How do foreign hedge funds use options to achieve stable returns?

Lee: How do foreign hedge funds use options to achieve stable returns?

The following is a transcript of a speech given to Mr. Li, co-founder and CEO of Renesan Capital:

Good afternoon, ladies and gentlemen! I myself started quantifying when I joined Merrill Lynch in '93. I did things like financial derivatives, model trading strategies, or self-providing models, segregated controls, self-managed strategies, profitability and risk reduction.

There are some experiences and experiences in this regard, and I want to share them with you today. It is a good time for quantitative analysis, quantitative investment, options and financial derivatives to flourish in China. I hope to contribute to the development of financial derivatives in China.

What is it?

I'm talking about four things today:

First, how to use options trading as a means of earning income to increase earnings; or to do options specifically to generate profits, such as managing a hedge fund that specializes in option classes.

Second, use option profitability and controls as an auxiliary means to increase the returns of the portfolio and control its risks.

Third, an example of how to help a few major categories, such as the trend-class strategy of CTA, which often encounters volatile markets, and then helps to get through a difficult time when the trend has already been volatilized.

Fourthly, talk about some of the key points of options that can help in risk management. Much of what you learn in textbooks or classrooms is not necessary, and the time is very limited. I tried to share and discuss with you some practical aspects, as well as some mental aspects, and unique insights, hoping that you can reap the rewards after the communication, which is the purpose of today's talk.

What is it?

First, let's look at hedge funds that specialize in trading options as a means of profit.

There are many such funds in Chicago that perform very well, charge 3% to 5% per year in management fees, and give managers a return of 40 or 50%, and only lose a month in over a decade. Many funds doubled in profit during the 2008 global financial phase, and did not generate a loss, relying mainly on options.

These funds have a characteristic: they have a limited capacity of funds, so it is difficult for ordinary investors to participate.

The first thing hedge fund companies that use options as a means of profit to do is to do research analysis, which is actually very important: basic analysis of the market form, basic estimates of the market environment. This is very important because we in China have a tendency to overemphasize quantitative investments, the relationship between quantitative analysis and fundamental analysis.

For example, what is the current state of the overall risk of the market, how much volatility is there, the market is in one that is already feeling like it is in a bull market or another bear market, it is difficult to predict exactly what will happen tomorrow.

But having a better understanding of the risk environment, such as the risk is like the temperature in the Shanghai area, it's particularly hot today, it won't be very cold tomorrow, the temperature varies in different seasons, the risk is a bit like the temperature.

The other is the technical analysis, which is to see if the price of the options is at historical levels, if there is a mismatch between the prices of the other options, if the valuation is too high or too low, and if there is a chance to make a profit or profit from it.

It's knowing that there are risks, but there are also rewards, risks and opportunities that are good for us. In general, through fundamental and quantitative analysis, we try to find as many opportunities as possible to diversify trades.

The next step is to implement the results of the analysis into the transaction, to actually know which contracts to buy, which contracts to sell, how to do it, when. Then there is risk control. Risk control must be integrated into the portfolio structure. When the portfolio is in place, the risk objective is also in place.

Now let's get a sense of this, this is the historical record of a company that specializes in doing options investing in Chicago, with a return of more than 40% per year. This company is characterized by doing a lot of products in a decentralized way, there are stock options, stock options, and some commodity options, they have hundreds of computer experts and PhD mathematicians, they have a lot of machines, application software equipment is well in place, risk control, this is typically a good option company.

This example is also very interesting, this is actually an option fund made by a friend of mine, an alumnus of mine. He now manages over $200 million and makes money almost every month. This comparison is interesting and very inspiring for us.

What he does is simply the best market in circulation in the United States, or futures, which is recognized as the best, largest, and most efficient market in the world. After-tax performance, very high underfloor index, reaching a 7.0 underfloor index, annualized earnings of 19%, with 96 percent monthly profit.

Now to make a comment on this result: first of all we see that it performs like a mountain, doing very well. The market has had a few big swings and is mostly profitable. And doing what is generally recognized as the most efficient market, why does it still perform like this?

What is it?

Perhaps we all have a misconception that in order to make a sustained and stable profit from the financial markets, we have to grab the holes in the market, grab some of the inefficient mechanisms of market pricing or trading, or it's a mistake, in order to be profitable.

This is true for many stock markets, but not for options and derivatives markets. Options should be viewed as an insurance contract, and to understand options well, think of it as an insurance contract.

Option pricing is essentially the pricing of risk. But risk is different for different participants, for different traders. It is different for different participants, the effectiveness of the market is different, the effectiveness of the market is a relative concept.

This risk pricing is not effective for you, and you can profit from it if you take certain approaches to participate in this market from different sides.

Let me give you a very simple example. This is a very important point, that is, it is possible to make a steady profit from the derivatives market, from the options market, even in the efficient market, even in the mainstream market. This is a very important concept, and it has been proven in practice.

The example I've just given is mainly by selling options, and then managing the risk, managing the performance of the current risk. This is also the performance of another hedge fund that mainly does options in the United States. It's actually very good, but this company is special, it mainly profits by buying options, and there are very few such funds, but if you look at the return results, some years are 150, 120, and in recent years the lower positive return is either not making money, or flat, or a loss, which is the characteristic of doing multi-option hedge funds.

I would like to tell you that it is not easy to make money with a fund like this, it is very difficult to make money with multiple options, it is necessary to find special opportunities in the market to achieve such a performance, which is a very good thing.

In addition to the above, the company has also been involved in a number of other projects, including the development of a hedge fund.

First of all, the risk valuation of each market participant is actually different, and therefore the valuation of options is actually different, which is the key to why profits are made.

Secondly, you build a portfolio based on your own situation, which is actually a risk management system and trading strategy, and you revalue the option products in the market according to your own situation, and you will find that according to your own system, some are overvalued, you should sell, some are undervalued, you should buy.

What is it?

Different market participants estimate the risk differently. For example, if two athletes are playing in a different tournament and the prize money is 10 million, the winner gets 10 million, the loser gets nothing.

A, B, the two finalists, in order to guarantee income, they signed a contract with me, and if he won, he paid me 5 million, if he lost, I paid him 4.5 million. That way, he could always make 5 million, or 550, and win or lose. This is really important.

I always win 500 000 if the contract is signed and the match is not canceled. I have two contracts that I meet with everyone and I talk to each other privately. In fact, each contract is more reasonable because I forget the huge risk, I lose and I pay him 4.5 million and he wins and pays me 5 million.

In fact, expand this further, if I do this. A and B don't have to play the same game, it becomes a statistical leverage, there are 1,000 games in the market all year, and I sign similar contracts with all the players, and the end result: I can still make a profit, but it becomes a statistical leverage, not an absolute leverage.

In fact, this example can be further explained by the fact that if the race is canceled, I will be miserable. I can find an insurance company to buy it, if the race is canceled, there is an earthquake, what, he pays me 5 million, I think the safety insurance will also accept, because the probability of cancelling the race is very low.

A thought the risk pricing was reasonable when he signed with me, and B thought the risk pricing was reasonable when he signed with me. But in fact, it was completely profitable after the contract was signed with A. B. Options listed on the market, each option has a buyer, a seller, his pricing, an estimate of the risk, the price is reasonable. But these options were bought or sold in general, and the statistical risk management was followed by similar risk management in this example, and for me, the much lower the risk, the net profit.

I think it's very important to talk about so many of these things today, and I want to talk a little bit more about it: for example, there is a lottery now, and tonight there will be a lottery, it's a lottery of 1 dollar for the people, and the prize is 1 million yuan, and everyone wants to buy this lottery. This lottery is a lottery outside the lottery center, but it's a lottery of 1 dollar, but it's a lottery of 1 dollar, but it's a lottery of 1 dollar, but it's a lottery of 1 dollar, but it's a lottery of 1 dollar, but it's a lottery of 1 dollar, but it's a lottery of 1 dollar, but it's a lottery of 1 dollar, but it's a lottery.

Let's now look at a bullish option, what kind of people would buy a bullish option. I'm sure if you're interested in options, you'll be interested in the financial markets, you'll be interested in stocks.

First of all, you can make money by buying a stock that is going to go up. But you can also make money tomorrow, the next day, as long as you keep holding it. But the difficulty of buying a stock option has increased a lot.

Unless there is no way, have the money; because the option is leveraged, if I am positive about a stock, I should buy the stock directly, not buy the option, because there is not enough money to use the leverage. There is also a trader who builds a stock by being able to buy the option.

How is the price of a listed option set? I want everyone to realize that it is absolutely not the model that determines, it is the supply and demand relationship of the market that determines, what price the buyer is willing to pay at this moment, how many contracts are bought, what price the seller accepts, this is determined, not the model.

There is a tendency for people who are in a hurry to buy to buy higher prices. Last month, I attended a conference where a scholar did an in-depth study of many markets around the world more than a decade ago: the systematic selling of options holds very, very strong evidence that the market price of options is higher than the price at which the volatility achieved in the last historical period should be. Options are like insurance, they are actually expensive.

Let me give you another example, it's very much related to the risk management of options. If I were an insurance company, I'd give millions and tens of millions of people car insurance. If I calculated the risk of an accident, I'd get about 150 a month, and I'd be the one who made the calculation. If I had an accident, I'd lose, and if I didn't have an accident, I'd make 150 a month. If I sold it for 180, I'd make an average of 300 a month. That's the insurance company's profit model.

You know that a few months ago, in Guangzhou, many streets and cars were flooded due to heavy rains, so the insurance company had to pay. I actually bought reinsurance, sold 180 to the entire city of Guangzhou, and then I used 1/3 of the money, which I would have earned 300, to turn it into 200 yuan, and 1/3 to find another insurance company to buy disaster insurance, and transfer the risk to it in the event of a flood, which is a tail risk management transfer.

Whoa.

The same goes for this option portfolio, and I'll make a few points:

If you do not have a special knowledge of some markets, you should not do multi-option trading without special analysis, because the valuation is always too high and it is not easy to make money. If you think the market is looking ahead, you do not need to do options, buy futures directly, buy stocks.

If the reason is not to make money with options, it is because the macroeconomic perspective of the market is acceptable, it has nothing to do with the options strategy. Since you do options, you should be inclined to sell options and sell insurance, it is equivalent to me selling the entire car insurance in Guangzhou, first playing a decentralized role. Guangzhou has sold so many contracts, only a small part of which will be in a car accident, will lose, so the risk is distributed, no problem.

After a disaster, because you buy reinsurance, you don't make a loss. That's the spirit of managing a portfolio of options. So what Chicago does well is diversify, diversify a lot of options, contracts and strategies.

In addition to diversification, there are subtle adjustments, when measuring the current risk exposure, for example, one point per share and a portfolio loss of 100,000, the corresponding futures contract must be sold to offset this risk.

Let me give you a typical example of an option's statistical leverage: this is the stock of Baidu trading in the United States the other day, which fell 15% all of a sudden because of some news, and the volume of trading was quite high.

At this point, if we sell a bullish option at the price before it expires, then a two-month or a one-month expiration option is quite powerful. I'll explain why. This example runs through the whole idea I just talked about. After the fall, the vast majority of participants in the options market are concentrated in the current price range of about 10%, 5%, and the vast majority of traders are interested in this region.

The other side of this market is also the mainstream participant, so he is a fool not to be a market trader in terms of option pricing. Basically, pricing in this range is very effective or more reasonable.

If a stock falls sharply, there is a high probability that it will immediately fall another 10 pieces, rebound 3 pieces, 5 pieces, or continue downwards again. It has a fairly high probability of continuing to fall another 2 or 30 pieces. The downside is large, but there is also a high probability that it will rise, and the probability of quickly bouncing back to the price before the fall is actually relatively small.

In addition to the hedge of this bullish option, another area of focus for mainstream traders in this market is the serious deviation of the valuation of these contracts, which are farther apart and farther apart. In terms of implied volatility, red is the probability distribution of volatility explained historically. Black is a distribution of the market, the distribution of market transaction prices.

The implied volatility here is much higher than the actual possible volatility. It is a non-linear relationship from this quantitative model. What happens?

The equivalent of a house worth only 1 million, but selling 20 million, that would definitely sell the house. So sell this option. This is just a model, there are hundreds of such opportunities, there are dozens of models, different products, find them all, find them and do it systematically later.

For example, the implied volatility curve of a product can be calculated and plotted by accumulating historical data. A cross-section of this curve is probably like this, you will find that today observing the implied volatility of a product, the implied volatility understood as the price of an option, is too high, this is too low. Buy this contract, sell this contract.

If you don't do risk management, then you need to make adjustments when buying and selling, and if the market changes dramatically, it can cause huge losses. So the next step is risk control.

The land

Options themselves earn profits to support the profits of a hedge fund. Similarly, we can use options to support other strategies and portfolios to increase returns and eliminate risk.

I'll give you a few examples. It's actually very, very effective. I think the first thing that's probably the most useful to do after you launch options in the Chinese market is this. I actually have a good friend, a lady who's extremely good, but very low-key. It's over $6 billion, and sometimes it's very simple, they pick stocks, they have a good portfolio.

For example, the volatility of the Chinese analogue index five stocks is 25% to 30%, if this is the case, if you manage a mutual fund, you need to have a basic understanding of fundamental analysis.

The Chinese market is still a relatively moderate market, which does not have too much bullishness in a month, which will sell a stock market's bullishness option. The bottom has money coming in, low 5%, a little bit more selling, now the volatility environment is 25% to 30%.

In fact, your performance is almost everywhere, you get 7% more in a year, unless this market is making more than 5% every month, you may be doing seriously worse than others, but you will not lose your bowl at this time, this strategy is very, very useful, using options to increase the return of ordinary funds.

The other high frequency is that the market is a private act or a small sector act. Increasing the effectiveness of the market is not as important as the macro role. This is actually what better fund managers do, and often do. Do it systematically.

This is a very interesting success story that deserves to be shared with you. My friend Jiang Ping, who is known as the only Chinese among the world's top traders, had previously worked at LeMans for 13 years, starting with one or two people in the Latin American trading department and ending up in charge of the LeMans Latin American trading department, or 99% of the foreign exchange risk.

He also wrote an article a few years ago, also physically active: The Strategy of a Weak Dollar. At the time, economists, including Wall Street analysts, were all in favor of the dollar, and felt that the dollar and the euro had a long-term weakness, and indeed, there was a capital side to it.

For almost two years, this period saw almost all the deals, Wall Street, almost all the players, and even the individual players, being shaken out, losing a lot of money. But Jiangping not only stood up, and eventually made over $2 billion, and then went out of the place.

I'm not sure.

Why did it work in the past? It was a good use of options to increase returns, to win each other over the past two years. After hearing about CTAs, I wanted to do the same thing with options, but it must be supported by the fundamentals. It is true that the dollar will weaken, but there is a certain amount of repetition, you do this trend trading strategy you can not accept, but it will not fall to this place, if it is not so, it does not work, and the option does not solve the problem.

The most basic method is to first divide the stockpile, say you can't go up and buy 2 billion, maybe buy 1/4 first, you can take directly buy some inventory, then sell some, move, you can save some costs. Then gradually increase the stockpile. If you go back to the call, you can sell some of it appropriately.

As long as it is below 0.5, it is generally safer to sell two options, as you will not lose money. You can adjust your position, reduce your position. So in general, you can sell twice as many options, so you can accumulate 1% profit per month.

In the process of going backwards, others lose heavily, you lose a little bit, you have some accumulation, profit every month. The last two years you have no loss, then the position is built. You add some profit, then reduce the position, finally get out. This is the way to use options to protect this trend strategy.

The risk path of an options portfolio should be something like this: the market index, this is bullish, this is bearish, this is today's situation. The market bullish, this is basically a win-lose, or slightly profitable. You want the market to move big, bullish when it's bullish, bullish when it's bullish, so the portfolio is not afraid to predict catastrophe. To do this, you need to buy some long-term, far-price options, or do some hedge options, negotiate a contract with them, and protect them at a minimum cost.

What is it?

Risk control has two parts: one is the current risk, one is the portfolio, the portfolio is multidimensional, one is the concentration of the period, the period indicates one point, how much I win or lose. The interest rate fluctuates by one or two points, how much I lose or lose. The volatility increases, the sensitivity is this, the discount is very easy, after modeling, the quantitative analyst makes a model and calculates these things.

The next thing to do is to do this long-term comparison. For example, in each case, the portfolio has a big loss-and-gain situation, the resulting profit is within the limits allowed by wind control, if not, a part of the profit is taken out to buy reinsurance, this is very important.

I know that some long-term security options companies do a better job of spending half the 2.5% or even 3% to buy reinsurance, multi-level insurance. When the market is not unexpected, you can make up to 2% a month because you pay the premium. That's why you have good profits every year for more than a decade, but you occasionally lose money.

Well, my report for today is done here.

Source: and news futures

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