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
profits while in college.
“I liked selling options for an eighth
(0.125) and buying them back at a six-
teenth (0.0625),” he says. “Or I’d buy at
a sixteenth and sell at an eighth. That
piqued my interest.”
Despite his interest in trading,
Padon entered the construction indus-
try after graduating from Southern
Adventist University with an account-
ing degree in 1982. In the mid-80s, he
managed rental properties and two
construction-related businesses.
However, he found financing and
developing residential and commer-
cial construction projects frustrating.
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
for a decade, he began managing
funds in December 1999. Since then,
his Zenith Resources index option pro-
gram has gained at least 14 percent
annually with a maximum monthly
drawdown of just 3.12 percent (see
Figures 1 and 2). His performance gen-
erated the top-ranked Sharpe ratio
among CTAs over the past five years
through May 2006.
Padon’s success hasn’t gone unno-
ticed. Although Zenith no longer
I’m not trying to make accepts new individual managed
accounts, both strategies are still open
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-
tional bet. I’m just trying to determine where the market’s
not going to go.
OT: So your goal is to take advantage of time decay?
EP: Absolutely.
OT: Could you explain how your approach developed? Did
any past experiences or mistakes when trading your own
account in the 90s help form your put-selling strategy?
EP: It was a process of trial and error that took 10 years. I
realized there was a big difference between selling option
premium and selling risk.
EP: Many managed futures programs that sell options are
based on selling premium. In other words, managers want
to sell options for $1, $2, $3 — whatever their model says.
But you have to understand what risk that premium [rep-
resents]. I first determine a trade’s statistical risk, and then
I try to sell put strikes at that level or lower.
For instance, I want to take a 1-percent risk. That risk
[could yield] $0.20 premium or $2. But I’m worried about
the risk, and I’m not trying to sell a certain amount of pre-
mium. That’s what I learned from past trades. If I go back
and look at profitable trades, maybe it made sense to sell
high premium. But if I consider the risk involved, I’ll think,
“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
risk of a put’s strike price going into the money — the mar-
ket dropping to the strike by expiration?
EP: Right.
OT: How do you find put strikes that have just a 1-percent
risk of loss?
EP: I have custom formulas that use the S&P 500’s current
implied and historical volatilities. The first formula uses the
S&P 500’s historical volatility and shows the worst-case sce-
nario (how far the market might fall). The second formula uses
implied volatility to show what the marketplace is imply-
ing.
To find a strike to sell, I assume the current month prob-
ably won’t be the worst (the largest loss) we’ve ever seen.
And the implied volatility is probably wrong. Otherwise,
there would be no option premium.
The implied volatility [suggests] selling a higher strike
than the historical volatility, because historical volatility
shows the worst-case scenario. I sell the strike in between
the statistical and implied volatilities.
When the market starts falling,
and traders become fearful, some
of the prices that result surprise me.
OT: Is your formula for determining strike prices a probabil-
ity calculator where you enter the S&P’s price, its expected
future volatility, and time until expiration, and you’ll find a
probability of the index ever touching that strike within a cer-
tain time period?
EP: No, but it’s similar — the same basic situation.
OT: So you think the S&P 500’s most probable move is
somewhere between what its historical and implied volatili-
ties suggest?
EP: Well, it maximizes your return for the risk taken.
Obviously, you could go out to the worst-case scenario (sell-
ing the lower strike). That’s the more conservative bet. But
you’re not going to get any premium. This area — between
implied volatility and historical volatility — helps me find
the best risk-reward possibility.
I’m just trying to find the optimum risk-reward ratio that
makes sense to me. It has worked. Over the last several
years, we’ve had the highest Sharpe ratio (risk-free
return/standard deviation) of any CTA program.
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-
28
mium. For example, I can’t even start to sell strikes at a 1-
percent risk in bond futures. You might get 1/64th of pre-
mium, if that.
OT: So what’s the answer?
EP: I don’t trade those contracts. You might trade them
directionally. Or to sell options, you’d have to take three or
four times the risk. Right now, the T-bond’s implied volatil-
ity is just over 5 percent and the S&P 500’s implied volatili-
ty is 9 percent, which is historically low. That’s why we’re
having trouble selling the put strikes I want to.
OT: How has the drop in the VIX index affected your per-
formance? Has it made your job harder?
EP: Yes. Because of the low volatility, we’re not selling
options for more than $1. When you’re selling options for
less than $1, there’s a lot less flexibility between the bid and
ask prices. If an option costs between $1 and $3, you don’t
mind giving up $0.10 or $0.15 to execute the trade. But with
$0.50 to $0.80 options, every nickel makes a big percentage
difference in your returns.
OT: So you’re placing sell orders at limit — higher than the
bid — and not getting filled?
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
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
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: Would you consider changing your strategy to adapt?
EP: I don’t know what changes I can make other than lim-
iting the capital we manage. You can try to sell more con-
tracts at a lower price, but I don’t see the advantage. I’d
rather start trading S&P 500 index-based options at the
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
rather try to get more liquidity from another exchange than
reduce the price of the puts we sell.
I’ve heard the CBOE is considering lowering their mar-
gins in the fourth quarter. I don’t think our programs could
hold more than $100 million at the CME. So it’d be good if
the CBOE adjusts their margins.
OT: Getting back to your strategy, do you create put
spreads in addition to simply selling uncovered puts in the
S&P 500 futures? In other words, buying a lower-strike put
for protection?
EP: We did a couple of times last year in our main index
program, but not in 2006.
OT: When you sell these spreads, do you buy and sell one
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
S&P trades at 1,300. If I sell it outright, I’m selling one con-
tract for $10,000 of equity (margin). If the market gets with-
in 75 points of the sold strike, margin will rise above
$10,000. So if the S&P 500 drops to 1,275, I have to adjust the
trade.
At that point, I either need to exit or purchase a put below
the one I’ve sold. That’s another way of creating a put
spread and legging in.
Here, the market can only drop 25 points before you have
a problem. But if I enter a spread initially, the market can
drop to 1,225 before the margin rises above $10,000,
depending on the spread.
If you’re selling puts 100 points out of the money, it
makes a lot more sense to assume the S&P 500 will drop 75
points instead of just 25 points in the next 30 days. Because
of the recent low volatility, a 1-percent risk is roughly 100
points below the market, whereas a few years ago, the same
risk was 300 points out of the money.
I’m trying to sell puts at the same risk distance below the
market. But if I expect the S&P to drop 25 points this month,
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
75 points of flexibility.
But my October options expired Oct. 20, and they were
all naked puts.
OT: How do you determine your stop-loss point?
EP: When we sell an uncovered put and we’re in danger of
a margin call — the S&P 500 is within 75 points of its short
strike — I’ll purchase a put 40 points or less below the one
I sold. That ensures a margin call won’t occur if you’re
using $10,000 margin. If the market drops near the short
strike, I’ll buy back the short put and leave the long one in
place.
Then, I’ll consider reselling the put when the volatility is
still high, but not necessarily that day or in the same con-
tract.
OT: How do you feel about repair strategies — buying or
selling other options to get out of a losing position?
EP: I don’t have a problem with it. If I were writing options
60 to 90 days before expiration, and there’s still 50 days to
go, I’d be leery of trying to roll down (buy back a short put
and sell a lower-strike one). But if you’re selling options that
expire in 30 days or less, you can often roll down far enough
to get out of harm’s way and get past the options’ expira-
tion.
OT: Why is that not a good idea with a longer time frame?
EP: When you’re in trouble, you’re trying to fix the prob-
lem now. You’re probably not considering what will happen
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
futures that were at least 150 points (11.3 percent) below the market.
Source: eSignal
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
trade, you’d probably never place that repair trade. If
you’ve got just a few days left until it expires, time can heal
it. But more time just gets you into more trouble.
OT: Do you consider seasonal trends in the S&P 500?
EP: Definitely.
OT: Which seasonal trends stick out?
EP: The September-October downtrend. And it was totally
out of whack this year. That’s why we got caught off-guard
a little bit last month. We sold October 1,395 and 1,400 calls,
and they threatened us the entire time.
September has been the worst month for our programs
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
trends. We’re not negative in those months, but they pro-
duce smaller gains.
OT: So in September you try to sell puts even further below
the market?
30
EP: No. I would use the same strategy
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
not bad, considering the market went
straight up the whole time.
OT: In a typical month, do you tend to sell a couple of dif-
ferent strikes or do you focus on one strike?
EP: I try to sell at least two strikes in each program. With
the quantity of options we sell, I want to spread out over at
least four strikes overall.
OT: Why is that an advantage?
EP: If the market goes against me, I only have to exit one-
fourth of the trades at a time. In the fund, I may sell 10 dif-
ferent strikes, because I take odd-lot fills (trades of less than
100 contracts). I can’t do this with the segregated accounts
because I have to treat all accounts equitably. But if a deal
comes along on a 50-lot (contract) trade, I’ll put it in the
fund.
OT: Do you sell options within 30 days of expiration to take
advantage of an option’s increased time decay as expira-
tion approaches?
EP: Yes. And I’ve found the market is much more pre-
dictable in that time period. It becomes increasingly harder
to predict beyond that point.
December 2006 • OPTIONS TRADER
 FIGURE 4 — CRUDE OIL — SELLING PUTS AND CALLS

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

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