From the September 01, 2011 issue of Futures Magazine • Subscribe!

The short-term trading dilemma

"Cost of trading" (below) summarizes the total cost estimates for various styles of trading programs.

Clearly, short-term trading is expensive. Every time the trading frequency is doubled, so is the trading cost. There is an additional, fuzzier and more insidious "cost," and that is capacity. If we double the trading frequency, that simply means we are trading twice the number of contracts per day than previously. Directional traders generally want to avoid having a noticeable footprint in any given market, as they fear others front-running them or arbitraging away their informational advantage. To maintain a constant footprint at a trader's comfort level of market participation, this requires halving traded assets under management (AUM) every time a trader doubles the system trading frequency. In other words, if one believes that $9 billion is a reasonable upper bound for a trend-following system (again at a 12% annualized volatility), then a typical short-term system would need to cap its trading level at $3 billion to maintain the same trading footprint. A higher-frequency, short-term system that holds positions only for hours would see its capacity limited to somewhere around $250 million – $750 million (again at 12% annualized volatility). Cleverer execution strategies, better diversification across markets and other "engineering" feats can alleviate the constraints to some extent. But the scaling laws outlined above are as unavoidable as death and taxes.

Another considerable challenge with short-term systems is risk management. Trend-following, by definition, is a loss-limiting strategy. With trend-following, positions that move in a trader's favor are maintained or even strengthened, while unprofitable positions are neutralized in fairly short order. This typically gives rise to a positive skew of returns. On the downside, positively-skewed return profiles are necessarily intermittent; much of the overall portfolio return comes in bursts of performance represented by the positive tail. On the upside, the drawdowns generally are less deep than for a non-skewed strategy with the same Sharpe ratio. Trend-following systems can chop around for a long time, but eventually they tend to pay off in brilliant bursts of positive performance.

Most short-term systems, in contrast, look for anomalies. Although they aren’t necessarily mean-reverting by design, they often share features exhibited by the so-called "relative-value" strategies common in the equity space. These are strategies that, for example, seek to exploit price anomalies between over-valued and under-valued stocks (statistical arbitrage); stock prices between buyers and sellers in a merger (merger arbitrage) or more-obscure debt/equity relationships within a stock (convertible arbitrage). A quick glance at the performance of these strategies over the past 10 years reveals long periods of consistent performance punctuated by briefer periods of significant drawdowns. Short-term systems in the futures space generally exploit completely different dynamics than these equity-based strategies, but systems that exploit price anomalies sometimes can be very wrong and thus, a sophisticated risk-management ideology is necessary to ensure that overall performance stays within reasonable boundaries.

Final remarks

Too often in the managed futures space, programs are bucketed into broad categories such as medium- to long-term trend following and short-term strategies or simply everything else. In reality, strategies fall into various spots along a larger spectrum. That being said, short-term systems can be hugely beneficial to a portfolio. But you need to understand that, even though diversification truly may be a "free lunch" for the recipient, someone ultimately bears a cost. In this case, it is paid by the system developer(s). Untold hours must be spent in areas such as trading-signal development, the development of sophisticated risk-management tools and the generation of maximal-efficiency execution algorithms. All of these pieces are needed to deploy a system that offers reasonable risk/reward tradeoffs yet also manages to provide a return stream that is largely decorrelated from standard trend-following systems. If these tasks are done well, however, customers ultimately are rewarded with a powerful tool for diversifying their portfolios and improving their overall risk/reward balances.

Michael Mundt is a principal with Revolution Capital Management. He has built successful long-term and short-term trading strategies.

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