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Roman King
Roman King

The Option Trader's Hedge Fund


The world of investments is very large. You can invest in stocks, bonds, options, real estate, CDs, commodities, or futures. Regardless of where you choose to invest your money and time, it would be very wise to have a framework with which to manage your investments. This book suggests a framework for trading options profitably; this framework has been used by an option trading hedge fund. The book is a road map for anyone wanting to trade options. We provide guidelines on how to run an option trading business successfully. We also provide you with our own experiences, learned along the way as a professional hedge fund manager (Dennis Chen) and a former market maker and trading coach (Mark Sebastian).




The Option Trader's Hedge Fund



If you are reading this book, you already may have experienced trading options. We will not teach you how to set up a hedge fund or how to invest in hedge funds. There are other books to help you set up a hedge fund if you so desire. This book gives you a glimpse of how a particular hedge fund, Smart Income Partners, Ltd., successfully trades options for its partners. Smart Income Partners, Ltd., is an option trading hedge fund managed by Dennis Chen, a co-author of this book.


This is the same framework used at a hedge fund managed by Dennis (the co-author of this book). So, for this book, we create the concept of The One Man Insurance Company (TOMIC). You will need to know how the insurance business works. What is the good, the bad, and the ugly of the insurance business? How does an insurance company make money? How does it lose money? What are the key profit drivers of the business, and what are the key success factors?


So, by now you are probably wondering how an option selling hedge fund works like an insurance company. How is one option trader able to do everything an insurance company does to make money? Keep on reading. We will show you how to trade options exactly like running an insurance company. A side-by-side comparison of the automobile insurance to writing (or selling) a put is shown in Table 1.1.


The hedge fund trader determines the best way for the hedge fund to make a profit through investment. You will create the best investment strategy while you communicate with the investors, and you will sell the shares at the best possible price to make enough profits. To do this, you must have in-depth knowledge and understanding of the market and trends to be in the best position to take profits. Hedge fund traders must have expert analytical and asset management skills. The educational requirement for the post is a degree in mathematics, science, or engineering or a relevant degree. MBA is an added advantage. Knowledge of investing and proficiency in using excel and financial statement analysis is important. Strong quantitative and legal skills are required for the post of hedge fund trader. The hedge fund trader earns an average of $49.83 an hour or $103,649 a year.


There are certain skills that many hedge fund traders have in order to accomplish their responsibilities. By taking a look through resumes, we were able to narrow down the most common skills for a person in this position. We discovered that a lot of resumes listed analytical skills, customer-service skills and detail oriented.


If you're interested in becoming a hedge fund trader, one of the first things to consider is how much education you need. We've determined that 83.8% of hedge fund traders have a bachelor's degree. In terms of higher education levels, we found that 9.4% of hedge fund traders have master's degrees. Even though most hedge fund traders have a college degree, it's impossible to become one with only a high school degree or GED.


The skills section on your resume can be almost as important as the experience section, so you want it to be an accurate portrayal of what you can do. Luckily, we've found all of the skills you'll need so even if you don't have these skills yet, you know what you need to work on. Out of all the resumes we looked through, 15.1% of hedge fund traders listed hedge funds on their resume, but soft skills such as analytical skills and customer-service skills are important as well.


This means that a $1bn hedge fund returning 10% per year on its investments would have annual revenue of $36m. The clients would receive 6.4% per year on what they put in. These figures are fairly typical. 10% per year is a typical performance target, and similar to what hedge funds actually returned before fees over the last two decades.1 A few funds charge higher fees and some charge lower ones. Many people think typical fees in the industry have shrunk in recent years.


Of course, very few people make it to this level. A $1bn hedge fund would probably employ tens of traders, suggesting each has only a couple of percent chance of making it to being an owner, even if we ignore those who drop out of the industry.


Much of the above also applies to prop trading. Prop traders trade on behalf of their institution, rather than external clients. They usually exist within small partnerships and banks (though new regulation has reduced the amount of prop trading in banks). Often prop traders trade with a smaller amount of money, but make more aggressive bets. Prop traders typically receive a larger fraction of the returns they make e.g. 30% rather than 10-20%. This means they end up earning a similar amount per year as hedge fund traders.


Some hedge funds have to disclose their total compensation, which means you can estimate the average compensation per staff member. Here is an analysis of 15 UK high-frequency hedge funds, which finds mean compensation from $200k-$1.4m. Many of these figures include support staff too, so they are underestimates of the trading salaries. This puts them in line with our estimates. Keep in mind that high-frequency firms generally offer higher pay than hedge funds.


While the hedge was effective during that volatility, the contracts in this example typically expired worthless, leaving the holder with a slight loss (the cost of the put option). This creates a long-term portfolio drag, shown in Figure 3 by plotting the cumulative profit (loss) of the strategy.


So is referring to incidents that took place last year, when retail investors banded together in online forums, such as Reddit, to prop up the stock prices of GameStop and AMC Entertainment, companies that were shorted by big Wall Street hedge funds. Doing so sent their stock prices to levels that were nowhere near their actual value and illustrated the role that retail investors can play in determining prices. Melvin Capital, a hedge fund that suffered big losses in the incident, announced earlier this year it was closing.


A career as an options trader can be lucrative, but there is also an inherent risk in speculative investing. If an options trader works for a large firm, such as a hedge fund, they are paid a base salary and then earn commissions for profitably buying and selling options. If you decide to become an independent options trader, you make money directly from each successful trade. Options traders working for large firms rely on bonuses. The more successful your skills at trading options, the greater your bonus will be at the end of the year; independent traders must do without this incentive.


Profile article on how Interactive Brokers uses technology and automation to provide hedge funds with a widerange of products and technological tools and help save them money. Executive Vice President Steven Sandersalso explains how IBKR used technology to adapt to new regulations such as MiFID II.


Amanda McLean of Interactive Brokers provides insight for hedge funds on selecting the right service providers. Picking a prime brokerage firm can often help maximize a hedge fund's long-term success, she says.


Compare Brokerages (comparebrokerages.in) reviewed Interactive Brokers in its "Insider View". The review details how Indian investors can work with Interactive Brokers and describes the products and services IB offers, including online trade and execution and clearing services for a wide variety of products, including stocks, options, futures, bonds, and funds.


The shifting regulatory landscape in the wake of the global financial crisis had major consequences for the prime brokerage industry. In an article published in Global Investor Magazine, Associate Editor Andrew Neil explores the effects of regulatory changes on prime brokers and the hedge funds they service. Neil quotes a number of industry executives, including Interactive Brokers executive vice president of marketing and product development Steve Sanders.


The VIX futures have dropped quite a bit in price recently, as has VIX. There isn't much of a premium on the October futures (October VIX futures and options will continue to trade through Tuesday, October 20th, with "a.m." settlement a week from today). The November VIX futures have a premium of 2.49, which is still quite large historically. As has been the case for months now, the heavy hedging activity has kept the futures prices inflated. It is likely to be the case that, when the hedgers finally get tired of "wasting" money on these hedges, that the market will finally top out.


From the sheer amount of volume it takes to "distort" the volume and implied volatility of such liquid options as SPX, SPY, and others, it is safe to assume that the hedging is being undertaken by major institutions -- probably hedge funds -- of considerable size.


"We monitor 60-something volatility strategies for various hedge funds, individuals, various emerging managers, and there is not one of those strategies that uses it as an indicator," Stuart Barton, managing partner at New York-based investment adviser Invest in Vol LLC, said. 041b061a72


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