When Ira Kawaller worked for the Chicago Mercantile Exchange as director of the New York office, he was precluded from trading, but as he marketed the relatively new options on futures products, an idea for a strategy occurred to him that would eventually be the basis for his commodity trading advisor (CTA).
“I was attracted to this concept of the basis convergence and the idea of buying options from early on,” Kawaller says.
The concept is relatively simple. If the spot/futures basis favors a short futures position (futures price above spot), buy puts; and if it favors a long futures position, buy calls. It assumes that the current spot price is a better gauge of where the price will be in the future than a far out futures contract. “I position myself with options only when I find opportunities where the futures convergence effect works in my favor more generously than the time decay works against me,” Kawaller says.
“I actually promoted this trade in a Futures magazine article years ago, but I couldn’t do it on my own until I left the exchange and that happened at the end of 1998.”
Once on his own, with his strategy successful, he decided to register as a CTA and offer the strategy to customers in July 1999. With that, the Long Option Convergence Trading Program was launched. It got off to a rocky start. The program lost 55% in its first three months and ended the year down 45%. After a flat year in 2000, the program took off, earning 65.77% in 2001 and 264.43% in 2002. After a 23% drawdown in 2003, the Kawaller Fund has had a relatively flat performance until this year, up 8.94% through July.
“So much due diligence involves looking at track records,” he says. “I know from my own experience that things can change dramatically in a very short period. The true rationale for whether a [CTA] is doing something that you should embrace [is] a question of what their philosophy is.”
Kawaller’s own track record has been uneven and perhaps that is why he is so confident in his underlying philosophy.
“I have not been successful in raising funds. The reason being, the only people who are there are people that realize there is an underlying philosophy that is the basis for my activity; and they appreciate that the cost of doing business is high volatility. You have to be in it to win it and you have to be prepared to take the downside with the appreciation that the upsides are so great.”
While high volatility is still ingrained in the program that trades options on three-month Eurodollar interest rates and currency futures, Kawaller has greatly reduced the value at risk, which produced more than one 50% drawdown and a 12-month period that earned more than 400%.
“I have definitely become much more cautious about the amount of my available capital that I have working at any given time. Right now, less than 20% of my available capital is invested in options. At one point I had closer to 50% working, so I clearly have become more cautious.”
While more conservative, the strategy still shoots for home runs. “In a really good year, I would hope to see something like 80%,” he says, adding he hopes to keep yearly drawdowns to 10%.
Kawaller says he may be entering one of those strong periods as the program is on pace for his best year since 2002. “My best year was 2002. The yield curve was upward sloping as we saw futures interest rates higher than spot interest rates. With futures rates above spot rates (futures prices below spot prices) I was buying calls. For the entire year the upward sloping yield curve persisted despite the fact that interest rates were going lower.”
Kawaller says a mirror image situation exists today. “Three-month libor had been 5.38% for about seven months, and then we had this liquidity crisis and two things happened: with the flight to quality everybody bought Treasury bills [and now] three-month Libor today was 5.62%. And at the same time, expectations have put futures rates at a discount of 90-basis points; so the futures are betting that the rates are going to go down while they are actually going up.”
Before Kawaller launched this program he dabbled with option writing. “I had a really nice run — until it stopped.
"I got creamed and swore off option writing. These guys operating in relatively stable markets do fine but every so often they get creamed. I would rather have the surprises work the other way. When the surprise comes I want it to be big and in my favor and that is the way I am positioned.”