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Managed Futures Strategy Focus: Discretionary CTAs
June 30, 2008
We’ve covered often in this newsletter how important it is to do your due diligence on individual commodity trading advisors before investing. To find out just how a manager will be handling your account, the ins and outs of their strategy, and what environments are good and bad for a specific CTA. Those steps are just good common sense, and will help any investor be more successful in the long term.
But it also pays to do your due diligence on the category of CTA program you’re investing in. If you’re investing in a trend following manager, for example, not only should you know everything you can about the manager, you’ll also want to find out all you can on what helps and hurts trend following on the whole.
To assist with this Strategy Type due diligence, Attain has done Strategy Focus newsletters in the past on Managed Forex and Option Selling; and is dedicating this week’s newsletter to a Strategy Focus report on an often misunderstood CTA type of trading: Discretionary Trading.
What is Discretionary Trading?
What exactly is discretionary trading? Well, that’s not as easy to answer as we would hope it to be, since the CTA category described as discretionary is actually a bit of a misnomer. All CTAs are discretionary in so far as they are hired to manage an account, and in so doing are given discretion over that account, to place trades as they see fit.
However, whenever you read the term discretionary trader, and our meaning of discretionary trader for the purposes of this newsletter, it means something different than someone who manages accounts. What we mean by a discretionary trader can best be described in terms of what they DO NOT do, rather than what they do do.
And one thing Discretionary traders surely DO NOT do is use systematic models. Now, they may use technical indicators, chart patterns, and more – but they won’t use those tools in conjunction with a systematic approach. That is, they won’t always buy when a certain indicator signals a buy. A systematic approach would always buy when getting a signal to do so, but a discretionary trader merely uses that information to aid in his or her decision on whether to buy or not.
So the best description we can give you of what it means to be a discretionary trader is that it is the opposite of a Systematic Trader.
But if not using systematic models, what do discretionary traders use to make their decisions on when to buy/sell, how many to buy/sell, when to get out, and so on. Many use the same tools Systematic Traders use – looking at technical indicators and chart patterns, and merely use discretion on when to follow those indicators instead of following them blindly.
Many discretionary traders also incorporate fundamental analysis into their decision making. Unlike technical analysis, which looks mainly at market specific information such as prices, volume, past history, and so on – fundamental analysis looks at factors outside of the market such as supply and demand figures, political events, economic indicators, and so on.
The classic example of technical versus fundamental trading occurs on every Fed announcement day. Technical traders treat it as any other day, following price movements and reacting if prices jump one way or another. Fundamental traders, on the other hand, are usually more apt to enter a position in anticipation of a particular outcome of the meeting (rates cut or raised). This example also lets us see another characteristic of a discretionary trader, as in this example a discretionary trader may not take signals initiated in the volatile moments immediately after the announcement for fear of the market just snapping right back.
Because many discretionary traders use fundamental analysis in their decision making, it is often assumed that all discretionary traders are fundamental traders, and vice versa. But that isn’t the case. There are many discretionary traders who don’t use any fundamental analysis at all, and just concentrate on the technicals. Still, it is not uncommon to see a trader who has been in the meat markets for 30+ years, for example, to be a discretionary trader who just seems to have a “feel” for the market they have seen millions of price ticks in.
The most common thread amongst discretionary traders, however, is not technical or fundamental analysis, but rather the use of their own judgment on each and every trade. They may have a gut feel about a trade, or use a compilation of technical indicators and fundamental analysis; but they will not do the same thing every time given the same set of circumstances. They have to decide on the best course of action given everything they know up to that point.
Pros and Cons
The pros to a discretionary approach mirror the cons to a systematic approach – and center on flexibility. The flaw of a systematic approach is that it will do the same thing given the same inputs each and every time, no matter what is going on outside of the price. We have heard all too many times from clients trading systematic approaches something along the lines of: “why would it buy when the Fed came out that morning and raised rates”
The pro of a discretionary approach is that it can take something like a surprise Fed rate cut into consideration before pulling the trigger. This flexibility can often save a discretionary trader from whipsaw moves (getting in at tops, and out at bottoms), as they will choose to wait until the dust settles and then decide on their trade.
Another benefit of a discretionary approach is that such a manager can quickly engage new markets which are “moving”. A systematic trader would likely have to test and re-test a new market, and risks the market losing its appeal by the time they are ready to trade it. A Discretionary trader can quickly move into a new market based off as little as his intuition.
For example, discretionary trader Dighton Capital does not typically day trade, but when stock index futures were really moving in January and February, they stepped in and did some quick day trades.
Another pro, is that Discretionary traders can quickly adapt to changing market conditions. Spread trader NDX uses technical indicators in its trading, but they defined themselves as a discretionary trader last summer when they reduced position sizing and trading activity to almost nothing in the face of what they termed an abnormal livestock market due to above average imports from China. They eventually returned to a more normal (for them) trading pattern and have done quite well since.
Finally, a real benefit of many discretionary traders is their experience and focus on specific market sectors. The aforementioned NDX concentrates on the Hog markets, while Dighton Capital uses its head trader’s long experience in the coffee markets to its advantage in trading coffee, and so on. A simple move in one of these markets may seem like nothing to you or me, but could mean something significant to someone who has decades of experience in that specific market.
Discretionary traders often get a bad wrap because of the cons for this type of trading style. And the main detriment and worry for those looking at discretionary traders is that you just don’t know how the decisions are actually made for a discretionary trader.
Does a discretionary manager buy when his dog goes to the green bowl, and sell when his dog goes to the red bowl? This is an extreme example, obviously, but the fact that we often don’t know a discretionary trader’s “secret” is what worries investors.
While his “secret” may have done quite well in the past, without knowing how the “secret’” works, we don’t know how the manager will react during drawdown, or during extreme market events. They may be tempted to double up to make up losses, for example, instead of staying consistent. And they may try a completely new approach (strategy drift) they have never done before, without anyone being able to tell. A systematic approach insures the trading remains consistent, but with a discretionary trader, we just don’t know about the consistency.
The other rather large negative about discretionary traders are that they are usually “one man shops”. This means the trading decisions rest on a single person’s shoulders, and rely on not only that person’s skill in looking at the markets, but also on their availability. This is in stark contrast to a systematic approach, in which once the models are developed – the approach can be followed by computers without the need for the creator to be ever present.
If the strategy depends on the availability of a single person, several questions arise. What if they get hit by a bus, want to go on vacation, quit, etc.? This lack of structure and reliance on a single mind, or in some cases a few minds, causes most institutional investors to stay away from discretionary managers.
The last negative for Discretionary traders is that they are tough to assign a risk parameter to when building a portfolio of CTAs. We can easily understand that we don’t want too many option selling CTAs in a portfolio, for example, because they all may do poorly when volatility spikes. But we don’t know when a Discretionary trader is going to do poorly, so we don’t know on a fundamental level if adding them to a portfolio is increasing or decreasing our risk.
It can also be tough mentally to stick with a Discretionary trader when in drawdown, because there isn’t a good scapegoat. The program is in drawdown simply because the head trader is wrong, not necessarily because there is a bad environment or the like. It can be reassuring for investors to know their option selling CTA lost money because volatility spiked, or that their trend following manager lost money because a sector was range bound, and indeed, this is in my opinion, is what makes the stock market such a popular investment. In all of the above, you know what to cheer for and what to blame if things go poorly. With a discretionary trader, when you don’t know what to cheer for, (and who/what to blame) it makes it a tougher investment.
Despite some drawbacks to the overall strategy type, there are several discretionary traders whom we recommend at Attain, based in no small part on their addressing those potential risk factors. Dighton Capital, for example, addresses the potential for managers increasing their trading size when in drawdowns by only allowing up to 6 contracts per $100,000 – making it possible for us to track their trading for potential style drift. The NDX Shadrach program, likewise, has specialized in hog trades exclusively over the past two years, making it possible for us to see if they start to move away from their bread and butter experience and knowledge.
Please see the table below for a performance summary on several Discretionary CTAs on Attain’s recommended list, or visit this link to view online:
IMPORTANT RISK DISCLOSURE
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Feature | Week In Review: Month in Review: Stocks hit new 2008 lows, Energies hit new record | Chart of the Week
Food & Agriculture products led all sectors in June as production problems due to weather issues caused a sharp rally. Severe flooding in the U.S. Midwest sparked moves higher as worries of lost production without time to replant sent corn futures up +20.35% for the month. The upward direction was also seen in Soybeans +13.25% despite ideas the lost corn acreage could convert to soybean plantings. Wheat ended up and impressive +14.67% on the idea the livestock sector could turn to the cheaper wheat over corn for their feed in an effort to lower input costs in the coming months until the corn crop is ready to harvest.
The other foods seemed to follow along with the grains as Cocoa added +13.75% scoring new multi-year highs on production concerns due to political turmoil in key growing regions. Other softs that scored decent gains include Sugar +10.59%, Coffee +10.44%, Cotton +8.56%, and OJ which ended +2.78% during the past month.
Stocks finished June in a desperate state as credit crunch worries seemed to rise from the ashes despite jawboning that the worst may be in the rearview mirror. The news seemed to be very unsettling to the sector especially with talk of write-downs and ratings cuts for several top investment houses. The SP 500 futures finished -8.83% and the Dow Jones futures ended down -10.24%, the latter experiencing a June skid not seen for many decades. The tech sector didn’t fare much better as the NASDAQ futures finished the month with losses of -8.83%. In small-cap trading the Russell 2000 futures were down -6.27% while SP Midcap 400 futures lost -6.97%.
Treasury futures posted modest gains across the board on flight-to-quality buying in the face of stock losses. Commentary from the June FOMC meeting hinting the most recent cut in rates could be the last for the foreseeable future kept the rally in check. The benchmark 10-year note gained +1.11%, and 30 year bond futures rallied +1.88%.
Currency markets continued to be in a holding pattern despite all of the action in other sectors. The U.S. Dollar index was off by -1.11% in June with the Euro Currency +1.20% higher and Swiss Franc up +2.45% being the main beneficiaries. The rest of the major foreign currencies ended the month basically steady.
Energies put together another month of solid gains as the main headlines remain to be strong demand versus doubts about production capacity. The leader of the sector during June was Natural Gas +10.74% followed closely by Crude Oil which ended the month ahead by +9.17%. Heating Oil +6.22% and RBOB gas +5.96% followed along, although the upside was curtailed by late month building of stocks in the U.S.
Metals posted decent moves in June led by the industrials: Copper +6.94% and Palladium +6.94%. In the precious metal sector Gold +4.38%, Silver +4.33 and Platinum +2.35% found investor support from the rally in other inflation sensitive commodities.
Six months ago - stock markets were making new lows for 2007, and we were writing about how option selling strategies were struggling to fend off the volatility. What a difference 6 months makes. In a month where the S&P 500 hit rock bottom (hitting new lows for 2008) investors might have thought they were in store for a repeat. Well, June was anything but, as most option managers we track ended in the black despite increased volatility. Topping the charts for June was LJM Partners which was ahead an estimated +4.46%. LJM has come roaring back from their January loss of -12.39% and is now ahead over 20% for the year.
Other estimated option manger returns for the month included; ACE Investment Strategist +1.58%, Ascendant S1 +1.78%, Cervino Diversified +1.57%, Cervino Diversified 2x +2.89%, Cervino COP +1.55%, Crescent Bay PSI +0.44%, Crescent Bay BVP -1.09%, Diamond Capital +1.13%, Financial Commodity Investments (FCI) +2.12%, Raithel +0.66%, Zenith Index +0.35%, Zenith Diversified +0.26%, Zephyr Aggressive +1.83%, and Zephyr Modified -1.13%.
With volatility levels at historic levels in the agriculture and meat markets, it is no surprise that we are seeing impressive returns for most mangers specializing in that sector. Among the most impressive was NDX Capital Management as its flagship programs Shadrach and Abednego, which each posted large monthly returns of +22.4% and +11.6% respectively (estimated). Many of the trades are still open, and where we go in the next few weeks off these historic levels will determine where and if the manger will officially lock in the gains.
Other estimated agriculture manger returns for the month included; Chicago Capital -1.52% and Rosetta +1.09%. For investors looking to enter in with Rosetta, the current drawdown represents an estimated 15% drawdown from their March equity high. Noting a maximum drawdown of -19.24% over the past 3 years, this is a relatively attractive level to consider starting (past performance is not necessarily indicative of future performance).
Elsewhere, June was mixed for multi-market managers. Attain’s own Attain Portfolio Advisors Modified Program returned approximately +9.0% for the month behind long positions in mini crude oil and mini natural gas as well as several nice day trades by the SP models. Next in line is the Dighton USA Swiss Futures program which was up approximately +4.02% in June. Dighton made money with their signature counter trend trades in the soft (coffee, cotton, sugar) markets. Other profitable managers in June included the Attain Portfolio Advisors Strategic Diversification Program which saw approximate returns of +2.49% and Robinson-Langley Capital Management which made an approximate +2.15%.
On the downside Optimus Capital Management was down approximately -9.25% after struggling in the precious metals. Other mangers including Northside (-0.42% est), Long Term Trading (-0.78% est) and Hoffman Assett (-1.00% est) were closer to break even.
The increased volatility in June played right into the hands of many day trading systems, which as a group had one of their best overall months ever. Swing systems had mixed results with bond systems underperforming the stock index programs.
Starting with the day trading systems, Rayo Plus Dax was the top performer with profits of +$15,461.44. Compass SP was close behind with June results of +$10,770.48 on 14 trades. AG Xtreme2 was selective with its trades and finished the month up +$4,025 on three trades. BetaCon 4/1 ESX had several small profitable trades that added up to a monthly result of +$1,701.28.
On the losing side, Bounce MOC eRL and eMD lost -$317.06 and -$701.11 respectively while Waugh eRL had twelve trades for a loss of -$1,636.
Moving on to the swing trading systems, Bounce eRL and eMD were +$70 and -$701.11 respectively for the month of June. Ultramini ES traded four times for +$61.25. Signum TY reversed long on the first day of the month and held its position ever since tacking on ~ +$1,281.25 in open trade equity after losing on the previous short trade. Signum EBL reached a profit objective on its short position early in the month, then reversed long on a spike early in the month, and reversed back to short on the last day of the month.
Elsewhere, Mesa Notes was stopped out of its long position just prior to the TY rebounding. The program is currently holding short and losing ~$1,500 in open trade equity. The Tzar suite of systems started the month out on the wrong foot with long positions in all three markets (ES, eRL, NQ), but has since repositioned itself to short ES, NQ and long eRL. Of the three markets, the NQ has been the top performer for the month after entering short prior to the other markets, and holding that position for a couple of weeks.
In long term trading, the major trends continued to be the long energy, long metal, and long grains. With risk levels exceeding $10K per contract in many of those markets, systems like Aberration Plus steered clear of these entries while holding its short EBL position, and adding a long entry in LC late in the month.
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.