Originally published by Managed Account Research, Inc. on June 6, 2008.
CTA ConfidentialSM
"An ongoing series of qualitative investigations
into managed futures trading programs"
CASE NO. 0314673
Summa Capital Management, LLC
John F. Summa, Principal
Options Spread Trading Program
PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. INVESTING IN FUTURES AND OPTIONS INVOLVES RISK AND MAY NOT BE SUITABLE FOR ALL INVESTORS. THE HIGH DEGREE OF LEVERAGE THAT IS OFTEN OBTAINABLE IN COMMODITY TRADING CAN WORK AGAINST YOU AS WELL AS FOR YOU. THE USE OF LEVERAGE CAN LEAD TO LARGE LOSSES AS WELL AS GAINS. THEREFORE, INVESTORS SHOULD CAREFULLY CONSIDER THESE RISKS AND DETERMINE WHETHER THEY ARE SUITABLE FOR INVESTING IN LIGHT OF THEIR FINANCIAL CONDITION AND INVESTMENT OBJECTIVES.
John F. Summa, PhD is the sole principal and trader for Summa Capital Management, LLC, a commodity trading advisor (CTA) and commodity pool operator (CPO) founded in August 2001. Dr. Summa, a former professional skier and journalist, earned his degree in economics from the New School for Social Research in New York City. He developed an affinity for option trading in the mid-1990s while managing a family portfolio, and eventually went on to author two books, "Options on Futures: New Trading Strategies" (John Wiley & Sons, 2002) and "Trading Against the Crowd: Profiting from Fear and Greed in Today's Markets" (John Wiley & Sons, 2004). In addition, Dr. Summa has written numerous articles on trading ideas and techniques which have been featured in Futures Magazine, Stock Futures & Options, and Technical Analysis of Stocks & Commodities. Managed Account Research recently conducted a phone interview with Dr. Summa to discuss the markets and his approach to trading.
It can be said that chess and options trading are similar in many respects, a key one being that when two experienced players are examining the same game they will respond with different strategies and tactics. Likewise, two veteran managers trading options on the same underlying asset may envision entirely different strategies and tactics in response to the same market conditions.
Since the millennium there has been a proliferation of CTAs with programs that are focused on S&P 500 options trading. From 2003 to 2006 the environment for option writing, a strategy which involves the collection of premium in return for offering risk insurance to other market participants, was favorable.
The reason this strategy worked so well during this time was because there was a bull market in stocks and a bear market in implied volatility on stocks. Decreasing volatility in combination with time decay has the effect of eroding the value of options, which is beneficial to premium capture strategies. However, when the opposite happens and implied volatility dramatically increases, this can make life difficult for option writers.
This is why so many option programs suffered large drawdowns during 2007. The transition from low volatility to high volatility was made difficult because many option writing programs were offering risk insurance too cheaply. But now that the market has undergone this transition there is a silver lining...
The first is that the market has built in a healthier risk premium because of the mortgage-related credit crisis. What this means is that higher implied volatility allows option writing strategies to receive higher premiums for the risk insurance they write. Second, the volatile markets of the past year provides a more meaningful set of data points in which to examine the risk management of CTA option programs.
While Summa Capital's managed account program started trading June 2006, Dr. Summa has in fact been trading the program as a commodity pool since May 2002. Over that period, the pool's performance was remarkably conservative relative to other option trading programs during this period. We note that veteran option traders whose experience dates back to the 1990s tend to be more conservative, and for good reason.
However since a 3.29% drawdown in February 2007, a month noted for its 100% spike in volatility on 2/27/07, Summa Capital's managed account program has racked up impressive gains of 32.38% for that year, and is up 4.78% through April 2008. The higher returns are due to a methodical evolution in trading strategies, and a change in the market environment where higher volatility plays to the benefit of the types of tactics that Dr. Summa employs in his trading. Summa Capital's return objective is 15% to 30% on an annualized basis.
Dr. Summa attended the New School University, which has an illustrious background, and trained under the late Robert Heilbroner, who wrote the best-selling economic book called "The Worldly Philosophers: the lives, times, and ideas of the great economic thinkers" (1953). His economic training was based on classical, Keynesian, Post-Keynesian and Neo-Ricardian traditions, and not in the neo-classical paradigm.
To the average investor this may seem obscure but it is of importance in understanding the core economic assumptions which underlie a trader's modus operandi. The neo-classical camp is what George Soros calls "market fundamentalism" which relies on the idea that markets already reflect all known information, whereas Dr. Summa describes his thinking as "heterodox" in which the world is more complex.
Essentially, Dr. Summa ascribes to a theory of competition in which markets generally operate in a state of disequilibrium, overshooting centers of gravity or equilibrium (i.e., stable markets), and that equilibrium is the exception rather than the rule. These notions generally support a counter-trend approach relevant to option trading, but also gives due respect to the fact that markets can trend beyond reasonable levels.
When writing his book "Trading Against the Crowd," Dr. Summa developed a ten-year sentiment database based on scanned good news/bad news clusters from Lexus Nexus. He then empirically compared that ratio indicator to econometric models and also performed systematic trading tests. The results he got showed that the crowd overreacts. Hence, one can say that crowds do not always efficiently price markets.
This thesis points to the crux of the matter when it comes to designing a robust option trading program. Option writers tend to rely on variance measures based on standard deviation and probability -- the further out the standard deviation, the lower the probability of an event. This results in what we at Managed Account Research like to describe as "white knuckle trading," which occurs when option writers hold on to a position hoping that the market will land out-of-the money on expiration and the option expires worthless.
Dr. Summa "has been there and done that," but early on in his trading other peoples' money, "controlling volatility and stabilizing account equity became a primary focus. To do that, you can't have a wait-and-see hang-on approach, and then respond if the market goes in-the-money."
This led Dr. Summa to develop a strategy "to preempt equity volatility, by having a defense line in place where he will intervene and close a troublesome position, to limit the losses on a short option, and then to decide whether to resell an option at a different strike price, or step aside and let the market trade for a few days." The key is defending the account against losses which are too large, the reason being that premium capture strategies have limited profit potential, and "you cannot let profits run."
Dr. Summa's years of experience has led him to develop a trading strategy where the primary objective is stable account equity, and from there try to achieve superior risk adjusted returns. "At the end of the day, that is how you are evaluated -- the amount of return you are producing versus drawdown risk your taking."
When establishing a position, or even liquidating a position, the most important element is the level of premium priced into an option at any given point in time. Generally, Dr. Summa establishes a diagonal spread where he is selling the nearby option and buying a back-month option. The time horizon is mixed up and may be the next month option cycle or options trading three, four months to a year out.
"The structuring of diagonal put spreads will depend on my outlook of volatility, my directional outlook," explains Dr. Summa. "There is an element of discretion which has grown to 30-40% over the years; the rest is just systematic structured writing every month where the trades get put on regardless"
A diagonal option spread is a type of option trading strategy which bets that time decay on the nearby short option position will work in your favor, while the time decay on the back-month option will decay at a much slower rate. At the same time, the long option position reinsures the short option position resulting in less account volatility as the underlying market goes up and down.
In Dr. Summa's experience, two or three times a year is usually the frequency of when he will have to close out a losing position. However, because he is using diagonal spreads, typical trend and counter-trend moves will not force him to make an adjustment. But if there is an adjustment, a significant move has occurred.
These adjustments are usually done on the short leg of the spread, and "that adjustment is always geared toward reducing the risk, in the assumption that if the market had made a break that far it is going to continue." So instead of doubling up in such situations, Dr. Summa actually reduces his risk exposure.
This explanation raised a question with respect to Summa Capital's 9.2% drawdown in January 2008 and subsequent 11.4% upswing in February 2008. To someone who is familiar with options trading, on the surface it seems that Dr. Summa either "white knuckled" the trade, or liquidated the position and doubled down in order to make up for the loss. However, this is not what happened as Dr. Summa describes...
As the market melted down during January, Dr. Summa closed out positions which had accrued losses, and at the same time repositioned put diagonal spreads, but did not double up on these positions. Rather, he "stepped up" and started to aggressively sell call spreads.
As Dr. Summa explains, "In the course of adjusting on the put-side to reduce my risk, I was picking up extra premium to compensate for that on the call side. Now because the VIX is increasing during these drops, the call premium is inflated as is the put premium. You can collect a lot of nice call premium in those down periods, especially on a relief up-day swing. Those are days when I would sell a lot of call spreads and collect premium."
Interestingly, as Dr. Summa points out, the VIX begins to implode as the market tone improves and market drifts upward, which causes both puts and calls to decline in value. This provides somewhat of a cushion to call-writes as the market goes up, and is what happened mid-January. Then in February when the market came back down, he collected the call-side premium and booked a nice gain from the month.
On a monthly basis, including Dr. Summa's track record going back to 2002 with his commodity pool, the greatest drawdown has been 15.8 percent in 2002, with the worst peak-to-valley drawdown of 20.17 percent. Given the drawdown's context in 2002, this generally reflects prudent risk management. Managed Account Research likes to remind readers that past performance is not necessarily indicative of future results.
One of the unique aspects to Dr. Summa's trading strategies is his use of diagonal spreads, which only takes place on the put-side because the nature of the call-side better lends itself to credit spreads. Diagonal spreads as he explains provide an opportunity to have the long-side closer to the underlying market price, and therefore provide an opportunity to play a role in generating gains, rather than just reinsuring the short. This is essentially what happened in 2007, which further explains why volatility can be an option traders friend in the hands of a skilled practitioner.
"I don't believe that because you know what I know you're going to make money. There is an element of personality and each individual brings something to the game. I use to be a professional skier, and I joke at my seminars that I got started in risk management as a freestyle skier 100 feet off the ground doing aerial acrobatics. I learned very quickly what it means to take on too much risk," says Dr. Summa.
Explaining further, "One of the things that distinguishes me, and I've had managers come to my seminars, actually some competitors, is that you need to know how much risk your taking and what your capable of, and what the reward is. So those five years of skiing professionally, while it seems completely remote from financial markets -- one is mental one is physical -- provided valuable experience."
Traders have to be disciplined -- they have to be willing to do the same thing over and over again. A stumbling block is getting tempted into trades when things are boring, or reactionary when things get too scary and a trader starts making emotional decisions. This applies to trading, skiing and even chess...
As Dr. Summa astutely recognizes, there is an element of overlap in the psychology of trading versus many kinds of pursuits. Masters of all these games learn patience, but also never lose their edge -- the intuition to know when it is appropriate to stay cool and stick to your game plan, when to get aggressive and take advantage of an opportunity when presented, or when to scale back and fight another day.
Good traders have a unique trait: balance -- stubbornness in keeping to a game plan, but enough flexibility to be able to adapt. Dr. Summa, in our opinion, exhibits this wisdom which comes from life experience.
