Hedge Fund Job Applicant #3

Background

Every job applicant in this series is real, in the sense that the stories are based upon fact.  Some of the applicants are specific people.  Some are based upon someone selling a system through email, telephone, and/or in-person presentations.  All are real.

Applicant #3 is a composite of many options traders over the last twenty years.

The Interview

Applicant #3 shows me trading records covering a three-year period.  During that time, he averaged gains of 18% annually.  He has references from other traders testifying to his skill -- speed, understanding of markets, and the ability to react quickly.  By telephone, admiring traders tell me that the applicant "DID SIZE."  One has to imagine the voice dropping to a deep baritone with extra emphasis.

When I ask the applicant why he is coming to me he explains that he "blew out."  This means that he lost so much in a short period of time that he lost his stake.  Possibly his backers had to make up a deficit.

Many great traders, perhaps most, have had similar experiences.  Those who have not experienced tough times are probably quite rare.  The key question is why and how this happened, and whether it might happen again.

Applicant #3's trading records show that much of the return came from selling option premium, going short both calls and puts on equities.  The strikes were significantly out of the money, and seemed safe against major moves.  For a long time the strategy worked extremely well, with expiring options generating income at each monthly expiration.  If the underlying stocks moved, he "rolled" the short options to a different strike, farther out of the money but increasing the position size.  It would take a move of more than 2 1/2 standard deviations to create a signficant problem.

Should I hire this applicant?  The monthly income is very tempting.

Comments

[Tyro]

2.5 standard deviations, huh? So he'd run into "serious problems" in about 1% of the time, roughly twice each year.

Hmm...

I would risk mid-term catastrophic failure for a few months only if the short-term returns were fantastic, say 100% every quarter, and even then it would only be with a relatively small proportion of my account. But to enter into a strategy with only 18% upside but 100% drawdowns seems, um, shortsighted.