THE FOLLOWING ARTICLE DOES NOT CONSTITUTE A SOLICITATION TO INVEST IN ANY PROGRAM OF CERVINO CAPITAL MANAGEMENT LLC. AN INVESTMENT MAY ONLY BE MADE AT THE TIME A QUALIFIED INVESTOR RECEIVES CERVINO CAPITAL'S DISCLOSURE DOCUMENT FOR ITS COMMODITY TRADING ADVISOR PROGRAM OR DISCLOSURE BROCHURE FOR ITS REGISTERED INVESTMENT ADVISER PROGRAMS. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
Courtesy of the credit mess and massive mispricing of risk that has built up in our system over the past decade, the first quarter of 2008 was for both the fixed income and equity markets one of the worst starts to a year in a rather long time.
The question now being asked, a little over a month after the global economy ‘whistled past’ the Bear Stearns’ run on the bank (which might of resulted in a systemic meltdown), is whether the Federal Reserve’s invocation of emergency powers was the right decision or wrong decision to make. This will remain into perpetuity an unanswered question, but on the morning of March 17th, Fed Chief Bernanke’s decision to finance $30 billion of illiquid Bear assets to secure its takeover by JPMorgan Chase & Co. came as a great relief to a market susceptible to another 1987.
Fortunately for our clients invested in the Diversified Options Strategy, we ended the 1st quarter with a solid 3.64% for the 1X program and 7.90% for the 2X program.
At the end of last year, our 2008 forecast called for continuing high volatility, strength in gold, and propositioned that the controversial idea of nationalizing losses was going to be put on the table in order to “save the markets.” In light of this framework, we traded the Diversified Options Strategy rather conservatively. The systemic risk was never this great and risk management was our main priority.
At the end of February, the odds of a systemic breakdown were, in our analysis, higher than ever and we constructed positions that would have withstood nicely such an event.
This prescience proved fortuitous, and even during the frightful hours around the Bear Stearns’ collapse and MF Global’s rout to a low of 3.64 from the previous day’s close of 17.35 (a 79% drop in price), our positions' volatility remained extremely low and the program was never at serious risk of loss.
Our Diversified Options Strategy’s risk-reward approach is validated by our Top 2 standing in BarclayHedge’s option strategy CTA ranking by Sharpe ratio.
Looking forward for the 2nd quarter, most studies based on sentiment indicators have been illustrating historical levels of negativity, especially when measured from the peak of October 2007 to the bottom of January 2008. This is in line with other recessionary periods. However, this negative sentiment often serves as a contrary indicator of where stock prices may go in the future.
Admittedly, the Damocles sword of additional credit market write-offs remains. This could eventually lead to a more pronounced credit contraction phase, resulting in more retrenchment by an overly leveraged consumer. But for the time being, mean reversion seems to be the leading factor driving the current retracement in stock prices.
For now, our outlook for the securities market in the second quarter of 2008 is more positive, at least in the near term. We expect the longer term will likely produce more disappointments, but the shorter term indicates a reversal to the mean type of action.
While on the subject of mean reversion, we would like to point out what we think are key differences between the capital markets versus the commodity markets. And in the process, also spend a few moments to provide a fresh analysis our trading in the Commodity Options Program.
Securities in general, and certainly stock market indexes, tend to be very mean reverting and therefore they offer numerous opportunities to play contrarian and volatility arbitrage strategies. On the other hand, the leveraged structure, speculative skew and liquidity constraints of commodity markets, as well as sudden changes in supply-demand dynamics, make commodities much more prone to reflexivity.
This state of affairs is due to a number of reasons, some clear cut and some more debatable. In any case, we do not believe one can routinely trade commodity options as you would normally trade stock index options.
Our underlying philosophy for the Commodity Options Program is to integrate income generation strategies with a significant number of directional bets. By definition such an approach will make the program performance more volatile and subject to a number of speculative market calls during the year.
That said, commodities in general have experienced record moves since the beginning of the year. This is a result of a combination of massive speculative inflows, and an inflationary monetary policy put forward by the Fed in response to the systemic risk posed by the credit crisis.
The convergence of these two factors overran our initial thesis that a global slowdown in the economy, and the need for a credit deleveraging, would force the commodity complex into a correction. The resulting situation put the Commodity Options Program into a difficult situation.
This specific program produces results based on a mix of mean reverting trades and directional bets (as opposed to the Diversified Options Strategy which is primarily mean reverting). Mean reversion—selling overbought and buying oversold assets—ended up having a poor risk-reward profile for commodities as three sigma moves became the norm. This was especially true in two markets where we were engaged: wheat and crude oil.
The historical trading anomalies of wheat were enough reason to cause an uproar from the farming industry as the futures-spot price convergence ceased to function properly. Crude has also started to pose valuation problems as it has begun to act more like an inverse dollar proxy than a commodity. In this environment even directional trades were not exhibiting positive risk profiles.
Notwithstanding the headwinds, the majority of our trades in this program were successful, but the poor risk-reward profile produced larger than expected losses in the wheat and oil contracts.
Going forward, we feel that the opportunities for a more rational trading may have finally developed for the Commodity Options Program after the entire commodity complex was hijacked by sheer speculation.
Arrivederci
-Davide Accomazzo, Managing Director
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