Position sizing methods for a trend following CTA HENRIK SANDBERG RASMUS ÖHMAN Master of Science Thesis Stockholm, Sweden 2014 Positionsskalningsmetoder för en trendföljande CTA HENRIK SANDBERG RASMUS ÖHMAN Examensarbete Stockholm, Sverige 2014 Positionsskalningsmetoder för en trendföljande CTA av Henrik Sandberg Rasmus Öhman Examensarbete INDEK 2014:47 KTH Industriell teknik och management Industriell ekonomi och organisation SE-100 44 STOCKHOLM Position sizing methods for a trend following CTA Henrik Sandberg Rasmus Öhman Master of Science Thesis INDEK 2014:47 KTH Industrial Engineering and Management Industrial Management SE-100 44 STOCKHOLM Examensarbete INDEK 2014:47 Positionsskalningsmetoder för en trendföljande CTA Henrik Sandberg Rasmus Öhman Godkänt Examinator Handledare 2014-06-04 Hans Lööf Tomas Sörensson Uppdragsgivare Kontaktperson Coeli Spektrum N/A Sammanfattning Denna studie undersöker huruvida en trendföljande managed futures-fond kan förbättra sina resultat genom att ändra positionsskalningsmetod. Handel med en enkel trendföljande strategi simulerades på 47 futureskontrakt åren 1990-2012, för olika metoder att för bestämma positionsstorlek. Elva positionsskalningmetoder undersöktes, exemplevis Target Volatility, Omega Optimization och metoder baserade i korrelationsrankning. Både tidigare beskrivna metoder och nya tillvägagångssätt testades, och jämfördes med den grundläggande strategin med avseende på risk och avkastning. Denna studies resultat visar att framförallt Target Volatility, och i viss uträckning Max Drawdown Minimize and Dynamic Stop Lock-In förbättrade nyckeltalen för den handlade strategin. Den slutgiltiga rekommendationen för en trendföljande managed futures-fond är att använda Target Volatility som positionsskalningsmetod, möjligtvis tillsammans med Max Drawdown Minimize. Nyckelord CTA, managed futures, trend following, positionsskalningmetoder, target volatility, omega optimization. Master of Science Thesis INDEK 2014:47 Position sizing methods for a trend following CTA Henrik Sandberg Rasmus Öhman Approved Examiner Supervisor 2014-06-04 Hans Lööf Tomas Sörensson Commissioner Contact person Coeli Spektrum N/A Abstract This study examines whether a trend following managed futures fund can improve its performance by changing its position sizing method. Trades for a simple trend following strategy was simulated on 47 futures contracts over the period 1990-2012, using varying methods for determining position size. Eleven different position sizing methods where investigated, among them Target Volatility, Omega Optimization and correlation ranking methods. Both methods previously detailed in academic papers as well as novel approaches was implemented, and compared to the baseline performance of the strategy. The results from this study show that the Target Volatility method, and to some degree Max Drawdown Minimize and Dynamic Stop Lock-In, improved the performance of strategy. The final recommendation for a trend following managed futures fund is to use Target Volatility as position sizing method, possibly in conjunction with Max Drawdown Minimize. Key-words CTA, managed futures, trend following, position sizing, target volatility, omega optimization. Acknowledgments Firstly, we would like to thank Jon Brewer, Ingemar Bergdahl and Björn Elfvin at Spektrum for their continues interest and feedback, and for supplying us with both ideas and the necessary tools required for this study. We would also like to thank our supervisor Tomas Sörensson at KTH, for his guidance and assistance throughout the processes of this thesis. Finally, thanks to Kathryn Kaminski for taking a special interest in this study and for contributing with valuable input. Stockholm, May 2014 Henrik Sandberg & Rasmus Öhman HENRIK SANDBERG & RASMUS ÖHMAN ⦁ POSITION SIZING METHODS FOR A TREND FOLLOWING CTA Table of Contents 1. Introduction ....................................................................................................................................... 1 1.1 Background ......................................................................................................................................................... 1 1.2 Research issue ................................................................................................................................................... 2 1.3 Purpose ................................................................................................................................................................. 3 1.4 Research questions ......................................................................................................................................... 3 1.5 Delimitations ...................................................................................................................................................... 4 1.6 Target audience ................................................................................................................................................ 4 2. Theoretical framework .................................................................................................................. 5 2.1 Futures .................................................................................................................................................................. 5 2.2 Commodity Trading Advisors (CTAs) and how they operate ...................................................... 7 2.3 Trend following - capitalizing on systematic price movements ................................................. 9 2.3.1 Trend following ........................................................................................................................................ 9 2.3.2 Channel Breakout as a trend following strategy .................................................................... 11 2.3.3 Simple moving average ...................................................................................................................... 13 2.3.4 Moving average as a trend following strategy ......................................................................... 14 2.3.5 Trend filter .............................................................................................................................................. 15 2.3.6 Autocorrelation ..................................................................................................................................... 16 2.4 Methods for volatility calculation .......................................................................................................... 16 2.4.1 Standard Deviation .............................................................................................................................. 16 2.4.2 Average True Range ............................................................................................................................ 17 2.5 Methods for portfolio allocation ............................................................................................................ 18 2.5.1 Equity curve-based .............................................................................................................................. 18 2.5.2 Target Volatility .................................................................................................................................... 18 2.5.3 Correlation ............................................................................................................................................... 19 2.5.4 Omega Optimization............................................................................................................................ 19 2.5.5 Max Drawdown ..................................................................................................................................... 22 2.5.6 Dynamic Stops ....................................................................................................................................... 22 3. Literature Review .......................................................................................................................... 23 4. Methodology .................................................................................................................................... 26 4.1 Data collection and sample ....................................................................................................................... 26 4.2 Choice of underlying trend following strategy ................................................................................ 28 4.3 Choice of portfolio allocation methods ............................................................................................... 30 4.3.1 Equity curve based ............................................................................................................................... 35 1 HENRIK SANDBERG & RASMUS ÖHMAN ⦁ POSITION SIZING METHODS FOR A TREND FOLLOWING CTA 4.3.2 Target volatility ..................................................................................................................................... 37 4.3.3 Correlation ............................................................................................................................................... 37 4.3.4 Omega Optimization............................................................................................................................ 38 4.3.5 Max Drawdown ....................................................................................................................................