Adantia: Taking software to the next level
Brad Kuhlin and Bob Clancy are partners in software company Vertical Management Systems (VMS). VMS has been so successful that a few years ago Kuhlin and Clancy were looking for an avenue to invest their profits, hoping to earn an additional 20% per year.
"Because we are software guys and we are math guys, we figured let’s create software to build our capital when we are sleeping," says Kuhlin, an architect of the Adantia LLC Foreign Exchange Volatility Strategy along with partners Jagjit and Punardeep Sikka.
They took a systematic approach, looking at dozens of indicators, and built hundreds of systems based on various combinations of those indicators to trade commodities.
"We eventually moved away from commodities and into FX because of the leverage, liquidity and all the attractive features of FX," Kuhlin says. "By the time we got to FX, we realized that volatility was the biggest problem. We eventually said we have to go off the reservation and make volatility our friend instead of our enemy."
What they came up with was a technical-based reversion-to-the-mean system that exploits the volatility of volatility.
"Our number one design requirement is that no human being touches a trade. We want to eliminate any potential for emotions to interfere with the mechanics of the strategy," Kuhlin says. "We have developed our own mathematics for trading mean reversion in the FX markets."
The program, which is offered at four different risk levels, runs 24 hours a day and has 125 mathematical properties that influence the decision making of the models.
"Our goal was to seize on volatility, which is more or less a constant in the FX market. The question is the magnitude of that volatility and the stationarity of that volatility in the time series. So we decided that we would not use any technique anybody else uses," Kuhlin says.
They tested the strategy on 16 currency pairs and trade the four that it performed best with: The euro, Japanese yen, British pound and Canadian dollar.
Though it is short-term and technical, it exploits central bank interventions that can create volatile swings. "That is a good thing. Every time [an intervention] happens, we ring the register because we really don’t care what influences volatility. It could be macro long-term conditions, it could be interventions, it could be anything; all we care is that there is volatility," Kuhlin says.
While this is a short-term, high-frequency approach, they can hold some profitable trades longer. "I’d say 50% of our trades are less than a day old, but the other 50% are anywhere from two days to three months," Clancy says.
The program takes advantage of less liquid markets that tend to produce movement away from the mean. "Thin liquidity is one of the behaviors that drive magnitude into the volatility signature. The fact that nobody wants to make a market at a certain location in the market forces prices adjustments. It keeps adjusting and adjusting until it finds stability," Kuhlin says. "That is by definition volatility and that is what we seize on. Stable markets are less profitable for us; we make money in them, but hyper volatile markets are where we make the most money."
Operating a completely automated system involves risk and in the fall of 2010 a glitch in their software created a large drawdown in one of their four programs.
"When you want to automate something entirely so nobody ever touches it, the exposure to bugs goes up," says Clancy. "We thought we encountered every potential for bugs in [testing] the stop-loss mechanism, but unfortunately we hadn’t and got hit by it. [If] you build software, you are going to have bugs."
It left them with a 68% drawdown, ironically in their moderate program. It is still part of their track record and a vivid reminder of the need for due diligence in an automated system. "We repaired the defect and then we tested all around where that bug was. We tested every logic combination in that part of the code to make sure we didn’t miss another bug," Clancy says.
So far in 2011 their very aggressive program is up 48.64% through August, their aggressive program is up 20.74%, the moderate program is up 19.52% and the conservative program is up 7.68%. The returns are not as correlated as you might suspect because they begin calculating the models at different times, which creates entries at
Kuhlin says the mass of technical traders leave a footprint, which often leads to herd behavior that can be detected and exploited. "They all are using the same indicators and it produces a herd dynamic in the market; that is part of what drives volatility. It is seizing on the behavioral byproducts of herds," he says.
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