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Lessons from the 2/26 market sell off and volatility spike (Dow -4.2%, Nasdaq -6.2%, S&P 500 -4.4%)

March 5, 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 (and more today). Markets across the globe sold off impressively for a single session on Tuesday (the Dow down over 400 pts), and the major indices in the US finished the week down more than 4% on average.

There's an old saying in the investing world that the market will always try and inflict the most pain to the most people, and that certainly was true last week for the general public holding on to a portfolio of mutual funds. The question coming from those folks this week is what investments are not correlated with the stock market.

And if we extrapolate that saying over to managed futures - where CTAs specializing in selling S&P 500 futures options and volatility have become very popular over the past few years - it's no wonder that the market put a scare into a lot of people invested in option selling CTA programs like ACE or World Capital. The question from those people centered on damage control (how bad is it, and how long will it take to recover).

And finally - those investors who had extra cash on the sideline, or are now looking to reallocate some stock/bond/futures holdings, asked the question of what is likely to do well in this current market environment with volatility nearly twice as high as it was during the better part of the past two years.

The discussions below highlight these questions we've been getting from investors since last Tuesday and the collective thoughts of the Attain team on each:

1. What trading systems are 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
FCI - Commodity Options Program	50.0%	performance	-0.045
Phoenix Energy	12.5%	performance	0.108
NDX - Abednego Program	56.2%	performance	0.140
NDX - Shadrach Program	142.0%	performance	-0.220
Dighton Capital USA - Swiss Program	75.9%	performance	0.448
(sorted by closest to 0.00 correlation)

Special mention here should go out to the Argus Capital CTA, performance, who despite a strategy of selling option spreads is actually negatively correlated to the stock market (-0.66) - and managed to post returns of about 6.5% in February. His secret, selling mostly covered call spreads, which gives the program a slightly bearish slant. The idea behind having a bearish slant is that it is an alternative investment - meant to do well when "normal" investments are not.

 

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 and Fusion). 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
Bounce ERL	performance	0.003
Rho H/3 DAX	n/a	-0.012
Spectrum ERL	n/a	0.020
Jaws US 60 US	performance	0.021
Impetus ERL	performance	-0.032
BounceMOC ERL	performance	-0.032
Tzar ES	performance	-0.039
Targets ERL	performance	-0.043
HP Intraday Breakout ERL	n/a	-0.046
Delphi EURUSD	n/a	-0.050

 

2. How did the option selling CTAs fare ?

As you might expect with the huge spike in volatility - option selling CTAs took some heat last week.

	Volatility spiked nearly 80% higher on Tuesday, taking option premiums right up along with them, and causing February losses for the following stock index option selling CTAs:
	Option Selling CTAs (Feb. estimates)
	Zenith Index:...................................-2.9%
	Zenith Diverisifed..........................-4.3%
	World Capital:.................................-6.5%
	Zephyr Aggressive........................-6.5%
	Zephyr Moderate:..........................-9.7.%
	ACE SIPC........................................-16.0%
	Argus Capital:.................................+6.8%

The lesson to be learned here is that there is a risk in these types of strategies - to the tune of one week losses equal to a few months of gains. But there are a few silver linings here.

One, these types of moves don't happen every day. In fact, the only similar move was back in 2001 following the 9/11 tragedy. Take the Zenith Index program as an example - and you can see that Zenith lost -3.1% in September of 2001 - then went on to make 155% over the next 51 months until losing -2.9% in February. 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. Last week was one of these periods, and quitting now would be similar to an insurance company paying for your car repairs - and then firing you as a client and not taking in anymore premiums to offset the expenditure they just made. That wouldn't be a good way to run an insurance company, and it isn't a good way to approach the past week's losses for option selling CTAs either, in our opinion.

The second silver lining, and one more important for recouping some of the losses from last week - is that the item the option sellers are selling - option premiums - have nearly doubled in price, as represented by the Vix chart above. While that causes pain in the short term, it means the advisor can sell the same positions for about twice what he or she used to moving forward. Imagine an oil producer like Exxon Mobil, who sees the price of Oil double. There may be short term pain while people cut back on consumption - but eventually people will need oil and Exxon Mobil is now receiving twice what they used to without any additional cost. No wonder they made $113 Billion in profits last year.

So 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 March 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. And if its another 6 years until the next volatility spike - that will be time well worth waiting.

Finally - 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 the February of 2007 volatility spike.

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 get paid twice what you used to to engage in that fight.

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 in February - 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.

- Jeff Malec