By Simon Kerr, Publisher of Hedge Fund Insight
Brand new instruments have massively changed markets – one thinks of Credit Default Swaps and corporate bonds, or MBS and the housing market. It is less common that a new iteration of an instrument makes a big difference to participants. But that is what has happened to Kyle Rosen and his use of traded options.
Rosen is a two decade veteran of the traded option markets in the United States. He has a 19 year track record in option volatility arbitrage, and takes advantage of the four familiar phenomena of option trading. They are implied volatility versus realized volatility, skew (differential pricing with respect to money-ness), the asymmetry of option pricing of trending bull markets and declines, and time decay. In the case of Rosen Capital Advisors LLC the option portfolio is market neutral and the manager utilizes real-time delta-hedging techniques to maintain that neutrality.
Nearly all of the strategies implemented by Kyle Rosen are in S&P 500 Index options. This has many advantages. The options are exchange-traded (CBOE cash options), they are highly liquid, and they have low execution costs. Because S&P500 Options are frequently traded and priced they are an excellent market in which to actively control risk. Many option strategies come unstuck because the markets become one-way, the spreads widen, the action (the spot area of the market) moves away from the open interest, or because the markets get dominated by one constituency (market makers, hedgers, traders or speculators). The market for S&P Options is always liquid and has a 3-d volatility surface (strike by expiry by type) that is always actively priced and has real depth for size. This is important for real-time risk measurement (to understand what your risk has become) and for risk management (the ability to do something about the changes to your risk from market change by dealing).
Rosen’s track record is made up of performance histories with positive attributes from each section. Kyle Rosen has made good money for his investors in each stage of his career, but the fund format, and hence risk appetites have varied. So it is not possible to share a conformed overall record for risk and return, but it is illustrative that in his tenure at Strome Susskind Investment Management (1995-99) there were five years with positive returns in which 43 out of 52 months were positive. In the next ten years there were eight up years and two years with minor losses. Over the period 2009 to March 2013 Rosen ran a less constrained account with great success before running capital in a fund format from April this year.
The results achieved by the Rosen V Partners LP Fund are shown in the Table.
|2013||Apr||May||Jun||Jul||Aug||Sept||Oct||Nov||Dec||Apr – Dec|
source: Rosen Capital
In the period during which these returns were produced the VIX was in the low to mid teens most of the time, and the stock market trended. These are not the best market conditions for volatility arbitrage, which tends to produce better returns when volatility shifts. Rosen Funds have historically produced the best performance results during or after crisis events when equities fall, hence the return target of low correlation can be met.
Rosen Capital Advisors states that it acts opportunistically to exploit option price inefficiencies and capitalize on the erosion of premium. The option premium criterion on which the firm majors is time decay. The trading strategy can be thought of as similar to an insurance company model. Premium is received upfront, there is a “Margin of safety,” and the firm only writes policies when the odds are favorable and risk is measurable. The benefit from time decay can be seen in the graphic below.
The graphic illustrates that the rate of decay of the time value of options accelerates as the option approaches expiry. Traded options lose most of their time value in the last month or so of their life. So a seller of options (someone who is systematically short of option premium) benefits from time value erosion, and particularly near expiry, other factors being equal.
This is where the new iteration of an instrument has potentiated Kyle Rosen’s strategy. The introduction of weekly options on the S&P500 Index has enabled the option arbitrage portfolio manager to harness time decay like never before. Weekly options now comprise almost 20% of the CBOE’s average daily volume. Not only have the weeklies increased the number of potential mispricing opportunities fourfold, they have enabled Rosen to fine-tune his hedging strategy, which led to 2013 being profitable and the least volatile year of his two decade track record.
(1) Net performance returns are unaudited and include deduction of net operating expenses, a 20% performance allocation and a 1% management fee. Past performance does not guarantee or necessarily determine future results.