Alt Investments

Embracing Equity Options In A Volatile World

Tom Burroughes, Group Editor, December 23, 2020


A fund harnessing tech such as artificial intelligence operates in the market for options, a familiar form of financial derivative used to both magnify returns and hedge certain risks. FWR talks to its manager about this market.

Some wealth managers have told this news service that they use options to help protect against market losses as bonds’ insurance qualities decline, but an investment sector figure argues that these tools carry risks if not fully understood.

A decade of wafer-thin interest rates means that the world’s government debt market no longer provides holders with much income – a large chunk of the German bond curve, for example, is negative. Using bonds to shield assets from equity market tumbles is costly. So, as a result, equity options are getting more attention. 

Michael Mescher, founder and chief investment officer of US-based Gammon Capital, employs quantitative approaches to making money, and his background in financial markets gives him a certain perspective on the case for using options. His business is now starting to take in third-party money.

“There is a need to caution people about working with options. Simply selling options to earn a yield can carry significant risks if there is a market selloff, such as what happened in March this year,” he told Family Wealth Report in a call. “People who were doing this [selling options] at the start of the year got carried out,” he said. 

A put option is a contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security, such as stock, at a pre-determined price within a specified time frame. This pre-determined price that the buyer of the put option can sell at is called the strike price. A call option gives its owner the right but not the obligation to buy such a security in a certain period. 

FWR has heard that wealth managers have sold put options at certain periods to earn yield, and also bought them to hedge downside exposure. Different strategies, mixing up different ranges of contracts, can be structured to manage risks, although this can become a highly complex area and makes big demands on technology and systems. For some time “rocket scientists” and maths PhDs plied a trade in the “quants” space. And now fast-expanding areas such as artificial intelligence are driving change. 

And this is the area that Mescher works in. Gammon Capital was founded so that he could use a quantitative approach towards options trading. “You can structure portfolios [with options] that perform in all kinds of environments,” he said. 

Explaining his firm’s name, Mescher said that in the past he had used AI software to learn and play Backgammon for money and decided that “gammon” was a good word to use. 

He has worked in the financial industry for more than two decades - working in the trading pits of the Chicago derivatives market for example. Mescher has also worked in hedge funds, at Lehman Brothers and later, as part of the restructuring of that business, he moved to Barclays, the UK bank, where he was in charge of special situations volatility trading.  

Since inception on December 1, 2018, the strategy has made an annualized return (for the share class taking a 2 per cent annual management fee and 30 per cent annual performance haircut) of 131.1 per cent, as of October 2020. On the share class with zero annual management fee and 50 per cent performance haircut, annualized net return was 102.8 per cent for the period. During the course of the strategy has moved from a separately managed account to co-mingled. Those results compare with the 15.1 per cent return from the SPX (Standard & Poor’s 500 Index) over the same period. 

The firm said its largest monthly return over the period was 205.9 per cent, while its largest monthly loss was -12.2 per cent. To redeem from the strategy, there is a quarterly 60-day notice period.

Mescher argues that the ideal clients are those who are “seeking high octane returns.”

“Some HNW individuals and sophisticated investors know it is possible to create excess return by levering your upside without levering your downside.”

Equities have been choppy at times this year. The more volatile they are, the more expensive buying protection becomes, just as fire insurance gets pricier the more fires there are. Volatility, though, can be treated as an asset class in its own right. (Certain measures of market volatility have become part of the regular market vocabulary. There is the “VIX”, a volatility index which is sometimes called a “fear gauge” – the higher the VIX is, the choppier and more unsettled a market is, and vice versa.) 

“When I look at an asset class like volatility, it pays to spend time trying to manage and anticipate anything you can think of. The incremental flexibility provided by options offers significant rewards to those who can anticipate risk,” Mescher said.

When entering this space, it is the manager that counts, he said. “You are putting a lot of trust in a manager when you invest with them. It is important to understand you are buying more than a strategy – you’re buying a manager.”

Because Mescher takes a quantitative approach, he can be agnostic about views on the state of markets and the broad economy. 

His approach also allows him to make money out of circumstances that might otherwise pass people by.

Options can allow a firm such as Gammon to position around possibly volatile events that might not be fully appreciated. For example, the expiry of financial assistance under the US CARES Act – which had lifted GAAP accounting and other obligations from firms – could trigger some instability and bad economic news at the start of 2021. There is also uncertainty about any further stimulus for the US economy, he said.

So, as a result, Gammon has bought some put options on financial institutions which expire in January, February and March, and financed these positions through the sale of shorter dated puts that expire in 2020, he said. 

FWR asked Mescher if the use of options and other derivatives received an unfair rap in the global financial crisis of 2008. 

“Derivatives were not the issue during the GFC - leverage and poor risk management were. There are many ways to acquire leverage without derivatives. AIG’s [the insurance group] highly over-levered position was similar in nature to selling puts – a position colloquially referred to as the widow maker amongst option professionals. When deployed with appropriate risk management, derivatives can be a tool which lowers the cost of risk reduction while providing superior upside potential,” he said. 

There are already a number of funds that make money via options, although some take the simple approach of making a large chunk of returns by collecting premiums by sales of options contracts, and nothing more complex than that. However, funds can also engage in “covered call strategies”, for example. In the latter case, the investor holds a long position in an asset (expecting it to rise in value) then writes (sells) call options on that same asset to generate an income stream. 

Mescher said that apart from option selling programs, as mentioned above, he has not come across firms taking a similar approach to his own. 

“The amount of data that goes into a derivatives quant strategy is multiple orders of magnitude greater than vanilla quant strategies. The ability to properly organize, clean, and process this data acts as a significant barrier to entry. Our analytics suite is the product of many years of work, whereas Wall Street historically has not been known for innovation with respect to trading,” he added. 

Many things have changed in financial markets over the past decades. What hasn’t altered, it seems, is their capacity for re-invention and mind-bending vocabulary. 

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