How to Analyze and Supervise a Managed Futures

ISSUE 3 • February 18, 2013 $399

In This Issue

The P(A|B) Method to Analyze STRATEGIES and Supervise a Managed Futures Making Money with Managed Futures & CTAs Investment This method of analysis categorizes the investment based on beta performance drivers and uses it as an overlay for analysis How to Analyze and Supervise a Managed of individual CTA performance...... 5 Futures Investment: The P(A|B) Method Volatility Investing Discussions Welcome to Opalesque Futures Strategies. take Center Stage at AlphaMetrix Educational Event The emphasis in this publication is the strategies aspect of the investment. With a debt crisis and always unpredictable The goal is to provide professional asset managers a framework for world events on the horizon, this article analyzing and managing uncorrelated investments on a going forward basis. provides high level insight towards deep discussions of market crash structure and While there are credible methods of managed futures evaluation put investor protection methods...... 14 into operation by several well known brokerage / portfolio management practitioners, this newsletter will introduce the P(A|B) Method of managed futures performance evaluation. What is The Appropriate Process For Selecting a Managed Futures In this issue we will utilize the P(A|B) Method as an overlay to understand Investment? the subsector of managed futures investing known as volatility investing. Selecting the appropriate investment First we consider the beta market environment exposure of the investment, methodology and account type might depend with an eye to setting performance expectations in a variety of market on the investor’s devotion of time and environments. In the case of a volatility-based investment, the system resources to the uncorrelated investment highlights specific performance measures to consider and discusses hidden category...... 15 risk of leverage usage relative to deviation and returns performance.

With a basic understanding of how the system works in place, consider Interview with Short Volatility Trader the related interview of LJM Partners, a short volatility investment. After LJM Partners this, visit the exclusive web site for OFS members to see in-depth video LJM is one of many well known short interviews with the manager as well as various performance analytics volatility investments. This interview goes relative to the investment. Consider LJM alongside their other CTAs with under the hood with the program’s risk similar beta performance driver exposure and interact with the author of the management techniques and helps set P(A|B) Method during specific live chat opportunities. performance expectations...... 16

After we reveal insight into managed futures volatility investing, we move to the Untold Story, which provides unique insight into the US debt crisis, MF The Untold Story Global and other issues seldom discussed in the mainstream. A realistic look at the global debt crisis and inside maneuvers in the world of finance that Opalesque Futures Strategies is about providing investors a framework for isn’t discussed in the mainstream...... 23 investment decisions; a template that provides structure for confidence.

If you have comments or questions, feel free to e-mail melin@opalesque. com

Mark H. Melin Editor, Opalesque Futures Strategies

QEP Risk Disclaimer:

This newsletter is confidential, available only to subscribers who have previously acknowledged their qualified eligible participant status. There is significant risk of loss in managed futures. Past performance is not indicative of future results. See full risk disclosure at the end of this document. This newsletter significantly represents the opinions of the author and may not have considered all risk factors.

Opalesque Futures Strategies offers unique insights about:

• Making Money with Managed Futures and CTAs • Detailed Analysis of Managed Futures Programs and CTAs • “Under the Hood”: Analysis how specific Formulas and Algorithms operate • Analysis of CTA Performance with Recommendations and Due Diligence • For Qualified Eligible Participants or Accredited Investors only • Analysis of Market Environments, Opportunities & vital updates on Investor Protection • Research & Intelligence on Portfolio Management, Tactics, Strategies for Uncorrelated Investing

Opalesque Futures Strategies is designed to include industry voices and information from a number of different perspectives and sources. Information must be factual, not promotional in nature and ideally address deep industry issues and reveal insight into how strategies operate, all delivered from a balanced perspective, addressing risk in frank terms.

For general information and education about Managed Futures & CTAs please refer to our sister publication Opalesque Futures Intelligence.

Managed Futures Key Performance Benchmarks IndexManaged Spotlight: Barclay BTop 50 Futures Key What is interesting about this index: It has very low study bias due to the fact that it consists of thePerformance top 50 industry CTAs based on Assets Under Management.Benchmarks The index utilizes an equal weighting formula and CTA participants are NFA members and have their past performance auditedIndex Spotlight: by the National Barclay BTop Futures 50 Association multiple times. It would be considered a statistical rarityWhat for is interesting a member about of this this index index: to It suddenly has very low cease study reporting. bias due toSurvivorship the fact that bias it consists is rarely of thethe top case, 50 industry CTAs based ason AUM Assets disintegration Under Management. would typically The index result utilizes in anthe equal CTA weightingbeing dropped formula from and theCTA index participants before are NFA members and have theytheir would past performance drop off, and audited the index by the is Nationalinvestible. Futures While Association it is one ofmultiple several times. “large It wouldcap” managedbe considered a statistical rarity for a member of this index to suddenly cease reporting. Survivorship bias is rarely the case, as AUM disintegration would typically result in futuresthe CTA indices being thatdropped typically from thedisplay index more before conservative, they would drop it is off,perhaps and the more index reliable is investible. performance While it is one of several “large cap” whenmanaged compared futures to indices broad-based that typically indices. display While more the conservative, index is heavily it is perhaps weighted more towards reliable performancetrend when compared to broad- following,based indices. the investible While the natureindex is of heavily the index weighted makes towards it an trendinteresting following, proxy the for investible overall nature managed of the index makes it an interesting futuresproxy forperformance. overall managed (Performance futures performance. Source: BarclayHedge) (Performance Source: BarclayHedge)

Compounded Worst Drawdown Average Monthly Annual / Worst 12 Losing Standard Return: Month Period: Month: Deviation:

+9.51% -13.31 / -12.72% 1.77% 3.07%

Leveraged Leveraged January Cyclical Returns Volatility Returns Market

Indicator© Indicator© Performance Environment©

1.24 66.15 +1.24% Negative

20.0% Jan

BTOP50 Index Historical Data ROR Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 1987 11.0% -0.7% 1.8% 14.5% 0.9% 0.2% 4.8% -0.1% -0.8% -0.5% 9.8% 7.0% 1988 -3.7% 0.8% -0.2% -4.2% 5.9% 13.6% -2.0% 0.8% 0.5% 2.1% 0.5% -1.3% 1989 3.4% -3.6% 2.6% -2.1% 7.4% -0.1% 0.2% -4.5% -0.9% -3.4% 1.4% 2.7% 1990 0.1% 0.4% 1.2% 3.0% -3.2% 0.2% 3.6% 4.9% 2.3% 2.1% 0.7% -0.9% 1991 -4.9% 0.2% 5.6% 0.6% -2.4% 2.9% -1.9% -0.5% 4.4% -1.5% 1.5% 10.6% 1992 -6.6% -2.3% -0.3% -3.2% 0.3% 5.8% 7.4% 5.2% -2.1% -0.5% 1.3% -1.6% 1993 -0.9% 6.9% -0.5% 3.2% 1.3% 1.1% 3.1% -0.2% -0.9% -0.9% -0.9% 1.7% 1994 -3.1% -2.2% 3.3% -0.8% 2.7% 2.8% -2.1% -3.1% 1.8% 0.4% 1.4% -0.9% 1995 -2.7% 2.9% 7.2% 1.3% 1.5% -1.6% -1.8% 2.1% -1.3% 0.5% 1.9% 3.8% 1996 2.9% -4.8% -0.0% 3.5% -1.4% 0.2% -0.1% -0.4% 3.1% 5.6% 5.7% -1.6% 1997 3.1% 2.4% 0.3% -1.3% -1.3% 1.1% 5.2% -2.9% 0.9% -0.0% 1.7% 2.5% 1998 0.8% -1.1% 1.5% -3.6% 2.0% 0.1% -0.4% 5.8% 4.9% 2.4% -2.7% 2.4% 1999 -2.0% 2.4% -0.7% 2.5% -0.9% 3.1% -1.6% 1.0% -0.0% -3.7% 1.6% 0.3% 5 Confidential Copyright © 2013 Mark H. Melin

OPALESQUE FUTURES ISSUE 3 • February 18, 2013 4

Jan Feb Mar Apr May Jum Jul Aug Sep Oct Nov Dec

1987 11.0% -0.7% 1.8% 14.5% 0.9% 0.2% 4.8% -0.1% -0.8% -0.5% 9.8% 7.0%

1988 -3.7% 0.8% -0.2% -4.2% 5.9% 13.6% -2.0% 0.8% 0.5% 2.1% 0.5% -1.3%

1989 3.4% -3.6% 2.6% -2.1% 7.4% -0.1% 0.2% -4.5% -0.9% -3.4% 1.4% 2.7%

1990 0.1% 0.4% 1.2% 3.0% -3.2% 0.2% 3.6% 4.9% 2.3% 2.1% 0.7% -0.9%

1991 -4.9% 0.2% 5.6% 0.6% -2.4% 2.9% -1.9% -0.5% 4.4% -1.5% 1.5% 10.6%

1992 -6.6% -2.3% -0.3% -3.2% 0.3% 5.8% 7.4% 5.2% -2.1% -0.5% 1.3% -1.6%

1993 -0.9% 6.9% -0.5% 3.2% 1.3% 1.1% 3.1% -0.2% -0.9% -0.9% -0.9% 1.7%

1994 -3.1% -2.2% 3.3% -0.8% 2.7% 2.8% -2.1% -3.1% 1.8% 0.4% 1.4% -0.9%

1995 -2.7% 2.9% 7.2% 1.3% 1.5% -1.6% -1.8% 2.1% -1.3% 0.5% 1.9% 3.8%

1996 2.9% -4.8% -0.0% 3.5% -1.4% 0.2% -0.1% -0.4% 3.1% 5.6% 5.7% -1.6%

1997 3.1% 2.4% 0.3% -1.3% -1.3% 1.1% 5.2% -2.9% 0.9% -0.0% 1.7% 2.5%

1998 0.8% -1.1% 1.5% -3.6% 2.0% 0.1% -0.4% 5.8% 4.9% 2.4% -2.7% 2.4%

1999 -2.0% 2.4% -0.7% 2.5% -0.9% 3.1% -1.6% 1.0% -0.0% -3.7% 1.6% 0.3%

2000 0.7% -1.9% -2.5% -2.6% 0.2% -1.7% -1.3% 0.4% -2.8% 2.1% 6.9% 9.8%

2001 0.6% 0.1% 5.2% -4.2% 0.5% -0.9% -0.5% 2.1% 2.5% 3.8% -7.0% 2.1%

2002 -0.5% -2.9% 0.2% -1.7% 2.9% 7.3% 3.6% 2.2% 3.4% -4.1% -2.6% 5.8%

2003 5.2% 5.6% -5.8% 1.6% 5.5% -2.4% -1.8% 2.0% -0.5% 2.4% -0.4% 3.8%

2004 0.7% 3.9% -0.8% -4.3% -1.4% -2.7% -1.0% -1.2% 0.3% 3.1% 4.1% 0.6%

2005 -2.9% 1.0% 0.2% -2.2% 1.4% 1.7% -0.2% -0.0% 1.8% 0.2% 2.7% -1.2%

2006 1.1% -0.6% 2.1% 2.4% -1.7% -1.1% -1.4% -0.4% -0.3% 1.2% 2.1% 2.1%

2007 1.1% -1.6% -1.1% 2.4% 2.6% 1.7% -1.2% -2.8% 3.5% 2.4% -0.1% 0.7%

2008 1.8% 4.8% -0.2% -1.5% 1.2% 2.2% -2.2% -1.9% -0.0% 4.9% 2.4% 1.6%

2009 0.2% 0.0% -2.0% -1.6% 1.0% -1.7% -0.4% 0.4% 1.4% -1.7% 2.1% -2.5%

2010 -2.0% 0.7% 2.0% 0.9% -2.4% -0.4% -0.7% 3.1% 1.7% 2.1% -1.8% 3.3%

2011 -1.2% 0.5% -1.3% 2.3% -2.6% -1.1% 1.9% -0.4% 0.1% -2.4% 0.0% 0.0%

2012 0.6% 0.6% -1.7% 0.4% 1.8% -1.7% 2.3% -1.4% -0.8% -2.5% 0.4% 0.4%

2013 1.2% 0.3%

This article introduces you to the P(A|B) Method of managed futures investment evaluation and ongoing risk management. The P(A|B) Method has heretofore been a private method for managed futures evaluation. The P(A| B) Method takes its name from Baye’s Theorem, which is an algebraic formula to assist probability factoring.

This system walks professional asset managers through a series of queries based on the risk exposure of each managed futures program. At its core managed futures is a derivatives-based investment and as such often has unique sets of performance measures relative to time horizon, related product structure and contract type. The P(A|B) Method start by providing asset managers the framework for analyzing the investment, and then provides the analysis on an ongoing basis.

The P(A|B) Method starts by considering the beta performance factors in the investment, then moves into alpha considerations. For the sake of brevity, this article only touches on key points.

Step One: Understanding System Analytical Structure

P(A|B) Method Educational Overview

The P(A|B) Method considers risk factors at the start of the process, applying a top down approach. It examines managed futures investments in different category slices, prioritizing based on factors that influence performance. For instance, the system’s first priority are beta performance drivers impacting the investment. In this respect, the system is similar to the analysis structure a hedge fund investor might view a private equity IPO. In the aftermath of the Facebook IPO occurred, for instance, many private equity managers accurately noted that the “market environment for IPOs has changed.” Market environments tend to be viewed as cyclical, and the attitude among those seeking to bring IPOs to market would return after market forces played their statistically validated game of asset rotation favoritism.

Thus, the first method of consideration in this system is to recognize the beta performance drivers and how this impacts exposure. After the beta exposure is understood, investors should consider the alpha factors of individual manager selection. A primary issue in managed futures is that, unlike other alternative strategies, the beta factors impacting performance are not as well known or defined.

In the case of this example, P(A|B) Method will examine the volatility managed futures investment category. This article only reveals top level considerations and does not provide detailed analysis, which is available in a separate report.

Copyright 2013 © Opalesque Ltd. All Rights Reserved. opalesque.com A primary issue in managed futures is that, unlike other alternative strategies, the beta factors impacting performance are not as well known or defined.

The P(A|B) Method 6

The P(A|B) Method Educational Hierarchy: The P(A|B) Method Educational Hierarchy:

Beta Performance Driver Exposure

Strategy Categorization / Understanding

Market Environment Exposure / Opportunity Analysis

Alpha Factor Analysis / Operational Account Selection

Ongoing Supervision / Risk Management Decisions

Step Two: Understand Strategy Categorization Step Two: Understand Strategy Categorization Building reasonable credible performance expectations for the professional asset manager is an importantBuilding reasonable point of crediblethe confidence performance building expectations process. for For the this professional reason, the asset P(A|B) manager Method is an important places a point of the confidence building process. For this reason, the P(A|B) Method places a priority of beta performance. As any strategy replication quant will priorityattest, understanding of beta performance. the strategy’s As betaany strategyis an interesting replication point quant of analysis. will attest, Some callunderstanding it key to setting the performance expectations in a strategy’sfashion that beta a private is an equityinteresting fund manager point of may analysis. say the Some “market call environment” it key to setting is not performance right for IPOs or a financial advisor might say to expectationstheir client, when in a explaining fashion that a string a private of negative equity performance, fund manager the “marketmay say environment” the “market doesn’tenvironment” favor tech stocks at this point.

With an understanding of the beta performance drivers, asset managers can communicate with a degree of intelligence and confidenceConfidential when discussing Copyright an investment. © 2013 MarkFor instance, H. Melin this issue is considering the volatility strategy, which is based on statistical probability9 of market outcomes. The strategy typically engages in the purchase or sale of options contracts. Like an insurance company considering probability tables to determine the rates for insurance in a given market, for instance, the managed futures volatility category often bases investment decisions on statistical probability of price movement force and price duration in a given market. Trading managers might base their decisions on probability tables, but the key to success might be found in how risk is managed and positions are sized.

This strategy categorization and understanding is used as a beta overlay on top of the alpha factor analysis and ongoing risk management. Step Three: Market Environment Risk Exposure

Start with Beta Market Environment Considerations

With an understanding of strategy categorization, look to the individual exposure of the managed futures program and pay particular attention to their forthright nature and respect for the intelligence of the professional asset manager. No credible investment

should be entirely black box and the expectation should never be that an investment will always generate return through all market environments. Although certain “all weather” strategies show interesting promise, as David Harding’s research staff of 100 might attest, market environmental factors are known to change and possess nuance.

Professional asset managers should expect the managed futures fund manager to provide enough insight so they can make intelligent decisions regarding the true risk in the investment. This includes providing a reasonable expectation of how the investment might perform given a variety of market environments.

In a volatility investment, the first question to answer is what “market environment” is conducive to returns production and in when the market environment might experience enhanced risk. In this case, the investment is exposed to the market environment of volatility, as implied by its categorization. Certain investments benefit during periods of rising market volatility and others benefit during times of declining market volatility. Once the asset manager recognizes the beta market environment performance driver to which they are exposed they can begin to establish a set of performance expectations.

Examination of historical patterns of price patterns indicate that volatility is a market environment that has been reasonably cyclical to various degrees and implications. As we can see from the stock market crashes from 1900 to today, on a past performance basis, volatility has been reasonably unpredictable but it has entered the market with increasing frequency, particularly in the equity markets. While past performance and probability tables don’t dictate the future, planning for a variety of scenarios and recognizing how standard deviation plays into risk management decisions is considered by the P(A|B) Method another key to success with the volatility strategy.

Major Market Crashes Since 1900

Name Dates Duration Comments

The market was spooked by the assassination of President Panic of 1901 (U.S.) May 17, 1901 3 years McKinley in 1901, coupled with a severe drought later the same year.

Markets took fright after U.S. PresidentTheodore Roosevelt Panic of 1907 October 1907 1 years had threatened to rein in the monopolies that flourished in various industrial sectors, notably railways.

The bursting of the speculative bubble in shares led to further Wall Street Crash of 1929 selling as people who had borrowed money to buy shares had • Black Thursday October 24, 1929 4 years to cash them in, when their loans were called in. Also called • Black Monday October 28, 1929 the Great Crash or the Wall Street Crash, leading to the Great • Black Tuesday October 29, 1929 Depression.

This share price fall was triggered by aneconomic recession Mid-1937 to mid- Recession of 1937–1938 (U.S.) 1 years within the Great Depression and doubts about the 1938 effectiveness of Franklin D. Roosevelt’sNew Deal policy.

Throughout Burst of an Boom (that had initiated in 1969), and its bear the 1970s market, which lasted so long due to the compound effects 1971 Brazilian Markets Crash July, 1971 and early- of1970s energy crisis coupled with early 1980s Latin American 1980s debt crisis

1973–1974 stock market crash January 1973– Dramatic rise in oil prices, the miners' strike and the downfall 23 months (U.K.) December 1974 of the Heathgovernment.

Silver Thursday March 27, 1980 Silver price crash

Souk Al-Manakh stock market August 1982 crash

Black Monday October 19, 1987

Rio Stock Exchange Crash, due its weak internal controls and Rio de Janeiro Stock June, 1989 absence of credit discipline, that led to its collapse, and of Exchangecollapse which it never recovered

Friday the 13th mini-crash October 13, 1989 Failed leveraged buyout of United Airlines causes crash

Share and property price bubble bursts and turns into a long Japanese asset price bubble 1991–2003 13 years deflationary recession.

The Conservative government was forced to withdraw the September 16, pound sterling from the European Exchange Rate Mechanism Black Wednesday 1992 (ERM) after they were unable to keep sterling above its agreed lower limit.

Investors deserted emerging Asian shares, including an overheated Hong Kong stock market. Crashes occur in 1997 Asian financial crisis July 2, 1997 Thailand, Indonesia, South Korea, Philippines, and elsewhere, reaching a climax in the October 27, 1997 mini-crash.

Global stock market crash that was caused by an economic crisis in Asia. The points loss that the Dow Jones Industrial October 27, 1997 mini-crash October 27, 1997 Average suffered on this day still ranks as the seventh biggest point loss in its 114-year existence.

The Russian government devalues the ruble, defaults on 1998 Russian financial crisis August 17, 1998 domestic debt, and declares a moratorium on payment to foreign creditors.

Collapse of a technology bubble, world economic effects Dot-com bubble March 10, 2000 3 years arising from the September 11 attacks and the stock market downturn of 2002.

The September 11 attacks caused global stock markets to Economic effects arising from September 11, drop sharply. The attacks themselves caused approximately the September 11 attacks 2001 $40 billion in insurance losses, making it one of the largest insured events ever.

Downturn in stock prices during 2002 in stock exchanges across the United States, Canada, Asia, and Europe. After Stock market downturn of recovering from lows reached following the September 11 October 9, 2002 2002 attacks, indices slid steadily starting in March 2002, with dramatic declines in July and September leading to lows last reached in 1997 and 1998.

The SSE Composite Index of the Shanghai Stock Exchange Chinese stock bubble of 2007 February 27, 2007 tumbles 9% from unexpected selloffs, the largest drop in 10 years, triggering major drops in worldwide stock markets.

The Dow Jones Industrial Average, Nasdaq Composite and United States bear market of October 11, 2007 2 years S&P 500 all experienced declines of greater than 20% from 2007–2009 – June 2009 their peaks in late 2007.

On September 16, 2008, failures of large financial institutions in the United States, due primarily to exposure of securities of packaged subprime loans and credit default swaps issued to insure these loans and their issuers, rapidly devolved into a global crisis resulting in a number of bank failures in Europe and sharp reductions in the value of equities (stock) September 16, Late-2000s financial crisis and commodities worldwide. The failure of banks in Iceland 2008 resulted in a devaluation of the Icelandic króna and threatened the government with bankruptcy. Iceland was able to secure an emergency loan from the IMF in November. Later on, U.S. President George W. Bush signs the Emergency Economic Stabilization Act into law, creating a Troubled Asset Relief Program (TARP) to purchase failing bank assets.

Dubai requests a debt deferment following its massive November 27, renovation and development projects, as well as the late-2000s 2009 Dubai debt standstill 2009 recession. The announcement causes global stock markets to drop.

Standard & Poor’s downgrades Greece’s sovereign credit rating to junk four days after the activation of a European sovereign debt crisis April 27, 2010 €45-billion EU–IMF bailout, triggering the decline of stock markets worldwide and of the Euro’s value, and furthering a European sovereign debt crisis.

The Dow Jones Industrial Average suffers its worst intra- 2010 Flash Crash May 6, 2010 day point loss, dropping nearly 1,000 points before partially recovering.

Stock markets around the world plummet during late July and August 2011 stock markets fall August 2011 early August, and are volatile for the rest of the year.

Source: http://en.wikipedia.org

Volatility is often, by definition, a result of a market “surprise.” If an event is known to the market, volatility can often be reduced through the lack of an implosion of chaos. For instance with the US debt crisis, if an event were to “surprise” the market it could have a much more dramatic impact than if an event were known, expected to a certain degree. This highlights one of the key points relative to a volatility investment.

While by definition volatility cannot be predicted, because of its “surprise” nature, the volatility investor must understand their risk / returns exposure to this market environment, which has always occurred on a cyclical basis.

Long Volatility

Long volatility and short volatility programs, as their description suggests, have very different risk exposures and returns profiles. Both investments are involved in buying (long) and selling (short) options. It is assumed this is an advanced audience understands the core asset traded is an option with premium being a primary influence in the value of the investment (assuming a delta neutral stance that does not take positional risk).

If the long volatility investment were to have a delta neutral stance, without a positional bias in the market, the returns profile this investment might exhibit skinny tails in the returns profile due to the fact the numeric distribution of positive returns might be slight, only existing during a volatility explosion. Such volatility implosions have been statistically rare, thus the market environment exposure of a long volatility investment is towards those rare moment of the market environment of volatility entering the market. A long volatility managed futures CTA exhibits such market environment exposure.

Due to its returns profile of low win percentage, a long volatility investment is not as popular as a short volatility investment. Some long volatility investments that come to mind include Shield Plus, which was a long volatility play along the energy complex. The CTA also structures custom hedge accounts as a play against rising energy prices. While understanding the benefits of long volatility during crisis is interesting to a professional asset manager, the more popular strategy is the short volatility program due to its more consistent return pattern, but there is a hidden risk.

Short Volatility

While the true long volatility program may exhibit a different returns pattern than a short vol program, the market environment of volatility is nonetheless the beta performance driver.

The short volatility program engages in selling volatility as opposed to buying volatility. While a pure delta neutral long volatility program, the returns profile would be expected to exhibit significantly large win size but low win percentage. Conversely, the pure delta neutral short volatility managed futures investment would be expected to incur a moderate win size but a high win percentage. This is statistically confirmed, as the average win size in the volatility category is benchmarked at 3.75% compared to 4.22% for all CTAs, while win percentage benchmark for the volatility category is 74.25% compared to 59.99% for all CTAs. [Source: P(A|B) Method proprietary analysis of past performance data.]

With an understanding of the individual strategy underneath the volatility investment asset managers recognize that the returns skew is almost reversed, long volatility is expected to exhibit high win size and low win percentage, short volatility is expected to exhibit low win size and high win percentage.

Market Environment Risk Exposure of Short Volatility Investment

The first step in considering a managed futures investment in the P(A|B) Method is analysis of the beta market environment. In the case of LJM, the managed futures program featured in this issue, we know they are a short volatility-based investment and we can expect returns patterns and risk exposure relative to the market environment of price volatility in the markets in which the program trades.

At the end of the first phase of analysis, the asset manager should be able to determine the overall beta risk exposure of an investment. In this case, that exposure is to the market environment of volatility. The short volatility investment might exhibit enhanced risk during periods of rapidly rising market volatility while the long volatility investment might find this environment rewarding, and vice-versa.

Questions to Consider:

What does the returns distribution of a short volatility strategy often look like and why? What is the typical win percentage of a short volatility strategy relative to win size? In what market environment can a short volatility be expected to find opportunity and conversely find enhanced risk?

Step Four: Alpha Factor Analysis Once strategy categorization and market environment exposure has been determined, we move from beta to alpha considerations. With a short volatility investment, the P(A|B) Method starts by considering risk management tactics and then reviews key statistics in past performance relative to the unique features of a volatility investment. Note that with each beta exposure strategically significant performance measures are favored during both analysis and ongoing management. Risk Management Strategies

With a volatility strategy, the professional asset manager may wish to consider how the trading program has planned for the worst case market environment. Trading programs that have not considered the worst case are those one might want to view with suspicion, and in fact this system eliminates managers who have not thoroughly considered probability tables and a variety of potential outcomes.

The primary point to consider in a short volatility risk management discussion is the point at which volatility may rise significantly. The key question is: What is the trading manager’s strategy to manage such an environment?

In the volatility segment, sophisticated consultants might recognize various volatility hedging tactics, including corresponding long volatility purchases across different time horizons and different price event levels. Still others with familiarity of this strategy might consider a time horizon roll into the forward month and still others might prefer an indirect hedge through a spread relationship with a related futures contract. Each of these risk management strategies have different risk implications. The consultant should document these tactics and use it as a benchmark for ongoing risk management phase, for it can be key towards making the tough decision to cut ties with a particular manager.

While even sophisticated asset managers might not need to understand the implications of each of these factors, an industry consultant should be aware of how risk management strategy can impact downside deviation and consistency of worst drawdown performance, which is used for performance analysis given to the asset manager.

Past Performance Analysis of Risk Management Acumen

It can be said with a degree of certainty that every successful trading manager / quantitative program has experienced a negative returns environment and will likely experience unfavorable market environments in the future. The interesting point is the understanding achieved during this period of time and how statistical knowledge learned translates into risk management techniques going forward. While this can be true in the trend following or relative value strategy more so than the volatility strategy, these are important points to consider and often a good point at which to engage the managed futures asset manager in a conversation. The reason volatility investments are different in terms of risk management from trend following, for instance, is in part due to the very unpredictable nature of volatility. In fact, the sophisticated asset manager may wish to employ is early in their interaction with a volatility investment play is to ask the manager how adapt their system is at predicting volatility? This can bring up an interesting discussion, because volatility by definition is unpredictable. Volatility is often based off crisis, which, we can logically determine, is driven by surprise. If something can be predicted it is not a surprise. The issue isn’t predicting volatility but rather having a realistic grasp of risk management during the inevitable unpredictable period.

With a short volatility program, the past performance can point to logical questions for the asset manager to further explore. Topic of discussion starts with worst drawdown. If a short volatility program has any track record duration of note, they have likely experienced a rapidly rising volatility regime. The professional asset manager should first focus on these periods of time, asking the short volatility manager to explain their risk exposure and tactics along with lessons learned. Specifically ask regarding margin usage and volatility spikes intra-month. All this will yield valuable information for analysis.

The Importance of Standard Deviation From the Market When Considering Risk Exposure

Risk in a short volatility programs can be in part measured by the standard deviation the trading manager often times places between the market price and strike price time horizon they have selected. For instance, a short volatility manager who sells options “closer to the money,” which indicates the distance from the current market and thus the “cushion” in time decay of the option, might experience a higher downside deviation level yet a higher returns profile than compared to a short volatility program that places trades “further from the money.” As an example, a volatility program may be short the $133 oil call when oil is at $100. As

Copyright 2013 © Opalesque Ltd. All Rights Reserved. opalesque.com OPALESQUE FUTURES ISSUE 3 • February 18, 2013 The P(A|B) Method 12 measured by standard deviation of prices, this might be considered a far “out of the money” short volatility strategy. However, if the volatility trader sold an option closer to the market, say at $116, for instance, this impacts the expected risk / returns profile of that investment. In the short volatility strategy, the distance “from the money” is often measured by standard deviations of variance and this indicates the expected risk profile. A managed futures volatility program close to the money might be expected to exhibit a higher degree of expected volatility but also a higher level of expected returns (as option premium collected closer to the money is higher than that which is out of the money, and the gamma of the option position might exhibit a higher variance.)

Importance of Markets Traded and Time Horizon

When considering a volatility investment, the P(A|B) Method disciples should recognize the implications of markets traded and time horizon on a short volatility program. Many short volatility programs operate on a 45 to 90 day time horizon, collecting option premium during the period of greatest theta / time decay. When evaluating the short volatility strategy, the asset manager should recognize the time horizon and its implications on projected returns profile. Further, this time horizon target should be benchmarked and utilized as a method to identify strategy drift in the investment supervision stage.

Also of consideration is markets traded. The short volatility strategy is known to have its origins in the S&P options pits. Today certain programs trade primarily equity options, finding the greatest premium collection opportunity in puts. Other programs trade diverse markets, finding variable opportunities in income collection. When evaluating various short volatility programs, the asset manager should heavily weight the markets traded when consideration of correlation among other volatility programs. For instance, if a well diversified portfolio including a variety of beta market environment exposure might include a spot for four volatility programs, two of these being short volatility. If the asset manager selected two short volatility programs with similar markets traded profiles, the short volatility aspect of the portfolio might be highly correlated during times of crisis.

Consideration of Leverage Usage

When considering the short volatility program, asset managers might want to consider issues of leverage usage relative to volatility and separately relative to returns. Consider a number of performance measures, including the leveraged returns ratio and the leveraged volatility ratio that are encompassed.

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With the P(A|B) Method the professional asset manager considers with a volatility investment is the margin usage relative to standard deviation. In particular, recognizes the implications of margin on performance during times of crisis. The investor might expect a degree of enhanced leverage usage during times of rising volatility and reduced leverage during periods of declining volatility. Leverage is an interesting risk measure to consider from several standpoints. The discussion gets interesting by considering that an interesting risk management tactic is to consider leverage usage after a drawdown. At first glance one might consider this might answer the question of the manager increasing leverage in order to overcome a drawdown high water mark. In many cases, this is an interesting leverage point to consider, but with the volatility investment asset managers might want to consider that after a volatility spike certain managers may wish to increase margin to equity ratios to benefit from what might be anticipated as a declining volatility regime. Assuming that markets revert to historical mean, this strategy might prove opportunistic under conditions of shrinking theta, or time decay factor in the option.

Asset managers and consultants should know the patterns and have realistic expectations for performance and risk management when in an inevitable volatility spike occurs. These benchmark performance assumptions are built during the first four steps of the P(A|B) Method and used in the final step: managing the investing on a going forward basis.

Questions to Consider:

How does standard deviation and “distance from the market” impact the risk profile of a short volatility investment? What is the typical win percentage and win size of a short volatility strategy relative to the managed futures benchmark? When analyzing a managed futures program are the benchmarks used for ongoing risk management?

Copyright 2013 © Opalesque Ltd. All Rights Reserved. opalesque.com OPALESQUE FUTURES ISSUE 3 • February 18, 2013 The P(A|B) Method 13 Step Five: Operational Due Diligence and Account Type Selection Determines Risk Controls

Operational Considerations

There are a wide variety of operational check points the asset manager should consider when investing in a managed futures program. In this brief section, we will review a few top considerations. The decision process for managing risk is always a consideration to consider. Start with the determination of the level of systematic decision process or discretionary. Walk through the decision process to establish a position and exit that position. Is a committee structure involved? Can the trading manager override decisions of the committee? If the trading manager utilizes a systematic approach with a discretionary overlay, at what point does discretion enter the picture? How often are decisions overridden? In managed futures, each program is audited by the National Futures Association, which includes a business process audit in addition to a performance audit. It can be instructional to ask the trading manager for a copy of this report, if they are open to sharing.

Account Decisions Drive Risk Management Technique

In managed futures, the account type drives risk management options to an interesting degree. Professional investors should be aware of the liabilities and fee structures of each of the account types.

It might be considered that the appropriate managed futures account type might rest in the sophistication of the investor. While the account type details are not going to be discussed in this issue, of consideration to the professional asset manager should be transparency into leverage usage, position risk exposure and fees, as well as ease of access, defined loss liability, liquidity and the restrictions and hidden tax benefits in a CFC corporate structure. Step Six: Managing the Investment Going Forward Many times setting up the supervision of an investment occurs in the initial investigation stage of the process. This can be particularly true with a number of performance measures as they relate to real time risk measurement.

With a volatility CTA, investors might want to initially benchmark the manager’s stated margin usage during a variety of market regimes and compare it to actual performance. If a short volatility program were to experience a volatility spike, the professional asset manager wouldn’t be surprised at enhanced margin usage in the account. After a volatility spike the asset manager might expect the CTA to capture high option premiums (during a potential period of time of heightened margin requirements). As volatility reverts to statistical norms, the asset manager might expect this investment to exhibit decreased levels of option premium collected, with a declining theta profile.

During the analysis process with a volatility investment, the asset manager should benchmark seven primary points for consideration and 12 secondary points for consideration. A scoring algorithm is used as a benchmark to highlight potential areas of concern which may require additional investigation or individual due diligence. This system includes a flagging system for both initial evaluation and ongoing risk management decisions. It is these risk management decisions that can actually be more significant than the initial allocation decision.

For additional information, register on the newsletter’s web site where asset managers can live chat with consultants, download appropriate white papers and find detailed educational opportunity and specific recommendations.

Unfamiliar to even many sophisticated asset managers, volatility investing provides unique opportunities for risk management and market understanding.

Volatility investing involves trading programs based on market price volatility. The primary volatility market is based on the stock market, but variations of volatility investing methods are used in commodity markets as well. In light of an approaching debt crisis and always unpredictable world events, volatility-based investment techniques, both long and short, are worthy of detailed investigation.

A recent educational opportunity sponsored by AlphaMetrix and the CBOE Futures Exchange revealed interesting issues as it relates to the debt crisis and volatility investment techniques. In addition to stock and commodity option contracts, one of the primary methods of volatility trading occurs with the VIX, the CBOE’s popular measure of implied volatility in the equity market.

Did Volatility Skews on December 21, 2012 Reveal a Market Imbalance?

“Just before the conclusion of the fiscal cliff debate, the time horizon spread in the VIX options exhibited unusual expectations,” noted Christopher Cole, managing partner at Artemis Capital Management and one of the panelists. “We could buy the front month VIX options and sell the back month with a positive carry.” This is unusual because such a long volatility position typically involves the purchase of premium, but in this unusual relative value situation the trading manager collected premium and had long volatility exposure.

“What was the shoe that was expected to drop?” questioned Bruce Rogoff who, as managing partner of option market making firm Gargoyle Group, noted highly unusual professional action leading up to the fiscal cliff negotiations. “And when is that shoe expected to drop.”

Behind the scenes, derivatives professionals have been observing the mathematical properties of the US debt crisis for several years. While predicting the exact date of a potential volatility implosion is speculative, what is known is there is a certain point at which compounding on the debt and a continued path of deficit becomes unsustainable, potentially leading to a transformational market crash. While the date cannot be predicted, the mathematical underpinnings of the problem are generally understood along with the practical knowledge of the likely political battles that could arise out of the problem. If the US debt crisis is left unaddressed, speculation is a transformational debt crisis crash could occur within three to five years, while more conservative estimates indicate a 10 year time horizon. Just like former CFTC Chairperson Brooksley Born predicting the OTC derivatives would eventually cause a market crash, she didn’t know the date would be 2008 but a logical understanding of derivatives structure and mathematical probability also indicates that at some point a debt crisis crash should be considered.

Can Market Volatility Be Predicted?

Perhaps one of the more interesting discussions to take place occurred regarding the predictability of market volatility. “Volatility can be predicted,” said Scott Reamer, CIO at volatility trading program Rotella Chora. In subsequent conversations Mr. Reamer, who operates a short-term time horizon volatility strategy, observed that even longer term volatility events can be predicted to a degree based on structural instability leading up to the event.

It has been assumed that volatility can be more easily subject to a probability table on a short term basis, due to the cyclical nature during a given trading day, week or month. It is the major volatility events, such as September 11, 2001 that would be difficult if not impossible to predict just by looking at previous pricing data. To this Mr. Reamer responded the insight that a pattern of structural instability often led up to major volatility events. Fascinating conversations to be sure.

What is The Appropriate Process For Selecting a Managed Futures Investment? By Mark Melin

Investing in a managed futures investment program can be significantly different from traditional hedge fund / alternative investing. To some, the required education process can be a foreboding task because the variables are new. Depending on the evaluation and ongoing risk management system, both the complexity of a program and its risk management features can be a variable output.

In this article professional asset managers are introduced to a systematic method of managed futures investment analysis and ongoing supervision.

Quantifiable issues professional asset managers may wish to include margin usage, leverage exposure to downside deviation, time horizon correlation, volatility exposure relative to beta market environment risk and the always sometimes business operations exposure. For those new to managed futures, this all might represent new variables.

Options Available to QEP Asset Managers

As a professional asset manager, you have several choices in evaluating and managing your investment.

1) Hire new in-house expertise or educate internal talent. Perhaps the most active approach is for the investor to engage the process through the use of internal assets or individual efforts. This could take the form of an investment evaluation apparatus and a separate risk management apparatus, each with focused responsibilities and mandate. The positives of this approach are it enables the asset manager significant degree of control and potentially transparency / liquidity, depending on the account structure selected. The disadvantage is this process could be costly along several fronts, including time / opportunity cost.

2) Invest in a managed futures fund of fund (FOF) approach. Hiring a FOF service enables a more passive approach for investors without the expertise or desire to engage in detailed understanding of managed futures. (Investing in a managed futures FOF is a process all its own detailed at a later date.) The benefits of the FOF approach is the ease of execution and ongoing management. The disadvantages might include an additional layer of fees and a lack of transparency with potential liquidity issues depending on the account structure selected. Choices include a mutual fund account structure or a more traditional hedge fund account structure. Again, each of these structures have different pros and cons, risk management implications, and should be considered alongside a direct managed futures account option.

3) Work with a Consultant or Platform Provider. If an asset manager wished a more active role in the investment process, with significant transparency, they might consider a platform provider or consultant. Available platforms in managed futures come with various benefits and risks. For instance, certain platforms may provide transparency and ongoing account management options, as a fund of fund service might provide. However, depending on the account structure selected, certain types of accounts may expose the investor to loss potential in excess of the initial margin deposit required. Niche account structures, typically available to select family offices, RIAs, pension funds that limit the liability structure risk of the investment are offered.

Once the method of investment access / analysis is selected, asset managers can then move to understanding the underlying principles of the investment and the risk factors to consider, as outlined in further articles on this issue. (Members to the OFS newsletters can log into the web site for consultation from the author Monday, Wednesday and Friday from 10 AM to 11:00 AM CST. For a free trial click here.)

Interview with Short Volatility Trader LJM Partners

Today’s interview is with Scott Sykora and Arjuna Ariathurai of LJM Partners, one of several well known short volatility investments. LJM has been an innovator in the short volatility space and has exhibited thought leadership in a number of academic research projects. A thoughtful piece was recently authored by their Chief Investment Officer, Anish Parvatenini. (I worked with Anish on a Barclay CTA Graveyard Database study when he was at University of Chicago, he has a tremendous quantitative mind.) In today’s interview we have Scott and LJM’s Chief Risk Officer, Arjuna Ariathurai.

Mark Melin: Why don’t you start identifying your program by defining it at a high level based on the market environment performance factors?

J. Scott Sykora: We offer a set of investment products that are all basically variations on a common theme. We only sell (short) options and S&P futures, and what we are able to bring to market are products that offer clearly differentiated risk return profiles, each targeting differing rates of return, and each that have extensive public track records. So the suite of products offers investors a clear choice in terms of investing to their personal portfolio requirements.

These products also tend to provide great ability to diversify traditional portfolios, and by traditional I say portfolios that invest in the traditional asset classes of equities and fixed income. So a big component of our products in addition to their return stream is the ability to add diversification to a broadly diversified portfolio.

Because of these performance qualities, we are getting a lot of attention in recent years, because whereas many investment asset classes have unperformed or outright failed, our set of products have been able to demonstrate very consistent and persistent performance now over a 15-year timeline.

So to speak roughly about when they perform well and when they do not, again, these are short volatility investment strategies.

Beta Market Environment Analysis

The hallmark is that they are profitable -- consistent and profitable in most market conditions, and by most I think that when equity markets are moving mostly sideways, our products are very profitable.

If equity markets are rallying, such as when volatility is falling somewhat slowly, we are most likely profitable.

If markets are selling off slowly; we call that market erosion, there is a very good chance that we are profitable.

So that begs the question, what is the stress point for these strategies? And the answer to that is when markets demonstrate a big increase in volatility and it typically corresponds to market sell off, that is the singular stress point for these strategies. So either when markets are trashing about, maybe not moving that much overall, roughly sideways, but with a lot of increase in volatility, or a single precipitous market sell off, where volatility escalates quickly, those are the stress points for the strategy.

Mark Melin: I would like to start drilling down a little bit if you do not mind. You talk about the stress point of the strategy being enhanced volatility over a short span of time. Let us talk about potential risk management tools that you have to work with that help mitigate exposure to short volatility implosion, because that is really the key point you want to manage.

This could include items such as portfolio sizing, rolling contracts to the forward month, options or futures contract hedges to name a few.

Arjuna Ariathurai (Chief Risk Officer): Hopefully I will qualify to give you some answers to your inquiry. Actually when it comes to risk management, we have evolved obviously from our earlier roots, but we tend to take a look at the combination of volatility and of underlying moves.

So the performance of the products, the funds themselves are really tied to change. If there is a lack of change, or if the change is controlled, we are able to manage our risk at a very efficient or cheap level and that impacts our return stream. The more change there is over shorter periods of time, both in volatility and in underlying movement, the greater the associated hedging costs to affect risk reduction cost which of course impact our performance.

So what our main focuses are with regards to risk management is this: a combination of proactive risk management (i.e. hedging traded integral to the strategy) and then reactive risk management in response to market behavior. With our more aggressive funds, we tend to be more reactive than proactive.

The concept to the idea there is we are looking to reduce hedging investments as much as we can while still maintaining a reasonable risk profile. In our most conservative strategy, we tend to spend more of our available capital on managing risk or proactively managing risk.

So we work on risk reducing trades in advance of market movements based off of macro scenario analysis.

Mark Melin: Drill down on that concept a little bit, as best you can, and I know you cannot give away your secret sauce, but can we talk about some of the different types of strategies you might be employing and the market environments in which they might work out? Particularly, are you hedging with futures or options? Are you trading different timeframes? Are you rolling certain months based on volatility disparities between the strike prices?

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Arjuna Ariathurai: I will give it to you in a very simple way. We trade options against options incorporating extensions to the classic Black–Scholes, models. We build off of a return target and we take that return and we execute trades in a systematic fashion to generate theta, or the decay value for the option. And the real risk comes in how much volatility exposure or vega we have in order to generate the desired theta decay collection on a daily basis.

Secondarily, we have a sort of relationship between the underlying movement, and it is actually encapsulated in gamma as opposed to delta, and I will get to that in a second.

Mark Melin: That is interesting!

Arjuna Ariathurai: Yes. What we do is we run our deltas as a latent hedge against the volatility skew in the market. So volatility spikes tend to occur in downward movements in the underlying S&P. So we will stay latently short delta which provides time to respond and that time offers a level of risk reduction in the cases where there is significant movement. We do not settle this risk mitigation immediately. We tend to keep ourselves in a hedge or at least a mitigated position for the first several percentages of movement. The more gamma we are carrying, the more short gamma we carry, the faster the protection of the proactive hedging dissipates,.

Mark Melin: I know exactly where you are going.

Arjuna Ariathurai: So that is a really critical measure as well. The corollary then is if we experience a scenario where the underlying does not move, but volatility increases, i.e. we were to engender immediate vega losses only, we would look at that as an opportunity to sell additional contracts rather than a scenario requiring risk mitigation.

So we will be looking at ways to take advantage of the spike and volatility. So you can see kind of our general methodology is to look at when are vols going to spike, because when they do, that can be beneficial for us.

Mark Melin: Right, after the spike the market environment can be productive given a reversion back to the mean.

Arjuna Ariathurai: Right. And we want to just sort of mitigate through that vol spike. So if things are in a controlled manner, even at low vol regimes, we will perform well because our hedging cost are low and because everything is moving in a controlled manner. But we do to some extent have to be prepared to take short-term pain for medium and long-term gain.

Mark Melin: That is a concept the United States needs to learn in regards to their fiscal deficit.

Arjuna Ariathurai: That is true. So how do we manage that? We will run merely three months, no more than 90 days of maturity, so our entire portfolio will turn over in those three months.

Mark Melin: Well, the 45-day window is kind of the sweet spot of delta / theta time decay opportunity.

Arjuna Ariathurai: Yes, to a certain extent. So we look at the second month as sort of our short vol or our systematic volatility placement. We used the third month as the back month for vega hedging, so we might do spreads in the back months to hedge. We will manage our gamma in the front month.

Mark Melin: What is your favorite book on Option Volatility? Are you a Natenberg fan?

Arjuna Ariathurai: Actually I am a Natenberg fan.

Mark Melin: I am a huge Natenberg fan. His book was amazing!

Arjuna Ariathurai: I am a textbook guy too, so Hull is really the book that I have used the most. I think Hull’s book provides a really great overview. It gives you a great overview of all the different types of markets, but it does a great job of explaining models, and from our perspective here, – the macro risk overlay is actually the behavioral overlay. So we do not just try and trade straight volatility, we are really looking at market behavior. So the combination -- there are three things we are looking at. We are looking at our current portfolio and forecast the response under different vol regimes that exist and may develop in the future. We look at the macro conditions but are not attempting to predict direction, but really model the response to several possible market scenarios.

Mark Melin: Scenario management, that is the top CTAs. It isn’t about predicting anything as it is portfolio management, position sizing, appropriate hedging.

Arjuna Ariathurai: Yes. And of course the third perspective is the specifics of the market we trade. We are looking at the volatility surface over those three months, even beyond that, and we will look at the relative values; where things are trading, how puts are related to calls, how short days are related to longer days. If there are, I guess for lack of a better term, juicer pieces on the surface, we will attack those. If there are places where we just do not see a lot of value, we will stay away from them.

So that is incremental, we do not try to make large scale bets. We are not taking entire positions off only to find three days later that we have to put them back on again, because we were a little bit too hasty in our actions. We are incremental in the sense of, we will take some more off, we are never being perfectly optimized, but who will? But we find that, that dollar cost averaging on the system side where we are entering everyday and collecting a little bit of theta and keeping that collection at low and manageable levels, that tends to work best for us.

Mark Melin: Well, that is kind of fascinating. So everyday you are collecting theta. A lot of times you look at the S&P option strategy, particularly in our retail direct account, and they will set that trade and sort of forget it for about 40ish days.

Arjuna Ariathurai: Right. In your example they are market a forecast - they are trading to the forecast that the market is not going to 1,200 or the market is not going to 1,600.

Mark Melin: Exactly, that is a simplistic method.

Arjuna Ariathurai: Yes, we are different in that important aspect.

Mark Melin: I can see that.

Arjuna Ariathurai: So obviously for options, the rate of decay changes over time, especially for out of the money options. What we are looking for is, in our portfolio what is contributing to theta? What is taking away from theta?

We ask the questions: If we are long an option, why are we long an option? Is it effective in its risk management? If they are not, then are we going to roll into a long cntract that is. That is kind of where we tend to look at things. If the market is not giving us great return, we are not going to try and go for big returns. We are going to trade within what the market is going to give us, and we think that, that model works very well. I mean, honestly, there always have been, and certainly at least in the foreseeable future, seem to be more option buyers than sellers.

Mark Melin: That is always the case.

Arjuna Ariathurai: The sellers are providing liquidity in a demand market and are able to extract premium from that, as long as we are able to keep our cost of hedging down in a responsible manner. We believe we can consistently generate returns, and that profile has worked well for LJM for 14 years now.

Mark Melin: Well, let me address a couple of other issues. First, I want to talk about that white paper that Anish put out, and then second, I would like to get into the direct account options versus a fund account option and talk a little about your target lines.

J. Scott Sykora: Okay. Now, we have invested in research for over six years now and it has totaled several million dollars. It has been very interesting to look at those investments in hindsight. Our focus and views for R&D have developed over time. Our investments today are more focused on the development side than pure research.

In one example, we invested the better part of a year-and-a-half and close to a million dollars supporting a senior guy in the industry, who built a system for us that we trademarked under the name of the LJM STORM System. STORM was an acronym (System for Trade Optimization and Risk Management) , but also a metaphor of course.

The point of the system was that it was a statistical and mathematical representation of historic S&P behavior. It was a very involved system that was built on a two components Student-T distribution, with fat tails on the left side. The system also incorporated GARCH(1,1) or GARCH(2,2) volatility clustering. It was a very, very ambitious effort that was intended to the the foundation for our risk modeling and trading operations.

We then tried to integrate that platform with best of breed, off-the-shelf software from Prime Analytics, their product called ProOpticus. They integrated some of the outputs of our LJM STORM System in their volatility modeling package as well, and that was another six to nine months effort.

Along the way we then realized that one of the most important factors of all is that it really is not possible to in any way predict the future, despite the best efforts of volatility clustering, where that yesterday’s event gives you an edge on forecasting today’s event, we realized that volatility is inherently unpredictable, these are random events, and so we began to move in a new direction. We ultimately pulled the plug on ongoing development for the LJM STORM System.

Mark Melin: Scott, think about this for a minute. Volatility by its nature is not predictable otherwise it would not be volatile. It is like a trend. What I like doing with short volatility guys or volatility investment is comparing them with trend following.

Trend following, there is a specific methodology of looking at momentum in the market to determine based on probabilities how things are going to continue in the market or price persistence. But volatility, if people knew that -- a couple of issues, look at the debt crisis. People knew about it so we were able to soften it up. For a while there was a big, keep it a secret, do not talk about it, it hurts market sentiment, but the fact is when you start to put things on the table and people see the risks, you can mitigate some of the volatility. There are no guarantees though.

J. Scott Sykora: Well, you are right, if volatility was forecastable, then the markets would not panic and it would not be volatility; the whole event would be traded forward so that the ripple would dissipate in the pond.

So I agree. The question was whether or not volatility clustering would allow you to have a little bit of an edge statistically over a very lengthy period of time. But when you look at events which have really happened, like Flash Crash, a risky event which was a mechanical breakdown in the execution side of the industry, it turns out this event was totally unforecastable.

Mark Melin: Okay, wait, Flash Crash was in part an electronic eye issue. They can see all those orders coming in. The electronic eye pulls the bids and offers.

J. Scott Sykora: Right. And it could have been a cascading of trades and various things like that. It occurred with an absence of cross- exchange firewalls, but there are so many ways the risk can play out. You have geopolitical events, you prominent failures of FCMs including fraud. We are clearly not trying to make any claims about predicting the future, we do not try to predict vol regimes, all that we are looking at is what is the market offering us today.

We try to maximize our performance based on what the market provides for us. And so then we have decisions to make, do we need to adjust the targeted rates of return for the LJM products based on what the vol regime is offering us.

So we have adjusted our thinking over time. We used to target consistent and uniform performance across various vol regimes; we have now evolved to the point where we will amend our targeted rates of return based on the vol regime.

So the best case study was this fourth quarter just ending. Volatility was surprisingly low given global uncertainty, including a US election, stimulus generated by the Fed, Eurozone instability and most recently the fiscal cliff. So we made a discretionary decision to temper our targeted rates of return, which softened some of the returns we would have received otherwise. But if markets had reacted with increased volatility, we had a ton of dry powder available to sell into that volatility. So we do apply a discretionary overlay to our systematic trading. That is one of the hallmarks of our approach.

Mark Melin: Talk about the dry powder in your returns. What are your targeted returns and what is your risk profile? Also, I want to talk a little about margin equity. Let us talk about leverage usage and how you manage that, particularly during a vol spike?

J. Scott Sykora: Absolutely! So we have three products as I stated earlier. We call them the LJM Aggressive Strategy, which is the oldest; that has a track record, starting in 1998. So that was the initial strategy that Tony, the founder, really launched this company with. The LJM Aggressive Strategy is essentially classic option premium writing that targets 30% a year and above rates of return.

In 2003, we introduced a hedged version of that strategy that we now call the Moderately Aggressive Strategy. This product targets approximately 2% a month, or 20-25% per annum, and these are net rates of return for the investor.

The third strategy, the most conservative, is called the LJM Preservation & Growth Strategy. This product targets 10% net return to the investor. The margins vary across the three strategies, as you would suspect, although there is a counterintuitive aspect to it all, which I will also touch on.

Margin for the LJM Aggressive Strategy can range between, at the low end maybe 60% and oftentimes above 80%, and in some market conditions up into the 90s. We have never had a margin call requiring a client to add money. We have had margin calls, but these are generally resolved by trading out of tselect positions, lowering the portfolio’s margin requirements.

A hallmark of our program is that we work with a select number of FCMs that understand our people, and how we trade, and how we model risk. These preferred FCMs the provide a full trading day or even trading day-and-a-half to respond to margin issues which occur very infrequently.

Mark Melin: We have all been there.

J. Scott Sykora: Yes, we have all been there. And it is good to point out that even in October of 2008 and August of 2011, we never had margin calls during those periods. The periods when we experience pressure is actually counterintuitive.

J. Scott Sykora: Where we receive, the greatest margin pressure is on the short call side, i.e. up ahead of the market, immediately prior to expiration. And the reason for this is a function of how the SPAN Margin models were constructed at the CME.

So they have one set of models that they use to provision margin for all the various futures that they clear. Some of these futures clearly can gap up; natural gas perhaps or certain agricultural or metals certainly have the potential to gap up double digits over a day or a couple of trading days.

We all know from history that the S&P has never gapped up 10-15% over one or even two trading days. It has never happened. I believe the biggest gap up in the history of the market was one day in October of 2008 after a precipitous sell off the day prior, there

Copyright 2013 © Opalesque Ltd. All Rights Reserved. opalesque.com OPALESQUE FUTURES ISSUE 3 • February 18, 2013 Interview 21 was a one day posting a 10% rebound. Other than that one day the market has never -- the index has never gapped up anywhere near 10% or above.

Mark Melin: Right! The reason that the gap up is a little more important is, and I am going to speculate here, you do not have to answer if it is private information, but you are a little closer to the market on the calls than you are with the puts, the standard deviation distance is probably a little looser on the puts.

J. Scott Sykora: Well, what happens is that mathematically market could go to infinity. So if you modeled the effect of a 25% gap up move in the S&P, which has never occurred, you run into some extraordinary results.

So we could be 15% out of the money approaching expiration, but the CME is going to put a lot of margin requirements on these short positions, because again, they may model an unlikely event of a 25% gap up, which has never occurred in the history of the market.

So we run into some of these margin issues for this counterintuitive effect, I just though I would mention that. We are well aware and we are very familiar with -- we have less of a problem managing margin to the downside that is what is interesting.

Mark Melin: I am fascinated that you touched on it, because it really started to speak to your risk management protocol!

J. Scott Sykora: Yes. And we do have a margin calculator, a SPAN Margin calculator in our trader tool models, their toolsets, and so they can model the effects of trades; whether adding a trade to the portfolio or eliminating a position immediately recalculating the impact on margins. We are very proactive in our ability to stay abreast of margins.

So in the second program, in the Moderately Aggressive Strategy, margin is less than the LJM Aggressive Strategy. margin might range between 40% right after expiry to maybe as high as 70% typically. Maybe on occasion margin gets into the 80s, but we generally have fewer problems, much, much less of an issue with potential margin calls with that.

Mark Melin: Let me interject, the risk management and the difference between the Aggressive and the Moderately Aggressive, is it distance from the market or is it just sort of just the leverage level?

Arjuna Ariathurai: It is the latter. It is positioned by option contracts per equity dollar, but it is also impacted by the degree of proactive hedging which I discussed earlier. By example, if you do not spend a thousand dollars to place a risk reducing trade, then if nothing happens in the market you have a thousand dollars additional return.

If on the other hand, if something does happen, it is possible that it may cost you more than a thousand dollars to reduce your risk once the market sources have moved. That is another kind of difference between the three different levels of funds is, the degree of proactive hedging we trade integral to the strategy.

Mark Melin: Quick question, do you have direct accounts and fund accounts both?

J. Scott Sykora: So as far as the products, yes, we offer individual managed accounts. The funding levels vary across the three strategies. We offer both onshore accounts and and offshore managed accounts. And we work with a number of individual FCMs; ABN AMRO Clearing is our most prominent FCM, We also trade accounts at FCStone. We have worked with Newedge and we have an account that may open soon at Archer Daniels Midland. We can work with most any FCM for the Moderately Aggressive Strategy and the more conservative Preservation and Growth program.

The Aggressive Strategy is something where we do need to go through a due diligence with the FCM’s risk department, to make sure that they understand the tenets of the strategy We introduce our traders and risk management team, and review how we model risk. So the LJM Aggressive Strategy does require an extra step.

Mark Melin: Let’s just cut through the jargon here. If an investor selects the Aggressive Strategy, it would be advised to go with the FCM that you recommend, I would speculate.

J. Scott Sykora: Yes, preferably, and that would be ABN AMRO or maybe FCStone, And then we have a series of funds. We offer two onshore commodity pools; one traded in the conservative P&G Strategy, one in the Moderately Aggressive Strategy. And then we have two offshore funds. We have one in the Cayman Island that trades in the Moderately Aggressive Strategy. That fund is strictly

And then we have a fund that is domiciled in Malta, which is traded in the conservative P&G Strategy, That fund is a European onshore fund. So the Cayman is a pure offshore for everyone; Malta is a European onshore vehicle offered through Custom House.

Mark Melin: I know the Custom House guys, they are great.

J. Scott Sykora: Yes, they are good guys, yeah. So we trade a series in their Nascent Fund.

Mark Melin: Fascinating, Scott!

J. Scott Sykora: One final thing, and I do not know if this is relevant, Mark, based on your audience but just this week we are launching a mutual fund traded in the conservative Preservation & Growth Strategy.

Mark Melin:Oh, that is big news! That’s great! We’ll have to address the mutual fund and the CFC issue another day. This has been a fascinating interview, with more on the newsletter’s web site.

The Underground Battle for The US Criminal Justice System By Mark Melin

There is a battle that is taking place behind the scenes, mostly unknown outside a small group of insiders. It is a fight for control of the US judicial system in regards to financial crimes.

It’s really a long running battle, hard to tell the start date. I tend to think it is 1998, the year CFTC Chairwoman Brooksley Born was humiliated out of office by a gang of thugs. Her offense? She requested transparency into improper derivative structures that ultimately imploded in 2008 and continue to underlie the economic structure across the Westernized world.

The fight for criminal justice has many causalities. This includes former CFTC Chairman William Rainer. (I must admit a bias, I am personally familiar with the subject.) In my opinion Mr. Rainer was a principled man who tried to stand up for common sense derivative regulation in the Enron illegalities, but was “chewed up,” a causality of the underground justice war. It’s interesting in this long-running war, the causalities tend to be people who have upheld the rule of law, fought for basic common sense derivatives management principals. Seems like those supporting the criminal ways seldom get chewed up, but rather lauded once they leave office. This could be considered reverse deterrence.

A recent Frontline PBS documentary, produced by the hard-hitting journalist Martin Smith, clearly documented the facts: In 2008 criminal behavior involving derivatives that was cause of the financial meltdown involved likely criminal behavior. Much of this criminal behavior was not investigated, the documentary points out. To benchmark the level of criminality, the documentary pointed to multiple examples where those with criminal knowledge were not questioned by investigators.

For those with an inside understanding, one key point was the rare move by career Department of Justice (DOJ) prosecutors inside the criminal division speaking out against the division head in charge of criminal investigations, Lanny Breuer, a clear signal “problems” administering justice were at play. Lanny Perkins, Associated Deputy Director of the FBI, noted frustration and arguments he had with Mr. Breuer regarding the lack of enforcement against high level Wall Street executives.

Anyone familiar with the concept behind a financial services regulatory structure knows deterrence is key. This is why the criminality tolerated in 2008 is significant, it led to what many consider a more brazen example of tolerance of criminal behavior: MF Global. MF Global is the story of a rogue trader, former Senator and Governor for New Jersey and investment bank president named Jon Corzine. Clearly the most politically powerful trader to ever operate in the regulated derivatives industry. While CEO at MF Global, Mr. Corzine was involved in what is known to be the illegal transfer of assets totaling $1.6 billion in “vaporized” funds. There have been no criminal charges to date.

“It certainly looks like someone got away with a crime,” was clarity provided by Professor Steven A. Ramirez, a former Enforcement attorney at the US Securities and Exchange Commission and now a law professor at Loyola University in Chicago.

In a broadcast interview on the Max Keiser show, the author noted the primary goal of the SEC. “Fundamental objective was monitoring Broker Dealers (BDs) to make sure customer accounts were not raided for speculative trading purposes. So that should never happen.” MF Global customer assets were transferred out of a customer segregated account held at a bank custodian and transferred to cover losses on MF Global’s proprietary trades. “That the crime happened is bad enough. But worse yet is that a politically connected and powerful individual completely escapes prosecution, as does everyone associated with his firm.” Despite what industry observers and regulators have publically called

Copyright 2013 © Opalesque Ltd. All Rights Reserved. opalesque.com OPALESQUE FUTURES ISSUE 3 • February 18, 2013 The Untold Story 24 criminal fraud, no member of the MF Global executive staff has been indicted to date.

“That does not pass the smell test,” Mr. Ramirez said. “There is something woefully wrong with our system of criminal justice when MF Global can happen right before the world’s eyes and money can disappear from customer accounts and no one faces any criminal accountability whatsoever.”

“That’s an outrage,” Mr. Ramirez said. “It’s not just the social contract in the united states that is at stake here. It is capitalism itself, on a global scale.

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“We currently have an economy where a small cadre of individuals who control vast wealth and they are now above the law. They control the law, they can change the law, they dominate the law. That’s a scary reality. If I’m correct on that thesis then we can expect huge economic costs on the 99.9% who do not enjoy criminal immunity…”

When asked about the lack of criminal prosecution for HSBC laundering money for drug cartels and Iran, the issue of destabilizing the economic system, Mr. Ramirez was clear. “That is utter hogwash. If you want to destabilize the global financial system, as we learned in 2008, allow a small band of financial elites to completely dominate law, to be above the law, and you will get plenty of financial instability.”

“If you want a stable financial system you need the rule of law. Investors need to have confidence that when they make investment decisions its backed by legal and regulatory frameworks that see to it their investment decisions are not plundered and their investment money is not bilked.”

“When we allowed certain components of the financial sector to become so large they can extort government officials and get all kinds of goodies and bailouts not available to other economic actors, that was a gigantic step.” Hitting on the unregulated toxic OTC derivatives at the root of 2008 that still to this day continue to underlie the financial system, Mr. Ramirez notes the key issue: “After September 15, 2008 and the derivatives de-regulation, we had little choice but to bankroll these Too Big To Fail giants to the tune of tens of trillions of dollars to keep them afloat.”

How should the problem be solved? “If I’m right that the legal system has been taken over by a small cadre of economic elites, we should

Lack of Prosecutions in 2008 Led to MF Global Criminality

By Mark Melin

The Frontline documentary, The Untouchables, was legendary on several counts.

But perhaps most historic was the establishment of fact that a policy existed to ignore criminality related to a small cadre of powerful Wall Street bankers. Ignoring this “criminal problem” has several costs and led to an even more spectacular crime: MF Global.

Here is the most significant fallout if MF Global criminal activity is not punished: It will lead to even more brazen crime because the concept of deterrence will vanish. While DOJ’s Mr. Breuer cites concern for market stability in prosecution of protected elite, by not enforcing the law the DOJ is in fact the cause of financial instability and a significant risk to the loss of confidence in the US financial system.

People on the inside the derivatives industry, such as Jon Corzine, might have learned the clear message of 2008. Fraud was committed by bankers at the “C level” that led to the US financial meltdown yet no punishment of relative significance occurred.

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2008, it should be noted, was the unregulated derivative implosion that was predicted by several people, including former CFTC Chairwoman Brooksley Born and current Dallas Fed President Richard Fisher. The main message of the Frontline documentary was criminal acts that led to a significant destruction to US market confidence, the 2008 derivative implosion, have yet to be properly investigated. This, all in the name of protecting market confidence.

This is absurd… and dangerous.

Unfortunately the message of 2008 was heard loud and clear in certain criminal quarters. It was open season for a career trader at heart. Traders are aggressive, type A, must win. I get the mentality. Corzine was looking for an edge on his trade, anyone inside the managed futures industry can understand that. While we don’t know for certain how Mr. Corzine interpreted the lack of punishment for 2008 crimes, we know that in March 2010 the most politically powerful leader ever seen inside the insular derivatives industry had taken over MF Global, a critical component for the burgeoning managed futures industry. We know that this individual ran MF Global to, shall we say, the edge of the regulatory extreme. We know he operated with apparent disregard for regulators and his bank counterparty. We can prove that criminal acts inside MF Global occurred and they are serious.

What must also be proven is that the system works. It must be proven that no individual is above the rule of law. It must be proven when the integrity of the commodity market is damaged that regulatory and judicial agencies stand up to their sworn duty and vigorously enforce the law. This must be the message of 2013 and it should speak louder than the message of 2008. Why Was Lanny Breuer Allowed To Remain at DOJ?

This is a serious question, since it’s been two days since his “voluntary” resignation as director of the criminal division was announced. Speculation is Mr. Breuer made an argument and an exit agreement is in place, with one stipulation: he is allowed to unwind the

Copyright 2013 © Opalesque Ltd. All Rights Reserved. opalesque.com OPALESQUE FUTURES ISSUE 3 • February 18, 2013 The Untold Story 26 most damaging government policy in history. Mr. Breuer will be allowed to order tough investigations into Wall Street crime before exiting. While that might sound odd (or hopeful), stranger things have happened.

It is Mr. Breuer who was so brilliantly called to task in the Frontline / PBS documentary “The Untouchables.” In the documentary Mr. Breuer admitted to Frontline producer Martin Smith that DOJ applies a different standard of justice to an elite list of Wall Street criminals. The transcript is too unbelievable to consider coming from an officer of justice:

MARTIN SMITH: You gave a speech before the New York Bar Association. And in that speech, you made a reference to losing sleep at night, worrying about what a lawsuit might result in at a large financial institution.

LANNY BREUER: Right.

MARTIN SMITH: Is that really the job of a prosecutor, to worry about anything other than simply pursuing justice?

LANNY BREUER: Well, I think I am pursuing justice. And I think the entire responsibility of the department is to pursue justice. But in any given case, I think I and prosecutors around the country, being responsible, should speak to regulators, should speak to experts, because if I bring a case against institution A, and as a result of bringing that case, there’s some huge economic effect — if it creates a ripple effect so that suddenly, counterparties and other financial institutions or other companies that had nothing to do with this are affected badly — it’s a factor we need to know and understand.

Speculation is the argument Mr. Breuer had given to stay on is that essentially many more were involved in providing criminal cover to a select list of Wall Street executives. Why should his name be associated with a “Do Not Prosecute List” that included, until recently, the likes of Lance Armstrong as well as banking executives Jon Corzine and Laurie Ferber.

The policy decision to provide certain citizens “Above The Law” status was about to be documented as having the worst impact on society in history. When the real facts behind MF Global emerge, a picture of complete disregard for regulatory authority and no fear of legal consequence will emerge. It can be logically observed that had a degree of deterrence been present in 2008, Jon Corzine might have thought twice about completely ignoring regulator orders and MF Global executives would not have acted with such apparent disrespect for the law and their counterparties.

Disclosure

There is a small group that has been working behind the scenes to end criminality on Wall Street. Many of us are also greatly concerned about the debt crisis. Speaking out on these issues has been punishing to anyone involved, so many of the names of participants are generally protected but known by certain insiders. The fight for justice, initially outlined in the bookThe Payout just scratches the surface. A minority on Wall Street is working to cover up criminal activity. This is evident in MF Global, but that’s part of the back story likely never to be told. The criminal activity must end. The real mathematical risks in the debt crisis – and the absurd leverage used by certain Too Big to Fail / Jail banks – should be known. The fact the US government is likely going to be on the hook for UNLIMITED LIABILITY must be known. That’s right. A derivatives contract, by definition, carries with it the risk of unlimited loss. These unregulated derivatives will implode and destroy the economy again. It’s just a matter of when and who pays for the risk on the trade. The traders at some of the TBTF banks have created a derivative structure that saddles the US tax payer with unlimited liability, while they pocket a small but lucrative percentage of notional transactional value. In other words, the “interesting” derivatives products sold in 2008 are going to be nothing compared to the derivatives crash ahead. The OTC derivatives these banks have on the books are a high probability for another implosion. The real risk disclosure is that because 2008 was not prosecuted additional derivatives scams and criminality ensued. MF Global is not only an example of a complete breakdown of the rule of law, but a man who thumbed his nose at the law, his industry and counterparties. This story, the real inside story, must be told. Volatility can sometimes be prevented by identifying it beforehand. It’s only volatile when it’s a surprise. Over the past 15 years, unregulated derivatives have been at the center of recent economic crisis. More troubling, they are at the center of the next great crash. A crash that we can hopefully avert… if the real issues are allowed to be discussed in public, that is.

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