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Joe Elmlinger on Option Based Investment Strategies

New Episode on NaluFM: Option Based Investment Strategies

vestr’s Head of Business Development, Stefan Wagner, speaks with Joe Elmlinger from Lake Hill Capital about how to use options strategies for portfolio management.

They also talk about the following in this episode:

  • How can option based investment strategies add value?
  • How to use option based strategies in your investment process?
  • How to maintain your desired risk profile?
  • What can kill the performance?

and more!

Tune in now and get the latest insights on structured products, technology and investment management here.

Schedule a call with us for additional questions.

No time to listen? We summarised the podcast for you:

Stefan: Tell me, Joe, what does Lake Hill Capital Management actually do?

Joe: We are a SEC registered investment advisor that focuses exclusively on options as our primary investment vehicle. So, we are an options based investment advisor. We tend to focus on equity options and in particular on the most liquid part of the options world, which are options on major equity indices. So S&P 500, Russle 1000, and things like that. We pride ourselves in being problem-solvers. We think that the best approach for our clients is for us to work with them to craft, to custom-tailor a solution for them. Much like the clothing industry. Often you buy the suit off the rack – not that anybody buys suits anymore, – but it typically does not fit perfectly. It needs to be tailored to your condition. 

As an options based investment manager, long ago we recognized that people use options basically for two different reasons. There is a third, but primarily the vast majority who get involved with investing in options are either involved in options because they want to hedge something, they wanna protect their downside. Down-side mitigation, risk mitigation. Or they want to enhance their income. That the receiving often existing portfolio. So they might be call-overriders or some form of yield enhancement and then there is a much smaller set that are involved for pure speculation. Leveraged exposure maybe. Some kind of pure alpha-type strategies. But I would say the vast majority of the market participants in the global options markets are either the hedger or seeking yield to enhance your yield. That is how we spend our time. That is how our AuM is reflected. 

Could you give some examples of some strategies that you already have?

So, we have three core approaches or solution sets for our clients. 

1) dynamic hedge

2) income builder; a yield enhancement or income generating

3) tactical trading

We have the most in dynamic hedge, then followed by the income builder and the smallest set is the tactical trading.

Do your clients overlay it?

They often overlay it, and we have clients who use it as an equity replacement. Essentially, we through in a unit of beta. Rather than holing spiders, we give you that S&P 500 beta exposure. And then the overlay all wrapped up in one single package. 

When these strategies were designed, they all sound excellent. But what were the challenges when you designed such strategies?

The pure amount of data. In the S&P 500 alone at this point in time there are nearly 10’000 different options to choose from. 

How do you measure your risks? 

We use all conventional and classic measures of risk. The most important thing we do at risk management at Lake Hill we do is we are always trying to evaluate probabilities. 

Probabilistically what is the likelihood that an option at this particular strike price priced at that price is fairly valued? The chances of a far out of the money option, be it a put or a call, ever ending up in the money are exceptionally small. But that does not mean the price does not change. And that there is no opportunity. A 25-cent-option has no practical likelihood of ever being in the money. But that doesn’t mean that it should not be priced at 35 cents. 

That is what we spend most of our time doing; evaluating probabilities. When you assess those probabilities, hopefully more often correctly that incorrectly. Then, you need to decide how much capital to put against those opportunities. 

How do you monitor your strategies?

Supply and demand are the essential drivers behind the movements that we see across the bell curve. Supply and demand occurs on a big global macro scale. We care about Korean and Japanese structured product issuance. We care about the big picture. We care all the way down to the day-to-day supply and demand dynamics. 

You mentioned the three types of strategies, maybe we can spend a little more time on one of them. The dynamic hedge, how does it work? How does it compare to a simple put option?

Let’s say you buy an insuring put option for a specific price. You are insensitive to price, and it protects you from moves beyond 5% movements. What happens the next day when the market rallies by 3%? Suddenly, your put option is much further away from your portfolio value than it was yesterday. And then you realize, your underlying portfolio is constantly moving up and down, your tolerance, your risk threshold might change.

Then, how do you find a disciplined approach to managing your risk profile and achieving the downside or risk mitigation goals that you want to in a constantly changing sea that you are floating on. That is the real value that Lake Hill delivers with the dynamic hedge product. The value that Hill brings is that multi-step, we call it the Lake Hill engine, which in the first instance is constantly evaluating the ball curve and the market and identifying potential opportunities. In the second instance, takes those opportunities together with the existing client profile and says “Should I make any changes and if I do, am I still going to be okay?”. Then third, once the portfolio manager reviewed those recommendations from the system and said “yes, go ahead and do those ” or “no, do not do that one”, the system then goes ahead and executes in the most efficient way possible.

One of the downfalls of a lot of systematic strategies in the end becomes the transaction cost that they end up paying. 

I don’t wanna diminish in any way the value of our internal execution algorithm which we have been refining for years, it makes a huge difference in the long term. The ultimate performance of any strategy is a combination of systematic drive and manager discretion. So, we thread togetehr the analytical portion, the portfolio risk management portion and the execution. 

What is the most significant learning that you can share?

Upon reflection, most of the core philosophy and tools that I needed in my work life, I largely acquired within 4-5 years of entering the business world. The passion the drive for me is creating something new and the real excitement is being able to create something new where others saw great obstacles or an impossibility. There is nothing more exciting to me than building something that no one has ever seen before. Have a reason, purpose to work.

Last questions, what are your up to 3 favourite finance movies and why?
  1. Trading Places; super entertaining and also quite instructive if you pay close attention
  2. Wallstreet with Michael Douglas playing the worst human being on earth, but these people exist
  3. Tinman; not directly finance, but it teaches you about selling