A strategy that has become more popular over the last 10 years in the managed futures space is something called option selling. Commonly known as selling options, option writing or selling premium, commodity trading advisors employ this technique in hopes of generating a profit for their investors. For many new investors coming into the managed futures space they are instantly drawn to these strategies because of their consistent positive returns month over month and year after year. Although these types of strategies have proven to do well in periods of trending markets, investors should be cautious of option selling strategies for a few specific reasons. Prior to investing with any option selling strategy or CTA, it is important to understand how the strategy works and consider if it’s a good addition to an investors overall managed futures portfolio.
Option selling strategies do have their place and should be included in everyone’s managed futures portfolio. How much you may ask? We feel that the nominal allocation (nominal allocation explained) amount should not exceed 10% to 15% of the overall managed futures portfolio allocation, anything greater exposes the portfolio to a greater amount of risk.
One of the best components of an option selling strategy is their consistent returns. These strategies can go months with positive performance without having any drawdowns (past performance is not indicative of future results). Since other type of strategies within the managed futures space tend to have more “choppy performance” (read our most recent blog post: Managed Futures Performance is NOT like Rental Income), it adds a sense of consistency that all investors look for in their portfolio.
With option selling strategies many investors fail to realize its downside. One of the most noticeable negative attributes of an option selling strategy is its high margin usage. These strategies tend to have an average margin to equity ratio of 30%-50% and have spikes in margin ranging from 60% – 90% of the nominal account value. For example, if you had a nominal allocation to a option selling strategy of $100,000, that means they are utilizing approximately $30,000 to $50,000 on average and at times margin can spike to $60,000 to $90,000 depending on their positions or market movement. With this, option selling strategies tend to have a very low return on margin (What is Return on Margin?). Lastly, one of the largest selling points within the managed futures space is that CTA’s, in general, are not correlated to the stock market. Option selling, on the other hand, has a high correlation to sharp moves in the market being traded.
There really is only one ugly truth about option selling strategies and that is that they have the probability to have a large drawdown (even if it has not happened in the track record). One of the main reasons why managed futures advisors and FCM’s are very strict when it comes to option selling strategies is because they can have very large drawdown’s with sharp moves in the market; sometimes occurring overnight. This is usually not a big deal if accounts are fully funded, however many investors choose to utilize notional funding (What is Notional Funding?) and if this is case they risk losing more capital then what they’ve funded with.
In short, option selling strategies do have a place in managed futures portfolios and should be incorporated in most circumstances. However, prior to making an investment it is important to consider all that comes with these types of strategies the good, the bad and the ugly!