Options Optimist
Hedge investor Kyle Rosen on how to play a market that only an expert could love
By SANDRA WARD
AN INTERVIEW WITH KYLE ROSEN -- In the five years since Rosen formed Santa Monica, Calif.-based Rosen Capital Management, he has delivered returns of 9%, net of fees, on average. He's done it by focusing on the narrow, but profitable, alternative investment strategy of selling put options and capturing the premium attached to the hedging instrument.
So far this year he's up 8.5%, following a gain of 16.7% last year, and hasn't had a down month in the past 13.
A longtime options investor, not to mention pianist and composer, Rosen learned at the knee of a master: his father, Al, who started trading stocks on the floor of the New York Stock Exchange through his firm Rosen & Co. in the 'Sixties and was among the first trading options when they were introduced in the early 'Seventies. Before launching his own firm, Rosen fils was in charge of options trading at hedge fund Strome, Susskind & Co., a general partner in Rosen Capital, for nearly a decade. For more on a strategy that's making money these days, please read on.
Kyle Rosen
Barron's: Some blame option sellers for much of the listlessness we have seen in the market this summer.
Rosen: People have been saying that people have been selling puts aggressively as they were in 1987. It is just not the case.
Q: What's creating the impression?
A: In the 'Nineties, the whole world was trading stocks. There was a lot of dumb money. Yet the bear market was so severe, it weeded out a lot of less experienced people. Professionals have retaken the market and this has evolved into a pro-versus-pro market. That means the market has become more and more efficiently priced. That's why a lot of hedge funds have been struggling. There aren't the pockets of opportunities of wildly overvalued and undervalued stocks you used to be able to find. A lot of people have lost their edge.
Q: So, why blame the option sellers?
A: There are a significant number of people selling covered calls, where you buy the underlying stock and sell a call on it, and there is no doubt that is contributing to the current conditions. It's ironic because when you could get 15% to 18% by doing "buy-writes" nobody was doing it. Now that you get 8% to 10%, they are opening funds left and right. Several years ago, the CBOE [Chicago Board Options Exchange] started the Buy-Write Index known as the BXM. Now every couple of months, a new fund pops up devoted to selling covered calls. It is similar to opening a tech fund or an Internet fund in the second half of 1999. When you do a buy-write, you give up the upside of a stock but hold on to most of the downside risk. If you buy a $100 stock and you sell an at-the-money call for 5, the value of the stock to you goes to 95. But you still have 95% of the risk of owning it and only 5% of the upside. [Calls give buyers the right to buy a stock at a certain price for a specific period. Puts give them the right to sell a stock at a certain price for a specific period.]
Q: How does that affect implied volatility?
A: A lot of people have been doing this, and it is one reason implied volatility has come down. For a long time, puts drove the whole market. When people were scared about the market, they would buy puts, and calls would be forced up in an arbitrage because if puts went up a lot and calls stayed cheap, you would sell a put and buy a call and short the underlying stock and you couldn't lose. For years and years, the markets would start to decline, people would rush to buy puts, and calls would go up as a result. In this cycle, people have been selling covered calls, driving down put prices. Calls are leading the way. The appetite for risk is different. Everybody wants to be hedged and covered. Also, a lot people aren't buying puts as aggressively as they were, and that could be because it hasn't worked for so long. Buying puts at the end of 2002 and through 2003 would have destroyed you.
Q: What else is at play?
A: When a new event or a fundamental development occurs, the market will adjust. Right now, it's the election. The ISI Group put out an interesting survey of hedge-fund managers recently. About two months ago, 100% of the respondents felt that Bush would win the election. More recently, 53% thought Kerry would win. It isn't a coincidence that as soon as perception started to change, the market started to fall. Investors are adjusting to the possibility that capital-gains taxes may go up next year.
Q: Go back to the point about this being a pro-versus-pro market. Wasn't that always the case prior to the bubble years?
A: It was. The last time you saw the VIX [the CBOE index that measures stock-market volatility] at these levels -- around 17 -- was in 1996, so we've come full circle. Yet it has been much lower. In December 1993, the VIX registered an all-time low of 8.89, even though market volatility was the same as now. That tells you people are paying much more for options, more than double, even though volatility is at the same level it was 11 years ago. That probably reflects terrorism concerns.
Q: What are you expecting from the market in the next five years?
A: It is a reasonable to assume the market will be relatively stable for quite some time, barring any terrorism or fundamental changes to the economy. The capital-gains tax may be one of the single most important predictors of stock prices. Reagan cut it in 1982 to 20% and the market went wild to the upside. He raised it back to 28% in 1986, and a year later we had a huge break in the market. Clinton reduced it back to 20% in 1997, and we had a huge bull run. Bush cut it to 15% in May 2003, and we had a huge bull run. The big fear is that the capital-gains tax rate is going higher. If we go back to 20% from 15%, then we have to unwind a lot of last year and that's what is in progress. It isn't terrible and it isn't a long-term thing. It is purely an adjustment. If you make $10 in profit on a $100 stock, that's 10%. If I tell you to pay a 50% tax on that, you aren't going to pay $100 for the stock.
Q: What about interest rates?
A: That is the second most important issue other than the election. There is only one direction they can go. They can't go down, but they can stay the same or go higher. Nothing stays the same for long. We are still at almost 50-year lows in interest rates.
Q: And the impact?
A: People have been locking in 30-year mortgages where their monthly payments are slashed by 40%. Housing is the No. 1 monthly expense of most people. If your No. 1 expense has now been cut by approximately 40%, on average, that provides a lot of stimulus. That's a 30-year stimulus Greenspan gave us. People talk about how oil is going to slow down the economy, but how much extra do people spend when gas goes from $1.50 to $2? Maybe it will cost an extra $20 a week or $100 a month. If you are saving thousands of dollars on your mortgage, who cares about spending an extra $100 a month on gas? People's wealth is at an all-time high, despite the market being down 30% from its all-time high.
Q: A lot of people seem to care about spending an extra $100 on gas a month.
A: The rise in oil prices has enabled the bond market to rally, which is a prop for stock prices. If rates weren't as low as they are, stocks would surely be trading lower. A decline in oil prices may actually be a negative for stock prices because then the economy would have nothing slowing it, and rates would rise faster and the stock market would fall.
Q: Are you worried about interest rates rising ?
A: I'm very worried.
Q: You think inflation is going to dictate the rise in rates?
A: It is a big problem. There is going to be so much demand for capital. In 2000, rates had to go up significantly to slow the economy down. To slow things down to a more modest pace of growth now, rate hikes could be dramatic. I hear a lot of people say rates are going up, but they will be nowhere near where they were in '94. I'm afraid this could be more significant than '94 because of the economic strength we are seeing.
Q: Are you bullish?
A: On the market, I'm very cautious. The economy is fantastic. This is one of those rare instances where the economy could be fabulous, but stock prices may struggle. If interest rates stay low, and Bush wins, and taxes stay low, then we'll be in good shape.
Q: One thing different from 1994 is the Fed signaling its intentions in advance of a rate hike.
A: There are no surprises. The people moving the market up and down are the hedge funds. Their mandate is to make absolute returns, no matter what the market does. So, when the market rallies, they are buying and when it's falling, they are selling.
Q: What are you doing?
A: I'm an option seller. I'm trying to generate absolute returns with minimal volatility that isn't correlated to the market. I'm trying to take the market equation out of it. I could give you 18 reasons why I'm bearish, but if the market is rallying, who cares? I have to be reactionary, not predictive, because if you predict and you predict wrong you are out of the game. My game is to generate returns in an up and down and sideways market with less risk than your typical stock portfolio.
Q: Why has selling puts worked so well this year?
A: Implied volatility is at the low end of an eight-year range into the mid-teens. People have been thinking implied volatility has been low for the past year and a half. When it was 25, they thought it was low, when it was 20 they thought it was low, and now that it is closer to 17 they think it is low. It is low. But it isn't as low as it seems. It only seems so because the volatility of the market has been so non-volatile, running between 8% and 12%. Puts trading at 15% implied volatility is a significant premium. Whatever happens with actual volatility, we expect implied volatility to continue to trade at a healthy premium because there are many more buyers of puts than sellers.
Q: Why isn't everyone selling puts?
A: Somehow, the notion of excessive leverage got connected with selling options. The one thing that hurt people in this strategy in the past is excessive leverage. I'll use modest leverage -- maybe 2-to-1, maybe 2½-to-1 -- but if you use 10-to-1 or 8-to-1, you could lose a lot of money. In my experience, selling a put is much safer than buying a stock. If you buy a stock at 100 and it goes to 95, you lose 5%. If it goes to 90, you lose 10%. Instead, you can sell a six-month 90 put for $10 and break even as 80, so you've cut your risk by a tremendous amount. If you hedge it by shorting calls or shorting some of the underlying stock, it is possible to ride a $100 stock down to zero using options. Whereas if you own a stock outright and it starts going down, you have two choices: Either sit with it and hope it bounces, or risk being shaken out at the low.
It's the level of leverage that can lead to disaster when selling puts. The game isn't just about making money. It's about making money on a risk-adjusted basis and figuring out how to manage your taxes. Taxes and risk are the two dynamics people don't focus on much, but they're the two most important things.
Q: You are up more than 8½% this year. Why are you having such a good year, while others are struggling?
A: I don't have to rely on the market to make money, and in a flat market our strategy is one of the few that can thrive. When nothing happens, we make money because time is passing. That's the crux of it: I sell time. In a flat market, I'm short puts and calls, and I make money on both sides when nothing happens. This is a nice market environment as long as these edges persist and people overpay for options. The problem is, in a flat market people don't pay as much for options.
Q: What is the biggest risk to your strategy, besides leverage?
A: My biggest risk isn't a bear market but an instantaneous move similar to 9/11. But my biggest risk is always my greatest opportunity to make money, because if I have a draw-down due to an instantaneous move, it is only because there is an incredible spike in implied volatility. I may lose money that day, that week, that month, but it opens up such incredible opportunities.
Q: Have exchange-traded funds altered the options market?
A: They have changed the options game a lot. Before ETFs, if you wanted to short the market you could buy puts at a premium. With ETFs, why pay a premium for put options when you can just short SPDRs [Standard & Poor's 500 Depositary Receipts] or QQQs (the Nasdaq 100 Trust). If there were a big break in the market, you would be better off buying puts, because you get the added benefit from the spike in implied volatility. Puts are also better if there is a huge market rally because you only lose what you put up, as opposed to being fully exposed to the market with SPDRs. In this flat market, the attitude has been to stay short ETFs, but if there is a rally or a break, investors will switch back to puts.
Q: As a put seller, who are you selling to?
A: There are fewer people to sell to. As a result, I take fewer positions and have lighter exposure now. Why assume risk if you don't get paid?
Q: You typically sell S&P 500 options. Do you also dabble in individual stock options?
A: I have traded single-stock options a lot, but I eventually ended that. When you trade one security, as opposed to 50, you are able to be more disciplined and knowledgeable. There were periods where I would try to recreate a basket of 50 stocks and trade options around it. Even though it is diversified, it is only 50 stocks, instead of 500, so it's one-tenth of the diversification of the index. When you deal with that many companies, you really have to spend hours a day on every fundamental development. That isn't where my edge is. I could look at Dell 12 hours a day, and I'm not going to see anything that a thousand other people haven't already seen. My edge is in understanding the time decay, the margin of safety and the risk-free rate of return and the pricing of options. Also, there are tax advantages that index options give you. About 60% of our gains are taxed at the long-term rate of 15% and 40% are taxed at the short-term rate of 35%, for a net of about 23%, compared with a 35% tax rate on single-equity options. Whatever excess return I may be giving up by staying with the indexes over individual options, I generally get back net of taxes.
Q: Any threat to that tax advantage?
A: A proposal to repeal the 60-40 tax rule on index options and futures showed up on the docket in this last cycle and, God bless the attorneys at the CBOE and, I am sure, at a number of major brokerage firms, it mysteriously disappeared. But it is a threat. If it happens, it happens. We'll deal with it and maybe find other ways. There are so many tools within options you can use to manage your taxes. There are all these little details hidden in the tax code that we can use to attempt to defer taxes a year or longer, to try to maximize our long-term gains and maximize our short-term loses.
Q: You don't bill your fund as one an investor should hold exclusively, do you?
A: No, not at all. If somebody wanted to give me all their money, I wouldn't take it. In this business, rule No. 1 is to diversify and spread your risk around. The only person who should keep their net worth or most of it invested in the fund is me. The big story for the next 10 to 15 years is Asia. People should consider putting at least some money there. The big growth of this century isn't going to be in the U.S. Every time there is a bear market in one of the Asian developing countries, I invest a little bit of money. India recently had a steep decline, so I bought a little bit of India. I buy a closed-end country fund or an index fund to keep the fees down. It is dollar-cost averaging, plain and simple.
Q: How did you do in the bear market?
A: We broke even in the bear market, which was disappointing considering we had been anticipating it for several months. But breaking even in the worst bear market in the modern era isn't a tragedy. I've come to terms with it, and now we're back on track. I learned 100 times more about myself in these three years than I did in the good times.
Q: Well, it looks like you learned something at the October lows of 2002.
A: There is one important difference here. My bread-and-butter has always been shorting short-dated options. As you get closer and closer to an options expiration date, the value of options deteriorate faster and faster. I sell front-month options [typically those with a duration of four weeks or less], because that's where the erosion happens. In the bear market, I wanted to reduce my risk, so rather than trading front-month options, I traded long-dated two-year options, and we were able to get through the period flat. But on a month-to-month basis, the portfolio was quite volatile. When you are trading a 20-day option, you can really control the volatility. With two years to go, controlling that volatility is a very tough game.
Q: Thank you, Kyle. |
