Three legs of the strategy

In simple terms, OptoFlex would sell a put option on the S&P 500 Index and then spend half of the option premium received to purchase two kinds of hedges: a more distant long put and a call option on the VIX. “We construct many such three-legged ‘packages’, diversifying them across a range of strikes and maturities”, says lead portfolio manager Horst Gerstner.

The strategy has been consistent for over a decade: “With the size of our fund growing over the years, so has the number of packages that we trade. The S&P 500 options market moving from monthly to weekly expirations in 2016 has also allowed for more diversification. Apart from that, there have been no substantial changes to the strategy in now almost twelve years,” adds Gerstner.

The strategy’s simplicity belies its complexity, as its success hinges on proprietary rules that dictate the timing for taking profits and rebalancing exposures. A back test of constant exposure to the three elements of each package – long put, short put and VIX call – would not produce the returns achieved by OptoFlex.

The average strike level of the short puts has been around 10% out of the money, while the net equity delta of the entire portfolio has averaged 27%. The rules governing the strategy are more complicated and sophisticated than the typical description of volatility indices that underlie many systematic volatility trading ETFs and funds that are based on swaps with indices. Unsurprisingly, FERI has not created any public index for the OptoFlex strategy.

Skew and synchronized puts

Some volatility strategies aim to profit from the internal structure of the volatility market. They try to exploit the skew and smile of the volatility surface, typically by selling options perceived as “expensive” to buy “cheaper” ones. FERI does the opposite in terms of implied volatility skew: OptoFlex buys puts more expensive than the ones it sells, while remaining a net premium recipient. The focus is less on the nuances of the implied volatility skew and more on the gap between overall implied volatility and realized volatility.

Within each package, all three legs share the same maturity. No attempt is made to structure calendar spreads which might earn more (short put), or pay less (long put, long call) time decay. Nor does the strategy entail speculation on the term structure when the options are rolled over to new expiry dates. In terms of trading, “The strategy ensures that all three legs of a package are either closed or opened simultaneously, thereby avoiding any over- or under-hedging during trade execution,” says Gerstner.

Finally, the long put is always identical to the short put in terms of not only expiration date but also quantity, thereby limiting the maximum potential loss incurred by the combination of long and short puts – the put spread.

Greeks exposures

A higher VIX generally means that OptoFlex earns higher premiums from selling put options. It should be noted that the VIX, which measures the implied volatility of at-the-money S&P 500 options, might understate the implied volatility for the out-of-the-money options traded by OptoFlex. “A VIX of 10 would typically mean that 10% out of the money puts might trade on implied volatility of 12 or 13,” says Gerstner. He estimates that, “When the VIX reached its all-time low of 8.5 on November 24, 2017, the fund was probably earning implied volatility of around 11”. Clearly, even a low implied volatility, such as in 2017, can be profitable if the subsequently realized volatility is even lower.

The difference between implied and realized volatility is the key return driver. Yet, strictly speaking absent delta hedging there is also some equity risk premium. “If investors want to avoid the equity delta exposure, they should focus on strategies that typically trade variance and/or volatility swaps to capture the VRP,” says Gerstner.

“The strategy is nearly always short vega and gamma, but in extreme cases of a huge VIX spike, the increased long vega from the VIX calls can outweigh the short vega on the short puts, and the fund might be net long volatility for some period before it rebalances,” explains co-portfolio manager, Stephan Bongartz. This happened in March 2020 in live trading and would have happened in October 2008 in the back test, when the VIX hit 80 on both occasions. “We spend a significant amount, approximately a quarter of the short-put premium, on these far-out-of-the-money VIX calls,” says Bongartz. “We want to be very good when things are very bad.” Before the back test period, the October 1987 crash predated the 1990 birthday of the VIX, but a hypothetical VIX has been estimated at between 130 and 150 on that fateful Black Monday. Given that VIX calls have a negative equity delta, OptoFlex might become net short of equity delta in adverse markets.

Stress tests: Covid, “volmageddon”, “flash crashes” and 2022

“Over time, the two long option positions typically incur losses, but are critical for performance during stock market corrections and crises,” explains Bongartz. The markets have experienced numerous such crises since OptoFlex was launched in 2012, allowing the hedges to demonstrate their value. In the month of the August 24, 2015 “flash crash”, the fund faced a 13% loss on its short S&P 500 puts. Yet the drawdown was significantly mitigated by profits from long puts and VIX calls; OptoFlex posted a 2.05% loss during the month.

The 2018 performance may be surprising, since the February 2018 “volmageddon” is a small blip on the OptoFlex performance chart. This is because the VIX spike on February 5, 2018, combined with the long puts, covered 5.8% of the 7% losses on the short puts.

In contrast, December 2018 saw a larger performance setback, down 5.53% for the month, because the VIX did not rise far enough to generate profits on the VIX calls. The magnitude of a VIX jump matters: “Our VIX call positions are meant to protect against adverse tail events and require a substantial rise in the VIX to become impactful,” says Bongartz.

“If the VIX does spike, we do not speculate on when it might peak. Instead, we continue to monetize positions systematically and gradually during the roll phases. This approach works best in case of sustained high VIX levels, which we expect to prevail in case of a “true” adverse tail event rather than a transitory shock,” explains Bongartz. Such a “true” tail event happened with the Corona crisis in February and March 2020. OptoFlex did incur some losses in February 2020, but the VIX spike to 80 came to the rescue in March and covered losses.

In contrast, 2022 overall was one of the worst scenarios because the long slow bear market generated some sharp drops pushing short puts into the money but did not produce any VIX spikes big enough to move the VIX calls into profit. Even the long puts contributed negatively, due to the uncharacteristically slow grind downwards. “2022 was an unusual year for markets, which normally experience losses more abruptly and severely,” points out Gerstner. While 2022 would become the worst year for OptoFlex, the fund’s 6.51% return for the year was still respectable, helped also by the portfolio’s low duration. “Unlike many competitors, the team had never succumbed to the temptation to pick up additional yield on the bond portfolio by taking on credit or interest-rate risk,” says Bongartz.

Cash management

In-house bond teams select a mix of debt from European governments, German Länder states and supranationals such as the European Investment Bank (EIB). No corporate or credit risk is taken, and the bonds have AA or AAA credit ratings. German Länder bonds offer a marginal yield pickup. “Given the smaller issuance size and lower trading volume there might be an illiquidity premium, reflected in a higher yield and wider bid-ask spread. Still, Länder bonds are highly liquid, and the yield spread to German federal bonds is small,” points out Bongartz. Most bonds are held to maturity. Interest rate duration is around 0.25. The fund has also historically used floating rate notes to minimize duration.

Market closure

An S&P “limit down” by 7% or 13% leads to equity indices being halted for 10 minutes and associated options for 15 minutes. “It does not necessarily force any rebalancing or trade since we always have the hedges. We are generally never forced to trade and can wait out periods of suspension. OptoFlex has ample collateral in relation to its risk, which is why we have never been forced to cut risk due to margin constraints, not even during February 2020. At maximum, our margin requirement was approximately 20 to 25% of NAV,” says Bongartz.

Discretionary intraday execution

The strategy is almost 100% systematic, though there is some discretion over the timing of intraday trading. “In addition, there is some freedom to delay rebalancing until the next roll phase in response to net inflows or outflows below a threshold. Those above a threshold would require an interim rebalance,” explains Gerstner.

Brokers

FERI have been able to maintain good volumes and execution amid the growth of the ODTE option markets. A Chicago based specialist options broker, XFA, is used. “They offer good service, supported by ample staff, even on busy and stressful days. Colocation and low latency are crucial during these times,” says Gerstner.

Team replacements, expansion and coding project

Three out of four OptoFlex team members left in 2023 and the OptoFlex team was increased to seven staff, to allow for additional redundancy. Hitherto two people could trade and now four can do so, namely the lead portfolio manager Gerstner and three co-portfolio managers.

Dr. Albina Unger is the lead developer and one of the relatively few female programmers working in finance. In 2022, she began migrating the existing VBA and R codes to Python and implemented a new SQL database to provide a faster trading environment. “Before I joined the team, the trading tools were programmed in several Excel sheets using Excel VBA. I used my expertise to create an efficient fund management and trading tool in Python. It contains all the Excel files and connects to the internal accounting system. The tool can be used by multiple portfolio managers simultaneously and is more efficient and reliable than Excel,” says Unger. Yannic Blecher, the team’s quantitative analyst, supports Unger in developing the trading systems, implementing back tests and creating reports.

Assets and distribution

OptoFlex has a diversified investor base. Around 12% of fund assets are in a zero-fees share class that accommodates FERI clients to avoid double charging. Around 58% of the assets are in institutional share classes and the remaining 30% in share classes reserved for retail investors. Share classes are technically distributing (for the convenience of pension funds), but in practice are virtually identical to accumulation classes since the distributions only started in 2018 and have been minimal, never exceeding 0.3% per annum.

The strategy was briefly soft closed at assets around EUR 2.25 billion while the team reviewed liquidity on VIX calls (the S&P 500 puts have much greater liquidity and capacity). Current assets of EUR 1.3 billion leave plenty of capacity.

Strategy variations

Horst Gerstner and team head Rico Höntschel previously worked for LeanVal Asset Management (earlier called Conservative Concept Asset Management), which pursued a different sort of put spread strategy.

For the time being there are two existing products combining the OptoFlex strategy with long-only equities. US EquityFlex combines the OptoFlex strategy with a full replication of the S&P 500. Similarly, EuroEquityFlex is a combination of the OptoFlex strategy applied to the EURO STOXX 50 and a full replication of the EURO STOXX 50. A nuance is that EuroEquityFlex would ideally use the VSTOXX instead of VIX calls but due to liquidity constraints it is replicating the VSTOXX with two additional long puts.