Commodity traders need to prepare themselves for the worst-case scenario. Your worst drawdown is always the one ahead of you. The markets are unforgiving, especially with leveraged vehicles. One can look at 2008 as well as 2001, 1998 and1994 for periods with massive disruptions and tremendous volatility. When you are convinced of the rarity or the impossibility of a six-sigma event (six standard deviation move thought to be statistically impossible under a normal distribution assumption), you are open to risk of ruin.
These six-sigma events in the markets seem to be occurring in greater frequency. The goal of commodity traders is to produce positive returns while managing their risk. Too often traders delude themselves into thinking correlation ratios are written in stone. What may be proven as a concept does not prove certainty; there is no certainty in the markets. The irony is that by studying correlation to reduce risk, traders can expose themselves to greater risk through making faulty assumptions.
There are well known assumptions in various markets regarding correlations that supplement this delusion. We assume a perfect negative correlation between gold and the U.S. dollar; gold and the Swiss Franc generally trend in the same direction. There is the correlation between the Canadian, Australian and New Zealand dollars to commodities. There is the correlation between the Canadian dollar to oil prices, as it is a major exporter. Conversely, there is the Japanese yen, which is at risk because of rising oil prices as it imports most of its oil.
These correlations are real and knowing them can be helpful, but they are not law. As much as we rely on these correlations in asset allocation, we must realize they can change and, in extremely volatile markets, break down.
The correlation between crude oil and the Canadian dollar from 2006 to 2009 exemplifies this. The markets had a correlation of approximately 0.8 over long periods of time; however, in January of 2008 there was a major divergence (see "Side by side," above).
Gold and the U.S. Dollar Index is in near perfect negative-correlation most of the time, but look what it did for nearly three quarters in 2010. "Best buddies," (below) shows not only that the dollar and gold aren’t always polar opposites, but sometimes move together.
Even with today’s powerful correlation platforms that try to give traders confidence, they miss the fact that just because a correlation exists or existed over time, they can and do change. There will be times when these strong correlations even may reverse.
Commodity traders can be misled easily by using correlation studies. An example is a trader who does a correlation study on the euro and Swiss franc. These currencies can be negatively correlated 95% of the time. However, when market volatility increases and the U.S. dollar strengthens, they become highly correlated.
These types of correlation flips can be fatal for the arbitrageur highly leveraged in similar markets, but also can be dangerous for the trend-follower adding risk based on the belief that he has a well diversified portfolio. Trading a diversified group of markets allows a trader to take on more risk than if all that risk capital was concentrated in one market or one sector. Diversification, however, implies non-correlation and, as correlations change, so does the level of risk.
David Ricardo accumulated a fortune through trend-following in the 1700s. He had several simple trend-following rules: Never refuse an option when you can get it (identify via relative strength markets that seem to be trending), cut short your losses and let your profits run on.
Ricardo’s idea of using relative strength can help traders identify which markets to trade. Relative strength is identifying the strongest and weakest trending markets and can be determined by rate of change. Each market has a score, making it easy to identify the weakest and strongest. This could become your universe for trades. As opposed to trading a group of non-correlated markets in a trend-following approach, you can pinpoint your best options using the relative strength method.
Risk should be measured in three ways: Risk per trade, risk per sector and total portfolio risk or portfolio heat. The more risk per trade, the more volatility in your account.
Choose your own risk tolerance, but a good gauge is not to exceed 2% risk per trade. Risk per trade is how much money you are willing to lose on a trade based on your account size. An additional filter to include is maximum dollar risk per contract; 1% risk on a $200,000 account is a maximum risk of $2,000.
The next issue to consider is the maximum risk per sector. All markets in the same sector are correlated to some extent. Gold is correlated to silver, copper and even palladium. The same can be said for the interest rates, grains, currencies and stock indexes. You can have an appropriate level of risk per trade, but if you are trading Eurodollars, two-year-, five-year and 10-year-notes as well as the long bond or six currencies against the dollar, you have quite a bit of concentrated risk. You can wake up some morning seeing all those positions going against you. Consider a maximum of 5% risk of your account in any particular sector. This should keep you out of trouble, yet enable you to participate when there are trends. It also can help you select the best opportunities in markets within a sector.
The most important issue in trying to achieve risk-adjusted returns is to know how much total risk is in your portfolio. This total risk, or heat, is in your control and is your worst-case scenario. Look at your core equity, that is the equity in your account if you were stopped out of all open positions, and see what your open trade risk is. You must have a maximum percentage that is preset and written in stone as part of your rules. A maximum portfolio risk of 20% is a good standard. Assuming a diversified portfolio, there is almost no way you would see such a loss, but if you did, you would survive.
By keeping your total risk at safe levels, you are protected from sharp shifts in correlations. As they say in volatile times, all correlation tends to move toward 1.0. However, traders, particularly those managing other people’s money, should attempt to keep their risk capital consistent. In 2008 many futures markets became highly correlated. This fortunately led to strong returns as many trends developed, but smart managers reduced their position size as a result. This helped them shrink losses as market reversed in the middle of the year. It also probably kept down losses in what was a difficult 2009.
When diverse markets begin to move together, it means you have more risk. To keep your risk consistent, you must reduce position sizes.
Andrew Abraham has been investing in commodities and managed futures since 1994 and is in the process of registering his CTA, Abraham Investment Management, with the NFA. His blog is MyInvestorsPlace.com