TRADER INTERVIEW

Ed Padon:
Balancing risk and reward
After selling options for more than a decade, this fund manager knows how to generate consistent
gains while avoiding drawdowns.

BY DAVID BUKEY

E d Padon, fund manager of Zenith Resources, a

managed futures program and commodity
pool based near Dallas,
Texas, has come full circle.
Padon, 46, started trading far out-of-
the-money (OTM) options on gold and
silver mining companies for small
says. At first, he was successful, but his winning streak only
lasted a couple of months. “I took some drawdowns as I
learned the technical indicators, and I
was underwater for three years,” he
says.
Today, Padon stands firmly on dry
ground. After trading his own account
profits while in college. for a decade, he began managing
“I liked selling options for an eighth funds in December 1999. Since then,
(0.125) and buying them back at a six- his Zenith Resources index option pro-
teenth (0.0625),” he says. “Or I’d buy at gram has gained at least 14 percent
a sixteenth and sell at an eighth. That annually with a maximum monthly
piqued my interest.” drawdown of just 3.12 percent (see
Despite his interest in trading, Figures 1 and 2). His performance gen-
Padon entered the construction indus- erated the top-ranked Sharpe ratio
try after graduating from Southern among CTAs over the past five years
Adventist University with an account- through May 2006.
ing degree in 1982. In the mid-80s, he Padon’s success hasn’t gone unno-
managed rental properties and two ticed. Although Zenith no longer
construction-related businesses. I’m not trying to make accepts new individual managed
However, he found financing and accounts, both strategies are still open
developing residential and commer-
cial construction projects frustrating.
a directional bet. through limited-liability funds, which
Padon introduced last spring. He now

I’m just trying to

“It took longer than the actual con- manages $112 million and focuses on
struction,” he explains. selling far out-of-the-money (OTM)
After facing a third recession in the puts on the S&P 500 (SP) futures as
industry in 1989, Padon sold his busi- determine where well as on currencies, treasuries, ener-
nesses and began trading full time. gy, and meats. His main index-option
Initially, he traded gold, silver, and
copper futures, but soon began selling
the market’s not going program sticks to the S&P 500 and is
the most risk-averse, while the diversi-

to go.
options on those contracts. He traded fied program also sells puts and calls
without charts for six months before on other futures contracts and takes
changing brokers and discovering slightly more risk.
technical analysis. Unlike many options fund man-
“I tried all the indicators — Relative Strength Index, sto- agers who sell strangles (short puts + short calls) on the S&P
chastics, moving average convergence-divergence,” he 500, Padon’s approach is not market-neutral. Instead, he

26 December 2006 • OPTIONS TRADER

 FIGURE 1 — INDEX OPTION PROGRAM VS. S&P 500
sells puts with strikes that have just a
one-percent chance of being in the Zenith Resources’ index-option program sells puts on S&P 500 futures that are
money at expiration. Because puts are far enough OTM to have just a 1-percent risk of going into-the-money.
sold so far below the market, the strat-
egy offers a great deal of flexibility in
terms of market direction.
We spoke with Padon in late
October about his strategy and recent
trading experiences and the trade-off
between risk and reward.

OT: Are you selling both puts and calls

— a short strangle — on the S&P 500?
EP: No. We primarily sell naked puts
in the index option program. We sell
some above-market calls on the S&P
500 futures a couple of times a year, FIGURE 2 — DIVERSIFIED PROGRAM VS. S&P 500
which might help accent our returns a
The diversified program sells puts and calls on the S&P 500 and other futures
little bit. contracts — currencies, treasuries, energies, and meats. Padon takes slightly
In the diversified program, we take more risk with this program, but it has gained more than the index-option
a bit more risk. We sell different-strike program since January 2005.
puts closer to the money. I wouldn’t
want to sell the same strike in both
programs. Here, we write put spreads
(short put + long lower-strike put) and
also sell naked calls about six times a
year.

OT: Is it a slightly bullish strategy, one

that isn’t market neutral?
EP: Right. You could call it a bullish
strategy. But a slightly bearish or neu-
tral market doesn’t hurt us either. In
fact, a slightly bearish market is the
best scenario. You could sell good pre-
mium the whole time, but you may
have a few more heartaches. I’m not trying to make a direc- EP: Many managed futures programs that sell options are
tional bet. I’m just trying to determine where the market’s based on selling premium. In other words, managers want
not going to go. to sell options for $1, $2, $3 — whatever their model says.
But you have to understand what risk that premium [rep-
OT: So your goal is to take advantage of time decay? resents]. I first determine a trade’s statistical risk, and then
EP: Absolutely. I try to sell put strikes at that level or lower.
For instance, I want to take a 1-percent risk. That risk
OT: Could you explain how your approach developed? Did [could yield] $0.20 premium or $2. But I’m worried about
any past experiences or mistakes when trading your own the risk, and I’m not trying to sell a certain amount of pre-
account in the 90s help form your put-selling strategy? mium. That’s what I learned from past trades. If I go back
EP: It was a process of trial and error that took 10 years. I and look at profitable trades, maybe it made sense to sell
realized there was a big difference between selling option high premium. But if I consider the risk involved, I’ll think,
premium and selling risk. “That was foolish.”

OT: What do you mean? continued on p. 28

OPTIONS TRADER • December 2006 27

 TRADER INTERVIEW continued

OT: When you say risk, are you talking about the statistical mium. For example, I can’t even start to sell strikes at a 1-
risk of a put’s strike price going into the money — the mar- percent risk in bond futures. You might get 1/64th of pre-
ket dropping to the strike by expiration? mium, if that.
EP: Right.
OT: So what’s the answer?
OT: How do you find put strikes that have just a 1-percent EP: I don’t trade those contracts. You might trade them
risk of loss? directionally. Or to sell options, you’d have to take three or
EP: I have custom formulas that use the S&P 500’s current four times the risk. Right now, the T-bond’s implied volatil-
implied and historical volatilities. The first formula uses the ity is just over 5 percent and the S&P 500’s implied volatili-
S&P 500’s historical volatility and shows the worst-case sce- ty is 9 percent, which is historically low. That’s why we’re
nario (how far the market might fall). The second formula uses having trouble selling the put strikes I want to.
implied volatility to show what the marketplace is imply-
ing. OT: How has the drop in the VIX index affected your per-
To find a strike to sell, I assume the current month prob- formance? Has it made your job harder?
ably won’t be the worst (the largest loss) we’ve ever seen. EP: Yes. Because of the low volatility, we’re not selling
And the implied volatility is probably wrong. Otherwise, options for more than $1. When you’re selling options for
there would be no option premium. less than $1, there’s a lot less flexibility between the bid and
The implied volatility [suggests] selling a higher strike ask prices. If an option costs between $1 and $3, you don’t
than the historical volatility, because historical volatility mind giving up $0.10 or $0.15 to execute the trade. But with
shows the worst-case scenario. I sell the strike in between $0.50 to $0.80 options, every nickel makes a big percentage
the statistical and implied volatilities. difference in your returns.

OT: So you’re placing sell orders at limit — higher than the

bid — and not getting filled?

When the market starts falling, EP: Only one of 15 orders I send gets filled. The lower the
volatility, the worse it is. And I’m not seeing the strength of
the bid as I had in the past. Previously, market makers
and traders become fearful, some would quote 0.40 (bid), 0.60 (ask), and you could bank on
some $0.40 options there to sell. But now you might sell 100
of the prices that result surprise me. contracts before the bid drops to $0.30.
With low volatility, no one who fears the downside is
buying options, and the quantity [of puts dries up].

OT: Is your formula for determining strike prices a probabil- OT: Would you consider changing your strategy to adapt?
ity calculator where you enter the S&P’s price, its expected EP: I don’t know what changes I can make other than lim-
future volatility, and time until expiration, and you’ll find a iting the capital we manage. You can try to sell more con-
probability of the index ever touching that strike within a cer- tracts at a lower price, but I don’t see the advantage. I’d
tain time period? rather start trading S&P 500 index-based options at the
EP: No, but it’s similar — the same basic situation. CBOE. If the margins were the same at the CBOE as at the
CME — dollar for dollar — I’d trade on both exchanges. I’d
OT: So you think the S&P 500’s most probable move is rather try to get more liquidity from another exchange than
somewhere between what its historical and implied volatili- reduce the price of the puts we sell.
ties suggest? I’ve heard the CBOE is considering lowering their mar-
EP: Well, it maximizes your return for the risk taken. gins in the fourth quarter. I don’t think our programs could
Obviously, you could go out to the worst-case scenario (sell- hold more than $100 million at the CME. So it’d be good if
ing the lower strike). That’s the more conservative bet. But the CBOE adjusts their margins.
you’re not going to get any premium. This area — between
implied volatility and historical volatility — helps me find OT: Getting back to your strategy, do you create put
the best risk-reward possibility. spreads in addition to simply selling uncovered puts in the
I’m just trying to find the optimum risk-reward ratio that S&P 500 futures? In other words, buying a lower-strike put
makes sense to me. It has worked. Over the last several for protection?
years, we’ve had the highest Sharpe ratio (risk-free EP: We did a couple of times last year in our main index
return/standard deviation) of any CTA program. program, but not in 2006.
The problem is I can’t go the distance out-of-the-money
that I’d like in most futures contracts. You can’t get any pre- OT: When you sell these spreads, do you buy and sell one

28 December 2006 • OPTIONS TRADER

option at a time or execute both trades simultaneously?
EP: Simultaneously. Let’s say we sold a 1,200 put and the OT: How do you determine your stop-loss point?
S&P trades at 1,300. If I sell it outright, I’m selling one con- EP: When we sell an uncovered put and we’re in danger of
tract for $10,000 of equity (margin). If the market gets with- a margin call — the S&P 500 is within 75 points of its short
in 75 points of the sold strike, margin will rise above strike — I’ll purchase a put 40 points or less below the one
$10,000. So if the S&P 500 drops to 1,275, I have to adjust the I sold. That ensures a margin call won’t occur if you’re
trade. using $10,000 margin. If the market drops near the short
At that point, I either need to exit or purchase a put below strike, I’ll buy back the short put and leave the long one in
the one I’ve sold. That’s another way of creating a put place.
spread and legging in. Then, I’ll consider reselling the put when the volatility is
Here, the market can only drop 25 points before you have still high, but not necessarily that day or in the same con-
a problem. But if I enter a spread initially, the market can tract.
drop to 1,225 before the margin rises above $10,000,
depending on the spread. OT: How do you feel about repair strategies — buying or
If you’re selling puts 100 points out of the money, it selling other options to get out of a losing position?
makes a lot more sense to assume the S&P 500 will drop 75 EP: I don’t have a problem with it. If I were writing options
points instead of just 25 points in the next 30 days. Because 60 to 90 days before expiration, and there’s still 50 days to
of the recent low volatility, a 1-percent risk is roughly 100 go, I’d be leery of trying to roll down (buy back a short put
points below the market, whereas a few years ago, the same and sell a lower-strike one). But if you’re selling options that
risk was 300 points out of the money. expire in 30 days or less, you can often roll down far enough
I’m trying to sell puts at the same risk distance below the to get out of harm’s way and get past the options’ expira-
market. But if I expect the S&P to drop 25 points this month, tion.
selling naked puts isn’t reasonable. I’ll try to sell a spread,
so I can sell a put strike with a 1-percent risk and still have OT: Why is that not a good idea with a longer time frame?
75 points of flexibility. EP: When you’re in trouble, you’re trying to fix the prob-
But my October options expired Oct. 20, and they were lem now. You’re probably not considering what will happen
all naked puts. continued on p. 30

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OPTIONS TRADER • December 2006 29

 TRADER INTERVIEW continued

FIGURE 3 — S&P 500 FUTURES — SELLING PUTS

In September, Padon’s more conservative strategy sold puts on S&P 500 EP: No. I would use the same strategy
futures that were at least 150 points (11.3 percent) below the market. and take the same risk every month.
We can’t sell put strikes further out.
The lower returns have to do with tim-
ing.
For example, our last drawdown
was in September 2003. That month
ended on a Tuesday. We were prof-
itable on the Monday and Wednesday
surrounding our monthly report date.
But on Tuesday, we lost ground. The
S&P 500 [bounced around] and put us
in negative territory for one day.

OT: Could you describe a past trade

in the S&P 500?
EP: From Sept. 14 to 19, I sold a few
October 1,180 puts and many 1,165-
and 1,175-strike puts in the index
options program. Here, I didn’t sell
calls (see Figure 3).
But in the diversified program, I
sold October 1,210 puts and bought
1,110 puts (credit put spread). Also, I
sold 1,395 calls. The calls went against
us, but I didn’t exit and they expired
worthless.
We sold the 1,395 calls for $0.45 and
they rose to $0.80 at some point. That’s
Source: eSignal not bad, considering the market went
straight up the whole time.
in the next 50 days. You often don’t establish a position you
want. If you’re just walking in the door to establish a new OT: In a typical month, do you tend to sell a couple of dif-
trade, you’d probably never place that repair trade. If ferent strikes or do you focus on one strike?
you’ve got just a few days left until it expires, time can heal EP: I try to sell at least two strikes in each program. With
it. But more time just gets you into more trouble. the quantity of options we sell, I want to spread out over at
least four strikes overall.
OT: Do you consider seasonal trends in the S&P 500?
EP: Definitely. OT: Why is that an advantage?
EP: If the market goes against me, I only have to exit one-
OT: Which seasonal trends stick out? fourth of the trades at a time. In the fund, I may sell 10 dif-
EP: The September-October downtrend. And it was totally ferent strikes, because I take odd-lot fills (trades of less than
out of whack this year. That’s why we got caught off-guard 100 contracts). I can’t do this with the segregated accounts
a little bit last month. We sold October 1,395 and 1,400 calls, because I have to treat all accounts equitably. But if a deal
and they threatened us the entire time. comes along on a 50-lot (contract) trade, I’ll put it in the
September has been the worst month for our programs fund.
on a calendar basis. April has been the second-worst month,
and I think it’s in line with some of the S&P 500’s seasonal OT: Do you sell options within 30 days of expiration to take
trends. We’re not negative in those months, but they pro- advantage of an option’s increased time decay as expira-
duce smaller gains. tion approaches?
EP: Yes. And I’ve found the market is much more pre-
OT: So in September you try to sell puts even further below dictable in that time period. It becomes increasingly harder
the market? to predict beyond that point.

30 December 2006 • OPTIONS TRADER

 FIGURE 4 — CRUDE OIL — SELLING PUTS AND CALLS

OT: In your diversified program, you In August, Padon’s diversified program sold $64 October puts and $100
sell options on other futures contracts October calls. The puts went into the money on Sept. 12, and he exited and
in addition to the S&P 500, right? sold $62 puts. Despite this loss, the strategy gained 1.5 percent overall.
EP: Yes — currencies, treasuries,
energies, and meats.

OT: Do you use the same strategy —

selling far OTM puts within a month of
expiration?
EP: It’s similar, but we have to risk
more to get any premium in these
instruments. I may sell options with a
4-percent chance of going in-the-
money.
But the higher-risk trades are
weighted less. I don’t take a 1-percent
risk in one trade and a 4-percent risk
in two other trades that each represent
one-third of the account. A higher-risk
trade will have more problems, but
the overall effect isn’t as large.
Last month, we were hurt in crude
oil futures. I sold $64-strike October
puts when crude oil closed at $73.19
on Aug. 16 (see Figure 4). I also sold
October calls with a strike of $100.
The short calls were four times fur-
ther out of the money than the puts,
but I received approximately the same
premium for them. It’s the opposite
situation in the S&P — you can sell Source: eSignal
close-to-the-money calls for $0.40,
while you can sell puts 150 points below the market for the He asked if I wanted to sell them, and I thought “No one
same price. would pay that.” Maybe the broker was wrong and quoted
When crude oil dropped near $64, I [got out and sold] a higher strike. I only sold 400 contracts, because everyone
$62-strike puts. This was the only trade in years that went else sold them before I could decide whether it was a mis-
in the money. Had I taken a 1- or 2-percent risk, I wouldn’t take. Those puts were 14 percent out of the money, and they
have had a problem. dropped to $0.20 two days later.
We still gained 1.5 percent in September for that pro-
gram. If I’d sold as many crude oil puts as S&P 500 puts, we OT: You gained at least 31 percent in 2001 and 2002 when
would have lost money. the market fell and was quite volatile. How did you manage
to avoid losses during these volatile years?
OT: Has an option’s price behavior ever truly surprised EP: Our returns closely follow the VIX index. If you over-
you? lay a VIX chart over our monthly returns, you’ll see a very
EP: Absolutely. When the market starts falling and traders similar correlation. We’re selling the same risk each month,
become fearful, some of the prices that result surprise me. so a high-volatility environment is the only way to collect
more premium. If you take different risks each month, this
OT: Do traders want to buy options for more premium than will vary.
you’d expect? This program earned about 110 percent of the VIX’s aver-
EP: More premium than you could imagine. On June 19, I age value. So if the VIX is around 15 percent, we’ll gain
was talking to a floor broker and he quoted 1,075 puts — about 16.5 percent per year.
175 points out of the money — for $1.70.

OPTIONS TRADER • December 2006 31