Robert Hay founded Bayou City Capital LP in November 2000. Both Hay and William Monroe (pictured), who joined in 2011, represent the fund’s General Partner, Omni Trading LLC, a registered Commodity Pool Operator and Commodity Trading Advisor with the National Futures Association.
The Fund’s trading origins lie in a natural gas physical storage option-writing strategy. Over the years, Hay experimented with various asset classes including the S&P 500, natural gas, as well as WTI crude oil futures. It was only in 2004 that the Fund adopted its current S&P 500 Option Overwriting Program, trading the S&P 500 futures market at the Chicago Mercantile Exchange.
The Fund is focused on capital appreciation and is based on two key assumptions:
• Equity markets appreciate in the long term.
• Compared to historical volatility in the equity markets, stock options are overvalued based on the current market volatility their prices imply.
Expanding on the second assumption, Monroe explains: “Options carry an inherent risk/fear premium, not dissimilar from an insurance policy that creates an overvaluation for such contracts over a period of time. Over the years and several refinements to the strategy, we’ve stuck to option writing with near “at-the-money” options, not the tails of the market’s distribution. After the previous crises and shock events over the last six years, the Fund has adopted a more active management mindset.”
Since 2012, the Fund has introduced a series of safeguards to mitigate drawdowns during periods of market stress, such as in the summer of 2011 as a result of the Eurozone crisis. These safeguards include technical indicators to flag up potential market downturns, as well as a futures strategy based on the VIX (also known as the Fear Index which measures option price volatility on the S&P 500) that is designed to offset losses during option price spikes.
“With the experience gained during the last decade’s volatility, and a decreasing expense ratio as AuM increases, we’re aiming to increase the annualised return over time,” says Monroe.
Bayou City Capital is not just a short volatility strategy. The occasional market jolt is helpful to keep the fear and uncertainty premium present in the options landscape, confirms Monroe, who adds: “The art is in keeping dry powder available to apply in such events. We keep the portfolio delta-long to capture stock market appreciation. Managing the trade-offs between short-volatility and delta-long positions (and in the case of 2012, applying both) comprise the human discretion element of our strategy.”
The Fund has performed in lockstep with the S&P 500 this year – which is now up around 16 per cent YTD – although patience has been paramount for the team given that equity option prices have tumbled on the back of bullish sentiment.
“In 2012, implied volatilities in option prices were higher than historical norms. This year, it is has been important for prudent execution in option-writing. If a market correction occurs and implied volatilities rise, this will grant us the opportunity to generate alpha over the second half of the year,” notes Monroe.
Monroe adds that the strategy now includes VIX futures as “effective hedges during quick panics. In the direst crises, the market’s liquidity allows us to close the Fund’s positions for a period of time until the market displays more favourable conditions.”