THE FOLLOWING ARTICLE DOES NOT CONSTITUTE A SOLICITATION TO INVEST IN ANY PROGRAM OF CERVINO CAPITAL MANAGEMENT LLC. AN INVESTMENT MAY ONLY BE MADE AT THE TIME A QUALIFIED INVESTOR RECEIVES CERVINO CAPITAL'S DISCLOSURE DOCUMENT FOR ITS COMMODITY TRADING ADVISOR PROGRAM OR DISCLOSURE BROCHURE FOR ITS REGISTERED INVESTMENT ADVISER PROGRAMS. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
As we begin 2007 and close the curtain on 2006, our first year of trading for Cervino Capital Management LLC, we look back at a year of many accomplishments:
- robust and positive performance – our Diversified Options Strategy program was up 0.46% for December and 10.35% for the year
- steady growth of assets under management
- established test investment portfolios in Master Limited Partnerships and Closed End Funds that exceeded S&P 500 returns
- an increasingly important role in the investment community stressed by speaking engagements on matters of finance at various academic institutions, and articles published in investment magazines and on websites
These accomplishments, however, are no reason to rest on our laurels as we recognize that the path to trading success is arduous and unpredictable. Year-end, on the other hand, is a good opportunity to make an introspective review our trading and risk management philosophy and approach. Interested investors should note that the best place to begin a thorough review of our trading program, associated risk factors and specific risk management strategies is our disclosure document. What can better be discussed here is the broader context in which our trading operates.
Our core philosophy is based on the principles of modern portfolio theory which states that, the addition of an uncorrelated asset with a positive expected return to an existing portfolio will increase that portfolio's risk-adjusted return.
While past performance is not necessarily indicative of future results, Barclay Group reports that our correlation to key indices (based on monthly returns Jan. - Dec. 2006) are as follows: S&P
-0.03, EAFE -0.18, Barclay CTA Index -0.32, and US Treasury +0.53. Within the context of a diversified portfolio of stocks/bonds and based on our correlation numbers and positive returns to date, an allocation to our program this past year would have likely enhanced the efficient frontier of the typical stock/bond portfolio.
At the same time proper diversification of trading styles is important when seeking to construct a robust multi-advisor managed futures portfolio. This is a complicated subject made much more difficult by the intricacies of standardizing/comparing performance records and risk/return profiles. Jack Schwager (of Market Wizards fame) wrote an excellent book on the subject we highly recommend called "Managed Trading Myths & Truths" which delves into various factors related to the evaluation of Commodity Trading Advisor (CTA) performance and the potential pitfalls and issues when comparing a CTA's performance with other CTAs or industry indices.
Below are some broad risk/return considerations when comparing our program relative to other CTA programs, and within the context of a multi-advisor portfolio:
1) Generally speaking we believe a good risk-return profile for CTAs is one that over the long run can consistently generate 2.5 to 3 times positive return relative to subsequent drawdowns. For example, a CTA that generates 30% return should manage peak-to-trough drawdowns to no more than 10%, and so on. Given that our fully-funded return objective is 10-15% annually, we designed our options program with the intent of keeping peak-to-trough drawdowns between 3-5%. That said we cannot guarantee that we can always contain drawdowns as such, and there is ample risk as better explained in our disclosure document for substantially greater loss.
2) Trading futures is less than a zero sum game; for every winner there is a loser plus commission. The key question is who in the futures market is taking money from whom (hedger, speculator)? What's the trader's "edge" (blackbox, scalper, etc.)? What type of market does the program best operate: choppy, trending, high volatility, low volatility, time horizon?
When putting together a multi-advisor CTA portfolio it is important to try and combine trading programs that are non-correlated and smooth out overall portfolio volatility. For example, a potential complimentary match is a trend following futures program with our program which often trades options on a contra-trend basis. While our options program may underperform a trend following program for any particular period, it is likely to outperform when markets are choppy or at turning points, thereby helping smooth out the portfolio's overall returns as this is most likely when trend following programs have difficulty.
3) The high degree of leverage in futures and options can work both for you as well as against you. Unfortunately many investors involved in managed futures are geared toward chasing "hot returns" without due consideration as to the risk/leverage that was utilized to generate outsize returns. It is a common tendency for many new CTAs to start out with strong proprietary or first year returns that quickly attract assets but also set up return expectations that are unsustainable over the long run, especially when assets substantially increase and capacity/liquidity constraints become an issue.
When we developed our Diversified Options Strategy the goal was to design an absolute return type program that reflected conservative performance utilizing a 15-45% initial margin/equity range. Rather than leveraging up performance in an effort to quickly attract assets, we sought to establish a program with reasonable and sustainable risk/return expectations. We think that is best done by setting specific performance goals and margin constraints, and then allowing investors to adjust leverage of risk/returns through notional funding.
4) In order to properly compare multiple CTA track records one has to take into consideration the cost structure (commissions, trading velocity, management/incentive fees, interest, etc.) reflected in the actual performance of each CTA being evaluated, as well as the respective "model trading levels" including leverage utilized (margin/trading level) to generate returns. Unfortunately, "model trading levels" are not standardized from CTA to CTA. Moreover, as margin/equity ratio is a misleading indicator of value at risk, standardizing the performance measurement of risk adjusted returns becomes complicated, especially when option trading is involved and time decay and probabilities are factors.
Most investors fail to recognize the nature of the returns they are analyzing; in many cases returns are just a function of leverage and higher risk rather than “alpha” or in layman terms the component of return generated by a trader’s skill. If not for the mechanism of price arbitrage with the underlying cash asset, as well as the insurance premium bona-fide hedgers are willing to pay, the returns that speculators in futures generate should largely be a function of skill or “alpha.” For previous generations of professional futures traders profitable trading opportunities were more easily exploitable. But now the playing field is increasingly competitive and a trader’s “edge” is more likely to be linked to a particular systematic approach that does well under certain market environments.
Options on the other hand are wasting assets linked to probabilities of an event risk. For the most part, premium writers can “allow time to do the heavy lifting” in producing returns. The trading model for pure option writers is simple, easily repeatable and generally profitable provided that again certain favorable and consistent market conditions prevail.
To a sophisticated investor we are restating the obvious. But this is where we believe ourselves to be differentiated from the majority of other CTA option programs which from our analysis tend to be one-dimensional and systematic in their approach…
Market conditions are constantly changing, bringing along with it new unforeseen risks. Regardless of instruments traded, we believe that what investors are ultimately hiring us for is our trading skill; that is, the skill in being able to recognize and adapt to different market conditions, readiness to exploit opportunities as they arise, and most importantly the flexibility to manage associated risk. With that perspective in mind, the question we constantly ask ourselves when working to adapt and refine our trading is whether we are increasing “alpha” or just leveraging risk exposure in order to enhance returns.
Paradoxically, a flexible and adaptive trading approach needs to be integrated within a disciplined trading/risk management framework, which for our program we have outlined below:
A) Unlike most other CTA option programs that focus only on the SP, Cervino trades a diversified portfolio which includes equities, currencies, fixed income, agriculturals, energies and metals. We routinely studies in excess of ten markets (SP, EC, JY, CL, GC, SI, NG, C, OJ, US, SB, HG) and our program is typically engaged in active trading on an average of 3-4 contracts.
By performing market analysis across a variety of asset classes and underlying contracts we expose our program to increased profit opportunities as well as diversify risk exposure. Additionally, we can observe the interplay between contracts and their fundamentals thereby placing ourselves in a better position to identify “viral” market risks.
B) Because options include directional, time decay, volatility and probability characteristics, various multi-dimensional strategies can be established on any single underlying contract simultaneously thereby diversifying opportunity and risk exposure further. For example, we may have on the SP between 3 and 6 different option positions/tactics in play at any particular time each with different opportunity objectives and risk profiles.
Effectively, the trading strategies we deploy are designed to capture returns in several ways, including but not limited to: (i) replicable relative value spread positions with the intent of capturing premiums; (ii) fundamentally based trades involving a directional trend bias that can be deployed through either long or short option positions, or debit or credit spreads; and (iii) opportunistic volatility plays that take advantage of option under- or over-valuations as well as trend reversal/mean reversion opportunities.
C) Our trading methodology allows for regular adjustment of positions as material shifts in market conditions may warrant. From a risk management perspective this is an advantage over many CTA systematic option writing programs we have analyzed and who typically rely on the probability that their routine option positions will expire worthless. But as a result, our program may have higher commission costs than other option programs.
What should also be noted here is the fact that the option markets have become increasingly efficient. Because we are “upstairs traders” and subject to bid-ask spreads, commissions and other costs/constraints such as market liquidity, our trades are essentially positional in nature with time horizons ranging from 2-3 weeks to 3-6 months. This increased efficiency has also impacted, but to a lesser degree, option floor traders/scalpers as bid-ask spreads have become tighter.
D) Most of the investing public harbor misunderstandings about the mechanics and risks associated with options as an investment tool. We typically establish option positions out-of-the-money where the probability that the underlying goes into-the-money is a major consideration. Such positions will start out with a reduced delta exposure relative to the underlying futures contract; in other words, a point move in the futures contract will result in a reduced directional movement in the options contract.
This is one of the important ways in which we manage account volatility. It also explains why the majority of our daily equity swings tend to be in the 10-40bps range, and why our program’s volatility is generally much lower than that of CTAs who focus their trading mainly on futures.
That said, the main risk concern with respect to short option positions is managing positions when either a trending market evolves against a strike price or an abrupt exogenous event occurs and option writes convert to a futures equivalent exposure. This is why when we write options or credit spreads our trading focus becomes keyed on risk management stewardship.
On the other hand the same above scenarios (trending market, exogenous event) work in favor of long option or debit spreads, assuming it is in the same direction as the established position; which is why when appropriate we encompass those tactics within our portfolio approach too. Alternatively, risk is inherently limited in long option or debit spread positions.
E) Another important underpinning in our managing risk is achieved through position sizing adjusted according to account size, volatility and risk-reward analysis. Generally we adjust positions sizes to $50k levels, and sometimes we refine risk exposure by changing the traded strike. Additionally, we may choose to increase or decrease position size/leverage based on our confidence level in a particular trade. And with delta neutral type strategies (strangles, condors, etc.) we may skew contract quantities to one side or the other.
F) Risk control is also achieved through money management rules and the utilization of stops (see Section 3.10 of our disclosure document for a discussion on risks associated with the use of stop-loss techniques). Occasionally we may adjust positions either by entering into new positions which hedge existing market exposure, or by liquidating/covering existing positions in order to reduce market exposure, or reset a position at a different strike price and/or contract expiration. For example, we may lift one leg of a credit spread to take advantage of a trending market, then “roll-up” and reestablish the credit spread at a higher level.
G) Lastly but just as importantly, what lies beneath our trading framework/methodology as outlined above, and what ultimately triggers trading decisions, is a blended analytical process combining quantitative analysis, fundamental studies, and technical and sentiment indicators. Our disclosure document goes into more detail on this aspect and should also be refer to for a more complete description of principal risk factors associated with our Diversified Options Strategy, something which cannot be adequately addressed in this piece.
When all is said and done, we feel that our approach is unique among many of the other CTA option programs. Our trading encompasses a core disciplined methodology yet allows for the application of multi-dimensional trading strategies depending on perceived market conditions, opportunities and related risk. The result is a program that is not static but dynamic and focused on increasing alpha rather then leverage in order generate consistent risk-adjusted returns.
This piece would not be complete without a macro-level analysis of the current market environment as that reflects in option valuations and by extension our program.
As indicated above, implied volatility is central to any option program and a key factor in the risk associated with collecting premiums. A review of our program's performance shows that three of our best four monthly returns in 2006 were during June, July and August. This is not by accident but reflects a period when implied volatility in the S&P 500 (as measured by the VIX) was at its highest for the year. At the time we were exploiting a premium capture strategy. Conversely, it is transition points in market volatility such as in May when the S&P first began its correction that indicate periods of greater risk to existing option write positions.
October and November 2006 has also been a period of high risk for option writers but for different reasons, specifically the strong trending stock market and imploding volatility. In fact, the VIX hit lows not seen since January 1994.
Sellers of options during this period have had to either increase their positions and/or place their selected strikes closer and closer to the underlying price in order to collect the premium/maintain the returns they have historically generated; or alternatively they have had to reduce risk and accept lower returns by selecting option strikes that are more in line with historical price standard deviations. Our response to this extreme market environment has been to shift more of our tactics to purchasing options through debit spreads. For that reason November ended up being our strongest month with a Euro debit spread position we put on the prior month working strongly in our favor as the contract rallied.
To emphasize this point here is a link to a chart going back to 1990 showing the S&P and VIX (the link also provides an interesting esoteric piece about the construction of the VIX). The chart clearly shows that from 2003 to present volatility has been steadily declining. Given the three year bull market in the S&P and the bear market in the VIX, the chart makes obvious in hindsight the reason for the performance/success of CTAs who just write puts on the S&P.
Our aim here is to illustrate that different trading approaches work best in different market environments. During the late 1990s, breakout and trending markets were a rarity in commodities and therefore trend-following programs generally suffered.
For option programs, however, return potential is not a function of markets going up or down, but of implied volatility which has recently evaporated. The time of greatest risk (as well as profit potential) for option strategies is when implied volatility diverges from mean historical volatility, which happens to be the situation now.
This raises two questions: first, is this trend in low volatility here to stay, or is it just a short-term phenomenon and we eventually return to a period when the VIX averages between 15-25; and second, how prepared are the plethora of option programs that have come into existence in the past few years set up to manage risk in a potentially different market environment in the future.
When all is said and done, we believe our primary job to be sensitive to risks and manage them when they arise. Backed by our many years of professional experience in the managed futures industry, we strive to be the “thinking man’s trader” and deliver for our clients a conservative yet robust trading approach that is a value-added augmentation to an investor’s total portfolio.
In conclusion and given that it is the beginning of a new year, we would like to try our hand at predicting the future and review a few elements we think will become part of this year’s strategy.
Continuing along the line of the last comments, we believe that 2007 will show increasing volatility across a number of markets: equities, dollar, possibly bonds. Volatility in crude oil should remain high and it should increase again in gold albeit not as high as this past spring. As stated in previous pieces, we still expect a recession sometime next year courtesy, among other factors, of a further decline in the housing market. Energy will prove to be a good buying opportunity after the recent declines and should a recession indeed occur and depress oil further we will look to accumulate the commodity.
Having said that, we endeavor to think flexibly and trade the markets as they evolve in real time. We will always strive to be agile enough to never act as if we are smarter than the market, and use prudence when constructing profitable positions with the benefit of our clients in mind.
We wish you a prosperous new year!
- Davide Accomazzo, Managing Director
- Mack Frankfurter, Managing Director
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