropped near $64, I [got out and sold] $62-strike puts. This was the only trade in years that went in the money. Had I taken a 1- or 2-percent risk, I wouldn’t have had a problem. We still gained 1.5 percent in September for that program. If I’d sold as many crude oil puts as S&P 500 puts, we would have lost money. OT: Has an option’s price behavior ever truly surprised you? EP: Absolutely. When the market starts falling and traders become fearful, some of the prices that result surprise me. OT: Do traders want to buy options for more premium than you’d expect? EP: More premium than you could imagine. On June 19, I was talking to a floor broker and he quoted 1,075 puts — 175 points out of the money — for $1.70.
OPTIONS TRADER • December 2006

He asked if I wanted to sell them, and I thought “No one would pay that.” Maybe the broker was wrong and quoted a higher strike. I only sold 400 contracts, because everyone else sold them before I could decide whether it was a mistake. Those puts were 14 percent out of the money, and they dropped to $0.20 two days later. OT: You gained at least 31 percent in 2001 and 2002 when the market fell and was quite volatile. How did you manage to avoid losses during these volatile years? EP: Our returns closely follow the VIX index. If you overlay a VIX chart over our monthly returns, you’ll see a very similar correlation. We’re selling the same risk each month, so a high-volatility environment is the only way to collect more premium. If you take different risks each month, this will vary. This program earned about 110 percent of the VIX’s average value. So if the VIX is around 15 percent, we’ll gain about 16.5 percent per year.

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