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Practitioner View: Four buckets of CTA styles by Rob Ross of White Indian Trading Co.

Friday, June 03, 2011

Four Buckets of Investment Style

This useful review is by Robb Ross, principal at White Indian Trading Co. Ltd., a commodity trading advisor.

When investing with a commodity trading advisor, commodity pool operator, broker who gives advice on trades, trading software, or newsletter, it is important to know the trading style of the system or advice employed so as to choose methods that fit one's needs. In this article I define and discuss the styles that investors frequently encounter. There may be other styles not covered here, but these are the majority of styles in the industry. For a summary, see the table below.

Day Traders

Day traders can and do employ various strategies. These include swing trades, trend, option, quick hit and scalping, to name a few. The one feature that is common among all these various strategies is that there are no overnight positions. Come the close of the session, the day trader is flat. Knowing that there is no exposure after the close helps investors sleep in greater comfort.

Plus, this style allows investors to ramp up their available capital. Day trading margin is much less than the standard margin required. Currently the S&P e-mini futures contract margin is $5,625. However, if you day trade, then the margin is 1/10th this amount, at $500. For an account that has $10,000, the investor could carry one contract overnight but could trade 20 contracts during the day. Some brokerages will require even less margin for day trading, like $300 per contract.

There are workarounds to the overnight margin. I've been told that some investors will exit before the end of day. Then as soon as the night session begins, which is at 4 pm CST, they put their positions back on and are thus able to bypass the overnight margin requirements. Of course there is a commission cost in doing this and the market might move significantly between the official daily close and the night session opening. There's always some risk in trading.

Day trading gives the investor a slice of possibly large returns due to the increase in leverage and greater activity that is in the nature of day trading. It's not unusual to find people transacting 5,000 round turn trades per million per month. Many will limit their exposure on any one trade to a given percentage, thereby providing some kind of goal on the liability per transaction.

In short, day trading offers increased activity, the ability to increase leverage beyond normal and the possibility of larger profits.

Four Investment Styles
Advantage Disadvantage
Day Traders Low margin Leverage risk
Option Writers Opportunity in decreasing time value High exposure
Trend Followers Long-term track records System accuracy less than 50%
Means Reversion High % trades profitable Profits might not offset losses

Option Writers

Nowadays option writers have a more refined name¢ā‚¬ā€¯option premium capture specialists. This style entails at least one part of the transaction to be the short sale of an option. Many of these strategies focus on out-of-the-money options where the odds of the option going into the money and being exercised is statistically low by the trader's analysis. What is usually being shorted are Proletariat options.

Here's what it means. Options fall into two distinct groups, namely Proletariat and Bourgeois options. Proletariat options are what I describe as the "People's Options." These are the options that usually have little time value and are normally out of the money. They are cheap and provide the opportunity for the purchaser to hit a smashing home run and have those 20-to-1 or better returns that an investor can brag about to his golf foursome or her bridge club for the rest of their lives.

The beauty of selling options is that time value decreases every day. The bad part is the level of exposure. There's a history demonstrating that. Through the late 1990s to 2007 option selling strategies provided consistent returns with low drawdowns and quick recoveries from drawdowns. Because of the attractive results, many investors placing money into these strategies levered up or notionalized their accounts.

Notionalization is the concept of phantom money. An investor can open an account with $50,000, but have it traded as if it is $100,000. All fees and trading are based upon the $100,000, but $50,000 is all that exists in the account. In this case the investor would be 50% notionalized, since 50% of the money is phantom capital. It's great when the returns are going the investor's way. If the manager makes 25%, then the notional account is up 50%. However, if the trader loses 50%, notionalized investors are wiped out.

Many of these programs were dealing in S&P 500 options. The S&P 500 provides a large amount of volume which in turn provides liquidity. When the S&P 500 went into meltdown in 2008, many programs were wiped out. I've talked to brokers that had clients lose 100% of their accounts. What is worse, it's possible to not only lose the entire account value but to be stranded with additional loses beyond the size of the account, because of options' ability to continue to increase in value. In other words, some investors lost all and owed money!

Not every body got wiped out. Many option programs survived. However, people are a lot more cautious after the market gyrations. Some firms discourage the short sale of options, otherwise known as a naked option position. Other option writing strategies employ volatility plays. This involves the trader selling options with high implied volatility and offsetting them by purchasing options for the same commodity that have low volatility. The theory is that the volatility on these options will eventually balance out and come back within a range, thereby causing the shorted options to decrease while at the same time the purchased options volatility will increase.

The number of option strategies are too many to cover here. Suffice it to say, as long as option writing is allowed by the exchanges, this will continue to be a vibrant style.

Trend Followers

There are countless axioms when it comes to trend following. These include:

"The trend is your friend." "The crowd is right during a trend, but is wrong on both ends." "Don't fight the trend." Such sayings have been around for years and for good reason. Trend following has proven to be a viable investment style, as demonstrated by the significant number of professional investors who ascribe to and utilize this philosophy.

Of the non-option overnight investment styles, trend following seems to be the biggest bucket. Look through the list of CTAs and CPOs that aren't day traders or premium capture programs and you see that the vast majority are trend followers.

I've talked to investors that catch trends lasting for years. When the market moves in a direction, the trend follower hopes to catch more of that move. And if it's a sustained trend, they can really hit a home run. The downside is that the accuracy of the average trend system is less than 40%. Of course, the goal is to have much larger winners than losers.

Short-term traders sometimes utilize a longer term trend indicator as a filter and make no short-term trade against the longer term trend. The idea is to not fight the bigger trend, just take the opportunities that the shorter term trend offers. The longer trend could be a week while the shorter trade is a day.

Counter Trend Followers

Finally there exists this very small bucket, which I see as a boutique style. Counter trend following is also referred to as means reversion or a swing system. This is basically the opposite of trend following. At some point when the underlying market, be it soybeans, Treasury bonds, or something else, is moving up, counter trend followers will short the market. Conversely, if the market is moving down, the counter trend follower goes long at some point.

Some traders will use a dollar-cost average to create levels of entry. If the market reverses from the multiple levels of entry then they can hit a home run. However, if the market continues in its initial trending direction, the loses can mount up since the trader has loaded up. One disadvantage to this approach is that when the first level is executed and the trader is right, the profits generated might not offset the losses incurred when the system gets fully engaged at several levels and has a loser.

Counter trenders seem to have a higher percentage of profitable trades. With a trend system the trader might only win 35% of the time, but the average winner is two-and-a-half to three times the average loser. For a counter trend approach to be successful it must keep the winning dollar amounts at least as large as the losers generated. This way the percentage accuracy works to the investor's advantage.

Conclusion

I did not cover such differences as short, intermediate, and long term versions of the systems in each bucket. I've described the general characteristics. With this understanding of styles, an investor can better determine how to get the best fit for their risk tolerance. Many investors and money managers employ more than one strategy in order to achieve system diversification. However, that takes more capital.



 
This article was published in Opalesque Futures Intelligence.
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