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 I sit down to write the first quarterly market review for 2007, I've been replaying February 27th’s abrupt fall and our trading in response, searching for clarity to the causes that precipitated the sudden bout of volatility on that date.
For the quarter ending March 31, 2007, our Diversified Option Strategy program returned a negative 3.59%. Regrettably, we have to analyze our first negative quarter, along with the first negative quarter for the Dow Jones Industrial Average in quite some time, which makes it more so disappointing when compared to our absolute return mission.
It turns out we got what we wished for… ironically, just a little too fast and a little to dislocating than what we had bargained. So it is not without some pain that we zoom in on the negatives along some positives.
At the end of 2006 we were pointing to an extremely low volatility level – especially in equities – which in our view did not correctly reflect the risk built into the market. As we grew more and more uncomfortable with the market complacency, we built hedges to our routine S&P 500 short puts. However, performance anxiety forced us to have positions, that although hedged, in hindsight we may have preferred not to have at all. From a probability perspective the statistical chance of such a storm at the end of February were rather slim and so we rolled the dice.
When the correction hit it developed in a span of a few hours, the machine of the NYSE jammed, the market grew unstable and volatility had its quickest and largest percentage-wise jump in more than a decade. The VIX, a key indicator for option traders, almost doubled in a couple of hours and the DOW made a precipitous fall of 200 points in a matter of minutes.
While we moved to cover our most aggressive positions, gamma exploded and uncorrelated markets began to move suddenly in sync due to fire-sale liquidations across the board. The technical problem at the NYSE unfortunately exacerbated the situation creating the condition for what we typically refer to as the “exogenous event.”
In our stress testing calculations, we run scenarios for this kind of day and we had calculated that an event of such characteristics would probably cost the portfolio around 6.75%. On a daily basis that level was approximately our max drawdown and on a monthly basis we finished February down a little over 4%.
It is at these times that a trading program’s risk management principles involving risk-of-ruin scenarios comes into sharp focus. The way our strategy responded seems to indicate that under duress our approach works and our backtesting was indeed on the mark.
We think the key difference between our approach and other option players is to quickly liquidate/stop out problematic positions in order to reduce exposure. It is our understanding that certain other CTAs employing option strategies held onto their positions. For some this gamble paid off because the market came back strong by option expiration date; for others they were forced out of positions because of margin calls.
The question to ask, though, is what would have happened if the market kept falling?
To one degree or another, premium capture strategies involve probabilities. Stops, however, tighten standard deviation parameters and increase the probability of booking losses. Booking losses makes it more difficult to regain positive performance because of the need to reset positions and time to recapture premium. However, not employing stops increases account volatility and the likelihood that at some point there will be substantial losses.
The interesting aspect that resurfaced in light of this recent market action was that a marketwide repricing of risk leads positions to move in the same direction. Thus the primary lesson of 1998 was revisited in February and our being less levered than some of our competitors made it is easier for us to weather the spike in volatility. In the end, a directional prognosis may be correct, but over-leveraging a strategy exposes investors to an insight attributed to the economist John Maynard Keynes, who is said to have warned that although markets do tend toward rational positions in the long run, "the market can stay irrational longer than you can stay solvent."
After a debacle, the first instinct is to come back as quickly as possible; we felt that the new volatility parameters were now in our favor for enhanced returns. Unfortunately, while we were well positioned to take advantage of a further downside move with the expectation that our debit spread would widen, the market followed our worse case scenario and reversed almost straight up after coming straight down.
While we still think that overall increased market volatility will help us in generating solid returns going forward, we have decided to ease into the new market environment incrementally. We recognize that volatility is our friend but it also represents new and still unresolved issues in the financial environment.
We ended March positive though still far from breakeven. We look forward to the rest of the year and while the top range of our annual performance objective now seems a bit rich, we still believe that the low-end, ten percent, is still in the cards.
- Davide Accomazzo, Managing Director
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