From the April 01, 2007 issue of Futures Magazine • Subscribe!

Scully: Long volatility short risk

Richard Scully first became interested in commodities trading growing up on his family’s corn and soybean farm in Central Illinois. That experience is what led him to take a position at Paine Webber’s futures division in 1983 upon graduation from Middlebury College in Vermont. At Paine Webber he researched grain markets and studied technical analysis, which eventually led to the creation of his Evanston, Ill.-based commodity trading advisor Scully Capital Management.

Momentum, breakouts and value investing are also part of the system, but Mistral does not rely solely on any of those disciplines. Instead it is based on exploiting three common behavioral errors of traders.

“We are looking to exploit behavioral errors. Identify them and quantify them in terms of degree,” Scully says.

Those three errors are over-reaction, under-reaction and complacency. Which error the market price is reflecting at any given time would be indicated by a particular trading strategy.

According to Scully, under-reaction errors can be indicated by momentum, price and volatility breakouts; over-reaction errors can be indicated by a market’s price relationship with historical value, and complacency errors can be indicated by low volatility and price consolidation.

“What our work has done is quantified each of these elements to get to a mathematical expectation of a trade,” Scully says. While he uses breakouts, momentum and value elements, the system usually will not signal an entry unless more than one of these indicators is present.

“We do not use a simple momentum or breakout strategy. What has made us different is our ability to filter out trades with lower expectations and concentrate on higher expectation trades” Scully says. “In general Mistral tries to predict a breakout before it happens rather than react to breakouts.”

If the system misses a breakout the momentum element may get it into the trend. “A breakout trade strategy is simply

an entry technique. It reflects the anticipation that there will be momentum or a trend,” he says, adding, “We always are looking at multiple factors.”

One factor is value. Scully notes that several commodities have been historically undervalued in recent years. He says if a commodity is trading at two standard deviations away from its 15-year average, there are opportunities for a profitable trade based on value. “Cotton is currently below its 15-year average price. It becomes much less interesting to short a commodity when it doesn’t have a relatively high valuation.”

The Mistral program will either not take a short signal or reduce the allocation if the value element is not strong. Usually a trade signal must be supported by more than one indicator. “Two of three generally will need to be there to trigger a trade,” Scully says.

He compares it to using three thermometers. “If one element is very hot, we might take a trade. We might take a trade if two elements are warm,” Scully says. “We are averaging the temperature over the three key elements: under-reaction, over-reaction and complacence. Under-reaction is indicated to us by either momentum or a breakout. Over-reaction is indicated to us by gross undervaluation or gross overvaluation. Complacence is primarily indicated by low volatility, sideways markets or consolidation.”

Diversification and risk management also are important parts of the program. His program allocates up to 60% of its trades to physical commodities and there are specific risk limits for each market and each sector.

“We will, in general, not have more than 1% risk for any given trade or 3% to any sector where the commodities are correlated.”

The program is 95% systematic. Scully says he will use discretion when rolling positions and in his risk management. The system will have open positions in five to 15 markets at any given time. If there are many positions on he may choose to lower risk levels to maintain positions. “If we have a number of trades on we may tighten up our exits so the total portfolio risk is lowered. We will never exercise discretion to increase risk — never.”

“Volatility is a key element,” he adds. “Low volatility acts like a catalyst enabling us to get a bigger bang for our buck.”

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