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Volatility Spike = Time to look at Investments NOT correlated with the stock market

July 30, 2007

 

Unless you're one of the characters on the TV show 'Lost' - you no doubt saw what happened to global stock markets last week). Markets across the globe sold off impressively - with the Dow losing more than 500 points, and most other major global indices falling roughly 5%.

Well, not everything falls in a down market, and volatility is one of the things that tends to rise any time there is a big move lower in US or Global stocks. This is due to many factors - but the main one is people are apt to panic, and when they panic, they tend to buy puts for downside protection.

While we often hear of volatility as an abstract statistical idea (how much a market is apt to move, or the standard deviation of returns), we can also think of volatility as the average price these protective puts are worth. When the market is tumbling down at an alarming pace, the downside protection Put options provide becomes more and more valuable, causing their price to rise.

Conversely, when the market is slowly climbing higher or stuck in a trading range not really going anywhere, investors make downside protection less and less of a priority, sending the price of the protective puts down.

CTAs who specialize in option selling, or "selling volatility", have become very popular over the past few years because of some very consistent returns and low drawdowns (Past Performance is Not Necessarily Indicative of Future Results). And what those managers are really doing is betting on the price of these protective puts, trying to sell high and buy back lower.

But there is always the danger of a volatility spike like the one we saw last week, which causes their sold positions to increase in value instead of decrease. A volatility spike doesn't necessarily mean losses for option selling CTAs, as the increase in volatility and corresponding increase in the short option prices must also be met by an actual move in prices below the strike price of the sold option before expiration in order for the trade to become a losing one upon exiting.

But whether the 5% to 20% open trade drawdowns amongst option selling programs is actually booked as a loss or not (most programs cut those DD numbers in half today with the market rallying), the volatility spike can still serve as a nice warning shot across the bow to ask how tied your portfolio is to stock market movements, and what programs you can invest in which are not correlate with the stock market.

1. What trading systems & CTAs are least correlated with the stock market?

As you can expect - many people are saying get me out of stocks right now, and looking at which investments offer little to no correlation with the stock market. While many people can get carried away running correlation coefficients on CTAs and systems versus the S&P - it's important to realize that the easiest way to get a non correlated investment is to have that investment be doing something else.

It's kind of like the old doctor joke, when the man tells his doctor his arm hurts when he raises it above his head - and the doctor says "then don't raise it above your head". The investing corollary is if you don't want correlation with the stock market - then don't invest in things that utilize the stock market. Sounds simple enough.

CTAs:

Atop the list of Attain recommended CTAs which don't utilize stock index futures are the following, with links to their performance records and S&P 500 correlation in the last column ( a correlation coefficient as close to 0.00 is ideal, with a maximum reading of 1.0 or -1.0 being least desirable)

Past Performance is Not Necessarily Indicative of Future Results

CTA Name - Program	Avg. Ann ROR*		Correlation to S&P 500
CKP Finance - LOMAX Program	40.9%	performance	0.000
FCI - Commodity Options Program	48.3%	performance	-0.017
Phoenix Energy	7.4%	performance	0.103
Walwood F/X	15.4%	performance	-0.202
PFG Fit F/X	34.8%	performance	-0.152
Chicago Capital - Spread Arbitrage	12.1%	performance	-0.013
Dighton Capital USA - Swiss Program	70.2%	performance	0.300
*as of June 30th, sorted by closest to 0.00 correlation

 

Trading Systems:

The conversation of which trading systems "stay away" from the stock market has to start with trend following systems like Aberration, Andromeda, Trend Simplicity, and the Trader's Tech suite of systems (the best of which are Checkmate, Fusion, and new system Relativity ). Trend following systems are designed to work on a basket of traditional commodity markets like metals, energies, grains, and softs (cotton, etc.), thus are non stock market investments by definition. The issue many investors have is - they haven't performed very well over the past two+ years while other investments (the stock market and option selling CTAs to name a few) have performed. But perhaps this down move in stocks marks a turning point in markets - where trend followers will return to their profitable ways. It would take a special kind if investor to ignore the past two years of performance amongst trend followers and get involved now - but just such an investor may be richly rewarded if trend followers move back into phase.

But an investment can be non correlated to the stock market, and still utilize stock index futures. This is due to a systems not being in the market every single day, and the fact that a system can go long or short. So, as we're not ones to completely ignore the statistics, we did run a correlation test amongst every system in our database to come up with the following list of the ten systems least correlated (closest to 0.00) to the S&P 500 stock index.

System Name		Correlation to S&P 500
Ultramini eMD	performance	0.005
Waugh eRL	performance	0.006
HP Intraday Breakout eMD	performance	-0.024
Bounce eRL	performance	-0.027
BounceMOC eRL	performance	-0.027
Impetus ERL	performance	-0.035
Tzar ES	performance	-0.036
HP Intraday Breakout eRL	performance	-0.074
Jaws US 60	performance	-0.085
Tzar Filter eRL	performance	-0.094

 

2. How did the option selling CTAs fare last week?

As you might expect with the huge spike in volatility - option selling CTAs took some heat last week. Open trade losses were anywhere between 7.5% (Zephyr Aggressive) to 20% (ACE) for those option selling CTAs specializing in stock index options. Option sellers like FCI, who does not do stock index options, were not negatively affected by the market sell off.

But as Zephyr managers Kevin MacLean and Joe Natoli pointed out in a letter to clients over the weekend, there was a lot of premium left on the books of option selling CTAs (12% in their case) which can bring the programs all the way back by the August option expiration in three weeks time. A sneak peek ahead to today's activity reveals that Zenith is only down 1% to 2% for the month now. There could be continued losses moving forward, but the swiftness with which the losses can be gained back is worth noting.

The question everyone is asking is what kind of recovery periods can we expect from the option selling CTAs. Well that does depend on their strategies, and how actively they rotate out of positions, initiate new ones, etc. But if we assume that none of the strike prices are eclipsed by expiration on August 16th and assume that the higher volatility will be here to stay in the coming months. (Remember, the premiums they are now collecting are nearly double), then we could be looking at recoveries anywhere from 2 to 6 months. Several of these option selling strategies (Diamond, Zenith, Zephyr) had just moved back to new equity highs after similar losses in Feb/Mar - so that recovery was only 3 months.

For anyone who has been thinking about getting started with an investment in any of the option selling CTAs - last week's market action represents an EXCELLENT opportunity in our opinion to get involved with these top rated managers at a discount of sorts, as you would have missed this volatility spike and the open trade losses associated with it.

Conclusion:

While nobody likes to see losses, it's unrealistic to expect an investment to make money each and every month. An investment is a return you receive for a risk you take - by definition - thus there is always some sort of risk. The risk of the stock market, and option selling CTAs became more apparent this week. But at the end of the day - the option selling CTAs survived the blow (there was not "unlimited" losses on the short option positions as the text books would have you believe). And that is the key, surviving to fight another day - a day in which you hope to get paid even more for the downside protection your selling.

The second lesson is that you can never have too much diversification, and it is always wise to look to add investments which are non correlated. The CTAs and systems listed in our first section above proved to be good complements to investments with stock market exposure during the volatility spike in Feb/March - and either by their make up (no stock market instruments) or statistical slant (no correlation) they should be able to protect your overall portfolio during stress periods such as this past week, adding to your bottom line while reducing the risk.