Wednesday, October 4, 2006

September 2006 Review and Buying the Bull


Our Diversified Options Strategy program for September 2006 returned a positive 0.77% resulting in a year-to-date return of 7.92%. The S&P 500 Index (GSPC) returned 2.46% adding to the gains from the prior month and is up 7.02% year-to-date. Meanwhile, the Barclay CTA Index is down as of this writing with a return of -0.20% for September; for the year the CTA Index is up only 0.64%. Please refer to our website at for the most recent performance statistics on our investment programs.

BUY BUY BUY!!!! The Wall Street trumpets and the airwaves of CNBC are at work again. The meaningless Dow is at historical highs and the S&P 500 is up 10% in practically a straight line since the lows of June. Volatility is again MIA as market players perceive the total absence of potential threats to this picture perfect situation.

Not to be cynical but the indices rallying so strongly in the name of suddenly “defeated inflation” and the much vaunted “soft landing” scenario seems na├»ve at best. Aficionados of this blog know well my tirades on how inflation is dramatically underestimated by official statistics. Again I will point out the rise in most of your daily living expenses and monthly bills…

For the bulls out there: yes, I acknowledge the rather significant decrease in oil prices, but I have to wonder on the timing given that on July 12th Goldman Sachs revised their benchmark commodity index (GSCI) from 8.45% dollar weighting in unleaded gas to 2.30%. This little noticed event forced hedge funds and institutions tracking the GSCI to sell 75% of their gasoline positions in order to conform to the reconstituted index. Mmmm... Goldman Sachs... Treasury Secretary Paulson... Elections anyone?

But seriously, the key question regarding oil is what will be the average price range going forward. Are oil prices settling into a much lower range or is this just a trading correction? Considering that some short term problems may indeed have been resolved, a re-pricing of the commodity may be justified. But then again, the ongoing imbalances of this depleting resource in the face of projected long term rising global demand supports my thinking that this current “re-pricing” is just temporary.

Another interesting fact is that soft landings in the history of this country have only been achieved once, in 1994, under much better structural contingencies. My fear of a potential “bull trap” seems to be justified by the “technicals” of this market. The rise is narrow and is concentrated in a few index related names. New highs have been hard to come by and the CNBC cheerleading thermometer is rising too far too fast. I suspect a lot of seasonal players and retail investors were caught on the wrong side of the fence after Labor Day and the oil drop added fuel, excuse my punt, to the fire.

Only time will tell if my thesis is correct.

As far as the other markets, gold seems to be searching for a floor and I believe it will have problems flying high until the dollar starts weakening again. I am not in the camp calling for the destruction of the dollar and the fiat money system but I do think gold should eventually benefit from a reallocation of foreign central banks’ reserves. This is a long term theory and I’m reminded of what J. M. Keynes once said: “In the long run we are all dead.” So in light of such wisdom we will continue to play the currencies (gold included) on a very short term and very technical basis.

It’s a short missive from the trenches this month but I am sure you would like me more engaged managing your hard earned money than fueling my vanity with these scripts.

I rest my case. Until next time...


-Davide Accomazzo, Managing Director

Options: A Three Dimensional Chess Game

"Could we look into the head of a Chess player, we should see there a whole world of feelings, images, ideas, emotion and passion"
— Alfred Binet (French Physiologist, 1857-1911)

One of my favorite pastimes is playing chess, which unfortunately I have not had the time to indulge as of late. To experience the full brunt and emotional psychology of the game try a five minute speed match against a chess hustler in Washington Square Park, NYC. Unless you’re rated 1800+ you will likely walk away feeling beat-up.

Don’t believe me? Bobby Fischer, the only US-born chess player ever to win the World Chess Championship, once said “Chess is like war on a board. The object is to crush the opponent's mind.” Even more revealing is what he said during a Dick Cavett interview, “I like the moment when I break a man's ego.”

For the uninitiated the inner nature of this multidimensional game is nicely explained by David Norwood in his book Chess and Education:

“It is often supposed that, apart from their ‘extraordinary powers of memory,’ expert players have phenomenal powers of calculation. The beginner believes that experts can calculate dozens of moves ahead and he will lose to them only because he cannot calculate ahead so far. Yet this is utter nonsense. From my own experience I can say that grandmasters do not do an inordinate amount of calculating. Tests, notably de Groot’s experiments, support me in this claim. If anything, grandmasters often consider fewer alternatives; they tend not to look at as many possible moves as weaker players do. And so, perversely, chess skill often seems to reflect the ability to avoid calculations. It is, in truth, not clear that chess is a game of calculation. Of course there are times when intense calculation is called for, and often the master is better at dealing with these situations than the amateur. No wonder, he has had more practice than the amateur, but all the same his innate calculating ability need not be any greater. Most of the time it is something quite different that is required, something akin to ‘understanding’ or ‘insight.’”

Interestingly, the analytical yet intuitive nature of chess and trading is very similar, and many great traders happen to also be fanatical chess players. In fact, the introspective process is so alike that Norwood’s description could have been written about trading.

The psychological aspect of trading is something that serious investors should spend time studying. Generally, investors have three choices when trading an asset directly:

(1) stay out of the market
(2) buy and “go long”
(3) sell and “go short”

Once either “long” or “short” the next decision becomes whether to stay in the position or get out; technically this is known as “liquidating the long” or “covering the short.”

The confluence of investor agendas results in historical market prices which can be tracked by charts. Anyone who has looked at charts can easily recognize markets that trend up or down versus markets that move sideways within a range. Charts are great tools, but don't forget they look backwards. As the regulators regularly remind us “past performance is not necessarily indicative of future results.”

From an emotional perspective such tactical investment alternatives, seemingly simple trading decisions, present an array of contexts. Remaining un-invested is neutral, but psychologically the trader is thinking in terms of greed or fear: “Should I stay out or get in? Is the reward worth the risk? What if I buy it here and it goes lower? Is it too expensive? What if I wait for it to go lower before buying?”

Common sense wisdom says “buy low, sell high,” but how many investors feel more comfortable “buying high, selling higher?” Unfortunately, most of the time we end up buying high and selling low, emotionally trapped by the “come back to breakeven before selling” curse. Chartists call this "resistance" because investors sell at these levels, while "support" levels exist because there are no more sellers as investors are willing to hold until a better price.

Purchasing an asset is the easy part; alas most investors don’t think about an exit strategy. The “trend is your friend until the trend ends,” but how far should you let a stock “run” before you sell it? How would you feel if you sold it but then it goes up further? What if it was higher, but now lower… Would you wait until it goes back up? What if it doesn’t go back up? What if it goes lower still? At what point would you feel forced to sell?

Thomas Huxley, known as "Darwin's Bulldog" (1825-1895), once quipped that “The chessboard is the World, the pieces are the phenomena of the Universe, the rules of the game are what we call the laws of Nature and the player on the other side is hidden from us.” The same sentiment could easily be applied to trading.

As you can see, there are many emotional dimensions to just buying and selling an asset. And when a trader has the sophistication to “go short” the thought process doubles.

This psychology underpins every day decisions/actions of markets participants. Quite a few books analyze the phenomena such as the 1841 classic “Extraordinary Popular Delusions and the Madness of Crowds” by Charles MacKay. Successful investors learn to discipline their emotions and act contrarian to natural tendencies.

Yet when all is said and done, for most investors the choice is simple: stay out of the market, go long at a certain price, go short at a certain price, or get out at a certain price (liquidate the long or cover the short). As with chess there is vast complexity behind such decisions, but in the final analysis the rules to game are simple.

Not so with derivative trading! If directly trading an asset is like playing chess, then as my business partner likes to say “option trading is a three dimensional chess game.”

An option is a contract whereby one party (the holder or buyer) has the right, but not the obligation, to exercise the contract (the option) on or before a future date (the exercise date or expiry). The other party (the writer or seller) has the obligation to honor the specified feature of the contract. Since the option gives the buyer a right and the seller an obligation, the buyer pays a premium for such right.

Because options are indirectly related to the underlying asset and have many more components for an investor to consider, the result is an unlimited variety of ways to structure trading strategies as compared to just buying or selling the asset.

● First, options are a wasting asset and therefore have a time component. If not "in-the-money" at expiration, they're worthless.

● Second, part of their value is determined by the relationship of the underlying asset’s price versus the option’s “strike price.” The degree of correlation between the pricing of the asset and option is a function of the distance between the asset price and strike price.

● Third and fourth, there are multiple options representing different strikes prices—this is called an "option series"; further, there are multiple expiration dates for each option series.

● Fifth, their price, while related to the underlying asset’s price, is also tangentially influence by the underlying asset’s volatility.

● Sixth, double up all of the points above because there are two basic types of options: “calls” which give the holder the right to purchase the asset at a certain price, and “puts” which give the holder the right to sell the asset at a certain price.

● Seventh, double up everything again because option traders can either be purchasers of options or sellers (“writers”) of options.

So how do all this option background work together in forming three dimensional trading strategies?

Suppose the S&P 500 is trading in a narrow sideways range and volatility is extremely low. Bullish and bearish sentiment is equal and you think that the market is going to breakout either to the upside or downside—but your not sure which way.

If you were trading the Spyder (ETF contract that is linked to the S&P 500 index) you could either go long and hope the market goes up, go short and hope the market goes down, or stay out of the market all together. Limiting yourself to three choices could be frustrating.

But with options you could purchase both a call and a put at the same time. Since your cost is limited to the premium of the option you have limited downside either way if the market rallies or crashes. But if the market does breakout to the upside or downside you will be positioned to take advantage of that move. The key is that you don’t have to be right on the direction—your betting both ways at once.

Now buying options can be expensive, so how do you pay for the right to be a holder?

Let’s say that in the above scenario you think the market is going to go up or down, not in the next month, but maybe three months from now. You could “write” options (both calls and puts) with a nearer expiration date to help pay the cost for purchasing options (both calls and puts) with a later expiration date.

With this situation you’ve got four different positions operating at the same time on the same underlying S&P 500 index. Each of these positions will increase and decrease in value differently depending on the price action of the underlying S&P 500 index.

The above two option strategies are just a sampling of the position combinations that can be created with options, thereby expanding a trader’s tactical repertoire exponentially.

But take note, because of the volatile nature of markets, the purchase and granting of options may involve a high degree of risk. Option transactions are not suitable for many members of the public. Such transactions should be entered into only by persons who understand the nature and extent of their rights and obligations, and of the risks involved in option transactions.

As you can imagine the variety of trading strategies that options offer are limitless and multidimensional. It is that variety that attracted Cervino Capital Management to develop its Diversified Options Strategy. For more information this investment program, visit our website at

- Mack Frankfurter, Managing Director