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Why trading systems love Volatility

June 7, 2010

 

With no newsletter last Monday owing to the Memorial Day holiday in the US, it’s been two weeks since our last newsletter, but with all that has happened in that time, it feels like it has been two years.

In just 9 trading days since May 24th, Copper is down -9.6%, the Euro down -5.1%, and Russell 2000 futures -4.9%. Some markets (and noticeable stocks like BP and XOM) have actually fallen below their 2008/2009 lows, or in the case of flight to safety instruments like US treasuries – risen above their 08/09 highs. Consider that the Euro and Wheat are now lower than at any time during the 08/09 crisis, Sugar and Corn are within striking distance of those lows, and flight to safety instruments like the 10 yr Note, Euro Bund, and Japanese Government Bond have broken above their 08/09 crisis period highs.

Whether this means the end of the global recovery or not is for the talking heads on television to debate. But what we do know is that all of this activity has led to a noticeable uptick in volatility, and while that has helped managed futures programs on the whole (see week in review below), it has been even more of a shot in the arm for volatility loving trading systems.

But what exactly do we mean when saying volatility has spiked? Many investors are familiar with the CBOE’s volatility index, lovingly known as the VIX, but don’t really know what that number is supposed to be telling investors.

VIX

The VIX, currently at about 36, is telling us that options traders are assigning a one sigma (one standard deviation) implied annualized volatility of 36% to the S&P 500 stock index calls and puts they are buying and selling on the Chicago Board Options Exchange (CBOE). That implied volatility level of 36%, in turn, comes out to a move of 2.60% over the next 30 days. If that seems too small, remember that it is just the one sigma move (defined as 68% of all instances should be below it). Using the defined probability levels represented by the standard deviation (click here to see them defined) and the 2.60% one sigma move represented by the 36% annualized move corresponding with the VIX reading, we can know that traders are assigning the following probabilities via the prices they are paying for options on the S&P 500 index.

31.73% chance S&P will move more than 2.60% over next 30 days

4.55% chance S&P will move more than 5.19% over next 30 days

0.27% chance S&P will move more than 7.79% over next 30 days

0.01% chance S&P will move more than 10.38% over next 30 days

0.0001% chance S&P will move more than 12.98% over next 30 days

If you’re wondering how they can only be assigning a 0.27% chance to a move over 7.79% when we just had a move that large in May – please note that the above are generated assuming normally distributed data, of which financial data certainly is not.  The traders actually buying and selling these options are likely using non-normal distribution calculations in their models (which would put the chance of such a move higher).

Average True Range (ATR)

Now that we explained volatility, we’re going to tell you to forget about it – and only consider it as a general gauge of whether volatility is on the rise or declining. The more important measure for trading systems is the Average True Range.

The Average True Range (ATR) is quite simply, the average of the true range over the last x periods. And the true range is simply the daily range of a market, plus any additional move in the ‘overnight’ session if that caused the market to open higher or lower than the previous high or low.

Unlike the VIX, which is concerned with how much the S&P 500 is going to move over the next 30 days, the ATR is run on daily data, and then smoothed over whichever look back period you choose. We prefer to look at both a short term (20 day) and longer term (100 day) ATR. Further, while the VIX is forward looking (it is an index of the probabilities assigned to options which look x months into the future), the ATR looks at what has actually happened in the market. It is measuring the actual trading range of the market you are looking at.

Why do we feel the actual trading range is important? Because trading systems are generally either day or swing trading systems – holding positions from a few hours to a few days. How much the market moves in those few hours to a few days is therefore directly tied to how much a trading system can make or lose. The ATR tells us the profit potential and likely risk for trading systems on a day by day basis.

You can see in the chart above that the S&P has moved from an average daily trading range of roughly 10 to upwards of 30 in the past two months. For a trading system, that means their potential profit per day has increased from $2,500 to $7,500 (or a 200% increase). Now, trading systems aren’t trying to capture the entire range, and most would be quite happy with capturing 25% to 50% of the day’s range. If we consider a theoretical trading system with a minimum investment of $20,000 which looks to capture 50% of the day’s range when correct and risks $1,000 per trade – we can see that the increase in volatility means an increase in profit potential from $1,250 to $3,750. Looked at from another angle, that increase in volatility means the profit potential as a percent of the minimum goes from 6.25% to 187.5%.

The cool part from a risk standpoint is that the risk represented by the ATR isn’t necessarily equal to the risk for a trading system. That is because most trading systems employ a hard stop, meaning they risk a set amount (say $1,000) on each trade regardless of how volatile or non volatile a market is. Because the risk is a set number, the profit potential as a percent of risk goes from 125% of the risk to 375% of the risk

And while they are designed to risk only a certain amount, most systems let the market’s price action and volatility dictate how much profit they can make on a trade when the model gets the price and direction correct.  This creates a profile where the system will risk -$1,000 in hopes of making $3,000 to $5,000 or more (if there is a very large outsized trading range such as last Friday with the Dow down 300+ points). 

So while the volatility can really help them by allowing them to make much more than they risk when they get a big winner, it doesn’t necessarily work both ways. That is, they aren’t at risk of losing oversized amounts when there is an increase in volatility. Their risk of loss remains tied to issuing the “wrong” trades many times in a row (or many more times than winning trades over a period of time), not to a single trade turning into a huge loser equal to 20% or more of the account (as we’ve seen with option sellers).

It is this ability of trading systems to make more in high volatility times than they lose in low volatility times which allows us to label them as long volatility plays. By long volatility plays, we mean they are a proxy for being long volatility (they enable you to profit from an increase in volatility). But unlike buying an option or other long volatility plays which will, by definition, lose money if volatility falls – investing in a trading system won’t necessarily do poorly when volatility declines. It is a poorer environment for them, to be sure, but some can filter out such times and remain viable.

Recommended Trading Systems

While we’re likely to see a bounce back to the upside sooner or later in stocks, we believe we’re in for more of the higher volatility ahead – as the main ingredient which kept a lid on volatility in 2009 (government stimulus) has less and less of a chance of being seen again given the levels of government debt across the world, political environment, and more.

Below are two stock index trading systems exclusive to Attain which we feel can capitalize on the current high volatility market environment.  Of course, they have the possibility of substantial losses just like any other futures investment as well. But the times they struggle appear to be tied to times when there isn’t enough movement in stock index futures, not the other way around.

> Strategic ES – $15,000 minimum

Strategic ES, along with Strategic SP, is one of the few long volatility type trading models that posted positive [hypothetical] results in 2009. Although the results aren’t as impressive as prior years, the system still outperformed most other short term trading models as well as the New Edge AlternativeEdge Short-Term Traders Index which was down -4.01% in 2009.  The fact that the system succeeded on this walk forward basis when so many others failed leads us to believe that Strategic is not the typical over optimized trading system and is robust enough to succeed in the most difficult market environments. 

Strategic is comprised of 8 separate internal models which each attack the market from a different angle. The eight different subsystems include models that specialize in trading overnight gaps, continuation patterns, range expansions, seasonality, counter trend, reversal logic, and volatility based entries.  The combination of these entry strategies along with an aggressive exit strategy has resulted in a unique short-term momentum-style trading model that can operate on many different market environments and be applied to a variety of markets including the SP, ES, NQ, ERL, EMD, US, and CL.

Sure, it will have volatile periods such as last year’s max DD of close to -40%, but many believe that risk is worth taking when viewing the potential rewards.  The system thrives when there are sharp reversals (1-2 day spikes) off medium term (5-10 day) market trends. Strategic looks to be a classic long volatility trading system which should do well when volatility spikes, and at least in 2009 – performed ok even when volatility was on the wane. View the Strategic System Spotlight here.

> Compass SP – $30,000 minimum

The Old Faithful of trading systems, members of the Attain team have been tracking this S&P 500 futures day trading system for 124 months. That’s longer than the track record of many popular managed futures programs combined. Most people are scared off by the program’s losing years in 2004 and 2006 and 2009, and the -82% DD which spanned from Nov. 2005 to March 2007.  But that DD coincided nearly perfectly with the period of extended low volatility, while the 2009 losses mirrored the free fall in volatility levels throughout 2009 (down over 80%). Once that volatility ended, in Feb 07, the program snapped back to its winning ways impressively.

Compass has a wickedly simplistic logic where it ignores all past price action, and only looks at the current day’s market activity. It measures whether the day is significantly strong or weak, and then puts in orders to get in line with that daily trend, if it exists. When such intraday trends hit the market, Compass likes to see follow through into the close in order to be successful. So a day such as today in which the market generally moved higher throughout the day and then closed on its highs would likely result in a Compass winner (days like last week when the market closed at its lows would also be likely winners – Compass doesn’t care whether the market rises or falls) Conversely, market action which sees the Dow up 200, down 300, up 100, and then finishing down 150 would likely result in a losing trade for Compass, as the trend didn’t continue on into the close.

As we’ve said many, many times in the past, Compass has the longest track record of actual fills for any publically available trading system we know of, and due in no small part to that lengthy experience; we recommend it as a component of nearly all portfolios. View the Compass System Spotlight here.

What if the Trading System Drawdowns look to high for me?

The sometimes large drawdown levels seen in trading systems past performance is often a concern for many investors who are looking at allocating some money to futures trading systems. These larger drawdowns are the result of trading systems being less flexible than CTAs. The trading systems do not have a manager overseeing each trade. They don’t have a manager who can decrease the number of contracts if we enter a low volatility period, etc; and that shows up in higher drawdowns over the life of a system as the track record shows the good, bad, and ugly of that system across many different environments.

But there are a few things investors can do to lower the effective drawdown of any system (or CTA for that matter) they are considering. One simple way to lower the worst possible drawdown you might experience is to time your entry into a trading system allocation. Instead of just jumping into Compass for example, and being at risk of seeing another 80% DD, wait for the system to have a 20%, 30%, or 40% DD. In waiting for one of those DDs, you can effectively remove that amount from the max DD you will have to incur moving forward. So you set -80% as the stop trade point, and get in at -40%, the real DD you are risking is just 40% (half of the past worst case scenario).

Another way to potentially lower the DD is to be your own portfolio manager. If part of the reason trading systems see larger DDs is because no one is actively managing it, then actively manage it yourself. A savvy investor could potentially lower the max DD by getting out of a system if the volatility goes back to the low levels seen in 2005, or instructing Attain to not trade on holiday weeks, or trying to call a top in volatility like in 2008 and then wait to reenter the system. The best thing to do in our opinion is usually to stick with a system until it goes through your predetermined stop trade point, and not try and start/stop a system; but that’s not to say it couldn’t work to your advantage.

The Time is Now for Trading Systems

In conclusion, this remains an uncertain time in the financial markets of the world, and there may be no better way to capitalize on these highly volatile times than allocating to one of the above futures trading systems which have a long volatility profile and appear to do well in this type of environment.

- Barbara Mueller

IMPORTANT RISK DISCLOSURE


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Feature | Week In Review: Global sell off great for most CTAs/Trading Systems

Overview

The headliners late week of Hungary stating they could have debt trouble rekindled sovereign debt issues which were then topped off by a weak jobs report sending shockwaves through the marketplace bringing nervousness back to investment sphere. The quake was also felt in most futures markets as the deteriorating financial health around the globe led to ideas that early demand projections for 2010 could be severely altered with the recent sell off in world equity markets. The lone bright spot Natural Gas +13.25% was aided by the problems of capping the leaking Gulf crude oil well, which has sparked heavy debate in Washington D.C. that a major alternative energy plan needs to become policy sooner rather than later. One of the major parts of the policy is to use natural gas especially in the auto and trucking sector as a conservation measure due to the fact that the resource burns more efficiently and has an abundant supply.

Industrial metals continued to have a poor time dealing with all of the global uncertainty as the sticky sovereign debt situation in Europe and poor economic reports in the U.S. quickly discarded any hopes of stability of construction growth.  For the week Copper -10.90% took on the most water followed by Palladium -6.14%, Silver -5.12% and Platinum -2.07%. Gold +2.12% was supported by flight to quality investment with world economic conditions currently on an uncertain path.      

Activity in Stock Index futures again was a victim on worries of sovereign debt problems on news the Hungarian government was concerned about their debt commitments. The monthly U.S. jobs report was also an aid to further pressure as the numbers were well short of expectations. The Russell 2000 futures shed -3.84% followed by Mid-Cap 400 futures -3.10%, S&P 500 futures -2.06%, Dow futures -1.78% and NASDAQ futures -0.95%.

The balance of the energy complex was again under pressure from further news of heavier supplies even after the Memorial Day holiday in the U.S. which is seasonally the start of stronger demand heading into the summer driving season. For the week Crude Oil -3.42% followed by Heating Oil -1.81% and RBOB Gasoline -1.56%.

Activity in the currencies featured another round of selling pressure for the Euro-2.45% and Swiss Franc -0.23% as investors nerves seemed to wane on more debt worries. The Japanese Yen -0.96% was victimized by news of the Prime Minister’s resignation on ideas that he had done little to stimulate their weak economy.  The Dollar Index +2.00% was a main beneficiary of all the global instability as investors sought safety.        

Commodity and Food products were mostly lower last week as heavier production estimates from government reports and nearly ideal growing weather not only in the U.S., but abroad added to the selling pressure. Corn -5.29% led the way lower followed by Wheat -4.81%, OJ -4.69%, Cotton -3.74%, Lean Hogs -2.45% and Cocoa -1.55%. Sugar +2.33% was the lone commodity to produce a rally as news that production could be lower than earlier forecast sparked support along with ideas that any new alternative energy policy in the U.S. could sharply increase sugar demand for fuel production.    

Managed Futures

That sound heard coming from Chicago last week was the voices of many CTAs yelling “finally!” after a late week surge in market volatility propelled many multi-market CTAs to great starts in June.  Stocks, commodities, and financial futures were all in flux after Hungary announced that they too are on the brink of default.  The result was a wild end to the week, which saw many managers post their best one day performance of the year.  (past performance is not indicative of future results)

After one week of trading, the top performing program in June is APA Modified at +6.58%.  APA Modified saw gains in currencies, treasury, and stock index futures last week.   Accela Capital Management Global Diversified also had a great day of trading on Friday and is at +3.38% for the month.   Others who are in the black include Applied Capital Systems +3.15%, APA Strategic Diversification +2.31%, Clarke Capital Worldwide +1.94%, Futures Truth MS4 +1.92%, Covenant Capital Aggressive +1.71%, Dighton Capital USA Aggressive Futures Trading +1.48%, Integrated Managed Futures Global Concentrated +1.18%, Futures Truth SAM 101 +0.89%, Robinson-Langley Capital +0.84%, Hoffman Asset Management +0.75%, 2100 Xenon Managed Futures (2X) +0.73%, Dominion Capital Management Sapphire +0.48%, and Clarke Global Magnum +0.11%.

Alas, despite the favorable trading conditions, not all multi-market managers posted positive numbers last week.  Managers in the red include GT Capital Management -0.17%, Mesirow Financial Commodities Low Volatility -0.18%, Mesirow Financial Commodities Absolute Return -0.23%, Quantum Leap Capital Management -0.23%, Sequential Capital Management -0.33%, and Auctos Capital Management Global Diversified  -0.90%.

Option selling programs were also not very receptive to the spike in volatility, although there were not any major hiccups.  Option programs in the black included Crescent Bay BVP +2.62%, ACE DCP +0.62%, and HB Capital Management +0.08%.  Kingsview Capital Management is right at breakeven.  Programs in the red include FCI OSS -0.24%, Cervino Diversified -0.25%, Cervino Diversifed 2X  -0.32%, Crescent Bay PSI -0.76%, ACE SIPC -0.89%, and FCI CPP -1.03%, and Clarity Capital Management -1.41%.

Most specialty managers also did not participate in the move, as the volatility remained tied to stocks and financials.  Fixed income specialist 2100 Xenon Fixed Income posted small gains at +0.17%, but they were the only ones in the black.  Spread trader Emil Van Essen was down slightly at -0.20%, Oak Investment Group -0.31%, NDX Abedengo -0.33%, NDX Shadrach -0.51%, P/E Standard -1.44% and Rosetta -3.94%.

Finally, stock index traders were mixed with Paskewitz Asset Management 3X Contrarian at +1.13% and Roe Capital Management Jefferson Index -1.58%.

Trading Systems

The equity markets last week rallied during the early portion of the week before they reversed and continue to slide down due to the European Sovereign debt crisis worsening. The increased uncertainty in the markets caused the bonds to make a big jump up on Friday but for the most of the week the bonds trended downward.  The Soybean market continued to range between the 935 and 950 price levels. The rangy action in the markets proved to be a good thing for most of the trading systems.

The majority of the day and trading systems were in the green last week with Strategic SP ahead of the pack with a profit of +$8,600. Strategic SP was able to make some nice long trades during the early part of the week and then reverse direction along with the market and get short near the highs. ViperIIA EMD came in second with a result of +$2,067.95. Early on in the week Viper got long early and was able to ride the moves up which helped produced some nice profits. The other positive results included Waugh ERL at +$2,060.00, Strategic ES at $1,667.50, Compass SP at $1,379.63, EVP 1 US at $1, 226.69, Balance Point ES at $1, 022. 50, AG Mechwarrior ES at $765.00, MoneyMaker ES at $732.50, Polaris ES at $395.00, Jaws US 60 US at $313.75, Compass ES at $227.50, Bounce EMD at $160.00, BounceMOC EMD at $160.00, and PSI! ERL at $110.00.

There were a few negative results last week. Clipper ERL last week got caught long near the highs early on and then made a solid short trade near the end of the week. Unfortunately, the short trade wasn’t enough and Clipper ERL finished at -$523.65. Some of the other results were MoneyBeans S at -$300.00, Waugh Swing ES at -$455.00, SITA ES at -$735.00, and Waugh CTO ERL at -$1,290.00.

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.