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What to Do If You're Making Money

January 30, 2012

 

While we commonly talk in this space about what to do when staring losses in the face, less time is spent here and elsewhere talking about what to do when you have had success with a program. Perhaps this is something to do with the human condition and focusing on that which causes us pain before considering that which brings us pleasure, or perhaps it is just a simple case of most investors thinking the upside is easy to manage when compared to the downside. 

Whatever the case, there have been some questions from Attain clients recently asking what they should do with gains in some programs, and, specifically,  what their options are for scaling up the trading of the successful programs in their portfolios. 

Now, many futures traders and commodity market investors have no doubt heard of the various money management techniques out there which, in one way or another, add to a position when that position is profitable. This technique is sometimes called pyramiding, pillaring, or margin scaling/trading. The basic idea behind it is to use the “market’s money” to add to positions.

These money management techniques are usually thought of and implemented on an individual trade basis, and involve making enough in profits to cover the margin requirement for a new position. But they can also be put into action on managed futures investments in CTA programs by scaling when a manager makes enough money to cover the margin needed for an additional allocation. Indeed, we ran a newsletter a few years back which tested this pyramiding technique on a few CTAs to see the effect of scaling up when times were good.

The result? Much bigger profits AND LOSSES, with risk adjusted ratios roughly the same. And it was highly dependent on which programs you scaled with. Scale into an eventual loser, and the losses would quickly eclipse the initial gain. Mostly, it was a non-starter.

We ended that piece saying the more correct way to look at "scaling up" a CTA investment would be to consider more than just the margin needed to add an additional allocation to a CTA, and instead consider both the margin needed and the average drawdown amount so as to build a cushion for future downturns.

And with some free time on our hands (not really, we have been feverishly working on our new CTA rankings due out next Monday), we decided to test that improved version by scaling up a CTA investment when that CTA made enough money to cover both the margin needed for an additional allocation and the amount of the average annual drawdown.

Normal Pyramiding/Margin Scaling

Before we get into how it can work on a CTA program, let’s take a step back and see how it works on an individual market.

First, we’ll need a reminder on what margin is. Margin is the amount technically needed to place trades – as required by the futures exchanges. Any account which wishes to trade a futures contract on a regulated futures exchange like the Chicago Mercantile Exchange must first have enough money in the account to cover any potential losses (the margin) This insures that the exchange can make the trader who takes the other side of the trade good should the trade go against the account.

For example, the margin required to put on a Crude Oil futures position today, with Crude trading at about $99.26, is about $7,500 . Technically, all an investor needs to invest in that market is that small amount (even though the market can move 5 times that amount in a few weeks and you would be hard pressed to find anyone who would recommend trading it with such a small balance).

To do margin scaling money management (pyramiding/pillaring) on the Crude Oil futures, an investor would add a contract each time the account was ahead by the $7,500 margin amount. For example, say an investor bought a single Crude contract today at $99.26, and unrest in the Middle East pushed Crude prices up to $106.76 over the next month. At that point, the position would have gained the equivalent of the margin posted, providing an opportunity to "scale up." Should the price move up another $7.50 a month later, another opportunity would present itself (even if your pocket book cringed every time you hit the pump). By adding contracts only when the open trade profits are enough to cover the margin for the new contract you want to buy – an investor is using the “market’s money”, and doesn’t have to add capital to the account in order to increase the position.

Now – this is a very aggressive method of money management, and as such comes with a great deal of risk. Let me repeat that, such trading greatly increases the risk of loss. In this case, Crude Oil futures could easily fall $15 in a single week, which would have lost the investor -$15,000 on their single contract, but will now lose them -$45,000 when adding two contracts using the margin scaling method. Basically, when you add the 2^nd contract, you can lose money twice as fast as you made it; and when adding a third, three times as fast, and so on.

Scaling is a high risk, high reward endeavor only suitable for the most sophisticated of the already sophisticated investors involved in commodity investing. 

Margin Scaling with CTAs

Now that the pyramiding explanation is clear, back to the task at hand – scaling up a CTA investment via margin (+drawdown) scaling.

While many investors may be happy enough to just find a program which makes money for them, and not consider what to do when that manager has made them money, some of the more aggressive investors out there aren’t content to just make money, and frequently look for ways to make even more with their favorite CTA program or programs.

One such method these aggressive investors use to exponentially scale up the performance of a CTA is to “margin scale” the CTA. The backbone of this strategy is the same as what was outlined above, where the investor adds to a “position” when their account has enough profit to cover the margin for another contract.

But in the case of margin scaling with CTA programs, instead of adding a contract, the investor adds an allocation to the CTA (going from $100,000 investment to $200,000 for example). And instead of considering the margin requirement for an individual market, the investor uses the average or maximum margin the CTA uses.

Using a fictitious managed futures program with a minimum investment level of $1,000,000, and an average margin to equity ratio of 12.5%, that means on average, the total margin requirement for all of the program’s positions on any one day is about $125,000.

To margin scale this program, and investor would add an additional allocation (and additional $1 million in trading level) to the program at every $125,000 in profits made in the account (including open trade gains). Again, with the idea that you’re playing with the “market’s money”.

The benefits of doing this are that profits can be compounded much quicker, creating exponential growth which can dwarfs the normal performance. Using our fictitious program above as an example once again, for every $125K in gains the normal investor makes, the margin scaling investor doubles his or her profits (going from $125K to $375K to $750K, to $1,500K and so on.)

But the risks of doing this are that your absolute dollar risk gets doubled, then tripled, then quadrupled, and so on, with every increase in allocation. Your absolute risk grows exponentially along with the profit potential. You can’t get something for nothing.

For more on the risks, imagine if our fictitious program had a -20% drawdown after making 25% ($250K). The initial allocation would merely lose the $250K it had made and be back to the initial investment of $1 Million. However, the investor who margin scales would have increased their allocation twice, and would be trading at a notional level of $3 Million plus $375K in profits when the drawdown hits. The margin scaling investor would then lose $675K (20% of $3.37 Million), and as such be down to just $325K out of the initial $1 Million investment. Ouch!

Margin (+Drawdown) Scaling with CTAs

Given what nearly all investors would consider too big of a risk on just margin scaling, we endeavored to add a bit of a cushion to the scaling process by considering what happens when considering the average annual drawdown amount in addition to the margin amount.

Using our same example of the CTA with a $1 million minimum and average margin usage of $125k, let us now assume this fictitious CTA also has an average max drawdown of -15%, or $150k. Using the margin plus drawdown scaling method, we would now add another allocation to the CTA upon the manager earning our account $125k + $150k, or $275K total.  Upon earning another $275k, we would add another $1 million nominal allocation, and so on for each new $275k in profits.

So just what does such a scaling technique look like on a few real life CTAs? We went to our database of CTAs to take a look, testing the method on  5 of the top ranked programs in our database, as well as 5 of the bottom ranked programs.

To run our tests, we looked at the month ending equity curves of 10 different programs (five top ranked and five bottom ranked) ranging across a variety of strategy types (systematic multi-market, agriculture, option selling, discretionary, and more).

For each program, we then doubled the monthly profit/loss in the month following the gain of the average margin amount plus the average drawdown amount ($275k in our example above), then tripled it at the next gain of that amount, then quadrupled it at the next gain, and so on.   The increase in the monthly profit loss was done by adding one minimum allocation amount (equal to the minimum investment amount), without increasing the cash balance at all – thus done completely with notional funding (i.e. trade my $100k as $200k, then my $150K as $400K, then my $200k as $600K, and so on).

Results

The results of this new scaling method did not show the smoothing effect we thought they would when adding the extra cushion of the average annual drawdown to the equation, with the results of the new method again being higher returns (for the top 5) AND higher risk (all around).

On the return side, the top ranked programs we tested saw their compound rate of return go up from an average of 32% to 73% utilizing the scaling method, while the bottom ranked programs did not see an improvement in returns, going from an average of 9% to -1%.

This jump in returns for the top ranked programs did not come without a price, and the price of that exponential growth was significantly increased risk . The Max DD swelled from and average of -14% to -48% in the Top 5 programs , and -42% to -79% in the bottom 5 programs. Likewise, the annualized volatility increased from 22% to 53% for the Top 5 programs and 26% to 103% for the Bottom 5 programs.

 

One look at the equity curve of one of the bottom ranked programs using this margin + drawdown scaling approach shows in one picture how volatile such pyramiding can be [ the following is for illustrative purposes and does not represent trading in an actual account]:

 

A normal investor would likely find these massive drawdowns extremely prohibitive, and, as we said earlier, a non starter (saying something along the lines of - no thanks, I’ll stick with the normal operation of the program). But an uber-aggressive investor may look at those big dollar drawdowns and be fine with them if the losses were still the “market’s money” (in this example everything over 0.50 being the market’s money).

This is the key to any type of scaling- knowing the difference between relative losses and absolute losses. A very aggressive margin scaling investor would in theory be unconcerned with large percentage and dollar losses, as long as those losses are above their initial equity levels. They are fine risking large absolute numbers with the “market’s money” or profits.

But one would have to time their investment nearly perfectly in order to avoid any losses of the initial investment, and only have losses of the “market’s money”. And indeed, in every one of the cases we tested such scaling at one point or another dipped below the initial investment (while having at least double the initial allocation active).

At the end of the day, we can safely say to those asking – I’ve made money, now what? – don’t scale up  your investment using the average margin and/or drawdown as a trigger level. The upside can be big, but the downside looks to be just as big, and if you are in a long term losing program, there may be no upside at all.

The better course of action in our opinion is to do one of the following: a. do nothing, and let the manager you have hired compound the account and manage the money management themselves, b. diversify into a non correlated program approaching the market in a different way, or c. add to your allocation to a current manager in the normal way, with additional capital.