Perhaps some of the more experienced option trades could answer the following: I still do not understand how LJM could lose so much in Feb 2018, when it survived Aug 2015, Summer 2011, Oct 2008, etc.? Not only did it survive these previous events, the fund's returns all for those years was positive. It does not make sense that a fund that targets 8%-12% (around the market average) would ever need to take on so much risk that it would face a blow up (ie. -80%) Which of the following describes what happened at LJM? 1. Due to the low VIX environment, LJM started selling options closer ATM with more risk to earn the same return it had been with OTM options when the VIX was higher. 2. Their strategy had not changed from previous years and the Feb 2018 volatility event (largest daily VIX spike) was so unique that their existing hedging (long calls) could not protect the fund. As I said, it simply does not make sense that a fund targeting the market average would ever face a blow up. JTunner
The post prior to yours gives some clues. If that inventory is typical then they were buying a few puts near-the-money and selling a LOT of puts out-of-the-money, ie a ratio spread of sorts. This suggests to me that it was the sheer directional speed of the S&P500 coupled with the extremely large % move in the VIX over the same short span that overwhelmed them. Probably, in order to maintain returns/volatility target they increased their size. They should have accepted lower returns...
I traded that night. Here is why they lost money. We sold S&P 500 Puts 1000 points away from the strike, expiring in 4 days on Friday for 9 points. This was so unprecedented that it was surreal. If VIX was being published, it must have been like 150. All models went out of the window that night. Another oddity was that the options spreads were tight, well for such situation, within 5 points. For example, August 2015 spreads were 20 points plus. I read few articles that this unprecedented situation was caused by ETNs liquidation. No one will really know. That was truly a night to remember unfortunately.
"I read few articles that this unprecedented situation was caused by ETNs liquidation. No one will really know. That was truly a night to remember unfortunately." It was a terrifically profitable night for people betting on a black swan event.
Only if they closed out their risk. That’s the problem with black swan strategies. You always have to be long the tail even when it gets expensive.
Correct, but vast majority gave up a long time before the event. hard to keep bleeding cash, year after year with the hope for such an event.
Thanks for this article. So, in short, selling deep OTM options without leverage is not viable (ie. too little income), and these options repriced in Feb 2018 to a level that nobody ever expected, leading to margin calls? I guess this entire fiasco points to the fact that OTM Puts might not be as overvalued as generally believed, esp. if the merger premium income gained over time is not even close to being enough to cover draw downs. The question is is there anything that LJM could have done differently or is there simply no edge is this strategy?
They could have reduced their position sizes relative to their equity given the extreme lack of volatility seen in 2017 and early 2018. The all time low VIX readings should have been a warning. It's easy to dismiss these though when you're making lots of money!