So I've been thinking (that's dangerous all by itself) about CTAs (Commodity Trading Advisors). Based on what I know of CTAs, a lot of them use some type of trend following strategy (as opposed to a mean-reverting strategy). Some of them, at least conceptually, are pretty basic strategies.
One example of such a trend following method is what the Turtles used...basically a breakout system. The strategy seems to have been pretty robust over the years (although maybe not such much lately with such low volatility in a lot of markets). In fact, over the long run, a lot of the trend followers have done pretty well. Sure, they have had down times. And yes, some of their drawdowns have been pretty deep (severe). But, a lot of them do pretty well with decent long term returns.
That said, there are problems with most trend following strategies. One, the drawdowns. The drawdowns are usually a result of taking a position when you think there is a trend starting and you turn out to be wrong. In other words, the trend followers get chopped up a lot, taking a lot of small losses that, when added together, result in a large loss.
The other major problem (that I can think of) is that the majority of a trend follower's profits may come from a very small percentage of their trades. What that percentage is I'm sure varies. But, let's say it is between 10 and 30%. Essentially, most trendfollowers need to catch (and are looking for) massive (2, 3, 4 standard deviation) moves to not only make up for their losses but to also have a decent return at the end of the year .
Now, I know I have made some generalizations and some oversimplifications but I think what I have said so far generally holds.
Okay, so here's what else I was thinking (ie., time to wake up.
This where I think it could get interesting). What if a trendfollower were to use DOTM options instead of, say, futures?
I think that DOTM options would do the following:
1) Minimize their losses during the chop. Since trendfollowers have to take every buy/sell signal (they never know which signal is going to lead to the "the big one") they are wrong a lot. When they're wrong, the losses would be minimized (in comparison to trading futures outright) since DOTMs don't cost much.
2) DOTMs, while minimizing the losses, still allow the trendfollower to benefit from extreme/outlier moves in the market (2+ standard deviation moves). And since the bulk (and maybe, in some cases, all) of their profits come from these outlier moves, they are maximizing their strength (so to speak).
3) DOTM options cap their losses in the event of a catastrophic move in the wrong direction (opposite of their position). If such an event occurred, the trendfollower might have a difficult time unloading their position without a significant loss.
4) Unlike ATM or slightly OTM options, this premium doesn't have any (at least minimal) time decay or vol effect (at least before it starts to move toward ITM). So if you're wrong about the market direction or the market just sits in a range, you're not losing money due to time or volatility (or you shouldn't be losing much). DOTM (at least initially) seem to be a pure directional (delta) play which is what a trendfollower would want.
5) Buying DOTM options are less capital intensive than the margin (capital) to trade the underlying market. If you've got anywhere from 100 million to 1B dollars (like some CTAs do) that is a LOT of DOTM premium.
To sum it up, DOTM options seem like a great instrument for minimizing losses during choppy periods while still providing the opportunity to profit nicely from extremely large moves in the market (which is what I believe most trendfollowers want to do anyway).
So, here's my questions. Why don't CTAs do this? Has any one looked at (possibly backtested) what the results would be if a trendfollower where to buy DOTM premium instead of the underlying? What would be the downside of such a strategy? What am I missing?
-SG
One example of such a trend following method is what the Turtles used...basically a breakout system. The strategy seems to have been pretty robust over the years (although maybe not such much lately with such low volatility in a lot of markets). In fact, over the long run, a lot of the trend followers have done pretty well. Sure, they have had down times. And yes, some of their drawdowns have been pretty deep (severe). But, a lot of them do pretty well with decent long term returns.
That said, there are problems with most trend following strategies. One, the drawdowns. The drawdowns are usually a result of taking a position when you think there is a trend starting and you turn out to be wrong. In other words, the trend followers get chopped up a lot, taking a lot of small losses that, when added together, result in a large loss.
The other major problem (that I can think of) is that the majority of a trend follower's profits may come from a very small percentage of their trades. What that percentage is I'm sure varies. But, let's say it is between 10 and 30%. Essentially, most trendfollowers need to catch (and are looking for) massive (2, 3, 4 standard deviation) moves to not only make up for their losses but to also have a decent return at the end of the year .
Now, I know I have made some generalizations and some oversimplifications but I think what I have said so far generally holds.
Okay, so here's what else I was thinking (ie., time to wake up.
This where I think it could get interesting). What if a trendfollower were to use DOTM options instead of, say, futures? I think that DOTM options would do the following:
1) Minimize their losses during the chop. Since trendfollowers have to take every buy/sell signal (they never know which signal is going to lead to the "the big one") they are wrong a lot. When they're wrong, the losses would be minimized (in comparison to trading futures outright) since DOTMs don't cost much.
2) DOTMs, while minimizing the losses, still allow the trendfollower to benefit from extreme/outlier moves in the market (2+ standard deviation moves). And since the bulk (and maybe, in some cases, all) of their profits come from these outlier moves, they are maximizing their strength (so to speak).
3) DOTM options cap their losses in the event of a catastrophic move in the wrong direction (opposite of their position). If such an event occurred, the trendfollower might have a difficult time unloading their position without a significant loss.
4) Unlike ATM or slightly OTM options, this premium doesn't have any (at least minimal) time decay or vol effect (at least before it starts to move toward ITM). So if you're wrong about the market direction or the market just sits in a range, you're not losing money due to time or volatility (or you shouldn't be losing much). DOTM (at least initially) seem to be a pure directional (delta) play which is what a trendfollower would want.
5) Buying DOTM options are less capital intensive than the margin (capital) to trade the underlying market. If you've got anywhere from 100 million to 1B dollars (like some CTAs do) that is a LOT of DOTM premium.
To sum it up, DOTM options seem like a great instrument for minimizing losses during choppy periods while still providing the opportunity to profit nicely from extremely large moves in the market (which is what I believe most trendfollowers want to do anyway).
So, here's my questions. Why don't CTAs do this? Has any one looked at (possibly backtested) what the results would be if a trendfollower where to buy DOTM premium instead of the underlying? What would be the downside of such a strategy? What am I missing?
-SG