Monday, December 22, 2008

2008 Year End Thoughts Going Into 2009


Given hindsight, my commentary from the end of 2007 now seems quaint when I wrote: “The long and winding year of 2007 has come to a close... In the annals of trading, this is one ‘vintage’ that will be remembered for some time as the year re-introduced the concept of investing risk and volatility. Unfortunately, some trading programs didn’t survive, and surely, the remaining players are breathing a sigh of relief.”

Unfortunately, any hopes for a calm year was dashed back in January. 2008 is not a year on which even the most hardened veterans of the market shall look back gladly—it has turned out to be an Annus Horribilis. And as we approach the start of 2009, I can almost hear the sigh of relief of many for whom this December 31st could not come any sooner. Indeed, we have witnessed an unprecedented global meltdown of the financial system and experienced massive wealth destruction in these turbulent twelve months.

Nevertheless, in this storm Cervino Capital Management LLC managed to post a positive year for the Diversified Options Strategy keeping true to this programs mandate of absolute returns. As of the end of November 2008, the D1X program is up 2.94% and the D2X levered program is up 7.43%. And although our year-to-date performance is currently less than desired, for most of this year until the market crash in October, our rolling twelve month rate-of-return was above our stated objective.

This is no small feat given that many CTA option programs this year suffered through significant drawdowns greater than 50%, and some are no longer even trading. Our understanding is that many CTA option programs, even now, are sidelined waiting for the historically volatile market conditions to settle down.

Meanwhile, our more beta exposed investment advisory portfolios were not so lucky and while they generally outperformed the benchmarks and held very well for 3/4 of the year, they eventually cracked with everything else in this dramatic autumn. The relatively stable performance of the Diversified Options Strategy is therefore striking in the context of such a ravaging bear market, where no asset class was spared and practically no strategy worked.

So much for Modern Portfolio Theory… just ask the much praised Harvard University Endowment. Then again this is what bear markets do: wholesale asset price destruction. It is interesting to note that bear markets will do more damage to your portfolio than wars—just look at a long-term chart of the Dow. But more on asset performances and expected return later…

What makes this bear more ferocious and treacherous to trade than any other meltdown since the 1930s is in the way our capital markets became dysfunctional during this crisis. The Fed and the Treasury (and most of their counterparts around the globe) have been engaged in massive interventions via standard monetary policy decisions, quantitative easing, capital injections in an effort to stop a seemingly unstoppable predicament.

While I do not believe they had much of an alternative, such conduct (and the possibly avoidable lack of consistency) has created recurrent unintended consequences, many of which we will not even face until years from now. This environment of uncertainty has had the additional destabilizing effect of making markets practically untradeable and even more dysfunctional. One day we can short, the next we can’t; one day the Treasury will buy a certain asset class, the next it will not; and so on…. not an environment conducive to improved functionality and liquidity in the global markets.

As mentioned above, the alternatives to these policy choices were practically non existent but in the long term we may be seeding more problems than solutions. I have argued in previous writings that hyperactive monetary policy such as the one implemented by the Federal Reserve Bank in the last fifteen years is highly correlated with the increasing frequency as well as the increasing size of financial crises.

Is the tail wagging the dog? Quite possibly…

The obsession of the Fed and most politicians to erase the business cycle is the direct cause of this hyperactive monetary approach. However, if the result of trying to eliminate mild but recurrent recessions (frankly, a necessary and not so negative part of an efficient economic system) is the creation of cumulative imbalances that threaten the system at its core, then perhaps a different approach may be appropriate.

For more on my views of this topic, see "A New Qualitative Capitalism"

But enough about the past—what should we expect going forward? The current situation makes it extremely hard to forecast as we are not even sure exactly what kind of economic system we are going to operate in going forward: capitalism, socialism or statist? This is a question that no Western country has had to face in almost 40 years, and yet today it is at the core of an investor long term strategy.

I wrote extensively on the kind of new qualitative capitalism that I would like to see flourishing after this crisis, but I doubt I will get my wish. For the moment we are clearly going thru a socialistic phase rather unavoidable given the collective missteps of our bankers, leaders, and let us admit it, the “average Joe” at large.

While most pundits have been likening these times to those of the Great Depression, I think we are beginning to look more like Japan—a sad, long deflationary nightmare. Perhaps this is how all “fiat” economic systems must end. I am no fan of the gold standard but there must be a price to pay for unbridled credit creation and the promotion of a standard-of-living greatly superior to the long term rate of growth of GDP.

The bond market seems to agree with the Japanese analogy and it recently went parabolic from an already overpriced level. I have occasionally tried to take the other side of this trade in the past few months. My belief was that even in the event of a Japanese scenario, one systemic variable was completely different—the Japanese ran a trade surplus and most of their debt was held internally while we are in the opposite position.

On the positive side, we have another difference: the U.S. has historically been a more dynamic socio-economic system, and unless we forget completely our entrepreneurial spirit, we might just be able to turn things around a bit more quickly. However, such a quicker turn-around would likely spell “inflation emergency” with all the dire consequences for bondholders.

Another explanation for the parabolic moves of the bonds (especially the 30 year) might be clever alchemy from Ben and Hank. Lets say you were to triple your debt load, and at the same time control interest rates, would you not also try to massively reduce the cost of money? In the real world, if a creditor triples its debt/equity ratio its cost of servicing such debt would go up percentage wise and in absolute numbers. However, if you are the U.S. government you can drive interest rates down artificially to refinance your debt long term. Seemingly, the typical rules don’t apply to the world’s reserve currency.

The U.S. is able to pull this off by getting the Chinese to play along. And despite all protestations, they seem happy to oblige considering the massive capital gains they are being gifted with for their old positions.

All the same, going forward the yield on U.S. debt is not attractive, which typically results in a weaker currency. But since the Chinese renmimbi is practically pegged to the dollar, it too will be devaluated, which in a deflationary environment is not such a bad thing (especially when you don’t have to take the blame for it, when oil is at a 5 year low, and you are the low cost producer of the world and want to stay that way). Furthermore, with yields so low, this will allow Hank and Ben to make a nice little (well not so little) profit on all those preferreds they bought from the banks which pay around 8%.

And to think the U.S. sent Martha Stewart to the jailhouse for insider trading, go figure…

As far as equities, this 2008 was a landmark year in terms of exposing the limitation of equities as solid beta components of long term investment/savings accounts. While I do expect equities to perform much better in the next ten years than in the past ten, I also believe that 2008 was the year that the “buy and hold” mantra was finally killed.

This “black swan” data-point, in my view, changes the return expectation of this asset class in general, and it does so within the context of a much worsened volatility profile. What seems clear now is that the long term viability of a passive equity portfolio depends solely on a favorable valuation of the asset class in general—the more undervalued equities are, the longer the affordable time horizon the investor has, and the more passive he/she may be. On the other hand, the higher the valuations, the more active portfolio management must be. This relationship is direct and accelerates at the extremes points of valuation.

Beta portfolios and passive indexing as increasingly perpetuated by the industry have massively failed the test of reality. I believe investors will have to resort to a much more active asset allocation and /or to a much smaller equity allocation. And this does not take into consideration a secular shift toward socialism which would imply a significantly reduced forward return-on-earnings in equities.

Not to get too sour, a bright spot next year might end up being real estate. The convergence of steep price reductions in the last 18 months, the cumulative efforts of all government agencies to reduce mortgage rates and possibly alter the price discovery process of this asset class in general, and a surfacing interest by foreign buyers may just be that needed energy to stop the bleeding sooner than expected.

With respect to option trading, we think that as 2009 evolves, actual volatility will start to settle down while implied volatility will remain high for a longer period of time. This is an optimum environment for volatility arbitrage using options. And after 2008, we could all benefit from quieter markets. In the least, any unexpected turns in the market will not come as such a surprise after Annus Horribilis.

- Davide Accomazzo, Managing Director

Steamrolling Over Option Trading Programs

[Originally published October 21, 2008 on SafeHaven and MarketOracle.]

"In days of old, seers entered a trance state and then informed anxious seekers what kind of mood the gods were in, and whether this was an auspicious time to begin a journey, get married, or start a war. The prophets of Israel repaired to the desert and then returned to announce whether Yahweh was feeling benevolent or wrathful. Today The Market's fickle will is clarified by daily reports from Wall Street and other sensory organs of finance. Thus we can learn on a day-to-day basis that The Market is "apprehensive," "relieved," "nervous," or even at times "jubilant." On the basis of this revelation awed adepts make critical decisions about whether to buy or sell. Like one of the devouring gods of old, The Market -- aptly embodied in a bull or a bear -- must be fed and kept happy under all circumstances. True, at times its appetite may seem excessive -- a $35 billion bailout here, a $50 billion one there -- but the alternative to assuaging its hunger is too terrible to contemplate."
--Dr. Harvey Cox, Atlantic Monthly (1999)
“To fly an airplane it must fly ‘in the zone.’ Too slow and
you stall and lose control; too fast and the wings come off.”
This is what Captain Dan Ryder, a former Navy fighter pilot who also served as Underway Command Duty Officer on U.S.S. Nimitz, explained as we sailed around Santa Cruz Island in a 37’ Tartan. That conversation took place the weekend before the “bailout” vote, and it has stuck with me ever since.

Since then world equity markets have plunged in a dive that hasn’t been seen since the Great Crash of 1929 stoking fears that we may be headed for the worst recession since the 1930s. Amid mounting fears that the frozen credit markets pose an imminent danger, the pressure for a coordinated rescue by the world’s economic policymakers has become acute. As stated in this weekend’s Financial Times in a telling quote, “Five years ago central bankers seemed almost omnipotent; now they seem scared.”

No doubt sentiment has materially changed since October 2006 when equity markets were in the midst of an extended bull run and the VIX, also known as the fear gauge, was hovering in a range between 10 and 12. For comparison, on Friday October 10th, the VIX hit an all time record intraday high of 76.94—that is 7 times higher than 2 years ago, and almost 3.5 times greater than levels for the VIX just a month ago. [Since writing this article, the VIX has hit 80 two times.]

The importance that volatility plays in options trading should not be underestimated. In fact, it is the key factor which drives how much premium can be charged/received when purchasing/writing options.

Low volatility makes for a difficult environment to write options and capture premium in a risk adverse manner. Like an airplane flying too slow, volatility during much of 2006 and through February 2007 was too low. This became apparent on February 27, 2007 when the VIX spiked nearly 100% and several option writing programs collapsed, giving back two or three years of accrued profits in a day.

Since that date volatility began to rise with the VIX trending higher. But this presented another problem for many CTA option writing programs—the transition from low volatility to higher volatility can be treacherous. Nonetheless, a group of these programs managed the transition, and arrived at what could be considered the “sweet spot” or “zone” for premium capture—a VIX ranging between 20 and 30.

This is the average range for the VIX from 1997 through 2003. But to gain insight into volatility spikes during this time period one must look back to three events. The first event was during the summer of 1998 with the implosion of Long Term Capital Management when the VIX reached 45. The second event was after 9/11/2001 when the VIX spiked to 44. This was followed by a VIX high of 45 during the 2002 bottom. However, each of these readings is far below a VIX of 70+ reached this past Friday.

More recently, since February 2007 the VIX has spike above 30 several times: first on 8/16/2007 when it closed at 30.83, then on 11/12/2007 at 31.09, followed by a spike on 1/22/2008 with a reading of 31.01. But the most memorable day was March 17, 2008 when the Federal Reserve Bank financed JP Morgan’s takeover of Bear Stearns in a controversial deal. The VIX spiked to 32.24 and market pundits debated on whether the Fed overreacted, or had helped us narrowly avert a crisis due to systemic counterparty risk.

We got our answer on September 14, 2008, when in one of the most dramatic days in Wall Street’s history, Merrill Lynch agreed to sell itself to Bank of America, while Lehman Brothers filed for bankruptcy protection and hurtled toward liquidation after it failed to find a buyer. That event set off the domino effect when on September 18th, the Fed provided AIG with an $85 billion loan in return for a government stake of 79.9 percent and effective control of the company—an extraordinary step meant to stave off a collapse of the giant insurer that plays a crucial role in the global financial system.

It’s been downhill ever since with the largest financial “bailout” in United States history causing an existential crisis amongst those who hold to purest free market ideology. Yet, even with its passage—noting that financial market “rescues” have precedence in U.S. history dating back to Alexander Hamilton—the deterioration in the markets has not stopped (yet, as of this writing).

It is a classic case of the road to hell paved with good intentions. Every action that central banks, the treasury or governments have taken so far to try and stem the bleeding has been dismissed by the markets. And last week it seemed that the metaphorical wings of market volatility finally came off.

With the VIX above 50, much less given its rise above 70, market conditions have become extremely imprudent to trade. This is the conclusion that we came to, resulting in our liquidating positions.

Has the options trading model blown up?

Investor interest is options programs is a study in contrarian behavior. During the 1990s there was a great deal of aversion to the strategy of writing options. This began to change after 2003 when the S&P 500 bull market and the VIX bear market provided a “goldilocks” environment for naked option writing. The result was a proliferation of CTAs offering such programs by the end of 2006.

The irony is that low volatility going into 2006 created increasingly dangerous conditions to engage in option writing. In order to maintain return expectations from prior years, a CTA had to increase risk by either moving the strike price closer to the underlying price, and/or increase the number of positions.

Conventional wisdom at the time was that these programs were uncorrelated to the underlying market. As a result, there was a flood of investor interest in option programs seeking 20+ percent returns. Then came the subsequent transition to higher volatility since February 2007 which has yet again chastened many investors.

There is an old saying when it comes to options trading—it is like picking up nickels and dimes in front of a steamroller. It turns out many players offering option programs in 2005 and 2006 were relatively new to the space, untutored in the violence of short “gamma” as happened during 1998, 2001 and 2002.

So what distinguishes one option program from another, as well as risky trading from less risky trading? The answer is qualitative, but the trick is to produce “risk-adjusted returns,” in which positive returns are generated while mitigating volatility and exposure to risk. In options trading, this is a difficult feat.

First, investors need to recognize that there is a direct correlation between leverage and return with any managed futures program. A program which produces a 30% return is not necessarily better than a program which produced a 15% return. In fact, these returns could be produced by exactly the same trading programs with one using twice the leverage as the other for the same size account. The key is risk-adjusted returns.

One of the crucial factors which provides for consistent absolute returns in option writing/premium capture strategies is “theta,” or time decay. Consequently, the most important responsibility for a trader to manage is the risk of positions in his/her book, which should be considered liabilities until expiration.

A standard strategy is to write options far out-of-the-money, with the idea that the probability such options will go into-the-money by expiration represents a low probability event. In this strategy, traders will “white knuckle” their positions with expiration the only true stop loss. Investors are required to suffer high intra-month equity volatility in their accounts with the expectation that if the options eventually expire out-of-the-money, any unrealized losses plus premium written will be earned.

Risk of ruin is high with this kind of approach, and there is a tendency for the “deer in the headlight” syndrome. If traders do cover such positions, thereby booking large “painful” losses, they will often “roll” the contract to another strike price in the hope that the market won’t reach that subsequent level.

This kind of strategy has worked reasonably well for many option programs, with some using variations of the strategy to mitigate risk and equity volatility by utilizing bull spreads and/or calendar spreads.

The critical question in this current environment is if implementing routine trading strategies is still viable or more importantly, is it prudent? There are rumors that certain CTA option programs have utilized more margin than the agreed-to account size. This situation, in my opinion, represents irresponsible trading.

The bulk of investment performance is typically a function of strategy and risk taken. Yet the complexity of human behavior can never be fully modeled. Therefore, a discretionary common sense approach is needed—one which balances the quantitative with the qualitative in order to manage cycles of volatility.

Traders like to talk about how they provide “alpha” or skill-based returns. Alpha is a byproduct of “beta,” which is often referred to as a benchmark. In alternative investments, one can think of beta as the core strategy and alpha as the tactical overlay in response to changing market conditions.

This is the strength of discretionary trading—the ability to tactically adapt to changing conditions.

Unfortunately, the ‘quality of returns’ is a difficult concept to quantify. My recommendation is not to analyze how well traders have performed in normal market conditions, but how they have performed under stressful market conditions such as February 2007, March 2008 and now during October 2008.

Where does option trading go from here?

The seeds of the economic crisis we currently find ourselves is founded on the ‘forward contract exclusion’ from Section 2(a)(1)(A) of the Commodity Exchange Act of 1936. From this loophole in the Act, and various court cases since 1936, as well as the CFTC’s 1992 exemptive order issued under then-chairperson Wendy Gramm, evolved the unregulated over-the-counter (OTC) derivatives market. It is this history, along with deregulation built into the Commodity Futures Modernization Act of 2000, which allowed for the exponential growth of the $50-$60 trillion credit default swaps (CDS) market.

But for the ISDA and its former CEO, Robert Pickle, previous market crises such as the Orange County and Metalgesellschaft derivatives debacles in 1994, as well as the implosion of Long-Term Capital Management in 1998, should have long ago forced OTC derivatives onto exchanges such as the CME.

The persistency of frozen credit market conditions in the face of multiple central bank, treasury and government actions/interventions is cause for great alarm. Meanwhile, the Sword of Damocles overhanging this crisis has always been the CDS market. Draconian as it may be, some are calling for international action to declare credit default swaps null and void. But could this fear be overblown?

Fear culminated in panic last week as the market eyed Friday’s Lehman Brothers CDS auction in New York. The average price at the auction was below 10 cents, and worry was that financial institutions worldwide would have to face a bill of as much as $400 billion leading to significant writedowns.

It turns out, however, that the net payouts that CDS sellers have to make on defaulted Lehman Brothers debt is only a small fraction of the amount of insurance that was written. According to the DTCC, the “multilateral” calculations it performed on swaps tied to Lehman “indicate that net funds transfers from net sellers of protection to net buyers of protection are expected to be in the $6 billion range.”

This is excellent news as it proves to the market that net exposure on CDS transactions is substantially less than the $50-$60 trillion nominal figure often cited, which in fact references the “underlying” bonds and loans being protected. In other words, contract offsets greatly reduced overall market exposure.

Meanwhile, there has been an announcement that the CME Group will launch by the end of November the first electronic trading platform that is fully integrated with a central counterparty clearing facility for the CDS market. At the same time, the G-7 has pledged to do everything in their power to prevent any more Lehman Brothers-style failures of systemically important financial institutions.

Nevertheless, there will be more dislocations to come. Concern now is focusing on insurance companies and automakers. At the same time, the cost of protecting Dubai’s debt surged last week as concerns mounted about potential investment losses in the Emirate and the refinancing of up to $22 billion of debt.

Meanwhile, Standard & Poor’s stated that GM and Ford may go bankrupt, which is just one indication that substantial damage has been done to the “real economy.” Further, expectation is that unemployment will increase causing a feedback loop into lower consumer spending and reduced earnings for companies.

All this leads to the idea that the US stock market is susceptible to a long malaise where the predominant trend will be wide ranging sideways action. Yet, after we turn this page in market history, systemic risk will also have been greatly reduced, and it is unlikely we will see the VIX at 60+ again for a generation.

Current volatility as of today makes any attempt at establishing option positions very risky/expensive. However, once the market finds technical support, the setup is one where there will be greater implied volatility than the actual volatility as exhibited by the market. This is a perfect environment for arbitrage.

So for option traders who survived and proved their mettle in managing risk, investors should recognize that markets over the next few years will likely be “in the zone” for these programs.

- Mack Frankfurter, Managing Director