This is the 19th year Futures has profiled emerging commodity trading advisors (CTAs) and it has been an interesting year. While in general it has been a very positive year for futures traders, 2008 also has included some major reversals that had the capability of wiping out several months of profitable trading. Risk management has always been a key element of any manager’s strategy and that has certainly been the case so far in 2008.
We have noticed a return of managers interested in traditional commodity markets and a large group of new managers in general. The Barclay Hedge database of managed futures programs includes 953 managed futures programs, nearly half of which were launched since 2005.
When reviewing candidates, we look at not only recent performance but also overall performance and the manager’s general approach to trading.
This year we once again looked at where a manager’s allocations came from and their fee structure. While acknowledging that raising money with short track records is extremely difficult, we favor managers who refrain from taking allocations from futures commission merchants (FCMs) or introducing brokers who charge added management fees or exorbitant execution fees.
It was disturbing to see numerous relatively new managers with above-market fee structures. The normal fee structure is a 1% to 2% management fee and a 20% incentive fee; we see a 25% incentive fee as reasonable if no management fee is charged. Anything above that is unreasonable for an emerging manager. Previous “Hot New CTA” profiles have gone on to great success and some have slipped into obscurity. This is not an endorsement but a review of new talent. We would like to thank all the managers who sent us their documentation. We will do this again next year, so look for our announcements.
Stepping up to the plate
Bob Meara has spent more than 20 years in the futures industry working all types of jobs: from a quoter, to working on a trading desk, to a risk analyst, to an operations manager, to a margin clerk, to a compliance officer and eventually to a broker. He says that to work in this industry you at some point have to have a desire to trade.
“Anybody who has gotten in the business that doesn’t have a little bit of the trader in him, probably shouldn’t be in the business,” Meara says.
So with 20 years in, Meara launched his CTA, MAD Group Investment. Meara has put together his years of experience into this discretionary CTA that trades based on both technical and fundamental inputs. His approach is as far from systematic as you can get. He trades mostly physical commodities with the exception of energy. He trades futures and buys and sells options. His trades last on average 30 days but he will trade longer if he is hooked into a good trend, like what happened in the corn at the end of 2007 and into the first part of this year.
“We got in corn when corn was $5.35 last year and held that out until $8. We were able buy corn all the way up,” Meara says.
He has an Aggressive program and Standard program. The Aggressive program, in addition to using more leverage, will also day-trade on occasion.
The Aggressive program is up 35.15% as of August but has pared down its trading due to recent volatility. The standard program has earned 16.24% through August.
“The difference now is that nothing is really trending. Gold is up $20 one day and down $20. I haven’t taken too many positions in the last two months because of the volatility,” Meara says.
The day we spoke, Meara bought Dec. $8 silver puts at 5¢, or $250 per account. “That is the kind of trading I am doing now because the volatility is stopping you out so much. If you are going to play these markets, you have to play things that are out of the money and not going to cost you too much.”
Meara goes through the technicals first, looking at daily, weekly and monthly charts, examining the parabolics and determining support and resistance levels. From there, he will see if the fundamentals match up and he will put on a position. But there are no hard and fast rules. “Right now my strategy is to sit on my hands and when I see something that I want to take a shot at, I buy an option. It is all based on what the market will allow you to make.”
In the first six months of the year, MAD traded a lot of grains because they were trending. MAD made money in corn, soybeans, soybean oil and coffee. The aggressive program earned 48.87% in February and retained more than half of those gains through the March reversals.
“I don’t care what I trade, as long as I have a chance to make money. I will take a chance if it looks good on the chart. If it is cocoa, I will trade cocoa,” Meara says. “If I come in tomorrow and see a double bottom in cocoa, I will trade cocoa. Have I done a cocoa trade this year? No. I trade what I have the best chance to make money in. When I don’t trade it is because I really don’t see too much out there or because the volatility is so great. There is no reason to be spending money in a volatile market that I see other clients getting chopped up in and losing money hand over fist,” Meara says.
The only hard and fast rule is that he will only risk $1,000 per trade per account. After years of working in the more obscure aspects of the industry, Meara is in the middle of the action, having fun and making money for his customers.
L1: Applying good science to trading
Jon Zimmerman and Elliott Waldron, co-founders of L1 Partners, have each spent more than a decade applying quantitative analysis to a host of business related goals and in 2007 they began to apply their massive quantitative knowledge to tackling the markets.
“The principal strategy grew out of something that I had been working on in my basement and traded a little money with,” Zimmerman says. “The basic strategy is one where we had been [working on] pattern recognition and prediction problems for a number of years using transaction data for people making purchases. We built up experience in dealing with noisy data and weak signals. We used the methods and techniques for solving prediction problems in other business contexts.”
What resulted was a short-term diversified systematic reversal model that is completely automated. “The computer wakes up at midnight Seattle time and starts trading and keeps on trading until 10 p.m. Pacific time,” Zimmerman says. “We typically trade during hours of good liquidity in the markets we trade. The hours it trades an individual market depends on the liquidity of that market.”
Zimmerman and Waldron were keyed into the Seattle tech community. In fact, Rich Barton, founder of Expedia where Zimmerman worked, encouraged them and provided seed capital to the Seattle-based commodity trading advisor.
The model is directional and trades 25 markets and is constantly on the lookout to add more. “We believe philosophically that this business is all about doing good science, doing good science meaning being very careful in how you go about moving models from research into production and making sure that not only are they sophisticated enough to capture the phenomena in the market, but not too sophisticated that you run the risk of over fitting,” Waldron says.
So far the program has been as consistent as a Seattle coffeehouse. It has earned 21.7% since its April 2007 launch with a worst drawdown of 6.80%. L1 is up 15.51% year-to-date through August. Its Sharpe ratio is 1.03 and it has produced on upside/downside standard deviation of 3 to 1.
“Each time a signal comes in [the model] will adjust the position in the market. In some cases it may tell us to [add to a position], in some cases it may tell us to scale down and some cases it may give us a signal in the opposite direction that may cause us to go from long to short.”
The model is constantly calculating the next signal so stops are not necessary. “We don’t have stops and we don’t have profit targets. The system trades quite frequently,” Waldron says. “Primarily we are letting the signals tell us how to manage the portfolio; we have built a risk overlay system on top of the trading system. Each trade time checks our risk and based on our criteria if the risk is too large it will automatically scale back on all the positions.” Their model hinges on their skills as software developers. “We view software as one of our core competencies and to effectively trade a strategy like this you need a robust software system in place and we feel that we have developed one,” Zimmerman says.
Often when experts apply knowledge from another disciple to trading futures, they select the most popular sectors like equity indexes or forex, but L1 planned to apply their know-how to as large a group of markets as possible from the beginning.
“We think we get a lot of research benefit by being able to test our models across totally different product sectors. The only way we would put a model into production would be relative to a requirement that it would have to perform across a whole bunch of sectors,” Zimmerman says.
And given that they produced a completely automated systematic program, their timing was perfect as whole sectors just established liquid 24-hour electronic markets.
“We picked a good time to get in to futures, we picked a good time to end up as a short-term systematic fund. The timing has just been very good for us. I don’t know if we set up to end up where we are when we started but we are fortunate to be here right now,” Waldron says.
The long and short (vol) of it
Like many traders, David Bedford, president of Crescent Bay Capital Management, has a background in quantitative research and science. Bedford was working as a research analyst in the mid 1990s when he began investigating trading methods.
He didn’t take much stock in the work of so-called “investment gurus” and went back to his roots in science. Bedford did a lot of testing of short-term index strategies but didn’t trust backtest results. “I wasn’t comfortable that backtesting was the way to go, what we do now is based on experience,” Bedford says.
And what Crescent Bay does in its Premium Stock Index program is sell naked options on the S&P 500 with a focus on risk management. The program is statistically based and about 75% systematic and does not use standard support and resistance measures to determine entries and exits.
The program is not market neutral but has a short-term market bias. “We are biased the first day of entry. If we have an up market for the day breaking to new highs we will not be selling calls,” Bedford says.
“When the market opens and it is heading lower, I don’t want to sell puts; I want to see a reversal in the market, I would sell calls. If it is trending down I will sell calls, if it is trending up I would sell puts. You are selling opposite of where the market is going.”
The program will get a little closer to the fire — selling strikes roughly 100-150 points away 30 to 45 days before expiration — but almost always takes profits prior to expiration.
The program gets out once it reaches 80% of its profit potential on an option. “We skim the cream and then we move on,” Bedford says. “We sell a lot closer than most options sellers, which is interesting because when we are buying back our options most of the time they are being sold to us by other premium sellers. The time decay on an option really slows down when the option gets to a certain price and that is where most option sellers are selling them. In essence we are taking the cream off of the top.”
Crescent Bay adheres strictly to its stops and will not roll to further out strikes when things get too close. “We will hit our stop and then take another position. [Rolling] is just building a bigger problem; you are not addressing the problem just putting it off,” Bedford says.
The program is up 18.08% through July and has produced a compound annual return of 19.11% since its October 2005 launch despite 2007 being a tough year for option writers. Crescent Bay managed to eke out a small profit, 2.09%, that year and Bedford says the experience was a valuable lesson. “We learned discipline,” he says. He was also working on his next program, Balanced Volatility (BVP), which he launched in August 2007.
“The goal [of BVP] is to isolate time decay and try to take the market movement variable out of the equation,” Bedford says. The program trades diagonal calendar spreads. It is different than bull or bear or credit spreads.
“Every option program where you are selling options, even in a vertical spread, [is] short volatility. With the BVP we are net neutral to long volatility, It is very hard to create that,” Bedford says. A typical position would be short September puts and long further out-of-the money October puts.
“It has less risk and you have the potential for a home run, which you don’t with a pure option selling program,” he adds. BVP has grown extremely fast and now has more money under management that the stock index program.
“If you have a portfolio of CTAs, including some options writers, you are short volatility,” Bedford says. He says by adding the BVP to his original program or to another option writing strategy, you bring your overall Sharpe ratio much higher.
And that is the long and short of it.
