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Using an Equity Curve Stop Loss with Managed Futures

May 24, 2010

 

We recommended investors look to book profits from volatility hating option selling programs in our May 3rd (yes, the Monday before the ‘flash crash’) newsletter;  thinking volatility was bound to see a spike in the near future.

And whether that call was lucky or good; the fact is that volatility definitely has been on the rise since then – causing some pain for stock investors and those short volatility option selling managed futures programs.  The 100 day average true range of the S&P futures, for example, has moved from 12.76 points per day to 16.53 for an increase of 30%, meaning stocks are moving about 1/3 more than they were each day.

The question now for those holding not just short volatility managed futures programs, but mutual fund and stocks as well – is whether there is more coming? Do you get out of stocks and short volatility programs now, or set some stop loss below current levels in case this is just a temporary setback before global stock markets start to march higher again?

As proof of concept - a friend called asking whether she should get out of some stocks she had made nice money in after getting in near the lows in 2009 – saying this looks like a repeat of the 2008 mess, only with countries (Greece, Italy, Portugal) instead of banks (Bear, Lehman, Merril). 

I told her that we’re not in the stock business, but that she should get an exit plan together immediately for whatever positions she’s holding based on statistics and how much of the profits she wants to keep. Nothing can sink a portfolio faster, in our opinion, than relying on your gut feelings on when to get in or out of a program – yet that unfortunately remains the main method investors use for timing the entry and exit of their investments.

There is a great line from Barry Ritholtz, the brains behind the excellent economics/investing blog The Big Picture which I quoted to my friend:

“There's a reason flight attendants show you where the emergency exits are before takeoff.”

The investment meaning of the quote, of course, is that you need to know what to do before your stock starts losing altitude quickly, yet very few people plan for the downside before they “take off” (usually because they are blinded by their hope of large moves to the upside).

Whether your flight plan has recently hit some bumpy patches or not - if you are one of those who doesn’t know where the exits are on your investment “plane” – whether those investments are in stocks, bonds, gold, or managed futures (both long and short volatility), there is never a better time than right now to lay out an emergency plan.  

This is the plan you pull up when you’re worried about an investment – the one you use instead of calling friends and family (or worse – your stock broker) asking whether you think it is time to bail on an investment.  The result – decisions not influenced by heat of the moment emotions, decisions based in logic and backed up by statistical relevance. 

Stop Loss

The main tool for your exit plans is the use of a stop loss. What is a stop loss? Well, it is mainly an order type used whether trading stocks or futures, which when triggered exits your position at the market. Stop orders were one of the problems of the ‘flash crash’ earlier this month – as unsuspecting investors with stop orders in place below the current value of their stock holdings had these orders triggered. The trigger, again,  tells the order to exit your position at the market. The problem during the ‘flash crash’, was that there were no bids (or only bids very far away) for the sell orders which came in. So, a stop order at 40 in stock XYZ was triggered when that stock suddenly went down to 39, but the best bid (what someone is willing to pay, or the market price, for the stock you are selling) was all the way down at $0.01. There were no other bids, and electronic order matching software simply matched your market order with the best possible market price at the time.

But a stop loss doesn’t have to be an order type. It can merely be the level at which you want out of an investment. Say you bought some speculative real estate from a foreclosure, and are willing to lose $100,000 on it. Your stop loss level in that case is your purchase price minus $100,000. If the property’s value falls by more than $100K, your exit plan (your stop loss) would have you sell (if you can) and get out with a manageable loss.

The goal of a stop loss is to protect against a catastrophic loss. You never know whether an investment will continue going down once it has started to fall – and the goal of a stop loss is to do exactly what is says – to stop the losses at some point.

Those without a stop loss -those who just ‘watch the market’ - may see their investment effectively go to zero, being frozen like a deer in headlights as the investment keeps making new lows and failing to rebound. They will suddenly find themselves wishing they had gotten out of a losing investment months ago, tens of thousands of dollars ago, and so on.

Now, a stop loss doesn’t guarantee anything. A stop loss order may be blown through like during the ‘flash crash’, resulting in you getting a price well below your stop loss level. In real estate and other illiquid investments, you may not be able to sell your investment quickly enough to receive the amount hoped for with the stop loss level. But similarly to how you still wear your seat belt when driving even though seat belts can’t guarantee you don’t die in a car crash – the use of stop loss levels still makes a lot of sense.

The aforementioned Barry Ritholtz lays out the different types of stop loss methods in his article: “The Apprenticed Investor: Stop Loss Breakdown”, which despite being written in 2005 remains spot on and as important as ever given the recent pull back in global stocks.  Barry covers five types of stop loss orders:  Moving Average,  Profit protection, Trend Line, Support Level, Trailing.

Managed Futures Stop Loss

Investments in managed futures don’t trade on an exchange where you can actually put in a stop loss order. There is no “price” which you can say I want out if it goes below, but you do have your daily account value with which to gauge ongoing performance.

Your stop loss “order” for a managed futures program may be nothing more than a mental note that you are only going to risk down to a level of $xyz in the account, at which time you will call or email your broker to cease trading the program. But these mental notes are notorious for not being executed upon.  Maybe you say – I’ll just give it one more day, or something similar – and before you know it the account is tens of thousands of dollars past your ‘mental’ stop loss level.

For that reason, we highly recommend employing a firm like Attain which can automatically set a stop loss level for your account, which will exit a managed futures program for you if a certain level you dictate is breached. This relieves you of the burden of having to remember, and more importantly – of having to execute.

But this all begs the question – where do you set the stop loss level.  We have long been proponents of using monte carlo simulations and other statistical methods to calculate so called worst case levels at which to exit.  After running thousands of these calculations across various managed futures programs and trading systems - we have seen time and again the stop trade levels come out around the following levels, which many investors use as a rule of thumb:

Length of Actual Track Record                                                Stop Trade/Line in the Sand

5+ years                                                                      1.5 times historical Max DD

3-5 years                                                                     2.0 times historical Max DD

1-3 years                                                                      3.0 times historical Max DD

<1 year                                                                          5 to 10 times historical Max DD

These have proven to work well for most investors, but they are generally designed to give a program as much room as possible before getting ‘stopped out’ – so that investors can see a program through a drawdown to the potential profits on the other side.

But what about those investors who aren’t as interested in getting to the other side of a program’s drawdown as they are in avoiding as much loss as possible? You may want to protect a certain level of profits, or use some quicker method of determining if a program is not tracking the way you expected it to.  You may want to use some of the indicators and technical analysis methods available for stock and futures prices to ‘trade’ the equity curve.

This has long been a dream of many investors. Who wouldn’t want to get out of a program right before it goes down, then get back in right at the bottom, and so on? But the devil, as always, is in the details; and trading a managed futures program’s equity curve is just not as easy as it looks.  In fact, it’s about as certain as relying solely on technical analysis for trading stocks or futures. Sometimes a stock holds its support, and sometimes it doesn’t – summarizing in a few short words just how difficult it can be to design a program for trading an equity curve.

Testing MA Crossover and Profit Protection Stop Loss

So instead of trying to design the perfect equity curve trading methodology (we’re working on that project, none the less), we considered two simple equity curve trading/stop loss methods for managed futures so as to further explain how such methods can be used.  We looked first at using a moving average as a stop loss mechanism, and then tested using a set amount of profit protection as a stop loss trigger.

The first test was done using a 24 month moving average of monthly returns for managed futures – stopping the program if the previous month’s equity cure value was below the 24month moving average, and starting up again if the equity curve value went back above the 24 month moving average.

For a quick reminder - an equity curve explains the graphical representation of the value of a hypothetical account trading a managed futures program, and is usually shown as the growth of $1,000 or something similar.  For such investments without a stock price or NAV, the equity curve value is essentially the same thing – a method of obtaining the current “value” of the program.

Next, we considered a profit protection stop loss, whereby we tested stopping a program once it gave back over half of the profits previously made (once it had made over 100%). As we will be doing with all of our testing of such methods – we included our library of dead programs to mitigate survivorship bias.

The results were interesting,  with the simple moving average crossover resulting in slightly lower average returns – but also noticeably lower drawdowns. The profit protection method resulted in both higher returns, on average, and lower drawdowns; pushing its return over drawdown ratio to the highest level among the three tested methods. The ‘normal’ being the averages across our expanded list of recommended programs, programs on our watch list, and our library of dead programs.

 

 

Normal

24mo MA

Profit Protect

Comp ROR

13.04%

12.78%

14.36%

DD

-27.46%

-24.96%

-23.72%

ROR/DD

                        0.47

                        0.51

                        0.61

 

Past Performance is Not Necessarily Indicative of Future Results

The conclusion is that there are real benefits to having a plan before you get into trouble. While these may seem small in the table above, those numbers are suffering from an averaging effect over 70 different programs.  The real benefit is seen on the so called dead programs, where a -62% drawdown was capped at -35% through the use of a profit protection stop loss, for example.

No one knows if the recent market bumpiness is a preview of a rocky rest of the year, but it pays to put together a plan for your stocks and short volatility managed futures programs in case there are more losses ahead. And for those holding stocks whose nice 50% to 100% gains over the last year are starting to evaporate – get some protection on those positions as soon as possible; while also thinking about how to diversify those stock holdings now, instead of after the next crash.

-          Jeff Eizenberg

Disclaimer: The testing statistics above are intended to be examples and exhibits of the educational topic discussed herein, and do not represent trading in actual account. They are for educational and illustrative purposes only.

IMPORTANT RISK DISCLOSURE


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Feature | Week In Review: Stocks test 'Flash Crash' Lows, Crude down

Industrial metals also had a poor time dealing with all of the global uncertainty as the previous week’s agreement to help the sovereign debt situation in Europe was quickly discarded with doubts about demand quickly back in the forefront. Precious metals also were under the weather especially late week when the Euro posted a strong bounce alleviating some of the flight to quality buying from the previous week. For the week Palladium -16.70% took on the most water followed by Platinum -12.49%, Silver -8.19%, Gold -4.21% and Copper -2.33%.      

Stock Index futures could not sustain the previous week’s relief rally as price activity fell victim to worries that the EU/IMF deal could fall short of averting further crisis in Europe. News that the Senate passed a sweeping overhaul of financial regulation also did little for market confidence as pressure accelerated when the details were released. The Russell 2000 futures shed -6.74% followed by Mid-Cap 400 futures -5.18%, NASDAQ futures -4.93%, S&P 500 futures -4.47% and Dow futures -4.23%.

Activity in the currencies featured some relief for the Euro+1.61% and Japanese Yen +2.77% as investors nerves seemed to stabilize after the recent steep drop with the Yen finding added support from some constructive developments in the Japanese economic situation. Swiss Franc -1.57%, Dollar Index -0.81% and British Pound -0.48% edged lower with spread activity being the main feature.       

Commodity and Food products were mixed last week as the soft’s ended mostly higher on ideas that the recent sell-off would uncover physical demand. Sugar +10.76% led way followed by Cocoa +2.95%, OJ +2.88% Cotton +2.79%. Grains ended mixed with Corn +1.65% finding support on news of Chinese buying, Wheat +0.13% on ideas that lower prices could induce feed demand and Soybeans -1.30% on growing world supplies. Livestock remained under pressure from weaker demand ideas as Live Cattle shed -1.90% and Lean Hogs fell -1.32%.

Managed Futures

Many managed futures programs have enjoyed a nice month of trading in May as increased global market volatility has led to quite few more trading opportunities.  Others have been on the wrong side of the markets and have suffered quite a bit over the last few weeks.  However, regardless of whether the programs are in positive or negative territory here in the short term, most managers we talk to are happy that market activity is finally picking back up and providing ample trading opportunities.

Leading the pack in the multi market sector thus far is Clarke Global Magnum, which is up +17.38% for the month.  Clarke has enjoyed the European debt scare and has profited from various foreign bond and foreign currency trades recently.   Futures Truth has also turned things around recently and is up +7.42% in the MS4 program, while SAM 101 is at +4.48%.  Discretionary trader GT Capital has also enjoyed a quick turnaround at +3.60%.   Other multi-market programs in the black include Applied Capital Systems +3.98%, Clarke Worldwide +2.24%, Dighton Capital USA Aggressive Trading +1.91%, 2100 Xenon Managed Futures (2X) +0.72%, Integrated Managed Futures Global Concentrated +0.70%, Dominion Capital Management +0.42%, and Mesirow Financial Commodities Absolute Return +0.28%.

Programs at or near breakeven in the multi-market sector include Clarke Global Basic, Covenant Capital Aggressive, and Sequential Capital Management -0.03%.

The bad news is that there are still a few multi-market programs in the red.  Managers in the red include Robinson Langley -0.55%, Hoffman Asset -0.80%, DMH -1.27%, APA Strategic Diversification -1.29%, Quantum Leap Capital -2.35%, APA Modified -2.99%, and Accela Capital Management Global Diversified -3.60%. Most of these managers have benefitted from the spike in volatility, but had to overcome losses in the first week of the month due to reversals in long foreign stocks and short grain positions.

Specialty Program performance has been mixed with the Ag traders doing well, while others have struggled.  On the Ag side Oak Investment Group +2.35%, Rosetta Capital Management +1.60%, NDX Shadrach +0.41% and NDX Abedengo +0.17% are in the black.  Others in the specialty category include Emil Van Essen Low Minimum +1.67%, 2100 Xenon Fixed Income +0.17%, Paskewitz Asset Management Contrarian 3X Stock Index -0.80%, and  P/E Investments Standard Program -5.693%.

Option traders have been on a roller coaster this month with many bouncing back last week although the month is not over yet.  Financial Commodity Investments is leading the pack with FCI CPP at +11.42% and FCI OSS +6.50% both trading very well this month.  Others in the black include Crescent Bay BVP +0.95% and Kingsview Management LLC +0.54%.

Stock index option programs in the red include Crescent BAY PSI -1.77%, Clarity Capital Management -9.02%, and ACE SIPC -17.75%.  Diversified Programs in the red include Cervino Diversified -0.12%, Cervino Diversified 2X -0.38%, HB Capital Management -1.95%, and ACE DCP -7.00%.

Trading Systems

The equity markets continued their recent run of losses last week, briefly breaking through the ‘Flash Crash’ low before rallying slightly, as the bond market continued to trend higher and the Soybeans market ranged. Overall, it was a tough week for most of the swing systems, while some of the day trading systems were able to produce some nice results.

Leading the way was AG Xtreme2 SP, which  made some nice short trades near the high for the week and produced a profit of +$3,150.00. Clipper eRL had a nice mix of trades by shorting early on in the week and going long during the rally on Friday, producing +$1,530.00. Some of the other positive results were AG Xtreme2 ES at +$592.50, Beta-DT eRL at +$100.12, and Strategic ES at $15.00.

Some of the systems that were close to being on the green side this week were Waugh eRL at -$180.00 and ViperIIA EMD at -$191.68. Meanwhile, the Compass ES and SP systems will be looking to rebound next week after producing results of -$882.50 and -$4,200.00. A long trade on Friday was just barely stopped out for Compass before the market rallied into the close.

Unfortunately the swing trading systems didn’t handle the market conditions well last week.  Swing trading systems results included Strategic V2 SP at -$400.00, AG Mechwarrior ES at -$650.00, Polaris ES AT -$830.00, Moneymaker ES at -$1,165.00, and MoneyBeans S at -$1,722.50.

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.