Spencer Patton Building Hedge Fund Using Far-Out-Of-Money Options Strategy.
(Kitco News) - Talk about an early start.
Spencer Patton has been actively involved with financial markets since grade school. Now, only a few years removed from college, he has founded a hedge fund, using a strategy of selling options far out of the money with strike prices that he figures are unlikely to be hit by expiration.
Patton began investing as a 7-year-old when his father Jim, a private-equity investor who bought failing companies and sold them as they became profitable, offered to match any money the lad put into the stock market. So young Spencer took allowance and gift money and began researching companies.
"I had about as much money as you have as a 7-year-old-like $20," he recalled. "But it allowed me to start thinking about different companies."
A family friend who was a stock broker handled trades at a commission of one penny until Patton was an adult. "My passion for it just grew," Patton said.
In college, he often used a laptop computer to put on positions while in classes at Vanderbilt University, where he earned degrees in psychology and economics. He continually refined his strategies.
After graduation, he went to work for KPAC Solutions, a private-investment company focused on acquiring and turning around distressed manufacturers. This enabled Patton to learn about commodities, since many of these companies were involved with commodities in some way.
Patton, now 25, has since founded Steel Vine Investments.
Fund Manager Looks To Pocket Premiums From Options Positions.
Patton aims to sell options far enough out of the money that strike prices are never triggered, allowing him to keep premiums collected for selling the option. This puts a ceiling on the profit from any one position, yet also takes away the pressure of having to correctly predict whether a market's next move will be up or down.
An option is a contract giving the buyer the right, but not the obligation, to buy or sell a commodity or stock at a fixed price, on or before a certain future date, from the seller.
He generally sells options on stocks and commodities that are 30% to 100% out of the money, with expiration anywhere from three months to a year away. He looks for strike prices that he views as "historically or statistically unlikely" within the options' time frame, in many cases selling options at strikes for which prices have never achieved.
"You're looking to capture the premium of selling those options," he said. "The historical issue with selling options is that there is a limited profit potential. The most you can make is make is the premium you are paid to sell that option. You can't make a single dollar more on that position, whereas your loss is theoretically unlimited. Silver could go to infinity, and you would have unlimited losses.
"But, the trade-off is that the likelihood you are going to keep that premium is very high…There are a lot of great statistics out there saying that roughly 80% to 85% of all options expire worthless."
As of this interview, silver was just under $50 an ounce. A trader selling a $75 silver option expiring on Nov. 22 would receive a premium of $4,100, which he would keep as long as any rally stops shy of $75, Patton said in listing a hypothetical trade. The risk would be that silver does in fact hit that price.
If silver keeps rocketing higher and threatens this price, Patton would favor simply closing out a position. By July, that option might be worth say $7,000, he said. A trader would have to pay this to close out, leaving a loss of $2,900, which would be less than if the options were actually triggered.
A "more aggressive" way to manage risk, which Patton said he tends to avoid, would be to hedge with a position in the futures market. For instance, if a trader sold a silver call at $75, he might buy a silver futures contract. Then if the option call ends up a loser, this would be offset by a gain in the silver futures contract. A double benefit would be if silver rises but stops shy of $75 by expiration. Then a trader would both keep the premium for selling the option and also gain on the rise in the futures contract, Patton said. However, should the futures contract instead decline, the futures loss might end up offsetting the premium from the option.
"You are paid a certain premium, and if you lose all of that money trading silver (futures) trying to hedge yourself, then you've done yourself no good," he said. "I just think the smarter way to go (to manage risk) is to just close out the position. Have a set, defined stop loss. Say 'if it reaches this point, I'm going to have the discipline to close the position.'"
With Patton's trading system, he simply has to decide "where commodities will not go" rather than "where commodities will go."
By contrast, a traditional futures trader has to decide whether the market will rise or fall from the current price. "If you say it's headed higher and it goes lower by one penny, you've lost money," Patton said.
He generally trades only equities or commodities with strong volume. He sticks to stocks in the Dow Jones Industrial Average or S&P 500, which seldom lose more than a percentage point or two a day. He avoids small, developing companies, such as a small biotech firm that could be vulnerable to 20% moves in a single day if major news breaks.
Assets under management in his fund are just under $5 million, which Patton concedes are "small potatoes" in the world of hedge funds. However, he has not been actively seeking capital as he developed his strategies. Starting May 1, however, the fund will be opened up to institutional investors. Steel Vine posted returns of 27% in 2009 and 26% for 2010, he reported.
Patton avoids putting more than 10% of a portfolio in any single position. He favors diversification, yet said "don't diversify just for the sake of diversifying," instead only putting on positions when confident in them.
His main advice for novices is to work with a mentor, such as a broker or another trader who can help walk them through potential pitfalls.
"There's a lot to be said for personal experience, and paper trading will not do it for you," he said. "Paper trading is so different…because you don't have the gain or loss of capital and swings of emotion that come with that. I'm not nearly a big of a believer in paper trading as most."
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of NASDAQ, Inc.

How To Invest Like A Hedge Fund.
Ever wonder how hedge funds think and how they are sometimes able to generate explosive returns for their investors? You aren't alone. For years, hedge funds have retained a certain level of mystery about them and the way they operate; and for years, public companies and retail investors have tried to figure out the methods behind their (sometimes) apparent madness.
It's impossible to uncover and understand each and every hedge fund's strategy - after all, there are literally thousands of them out there. However, there are some constants when it comes to investment style, the methods of analysis used and other preferences.
While many investors track metrics such as earnings per share (EPS), many hedge funds also tend to keep a very close eye on another key metric: cash flow.
Cash flow is important because bottom-line EPS can be manipulated or altered by one-time events, such as charges or tax benefits. Cash flow and the cash flow statement tracks money flow, so it can tell you if the company has generated a large sum from investments, or if it has taken in money from third parties as well as how it's performing operationally. Because of the detail and the breakup of the cash flow statement into three parts (operations, investing and financing), it's considered to be a very valuable tool.
This statement can also tip off the investor if the company is having trouble paying its bills or provide a clue as to how much cash it might have on hand to repurchase shares, pay down debts or conduct another potentially value-enhancing transaction. (To learn more, read The Essentials Of Cash Flow .)
Run Trades Through Multiple Brokers or Conduct Arbitrage.
Funds may also purchase a security on one exchange and sell it on another if it means a slightly larger gain (a basic form of arbitrage). Due to their larger size, many funds go the extra mile and may be able to pick up a couple of extra percentage points each year in returns by capitalizing on minute differences in price.
Hedge funds may also look for and try to seize upon mispricings within the market. For example, if a security's price on the New York Stock Exchange is trading out of sync with its corresponding futures contract on Chicago's exchange, a trader could simultaneously sell (short) the more expensive of the two and buy the other, thus profiting on the difference.
This willingness to push the envelope and wait for the biggest gains possible can easily tack on a couple of extra percentage points over a year's time as long as the potential positions truly do cancel each other out. (For more on arbitrage, see Arbitrage Squeezes Profit From Market Inefficiency .)
Using Leverage and Derivatives.
The downside is that when the market moves against the hedge fund and its leveraged positions, the result can be devastating. Under such conditions, the fund has to eat the losses plus the carrying cost of the loan. The well-known collapse of hedge fund Long-Term Capital Management occurred because of just this phenomenon. (To learn more, read Massive Hedge Fund Failures and Hedge Funds' Higher Returns Come At A Price .)
Hedge funds may purchase options, which often trade for only a fraction of the share price . They may also use futures or forward contracts as a means of enhancing returns and/or mitigating risk. This willingness to leverage their positions with derivatives and take risks is what enables them to differentiate themselves from mutual funds and the average retail investor. This increased risk is also why investing in hedge funds is, with a few exceptions, reserved for high-net-worth and accredited investors, who are considered fully aware of (and perhaps more able to absorb) the risks involved.
Unique Knowledge from Good Sources.
The downside to mutual funds, however, is that a fund may maintain many positions (sometimes in the hundreds), so their intimate knowledge of any one particular company may be somewhat limited.
Hedge funds - particularly those that maintain concentrated portfolios - often have the ability and willingness to get to know a company very well. In addition, they may tap multiple sell-side sources for information and cultivate relationships they've developed with top management, and even in some cases secondary and tertiary personnel, as well as perhaps distributors the company uses, ex-employees, or a variety of other contacts. Because hedge funds usually aren't beholden to the company/investment and because fund managers' personal profits are intimately tied to performance, their investment decisions are typically motivated by one thing - to make money for their investors.
Mutual funds cultivate somewhat similar relationships and do extensive due diligence for their portfolios as well. But hedge funds aren't held back by benchmark limitations or diversification rules. Therefore, at least theoretically, they may be able to spend more time per position; and again, the way hedge fund managers get paid is a strong motivator, which can align their interests directly with those of investors.
They Know When to Fold 'Em.
Hedge funds are an entirely different animal. They often get involved in a stock with the intention of taking advantage of a particular event or events, such as the benefits reaped from the sale of an asset, a series of positive earnings releases, news of an accretive acquisition, or some other catalyst.
However, once that event transpires, they often have the discipline to book their profits and move on to the next opportunity. This is important to note because having an exit strategy can amplify investment returns and help mitigate losses.
Mutual funds directors often keep an eye on the exit door as well, but a single position may only represent a fraction of a percent of a mutual fund's total holdings, so getting the absolute best execution on the way out may not be as important. So, because they often maintain fewer positions, hedge funds usually need to be on the ball at all times and be ready to book profits.

Do hedge funds trade options

First, let me say this: Most people lose money trading options.
It’s a very difficult game. But if you can find an edge, the returns can be huge. One of the best option-trading hedge funds in the business, Cornwall Capital, has averaged 51% annualized over the past 10 years. That turns a mere $20,000 investment into $1.2 million, in less than 10 years.
Two of the best option strategists that have ever worked on Wall Street are Keith Miller, formerly of Citigroup, and John Marshall, of Goldman Sachs. Both Miller and Marshall happen to be Blue Jays (i. e., Johns Hopkins University grads), like me. If you can ever find any of their research studies, print them out and examine them closely. They are excellent — and will give you an edge.
Below are the rules the best hedge funds use when trading options:
Options are like a coin toss; you’ll be lucky if half your option trades are profitable. That is why you have to make sure you get paid for the risk you take.
Only trade an option if your projected return is a triple or better. To do this you will have to buy an out-of-the-money option. And you should go out at least two months, preferably longer. Now, here’s the math:
Let’s say you make 40 option trades a year. Odds are at best you will only make money on 50% or half of these trades. Therefore, if you had 40 options trades and 20 of those trades expired as worthless, and the other 20 option trades averaged a triple or more, you would still make 50% a year. For example, on a $40,000 account taking 40 trades a year, if 20 option trades lose everything and the other 20 trades give you an average return of 200%, your account would be worth $60,000, giving you a 50% return.
So $20,000 would go to zero on the option trades that expired worthless. The other $20,000 would go to $60,000 on a 200% return.
Price predicts a stock’s earnings and fundamentals 90% of the time. According to Keith Miller of Citigroup, a stock will start to move one to two months ahead of its earnings date, in the direction of the earnings report. This means if a stock starts trending higher or breaks out higher before the company reports earnings, the earnings report will be positive 90% of the time.
When you are buying options on a stock, make sure the stock is owned by an influential investor or activist. These investors, such Carl Icahn, Barry Rosenstein of Jana Partners and the rest, are always working behind the scenes to push the companies to unlock value; this can come in the form of incremental positive change or big one-time catalysts. This positive announcement or catalyst usually emerges after the stock has moved up in price. So when you see an activist-owned stock breaking out, or trending higher, there is usually a good chance change is coming. Thus, you’ll want to buy calls on this stock immediately.
Only trade an option if there is an event or catalyst that will reprice the stock. This could be an earnings announcement, a company’s Investor Day or an annual meeting.
Only buy options when both implied volatility and historical volatility are cheap. Be a value buyer of options. Watch volatility. Buy volatility only when it’s cheap.
A perfect example of an option trade that fits all of the above criteria is Walgreens ($WAG).
> Jana Partners, run by billionaire Barry Rosenstein — one of the top 5 activist hedge funds on the planet — owns more than $1 billion of Walgreen’s stock. That’s more than 10% of the fund’s overall assets invested in Walgreen’s (Jana has $10 billion under management). Even better, they just added to their position last week, buying $77 million more during the market correction.
> Walgreen (WAG) just broke out of a consolidation pattern, and it looks like it is ready to make a big run (see chart below).
> Walgreen reports earnings on December 22nd. So whichever way the stock moves over the next month or two will predict whether the company’s earnings are positive or negative. Based on the stock’s current price momentum, the report will be positive.
> The Walgreen $65 calls are cheap, especially since they expire only two days before the company reports earnings. You can buy the Walgreen December $65 calls for just $1.10. That means, at $66.10 or higher, you will make money on this option. My price target for Walgreen, based on its recent breakout, is $69. That also happens to be where Walgreen gapped previously.
> If Walgreen stock trades just 10% higher to $69 by December 20th, you will more than triple your money on this option in less than two months. This is the risk-reward profile you want when trading options. Your goal should be to make 50% a year.

The Options Landscape for Hedge Funds.
Hedge funds remain one of the most active users of both exchange-traded and OTC options, particularly in the US, but some managers may still be missing the opportunity that these instruments can offer them. Equity-based investment strategies dominate hedge funds, which account for a large slice of the equity options market. Many funds focus on the liquid US equity markets and use single stock options, ETF and index options to hedge risk. This article takes a brief tour of some of the ways in which options are being employed in hedge fund portfolios, as well as looking at some of the broader themes affecting their use. Future articles will look in more detail at some of the most widely used options strategies.
TYPES OF OPTIONS-BASED STRATEGY.
Covered put or call options have long been a fixture for the long/short equity manager, particularly in markets where there is a wide availability of single name contracts. In Asia, where the choice of single name options remains very limited, managers are still reliant on OTC contracts or simple volatility strategies. The equity hedge fund can use index-based puts and calls to cheaply hedge upside or downside exposure. Managers have been able to simultaneously profit from both long and short positions using options. However, it is difficult to achieve consistent returns on the short side during an upward-trending market as call selling is not a ‘set and forget’ strategy.
There are more sophisticated defensive strategies that make regular use of options, like hedging tail risk. Hedge fund managers are highly cautious, as a result of bad experiences in 2007-08. They need to reassure investors that the fund is braced for the next black – or grey – swan event.
It has also been observed that the value of put options – and not just equity puts – exploded during episodes of high volatility (e. g. the credit crisis and the flash crash), leading more fund managers to explore options as an alternative to defensive cash and Treasury bond holdings.
Covered call selling and yield enhancement.
The sale of covered calls by hedge funds is favoured during periods when fund managers are relatively neutral on the market. This generates premium income, and mitigates the potential downside exposure of a long underlying position. It is vital that the fund’s risk management team has a solid quantitative methodology allowing them to assess the probability of short calls being assigned, and the impact that this assignment might have on the fund’s senior strategy.
One of the biggest risks with a yield-based strategy is that the holder of the option decides to exercise it to capture the dividend. While the maximum profit and break even are fairly clear from a risk management perspective, the likelihood of the option being exercised is also highly quantifiable, with a delta of .95 or above being a good benchmark. There also exists an early assignment risk for American-style options as the long holder of call options may exercise at any time prior to expiration, but most likely when the dividend is greater than the excess premium over intrinsic value.
Volatility-based strategies arguably make the most use of options, with implied volatility regarded as one of the most important components of options valuation. Many hedge funds use options to speculate on the direction of implied volatility, for example using CBOE® VIX® options or futures. Because implied volatility itself trades within a range that can be well defined via technical analysis, a fund can focus on the potential buying and selling points indicated via established price bands.
Using straddles (put and call options bought (or sold) at the same strike price with the same expiry) and strangles (out of the money put and call options), managers can also take advantage of the volatility strike map curve – i. e. trading the skew as opposed to the at-the-money implied volatility. Volatility trading is also popular with algorithmic hedge funds, which can focus on trading it in favourable ranges while retaining a hedging capability.
Collar (split strike conversion)
The collar’s appeal is its scope to reduce portfolio volatility, protect against losses and provide consistent returns, the Holy Grail for many hedge fund investors (see Fig.2).
In effect, if the hedge fund can buy sufficient shares to replicate an index (a 100% replication is not required), ideally leaning towards stocks with a higher dividend payout, then it can sell call options at a strike price above the current index price, limiting its gains, but at the same time generating cash. The fund uses the premium cash from its sale of calls to buy puts based on the index it is tracking, thereby both reducing the total cost of the strategy and potentially dramatically reducing the risk. Note that there will be basis risk if the underlying is not 100% replicated.
Options can be used by the activist fund to exploit a number of different arbitrage situations. Volatility arbitrage has evolved from a hedging technique to a strategy in its own right. There are a sizeable number of hedge funds trading volatility as a pure asset class, with systematic volatility strategies seeking to exploit the difference between implied and realised volatility.
Recently, there has been on average a 4% spread for one-month S&P 500 implied volatility versus one-month realised, although this can vary significantly. Funds can profit from this by using options while hedging out other risks, such as interest rates.
Fundamentally, hedge fund options desks can arbitrage options prices themselves, rather than simply using them to arbitrage other asset classes, using multiple options listed on the same asset to take advantage of relative mispricing.
The dispersion trade has become increasingly popular with hedge funds that want to bet on an end to the high level of correlation between the large stocks that constitute index components. A fund manager would typically sell options on the index and buy options on the individual stocks composing the index. If maximum dispersion occurs, the options on the individual stocks make money, while the short index option loses only a small amount of money. The dispersion trade is effectively going short on correlation and going long on volatility. The investment manager needs to have a clear view on when such an environment is likely to kick in and investors begin to concentrate on data from individual stocks rather than taking a vanilla ‘risk on, risk off’ approach to equities.
The tail risk fund – a fund designed to provide liquidity in the event of certain risks occurring (e. g. stock markets falling more than 20%) has become a sought-after portfolio constituent for investors still needing to meet liabilities in the event of market liquidity drying up. This is really an insurance policy, with the investor exchanging an underperforming strategy for the expectation of liquidity.
Tail risk funds often take contrarian macro positions by using long-term put options. The debate over whether it is really possible for a fund to anticipate tail risks – by definition hard to predict – must be offset against the expectations of the investor. The investor is looking for a bear fund to minimise portfolio damage. The cause of that downturn may be unpredictable, but the reaction of the market can be predictable. The real question is the size of the market decline.
With the advent of tail-protected ETFs for investors and given recent trading patterns, it is clear that products that can provide this level of hedging will continue to be popular with investors.
Options are the third most widely used asset class for algorithmic funds after equities and foreign exchange. This is thanks to the increased use of electronic trading for options transactions, trades that were previously reliant on manual options writing and voice broking. Now, touch of the button (‘low touch’) execution is pushing up volumes and attracting more hedge fund program traders into the options market.
One of the key selling points for hedge funds has been the liquidity and operational efficiencies associated with exchange-traded options. In particular, advances in algorithmic trading have permitted fund managers to access superior pricing across multiple exchanges via smart order processes.
Outside North America, locally traded equity options have not been enjoying the high growth experienced by US equity options. In Asia, single stock options are hampered by lack of opportunity and demand, while in Europe structural features such as country and currency fragmentation, and a preponderance of smaller company issues are retarding growth (see Fig.3).
Increasingly, hedge funds are embracing weekly options to more sensitively control positions, enabling successful positions to be harvested more quickly. They can also deliver competitively priced downside protection. Time decay is attractive to sellers, while buyers appreciate the gamma play – the ability to harness an upward move in the options delta, in response to a proportionally smaller rise in the price of the underlying.
As the options industry continues to develop, further opportunities will likely emerge for hedge fund managers. This will stem not only from the broadening of the product set available, but also from the enhanced operational efficiencies and transparency offered by exchange-traded and cleared products. Regulatory demands for a more robust marketplace will play no small part in this too.
The Options Industry Council (OIC) was formed in 1992 to educate investors and their financial advisors about the benefits and risks of exchange-traded equity options. Its members include BATS Options Exchange, BOX Options Exchange, C2 Options Exchange, Chicago Board Options Exchange, International Securities Exchange, NASDAQ OMX PHLX, NASDAQ Options Market, NYSE Amex Options, NYSE Arca Options and OCC. Options industry professionals have created the content in the software, brochures and website. Appropriate compliance and legal staff ensure that all OIC-produced information includes a balance of the benefits and risks of options. Go to OptionsEducation. org.
Sponsored by OIC. The views expressed are solely those of the author of the article, and do not necessarily reflect the views of OIC. The information presented is not intended to constitute investment advice or a recommendation to purchase, sell or hold securities of any company, but is intended to educate users concerning the use of options.