• Performance
• Services
• Company
• Learn About
• My Attain

Examining the Argus and World Capital Drawdowns

April 23, 2007

It's been a little over a month and a half since we wrote about the effects the Feb. 26th market down-spike had on investor's portfolios (and especially those investors with stock index option exposure). Well the market action in the 30 or so trading days since that spike lower has been nothing short of astonishing — with the market rallying over 8.5% in from the low made on March 14th.

But not everyone has been cheering the market higher. In fact, those stock index option selling CTAs which sell options on the call side have been anything but happy to see such a rally - as their seemingly well out of the money calls were suddenly close to, or in fact, in the money.

The losses for Argus and World currently stand at approximately -30% and -40% respectively based on our own estimates of client's accounts. While that isn't exactly the end of the world, and far better than the worst fears of option selling (being completely wiped out), it does represent new max drawdowns for both programs, and that needs to be addressed.

What happened?

The short answer as to what happened is that the market rallied 117 points in the S&P futures in just 26 trading days, or 8.5%. To put that in perspective, that's about 1/3 of 1% gain per day, which works out to an annualized rate of return of 79% for the S&P, which is only about 10 times its historical average and obviously not a sustainable pace.

But what's more - the move kept accelerating coming into the April options expiration (last Friday), with a 5.29% gain in just 15 trading days since March 30th (an 84% annualized pace), and a 2.2% gain in just 5 days last week (an amazing 113% annualized pace).

The more involved answer is that both Argus and World got caught with their hand in the cookie jar a little bit with this big bounce after the Feb. 26th big sell off. What we mean by that is that the sell off signaled that the market had made a dedicated shift to lower levels on that big move lower. That caused both managers to lower their "upper band" so to speak, which has a very low probability of the market going above, and that is where they sold the calls, over 100 points away from the lows made in the middle of March.

While we don't have space to get into the complicated math for calculating the probability of the market actually going above those strike prices based on the prices they were sold for - suffice it to say the probability was well below 5% as represented by the price the calls were sold at. But as engineers like to say - the probability was still greater than 0% - and this turned out to be one of the cases where the market ignored the probabilities and rallied at an amazing pace right up to, and then through the strike prices of the options each manager sold.

The end result was the option prices spiking nearly 10 times the amount the underlying market rallied. For example, the May 1500 Calls both managers were short went from a price of just 1.25 on March 21st to 12.60 as of Friday's close (a 900% gain). It's worth noting that a 900% gain in the option price did not bankrupt or complete wipe out any of the short option sellers accounts, as the text books telling you that short options have unlimited risk would have you believe.

Where do we go from here?

So now that we know what happened, the bigger question is where do we go from here. Are these managers "broken"? Should you stop trading them? What are they going to do differently if the current market environment persists?

These are all great questions, and ones we put straight to the managers themselves to answer.

Comments from World Capital :

This (the April trade) has been a trying time to say the least. What happened has NEVER happened before in all our history of trading this strategy. Here is what we are referring to. From Feb 20th to April 20th (60 days) which is virtually our trading period, we saw the market FALL 5% and then RISE 7%. NEVER before have BOTH boundaries been tested in the same trading period. We've seen both boundaries tested on two different trades but NEVER on one trade. If that's not an anomaly we don't know what is. We've only seen two things that blew us out of the water since we started - 9/11 was one and this is the other.

We fully expect a little more upside pressure early next week before we see some profit-taking kick in and give us a little relief. When we do get a break we may exit the sold 1500 and 1505 calls as any significant pullback has not held very long.

We are in the process of evaluating this trade as it applies to our program. No strategy or methodology can account for all market anomalies such as what we just experienced. There is no way to avoid losses. In saying this we will make the necessary adjustments to our parameters to mitigate another situation such as this. It is important to realize that our methodology has been validated per about 5 years of trading plus significant back-testing.

Comments from Argus:

Over the past month we have seen the market not only discount concerns of a slowing economy, increased delinquencies on mortgages, etc. but turn to new highs on this news. Last week alone we saw a 2.2% gain for the S&P.

Although we feel we have exceeded the top end of the range on the S&P, we need to readjust our stance on the market. We are closing and will be closing out the current 1500 May call positions and moving farther away from the market to approx 1535 level for May. We will also look to sell put spreads, hopefully on a down day, approx 7+% away from current market levels.

Obviously being only 1% out of the money a week before expiration under current market conditions was not enough. We will look to close out positons prior to expiration week unless we are more than 2.5% out of money. If that is the case, option premium should be less than $100 per position, and would probably close them out anyway.

As for whether these programs are "broken", as we've said many times before in relation to systems, they don't break, they just become more risky. And that is the case with CTAs as well. It is not as if they will never work again, but you need to reevaluate the risk parameters.

But we do believe that drawdowns in option selling CTAs need to be treated a little bit different than drawdowns in more traditional multi-market CTAs or trading systems. Past performance is not necessarily indicative of future results - but option selling is a strategy in which you get "paid" to take on the risk of events like these happening. Being successful over the long term with an option selling strategy means taking in as much premium as possible between periods when a spike takes some of what you've been "paid" away from you.

Attain Comments:

The first thing Attain likes to see in managers during times of stress for their programs is that they are still on top of everything that's going on, managing the risks, tracking the accounts, and doing all they can to make sure everything is as under control as it can be.

On this score, both Argus and World have been accessible to Attain throughout the past week (when approximately 75% of the drawdown has happened), and proven to us that they are not "deer in the headlights" unable or unwilling to manage the risk and positions. That speaks volumes about their firms and abilities as managers - and tells us that the program's losses are not due to user error on the manager's part, but rather markets merely going the wrong way.

But having said that, investors pay these managers to manage the risk as best as possible on their behalf; and its prudent to ask whether the manager should have done better in the current market environment. Indeed, investors should take any drawdown opportunity to evaluate whether the manager they have employed is doing what the investor expected in terms of risk control and management, while comparing their performance to other CTAs who were active in the same environment.

As for specific comments, we know Argus Capital has a bearish slant on the market, and will tend to do poorly during times of quick up moves like we've seen here. But they also made a good deal in February when the market was down. So Argus remains a valid choice for those investors who are otherwise making a good deal of money during this stock market rally. Argus isn't destined to do poorly in all up markets (after all they made 50% in 2005 when the market had a nice slow climb upwards). And Argus has been active in rolling away form the market as the strike prices have been approached. This books losses, but keeps the account from being in danger of very big losses (50,60,70% +) Finally - we like Argus acceptance of the "current market conditions" in his commentary above, and move to now require his strike prices to be at least 2.5% away heading into expiration week in order for the program to hold onto the position.

World Capital has blown past their previous max drawdown during this "anomaly" as they call it, in which first their Put side positions were under pressure, and then a month later their call positions were under pressure, and that in and of itself if very worrisome. Whether World should have not exited their Put side positions, or should have exited their Call side positions is 20/20 hindsight which won't get us anywhere. The more useful exercise is to accept that World has a new risk profile with a larger drawdown, and weigh the performance in that light. They have shown in their past performance that they are capable of recouping this drawdown, and even more so if market volatility remains above its past three year levels as it is now. They also believe with certainty that the market will not continue to run up (or down for that matter) at a 80% annualized pace as has happened over the past month, and that will mean better times ahead of World. Finally, we are encouraged to see them state in their commentary that they will make the necessary adjustments to their parameters to avoid any future such losses - although I believe more detail is needed.

- Jeff Malec