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Call us at 800.311.1145 to speak with one of our alternative investment specialists. We answer the phone in One Ring. Try It.Sign up to view performance on 100s of Managed Futures Programs, Trading Systems, and Managed Forex Programs. Sign up FREEWhat are Managed Futures? Is this the same as CTAs? How do I invest? Click here  to learn all of this and more on our extensive managed futures education pageHow to set watchlists? Build portfolios? Find correlations? and more. Click here to take a tour of our advanced toolsUse our most popular tool to create custom multi-program portfolios. Click here to get started today by signing up for FREE ACCESSClick below to learn how attain can assist your CTA in everything from back office creation and trade execution to finding a lawyer to create your D-DocNo upfront fees for managed futures funds is one of the unique benefits of a managed futures account at AttainOur alternative investment books list includes some of the most thought provoking and interesting books on alternative investmentsLearn how family offices outsource the managed futures research, due diligence, data collection, and ongoing monitoring of accounts to AttainWhat is a trading system? Who develops them, and how are they executed for client accounts? Our trading system education explains this and moreWe assist talented traders in getting their trading ideas into an automated trading system, do testing, marketing, and more

Avoid being a turkey, protect option selling gains.

November 30, 2009

 

With most of us in the United States celebrating our Thanksgiving holiday last week by means of a big family dinner with a masterfully cooked turkey as the centerpiece of the meal, we couldn’t help but ruminate on the wonderful turkey analogy used by Nassim Taleb in his equally wonderful book The Black Swan in this week's newsletter.

Mr Taleb tells us how the well being of the turkey builds each successive day leading up to Thanksgiving, being fed and nourished so that he grows fat and happy. Mr. Turkey builds confidence that every day he gets fed makes it more likely that he will be fed again tomorrow.  I believe the psychologists call it a positive feedback loop. The problem, of course, is that all that fattening and making the turkey happy are a means to an end – the end being THE END for the turkey.

What does this have to do with managed futures, you ask. Well, this turkey lives a pretty good life right up until the days before Thanksgiving, when he is slaughtered in order to be served up at the feast. That is strikingly similar to investors who live a pretty good life right up until they are served up unexpectedly to a market correction. 

There is a nice little graphic in The Black Swan which we have re-created below showing the well being of the turkey over the first 1000 days of his life, followed by that catastrophic 1001st day when the turkey is in for a big surprise. Not only is he not getting fed that day, he will actually be the one being fed to others.

 

If the chart above reminds you of looking at the performance graph of a managed futures program, trading system, hedge fund, or even the recent stock market selloff in 2008 – that is the point. We’re trying to bring your attention to the fact that your portfolio could be the turkey – walking unknowingly towards a big down side surprise.

The corollary for your portfolio is that its success right now might be a false positive feedback loop similar to the turkey’s, and that each successive success actually brings you closer to impending doom. We covered this just a few weeks ago when pleading with stock investors to diversify now, not after another crash (my apologies, but you’ll read about the turkey there, too).

Option Selling

One strategy in particular has a lot in common with the turkey, and that is Option Selling managed futures programs.  The turkey sees 100 days of small gains followed by one day of large losses. Professional option selling managers design their programs not to lose everything on a single day like the turkey, but they are set up to realize frequent but small gains in exchange for the risk of infrequent but very large losses.

The option sellers are technically short volatility programs which on the whole make a living by risking a large amount to make a small amount. They can get away with this (in theory), because they have a large winning percentage where the large losses are very rare.

But the problem as we see it is twofold. One, those losses aren’t quite as rare as we would hope, and two - it doesn’t really matter how rare the large loss is if it is completely debilitating to your portfolio when it happens. Would you play a game of Russian roulette with a hundred chamber gun (resulting in a 1 in 100 chance of being killed)? No way.  A 1% chance is too great a risk when something as significant as your life is at risk.

Similarly, even if the chance of an option selling portfolio blowing up is only 5% or so, is that really worth the chance of losing 75% of your investment?  We say no. But does that mean we don’t recommend option selling managers for your portfolio? Not necessarily.

We still do recommend option selling managers if it fits with what an investor is looking for, and in fact have seen several clients do quite well with option selling managers this year with programs like FCI having made back their entire 2008 drawdown for some of the clients at Attain. [the FCI track record as reported by the manager does not show new equity highs due to the manager reporting results adjusted for incentive fees for all clients, even though those clients who were in drawdown did not owe any fees until new highs were made in their account – and then only on the new highs, not on the amount clawed back from the equity curve low point.]  

We do not recommend getting started with managed futures through an option selling manager. For one, they won’t track the managed futures performance which likely piqued your interest in managed futures, and are more likely going to be correlated to the stock market.  But for those with portfolios of managers, option selling can provide a nice balance to the portfolio, as it will no doubt include a good portion of long volatility programs which will be flat or struggle during times of decreasing volatility. The trick is to not let the option selling program, and its potential for a big downside surprise in the future – dominate the portfolio. For this reason, we recommend option sellers take up no more than 10% of a portfolio.

But enough background already – if I am invested in an option selling program and have been enjoying their relative renaissance in 2009; how do I avoid being the turkey in 2010 or beyond? How can I protect option selling gains?

Protect Option Selling Gains

One option that option sellers have (pun intended), which the poor turkey does not, is that they can change the rules of the game. The turkey is at the mercy of the farmer, and has no choice really but to risk it all each day by eating his fill and packing on the pounds until his time is up. 

An investor in an option selling program, by contrast, doesn’t have to put everything on the line every day. Most option selling programs out there manage investors’ money by increasing position size as the account grows. This is great if the account keeps going up and up, but can be devastating when there is a big downside surprise.

After witnessing multiple volatility spikes over the last 2 years which wreaked havoc on option selling strategies, and with the VIX (volatility index) close to the levels it was at before the big sell off last fall; it occurred to us that perhaps there is a better way than letting an option selling manager continuously compound your investment with them.

We first thought why not just have the manager trade a fixed amount of money (the initial investment), and not allow them to compound and add risk at all. If 75% of your account is always at risk, the absolute value of the amount at risk grows as your account grows.  Why not try and keep the absolute value of the risk a constant, thereby treating the option selling investment as an income producer rather than something which will grow your assets.

This sure would protect against a big downside surprise, as you could only lose an amount equal to the drawdown times the initial investment. But it also curtails profits in a big way. One of the tenets of successful investing is to let your money work for you through compounding, and trying to not be the turkey by completely eliminating compounding seems to hurt more than it helps.  

The ideal scenario, of course, would be to let the investment compound, but then take all your winnings off of the table just before volatility spikes and you suffer a large loss. In reality, that is impossible without a crystal ball which tells you when the volatility spike is coming (and if you had one of those, you probably wouldn’t be reading this).

So, we need a way in which we can participate in the compounding effect, but at the same time take profits off the table with some regularity, so that when there is a double digit loss, it isn’t on my initial investment plus all of my gains to that point, and rather is only on my initial plus some fraction of the profits.

To test whether we could protect option selling profits without sacrificing too much return – to capture the compounding and avoid the downside surprise;  we came up with the simple idea of letting the investment compound for 12 months at a time, taking the profits off the table at the end of each year.

For example, if an investor started an option selling investment with $100,000 in January of 2005, and made $35,000 (after fees) during the year as the advisor saw success and increased position size as the account grew (compounding), this plan would entail having his broker move the $35,000 out of the account on Jan. 1, 2006 and instruct the advisor to trade the account at the $100,000 level. The advisor would then position size based off the $100,000 and any profits made during that year. This has the added benefit of reducing your management fee annually, as you would be paying on the new level, not the continuing balance.

We tested this strategy on two popular option selling programs, the ACE SIPC program and FCI OSS program; and were encouraged by the results.  

 

Past Performance is Not Necessarily Indicative of Future Results

 

 

 

 

 

 

 

ACE SIPC

 

FCI OSS

 

Normal

Book Profits Annually

 

Normal

Book Profits Annually

Annual Rate of Return

15.26%

12.60%

 

21.48%

17.64%

Volatility

29.17%

13.20%

 

21.89%

14.28%

Max DD

-69.54%

-25.93%

 

-34.63%

-15.65%

Sharpe (rfr=0)

0.52

0.95

 

0.98

1.24

MAR

0.22

0.49

 

0.62

1.13

Total Return

113.00%

149.00%

 

169.38%

138.45%

 

Annual Rate of Return & Volatility = annualized

 

The table above is for illustrative purposes only. It is an example of the educational topic discussed herein and does not represent trading in an actual account.

In both cases, the average annualized rate of return was slightly lower when booking profits annually, but this reduction of profit appears well worth it when looking at the reductions in Volatility and Max Drawdown. The maximum DD, in particular, is cut by more than half in both cases, sending the risk adjusted ratios higher for the ‘booking profits annually’ cases much higher for both ACE and FCI.

In conclusion, no matter how good your option selling manager is, or has been in 2009, there is no denying that he or she has a greater than zero chance of a large negative surprise akin to the turkey’s 1001st day at some point in the future.  It seems wise to us, to protect against that small, but still there, chance by taking some of your option selling gains off of the table.

Whether you do it annually as outlined above, or devise some alternative method – the goal should be to capture as much of the compounding effect as possible while getting money out of harm’s way from time to time. You could even take some of those profits off of the table and put them into something which is currently underperforming – and become one of those rare investors who actually gets out (of a portion) at the top, and in at the bottom instead of the less successful, but more common – getting in at the top and out at the bottom.

 

-          Jeff Malec

IMPORTANT RISK DISCLOSURE


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Feature | Week In Review: Dubai news puts scare into holiday thinned markets

Overview

Market activity was mixed overall, although a strong early week rally in most sectors based off of U.S. Dollar weakness gave way to news that a Dubai government back company risked defaulting on $60 billion of debt. The news was very unsettling to most world markets, especially given the fact that just a year ago worries of debt defaults by some U.S. investment banks helped advance the worst recession since World War II. Before the Mideast news the stance by most central banks was for leaving key lending rates unchanged with hints that low rates would be the norm in the foreseeable future other than in a few countries where growth has exceeded expectations. European news was mostly favorable as export and growth figures improved along with news of favorable earnings for some of the larger companies in Europe. Asian headlines remained constructive as China indicated it would continue to use stimulus on an as needed basis due to some struggling sectors. Other positive developments out of the Pacific Rim emanated from Australia and New Zealand as earnings news was much stronger than expected, especially in the raw material sectors. The lineup of economic reports this week is fairly heavy with several reports from the retail and home sectors with the headliner being the monthly Unemployment report on Friday. Stock Index futures ended the week mostly lower due to the Dubai situation and were led lower by Russell 2000 futures -1.76% followed by Mid-Cap 400 futures -0.84%, NASDAQ futures -0.24%, Dow futures -0.11% and S&P 500 futures -0.09%. 

Commodity and Food products were mostly higher as weather issues and a weak U.S. Dollar continued to spark investor support in most sectors of the complex. Weather concerns again led to higher prices in most grains as the late U.S. harvest continued to spark ideas that it would lead to lower output. Corn +1.57% led the way followed by Soybeans +0.80%. Wheat -1.89% ended lower on news a possible larger Southern Hemisphere crop. The livestock sector was higher as strong pork demand aided activity in the Lean Hogs +4.58% with Live Cattle +0.06% following along on better exports expectation for beef as well. The Soft arena was mixed as weather worries in the Southern Hemisphere helped spark support in OJ +4.22%, Coffee +1.69% and Sugar +1.34%.  Cocoa -0.82% and Cotton -0.27% were under pressure from position squaring after recent strong rallies.   

The energy sector was mixed during the past week as supply and demand scenarios turned to a more negative state for RBOB Gasoline -2.40% and Crude Oil -0.53%. Heating Oil +1.48% and Natural Gas +1.47% were supported by U.S. weather reports showing the first major cold wave arriving in the next week for most of the country.            

The U.S. Dollar Index -0.81% and British Pound -0.05% ended the weak lower despite late week rallies from the Dubai turmoil.  The balance of the majors remained firm on ideas that their economies would grow a better pace than earlier anticipated. Strong metal prices and slow growth in the U.S. versus that of emerging economies was a main catalyst for the rally in Japanese Yen +2.35%, Swiss Franc +1.04% and Euro +0.71%.  The rate sector remained firm aided by the Dubai default worries with 30-year Bond futures ending +1.77% followed by 10-year Note futures +1.01%.       

Trade in Metal futures was fairly active during the past week, although results were mixed due to default worries in Dubai and position squaring after recent sharp price appreciation. Another week of strong economic news from emerging economies also provided underlying support. Gold +1.38% and Copper +0.47% finished the week higher with Silver -0.66%, Platinum -0.28%, and Palladium -0.23% a bit under the weather.  

 

Managed Futures

November continues to be a good month for many multi market managers who are reaping the benefits of volatility and trendy market conditions across many commodity markets.   Clarke Capital Management made a strong move last week and is now at the top of the standings.  The Clarke Capital Global Magnum program leads the pack at +12.72% est., while the Clarke Global Basic Program is close behind at +8.72% est.  Hoffman Asset Management +4.50%and Integrate Managed Futures Global Concentrated +4.25% continue to post very strong numbers as well.   Robinson – Langley also made a strong push last week and is now up +3.97% est. in November.

Other multi market managers in the black include 2100 Xenon Managed Futures (2x) Program +2.70% est.,  Futures Truth SAM 101 +2.30% est., GT Capital +2.23% est., Mesirow Financial Commodities Absolute Return +0.76% est., and  APA Strategic Diversification +0.25% est.

Unfortunately, there are some managers still in the red.  Those with losses thus far in November include Mesirow Low Volatility -0.05% est.,  APA Modified -0.55% est., Futures Truth MS4 -0.74% est., Sequential Capital Management -1.04% est., Dominion Capital Management -1.47% est., Quantum Leap Capital -3.29% est., and Dighton Capital USA Aggressive Futures -5.17% est.

Option Trading managers held steady for the week and appear to have finished ahead on the whole for November.   The top performer for the month, heading into today, is Raithel Investments with estimated gains of +4.85%.  Raithel’s near 5% gain for the month is a bit unusual for their trading style; however can be attributed to a volatility spike in the last few days of October that quickly subdued.  The spike caused for a -3.15% return in October.  This month’s gains should take the program to near break even on the year.

Other Option Trading estimates are as follows: Ace Investments +2.26%, Cervino Diversified +1.15%, Cervino Diversified 2x +2.29%, Crescent Bay PSI +2.56%, Crescent Bay BVP +2.87%, FCI OSS +4.16%, FCI CPP +2.70%, HB Capital +0.89%, and Oak Investment Group +4.05%.

Specialty Trading manager Emil Van Essen also held steady last week with Emil Van Essen still leading the way +0.92%.  Emil Van Essen Low Minimum program was ahead +18.39% through the end of October and has been a true diversification tool for investors in 2009 -  You can review our research on their strategy via our July 27th newsletter http://www.attaincapital.com/managed_futures_newsletter/344.  Elsewhere, NDX Abednego is ahead +0.12%, NDX Shadrach is down -0.04%, and Rosetta is giving back approximately -1.46%.

Finally, Short Term Index trader Paskewitz Asset Management 3X Contrarian Program is up +0.67% in November.

Trading Systems 

While it was a slow week for domestic programs with traders on vacation last Thursday, foreign programs trading the Dax and Eurostoxx were hard at work that same day with global markets falling around 3 % in reaction to Dubai. Friday was a half day for U.S. stock index futures, but trading was more active than a typical day following a holiday as futures opened sharply lower then rallied back throughout the day.

Beginning with the aforementioned systems trading the Dax and Eurostoxx, ATB TrendyBalance v2 Dax was the top performer +€992.5 for the week on a pair of trades, the bulk of which came on Thursday during the main European trading session (middle of the night U.S. time). BetaCon 4/1 ESX didn’t turn as many heads with its weekly result of +€70 but was able to capitalize on Thursday’s sharp sell-off to wipe out losses from earlier in the week. Rounding out those two foreign programs was Rayo Plus Dax which finished the week down -€327.5 but like the others was successful in Thursday’s session +€1,040 on a short trade. Moving onto the domestic day trading programs, BounceMOC EMD lost -$80, PSI! ERL -$270, Waugh ERL -$438.75 and Upper Hand ES -$635.

Elsewhere, swing systems had a strong showing with Strategic SP +$4,670, BAM ES +3,391.25, Jaws US 60 +$2,150.93 and Strategic ES +$1,007.50. On the losing side, Ultramini ES dropped -$780 while Bounce EMD lost -$2,445 after holding onto a long trade that it entered on Wednesday and exiting on Friday’s open.

 

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.