Thursday, March 05, 2020

Why does our Tail Reaper program work in times of market turmoil?

I generally don't like to write about our investment programs here, since the good folks at the National Futures Association would then have to review my blog posts during their regular audits/examinations of our CPO/CTA. But given the extraordinary market condition we are experiencing, our kind cap intro broker urged me to do so. Hopefully there is enough financial insights here to benefit those who do not wish to invest with us.


As the name of our Tail Reaper program implies, it is designed to benefit from tail events. It did so (+20.07%) during August-December, 2015’s Chinese stock market crash (even though it trades only the E-mini S&P 500 index futures), it did so (+18.38%) during February-March, 2018’s “volmageddon”, and now it did it again (+12.98%) during February, 2020’s Covid-19 crisis. (As of this writing, March is up over 21% gross.) There are many names to this strategy: some call it “crisis alpha”, others call it “convex”, “long gamma” or “long vega” (even though no options are involved), “long volatility”, “tail hedge”, or just plain old “trend-following”. Whatever the name or description, it usually enjoys outsize return when there is real panic. (But of course, PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.) Furthermore, our strategy did so without holding any overnight positions.

Why is a trend-following strategy profitable in a crisis? A simple example will suffice. If a short trade is triggered when the return (from some chosen benchmark) exceeds -1%, then the trade will be very profitable if the market ends up dropping -4%. Vice versa for a long trade. (As recent market actions have demonstrated, prices exhibit both left and right tail movements in a crisis.) The trick, of course, is to find the right benchmark for the entry, and to find the right exit condition.

Naturally, insurance against market crash isn’t completely free. Our goal is to prevent the insurance cost, which is essentially the loss that the strategy suffers during a stretch of bull market, from being too high. After all, if insurance were all we want, we could have just bought put options on the market index, and watched it lost premium every month in “good” times. To prevent the loss of insurance premium requires a dose of market timing, assisted by our machine learning program that utilizes many, many factors to predict whether the market will suffer extreme movements in the next day. In most years, the cost (loss) is negligible despite the long bull market, except in 2019 when we lost 8.13%. That year, which seems a long time ago, the SPY was up 30.9%. (It was in the August of that year that we added the machine learning risk management layer.) But most investors have a substantial long exposure. A proper asset allocation to both Tail Reaper and to a long-only portfolio will smooth out the annual returns and hopefully eliminate any losing year. (Again, PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.)

But why should we worry about a losing year? Isnt’ total return all investors should care about? Recently, Mark Spitznagel (who co-founded Empirica Capital with Nassim Nicholas Taleb) wrote a series of interesting articles. It argued that even if a tail hedge strategy like ours returns an arithmetic average return of 0%, as long as it provides outsize positive returns during a market crisis, it will be able to significantly improves the compound growth rate of a portfolio that includes both an index fund and the tail hedge strategy. I have previously written a somewhat technical blog post on this mathematical curiosity. The gist of the argument is that the compound growth rate of a portfolio is m-s^2/2, where m is the arithmetic mean return and s is the standard deviation of returns. Hedging tail risk is not just for the psychological comfort of having no losing years - it is mathematically proven to improve long-term compound growth rate overall.

PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

For further reading on convex strategies, please see the papers by Paul Jusselin et al “Understanding the Momentum Risk Premium: An In-Depth Journey Through Trend-Following Strategies” and Dao et al “Tail protection for long investors: Trend convexity at work” (Hat tip to Corey Hoffstein for leading me to them!)

17 comments:

Jemma Riddiford said...

Hi Ernie

Very interesting blog post, especially given the current financial climate (but of course that's precisely why you've published the article now).

May I ask, why trend-following strategies and not an option-based strategy like Taleb and Spitznagel would employ? Apparently Universa Investments purchase 30-35% OTM puts on the S&P 500 with expiry in 60-90 days, rolling them out at 30 days until expiry. Wouldn't this be a better way to capitalise on market turmoil, capturing the sudden spike in volatility with the explosive growth in the option premium?

Jemma

Ernie Chan said...

Hi Jemma,
The question isn't whether long puts will make money in a crisis - of course they will! The question is how you can prevent them from losing large amount of premium during peace time. Do you have any idea how Taleb did it?
Ernie

Jemma Riddiford said...

Hi Ernie

Would it matter if they lost premium during peace time? Surely that would be the time to leverage mean-reversion up to the eyeballs, ensuring there's more than enough cash to purchase options that would cover losses in the mean-reversion portfolio during black swan events (and then some, if the anecdotes of Universa's performance are to be believed)?

Jemma

Ernie Chan said...

Hi Jemma,
It depends on how much premium it loses during peace time.
Our strategy is designed so that it loses minimal amount, while capturing about 50% return YTD.
Ernie

Anonymous said...

Hi Ernie,

Very interesting blog post and congratulations on your March performance! Seems Tail Reaper would fit nicely in a traditional 60/40 portfolio. Just to make sure I understand. The Tail Reaper is an intraday trend following system on the S&P 500 e-mini future?

Thanks,
James

Ernie Chan said...

Hi James,
Thanks!
Yes, Tail Reaper is intraday trend following on ES.
Ernie

Anonymous said...

Hi Ernie,

What is the transaction costs of liquid stocks in US stocks market? Many thanks!

Anonymous said...

Hi Ernie,

Is cryptocurrency a good target to trade?
Is there anything we should pay special attantion to? Many thanks.

Ernie Chan said...

Anon,
Liquid stocks have transaction costs of about 2-5bps per trade.
Ernie

Ernie Chan said...

Yes, one can profit from trading crypto at high frequency, and through cross exchange arbitrage. But credit worthiness of the exchanges are critical.
Please read my 3rd book Machine Trading's chapter on Bitcoins for some more nuances.
Ernie

Anonymous said...

Hi Ernie,

Where can we download free long historical tick data of cryptocurrency? Many thanks.

Ernie Chan said...

Hi,
You can download using Gemini exchange's API. Otherwise, please check out the Bitcoin chapter in my 3rd book Machine Trading.
Ernie

Anonymous said...

In response to those talking about Universa, it seems that someone actually posted the interim letter sent to investors online:

https://www.scribd.com/document/455607584/Universa-Letter-April-2020

Says that in 2020 they had made 4144% by April but the life to date return was 239%, so it does seem like they are burning a lot during peaceful times, but still increases CAGR.

Anonymous said...

Great article. However I do have a question for Ernie. How do you know whether intraday momentum strategies can stay profitable? For example after 2004 or so large opening gaps on major indices correlated to their daytime performance that day, especially near the close. But for at least a decade before 2004, this correlation between big gaps and the day returns was negative. Do you know what caused this shift and how you might be able to predict a future regime change? I do not know why

Ernie Chan said...

Hi,
Indeed, there is no guarantee *any* strategy will work forever. Hence one must monitor the market environment and understand whether the fundamentals or market structure have changed. One cannot predict regime change - one can only adapt to those changes once they occur.

The specific phenomenon you observed is due to the increasing volume of gamma hedging by options market maker, rebalancing by levered ETPs (and other levered vehicles), and variance swap delta hedging.

Ernie

Anonymous said...

I took a look at qtscm's returns. They are quite impressive! I've tried to trade intraday strategies myself without as much success, including variants of the index momentum strategies you discussed in your book, Algorithmic Trading. How do you minimize or negate the effects of slippage in your execution? I'm trading Micro-ES futures but I generally incur a non negligible amount of losses due to the spread, which makes my strategy unprofitable if the timescale is too restrictive.

Ernie Chan said...

Thanks!

There is not much one can do about slippage in a momentum strategy except to execute in small batches, and holding for long enough time.

Ernie