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Managed Futures Spotlight: FCI (Financial Commodities Investments)
June 14, 2010
We have been talking in this space for a few weeks now how we believed there was an increase in volatility coming, and then – once it arrived – that we could expect an elevated level of volatility for quite some time. And how such an increase in volatility would be to the benefit of multi-market systematic programs with their long volatility profile and be a drag on performance for option selling programs which have a short volatility profile.
And yet here we are this week, highlighting an option selling program. What gives?
Well, for one thing – there is at least a 50/50 chance that our volatility call is wrong and we see things slow down and return to the low volatility levels seen in April. The best argument for that is that we’ve already seen this year’s volatility spike with the VIX going from ~20 to ~40 on Europe’s debt problems, the flash crash, and the rest of it. With most of the news already out, it is more than possible the VIX slowly drifts back down to the 15 to 20 level, and if that happens, a short volatility program is where you want to be.
But perhaps more importantly is that the short volatility program we’re highlighting did just fine over the past month and half while volatility spiked – making it a unique sort of hedge which can thrive in declining volatility and survive in rising volatility. The focus of our managed futures spotlight this week is Financial Commodity Investments (FCI) and their two diversified option selling programs.
Who is the Manager:
Financial Commodity Investments is a group of financial professionals from the Washington D.C. area who offer a full suite of alternative investment and traditional investment products including two CTA Programs: FCI OSS and FCI CPP and a hedge fund. Craig B. Kendall is the sole principal of FCI, and oversees all aspects of the business. As a licensed CPA in the State of Virginia, Mr. Kendall has spent his entire career in the financial field with much of it being as a self-employed entrepreneur. In 1995 Craig launched Kendall & Co. CPA’s who provide comprehensive tax, accounting, and financial services to business owners, associations, corporations, partnerships and individuals.
Other key employees at FCI include Portfolio Manager Gaurav P. Gupta – who is responsible for the day-to-day operations of both the FCI OSS and FCI CPP programs. Mr. Gupta holds a bachelor of Commerce as well as a Masters of Commerce degree with an accounting major from Mumbai University in India. After graduation Gaurav came to the U.S. to study finance at The George Washington University in Washington D.C. where he graduated with a Masters of Science in Finance. Gaurav has an instrumental role with FCI and is the senior trader for both CTA programs.
Considering Mr. Kendall’s business acumen and background with startup companies, it is not a surprise that he has built a very strong and stable staff at FCI. Mrs. Melanie Martin is The Manager of Operations and has been with FCI since 1998. Since our last update on FCI - two employees, Mr. Ray Yzer and Mr. Nathan Rea have joined FCI and are responsible for business development including retail and institutional sales. The most recent addition to the FCI team is Mr. Jamie Walters who graduated Cum Laude from West Virginia University in 2008 with a Bachelor of Science in Mathematics and Bachelor of Science in Physics as well as a Master of Science in Finance from American University in Washington D.C.
How Does the Program Work:
As mentioned above FCI offers two discretionary option trading programs; the FCI Option Selling Strategy (OSS) and the FCI Credit Premium Program (CPP).
Of the two programs, the FCI OSS program is the old stalwart at one month shy of a 5 ½ year track record and approximately $14 million AUM. The FCI OSS CTA program was launched in the July, 2004 as an offshoot of the Financial Investment, LP (“FLIP”) hedge fund which was started by Mr. Kendall in 2002 and is still traded today. The hedge fund uses implied volatility valuation models to sell short term dated, far out of the money options and derivatives on equities and commodity contracts and Mr. Kendall saw an opportunity to offer just the commodity portion of the hedge fund’s strategy via individually managed accounts under the CTA designation.
This program’s strategy is to utilize a program of selling or “writing” options (puts and calls) on short term dated futures contracts. However, unlike traditional option managers who typically only trade stock index options on the S&P 500; the FCI programs look write contracts in commodity markets like Corn, Wheat, Crude Oil, Gold and Sugar. This type of trading allows Mr. Kendall to diversify clients away from the stock market, while also trading a universe of commodities that can have higher implied volatility associated with the related option contract.
The ultimate goal of this type of trading is to consistently collect monthly premiums to achieve absolute returns for client accounts. In other words, the manager is looking to piece together strings of small to moderate winning trades where the result is a target monthly return of 2% to 5% (there is no guarantee the manager can achieve these targets). In contrast, a traditional trend following strategy would take the opposite approach and try to hit homeruns by achieving returns on one or two big winning trades per month. Most option sellers will look to generate profits on 90% of trades, while trend followers typically only see success 40% of the time.
The monthly premiums are derived by selling “naked” options in markets that are experiencing above average volatility. The ultimate goal for selling naked options is to take advantage of premium decay where the value of the option is reduced as a function of time rather than a function of market direction in order to achieve absolute returns. It is important to note, since the options in the OSS strategy are uncovered, this program is theoretically exposed to an unlimited risk potential. In addition, while the actual risk of an investor losing his entire account is low in our experience, there have been a series of large drawdowns that investor’s have needed to weather throughout the years. The most recent large drawdown (34%) was in the fall of 2008 during the height of the financial crisis when nearly every market including stocks, bonds, currencies, and commodities experienced extraordinary volatility.
To FCI’s credit, their team remained confident, worked hard, and was able to bounce back to new equity highs in April 2010 (many investors who stuck with the program through the 2008 drawdown reached new highs much sooner - in late 2009).
In contrast to the OSS program, which only sells “naked” options, the FCI CPP program’s primary strategy is to sell vertical credit spreads. An example of a vertical credit spread would be a sell August Crude 90 Calls, and simultaneously buy September Crude Oil 100 Calls; with the premium collected equal to the difference between the premiums on the two options. In addition to vertical credit spreads, FCI executes or may execute calendar spreads, diagonal spreads with calls, and diagonal spreads with puts for CPP clients. Like the OSS program, CPP looks to also sell the spreads in commodity markets that are experiencing above average volatility.
FCI CPP was launched in January 2009 as Mr. Kendall recognized the need for an option selling strategy that did not rely on naked trading. Stated simply, many investors considered naked option selling too risky for their portfolio (rightfully so) after a rough 2008 for naked option sellers, leading FCI to deliver a program that better met such investor’s needs.
Within the spreads of the CPP program, FCI remains a net seller or premium collector of short term, out of the money, options; but has a defined risk on each trade as the risk loss is defined by the difference in price between the option sold and the option bought. That risk is 3-5 times the premium collected. So, while the OSS program has theoretical unlimited per trade risk, the CPP program knows exactly how much capital is at risk on each trade as it has a “hedged” position on. The contracts that are purchased act as protection, so if the underlying commodity goes against the program the purchased options can gain in value as the sold options lose. The defined risk aspect has gone over well with investors, with the CPP program already at $14.5 million AUM despite having a much shorter track record than OSS.
The downside of trading spreads is that buying options will diminish the alpha generated by the program. Therefore, it is necessary for FCI to sell options that are either closer to the market or sell more options to generate the same type of return as the OSS program and help finance the insurance or long option protection. For the CPP program, the manager will look to sell options that are 1 to 2 standard deviations outside the market, while the OSS program will sell options at 1.5 to 3 standard deviations away from the underlying commodity price. Because the options sold by CPP are closer to the market, there is a better chance that these contracts will see their strikes pierced and end up “in the money.” How FCI handles these times when the option goes in the money are paramount to its success.
While it may seem like the CPP program with its hedged positions should be less volatile than the OSS and its theoretically open ended risk - FCI has seen the opposite be the case in real time trading – with the OSS program exhibiting lower volatility than the CPP. The following example by Craig Kendall explains how this is the case, and gives more insight into how both programs work:
A few months ago, the crude oil market was short-term overbought and was experiencing above average volatility which by FCI’s standards is prime for shorting options. After initiating short call positions with 14-day expiration and a strike price of $93 for CPP and $97 for OSS, crude oil traded higher to approximately $89.00/barrel. Shortly thereafter, crude oil ultimately corrected lower but not before FCI re-adjusted their position in the CPP to maintain the net liquidity for their customers’ accounts. FCI found it necessary to re-adjust their short call position as the price of the option increased to a level beyond their maximum risk parameter causing them to exercise prudent risk management and roll the calls up to a higher strike price to minimize a potential draw-down. Ultimately, FCI ended up realizing a net loss on the CPP trade.
Meanwhile in the OSS, since we were farther away from the market, we stood our ground and maintained the position as the price of the option continued to trade below our pre-determined exit price. This is the reason why this approach can be considered to be less volatile than the CPP. The option continued to trade below our pre-determined exit price as we were farther away from the “money” making it less likely for the market to reach our strike price, before expiration, resulting in a net gain on the trade. (Past performance not necessarily indicative of future results). Please keep in mind; this is one example out of many positions, the results of which can differ significantly from trade to trade.
At expiration of the options, our proactive stance in the CPP proved to be futile as crude did exactly as we expected and corrected lower. So why do we need to sell the calls closer to the market? Remember, due to the hedge in the CPP, we must sell the options closer to the market in order to achieve an equal amount of net premiums as the OSS. Thus, the closer we are to the market, the more likely the option will expire “in the money” causing us to be more nimble with this approach in order to maintain customer equity and prevent a portfolio draw-down. The end result is the CPP experiencing more day to day volatility than the OSS due to the progressive adjustments which ironically is due to the hedge.
In terms or risk management, both programs use the same overlying risk management technique. Per this technique, FCI will either close out a position or roll up, down, or further out in time on a position to limit the loss on a position to no more than five times premium initially collected. More specifically, if FCI rolls as opposed to closing out a position, FCI tries to do so at a loss of no more than 3 to 4 times premium initially collected. FCI strives to limit losses on any position to no more than five times premium initially collected, but if FCI rolls a position to limit losses and the trade still goes further against the positions, FCI then targets a loss of no more than 5% of a client’s total account equity per trade. One risk management technique which is no longer used, after it met with poor results in 2008 – is hedging a position with the futures contract. FCI’s current risk parameters are to simply get out, and not hedge with a futures contract.
For investors invested in traditional Managed Futures strategies exhibiting long volatility profiles (basically anything that underperformed in 2009) FCI is an excellent diversifier to such a portfolio. The best proof we can offer as to when and why FCI adds value to a portfolio of Managed Futures strategies has been exemplified over the past 2 years (2008 and 2009). In 2008, FCI OSS ended the year down -23%, while most traditional Managed Futures program posted strong gains (Barclay Hedge index +14.09% in 2008). Meanwhile, in 2009 FCI fully recovered from their drawdown and posted a gain of +38.91% versus the Barclay Hedge Index that was down -0.1%. The net result was that over the two-year period, investors who included FCI in their portfolio experienced a much smoother equity curve than those who did not.
Mr. Kendall and his team have seen drastic extremes in volatility over the past five years, having traded in markets with extremely low volatility (05,06), moderate volatility (07,09), and record high volatility (08); yet are here hitting new equity highs in 2010. Of course, there have been drawdowns and their fair share of bad trades, but overall we have been very impressed with how the FCI team has reacted and learned from some difficult trading situations.
In 2005 the FCI OSS program encountered a 4 month stretch (April – July) where the program hit a max drawdown of -16.36%, before recovering to new equity highs in October of that same year. The second major drawdown of -12.94% occurred in September and October 2007 and the program recovered to reach new equity highs again in July ’08. Ironically, as soon as the program recovered it was in drawdown again as the financial crisis of 2008 put the program in a record drawdown of -34.63%.
The 2008 performance seemed bad at the time, but in retrospect it was quite a good performance given their strategy and the environment. Several other option selling programs ceased to exist during the same time. It also gave FCI a ‘wake up call’ of sorts in which they re-evaluated their risk measures. In a conversation with Mr. Kendall in February 2009 he noted that, “there were mistakes in the past and they are committed to correcting them and avoiding 'catastrophic' losses in the future through additional due diligence / research / and faster reaction to losing trades”.
These types of comments are usually little more than lip service to calm investors – but fast forward 16 months from the time he made those comments to the latest volatility spike (the Flash Crash, Euro Crisis, etc); and we can say with confidence that investors are in fact witnessing improved risk management from FCI, with their accounts not only surviving the latest volatility spike, but posting gains. (+16.31% est. YTD – past performance is not necessarily indicative of future results)
This is not to say FCI will not have drawdowns in the future when volatility spikes. There is no escaping drawdowns, and FCI will have them moving forward. But the recent performance during this volatility spike and their ability to survive in 2008 when other option sellers completely folded tells us their base logic of risking just a small amount of equity on each trade and diversifying across many markets can work.
Add to this their improved risk management procedures, and you can start to build a comfort level with FCI (especially if there has just been a volatility spike or FCI has just posted losses). The risks of option selling remain, including the possibility of losing a year or more worth of gains in one bad month when volatility spikes. And there are other risks like being correlated with the stock market at times due to volatility tending to fall when stocks rise.
One recommendation we make to clients is to reduce an option seller’s blow up risk by instructing the manager to NOT compound profits. In this way, if there is a blow up, the account loses x% of the initial account balance, not x% of the initial balance plus any profits. You can always add the profits back in after a down spell.
When using outside methods such as the one outlined above to manage option selling risk, picking a volatility spike or drawdown as an entry point, and going with a solid manager with experience such as FCI - we have no problem recommending investors put 10-20% of their total Managed Futures allocation into option selling managers. We don’t believe option selling should be the base of a portfolio, based on the risk and fact that it won’t exhibit portfolio saving crisis period performance like managed futures as a whole will when volatility spikes.
But option selling programs do bring a unique outlook on the market and a unique ability to do well when traditional strategies struggle (see 2009), making them a fit for the right portfolio. To see how FCI fits into your total portfolio, click here (http://www.attaincapital.com/managed_futures_portfolios) to create your own custom portfolio directly on our website.
IMPORTANT RISK DISCLOSURE
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News from the China that year versus year exports jumped a remarkable 50% in May led to ideas that the current economic situation not only in Asia, but around the world may not be as dire as the European sovereign debt troubles have led the marketplace to believe. Testimony from Fed chairman Bernanke where he indicated the U.S. economic recovery was on solid footing also aided in giving market participants added confidence that the recent break may have been a little too extended to the downside. A strong Spanish bond auction, which was well covered, was the final piece of the puzzle that helped investor perceptions leading to a strong flow of equity into higher risk instruments. The energy complex featured the growth euphoria as Crude Oil +5.05% led the rally followed by RBOB Gasoline futures +4.47%, Natural Gas futures +4.36% and Heating Oil futures +2.88%.
Industrial metals performed very well under the new guise that world economic conditions are better than the recent turmoil experienced from the sticky sovereign debt situation in Europe. The renewed optimistic growth scenarios led to a strong price recovery with Copper +7.78% leading the rally followed by Palladium +7.49%, Silver +6.18% and Platinum +3.18%. Gold -1.31% was pressured by ideas that the recent flight to quality investment possibly could have run its course with the new interpretations of world economic conditions.
Stock Index futures got involved in the more favorable outlook as signs that the European troubles might just be confined to that region sparked a nice relief rally. The sector also got a shot in the arm from news of a possible extension to the recently expired homebuyer tax credit in the U.S. Mid-Cap 400 futures +2.59% lead the charge higher followed by Dow futures +2.53%, S&P 500 futures +2.18%, Russell 200futures +1.85% and NASDAQ futures +0.55%.
Activity in the currencies featured a decent rally in the Euro +1.19% which was directly aided by the strong demand in the Spanish 3-year bond auction which was a €3.9 billion offering. Support filtered into the balance of continentals with the Swiss Franc +1.13% and British Pound +0.66%. The Yen +0.32% stabilized after investors seemed to pare down nervousness of the recent resignation of the Japanese Prime Minister. Dollar Index -0.98% felt the pressure from investors seeking higher risk investment in better yielding currencies.
Commodity and Food products also got into the optimistic outlook play as news of stronger exports by China helped lay the ground work for ideas that they would continue to buy foodstuffs to build stocks further. Reports of possible tighter supply situations also led to a strong investment flow into the sector. Cotton +5.08% led the rally in the grains and oilseeds followed by Corn +2.76%, Soybeans +1.20% and Wheat +1.15%. Price appreciation in the soft sector was led by Sugar +9.02% followed by Coffee +8.37% and OJ +4.00%. The livestock complex was under the weather from higher production estimates with Lean Hogs -1.60% and Live Cattle faltering -1.36%.
Last week we reported that systematic multi market CTA’s had a good start to June following a surge in volatility. This week it was the multi-market discretionary managers’ time to shine.
Halfway through the month, the top performing multi market manager is Dighton Capital USA who is ahead an estimated +9.95%. Dighton has been slightly in the red for most of the year; however they are now slightly ahead thanks to the run up in Sugar and Coffee so far in June. Other multi market managers benefiting from the expanding volatility and trends are as follows: Accela Capital +3.11%, APA Strategic Diversification +0.67%, APA Modified +3.97%, Applied Capital Systems +2.30%, Auctos Capital +0.44%, Covenant Capital Aggressive +1.29%, Futures Truth MS4 +0.44%, Hoffman Asset 250k +0.80%, Integrated Asset Concentrated +0.3%, P/E Investments Standard +0.34%, and 2100 Xenon Managed Futures 2x +0.73%.
Multi Market managers in the red include: DMH -0.09%, Futures Truth Sam 101-0.42%, Hoffman Asset -1.14%, Quantum Leap -3.88%, and Robinson Langley -1.05%
Short Term managers are posting mixed results with those trading in the stock indices outperforming the diversified managers. Thus far, in June, the following Short Term managers are ahead: Paskewitz Asset +4.52%, GT Capital +0.76%, and Roe Capital +3.62%. Short Term managers in the red include: Dominion Capital -1.05%, Mesirow Absolute Return -0.03%, Mesirow Low Volatility -0.18%, and Sequential Capital -0.37%.
Similar to the short term traders above, Option managers focused on stock indices have outperformed the diversified managers thus far in June. Leading the group is Crescent Bay BVP with an estimated gain of +6.82%, which takes their 2010 estimated gain close to +15%. Other option traders in the black include: ACE SIPC +0.13%, ACE DCP +3.02%, Cervino Diversified +0.68%, Cervino 2x +1.51%, Clarity Capital +3.09%, and Crescent Bay PSI +0.79%. Option traders in the red include FCI OSS -0.27%, FCI CPP -2.01%, HB Capital -1.42%, and Kingsview Capital -0.85%.
Finally, Specialty market manager estimates are as follows: Emil Van Essen -1.65%, NDX Abednego -0.33%, NDX Shadrach -0.51%, Oak Investments Group +0.55%, Rosetta Capital -2.88%, and 2100 Xenon Fixed Income +0.21%.
Last week was a difficult week for the trading systems. The day trading systems struggled more than their swing system counterparts. But there were some good results last week.
Bam 90 ES led the way last week amongst all the swing trading systems. Bam 90 ES started off the week by getting long near the low on Monday. Then it added onto its position during the rally on Tuesday. On Wednesday the E-Mini SP had moved up about 1.8% from the open, Bam 90 ES exited half way through that move for a profit of $1,747.50. MoneyBeans S came in second place with a result of +$1,030. MoneyBeans got long around the opening on Monday, rode the 3.5% rally in the Soybeans market for a profit of $635. MoneyBeans S then promptly reversed and rode the -2.2% drop down from the high for a profit of $382.5. The other positive results for the swing systems included Waugh Swing ES at $45, Waugh CTO eRL at $70, Polaris ES at $132.50, Bounce eRL at $330, Bounce Filter eRL at $330, Bounce EMD at $530, AG Mechwarrior ES at $595, and Bam 90 Single Contract ES at $845.00.
Leading the way amongst the day trading systems was Balance Point ES with a return of $522.50 for the week. For the most part, Balance Point ES made some small gains during the week. But the best trade for Balance Point ES occurred on Wednesday, Balance Point ES got short about an hour before the close and benefited from the 7 point drop in the E-Mini SP market during the last hour. The other positive results for the day trading systems were Clipper eRL at $45.29, Upperhand ES at $120, and Bounce eRL at $145.00.
On the downside for the week was Strategic ES. Strategic ES came into the week short and profited from that trade by getting out early on Monday. But then during the middle of the week, Strategic ES got short near the lows and unfortunately remained short during the rally took place on Thursday and got out near the close on Friday. The other swing systems in red during the week were Jaws US 60 US at -$467.50, Moneymaker ES at -$1,442.50, and Strategic SP at -$4,900.
On the day trading side, Compass SP got long near the high of the day on Wednesday and was able to get out before the big push down during the close but unfortunately it still produced a result of -$1,675. Some of the other results were Bounce EMD at -$205, Compass ES at -$367.50, and ViperIIA EMD at -$1,661.12.
IMPORTANT RISK DISCLOSURE
Futures based investments are often complex and can carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading losses are material points which can adversely affect investor returns.
Past performance is not necessarily indicative of future results. The performance data for the various Commodity Trading Advisor ("CTA") and Managed Forex programs listed above are compiled from various sources, including Barclay Hedge, Attain Capital Management, LLC's ("Attain") own estimates of performance based on account managed by advisors on its books, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.
The dollar based performance data for the various trading systems listed above represent the actual profits and losses achieved on a single contract basis in client accounts, and are inclusive of a $50 per round turn commission ($30 per e-mini contracts). Except where noted, the gains/losses are for closed out trades. The actual percentage gains/losses experienced by investors will vary depending on many factors, including, but not limited to: starting account balances, market behavior, the duration and extent of investor's participation (whether or not all signals are taken) in the specified system and money management techniques. Because of this, actual percentage gains/losses experienced by investors may be materially different than the percentage gains/losses as presented on this website.
Please read carefully the CFTC required disclaimer regarding hypothetical results below.
HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN; IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK OF ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL WHICH CAN ADVERSELY AFFECT TRADING RESULTS.