One of the most frustrating aspects of long-term trend following systems is drawdowns from unrealized mark to market peaks in equity. Let’s look at an example:
Figure 1 – May, 2022 NYMEX WTI Crude Oil futures.
On January 12th, 2022, we buy CLEK22 on the open at $79.25 (see Figure 1). A significant bull move ensues. As a result, on March 8th the market closes at $120.81 for an unrealized mark to market gain of $41,560.00 per contract. The “problem” is that our stop is placed at the 50-day EMA which comes in at $89.44. This represents a potential “drawdown” in unrealized profits from an equity peak of $31,370.00 (around 75% of the unrealized mark to market gain). Obviously, the market doesn’t hit our stop on the next trading day, but it does breach the 50-day EMA on April 6th, 2022, at $97.73 (or a drawdown from equity peak of $23.080.00) which is still around 56% of the unrealized mark to market gain from the peak on March 8th.
Traditional trend-following wisdom suggests that nothing can be done in this situation and that if we don’t like that fact we shouldn’t trade a trend-following system. In many markets, that’s true. But some assets have good liquidity in their options on futures offerings and if that is the case, we believe that there is a somewhat more robust solution to this problem.
Figure 2 – 3/8/22 – WTI approaches one year high in historical volatility.
As we can see (see Figure 2 above), on March 8th, 2022, WTI approaches a one year high in historical volatility. Based on this we decide to roll out of our long futures and into long call options. On March 8th the December CLE ‘22 $100 call options (CLEZ22 futures settled at $97.72, so the $100.00 calls are slightly out of the money, with a delta close to +.5) settled at $12.40. Consequently, our strategy would be to sell the long May ’22 futures and buy two of the $100.00 December calls. On April 6th, 2022, when our stop was elected the $100 calls settled at $8.79 (and our delta fell to around +.45). Notice that our drawdown from equity peak in unrealized profits is now -$7,720.00 (-3.61*2). This is a significant improvement from -$23,080.00.
What could go wrong? Our worst potential problem is, “theta burn” or the risk that crude oil could flatline and we’d lose the time value of the call options and have to spend more premium and buy more time. This risk is why we chose to buy the December ’22 call options. Furthermore, remember that we didn’t lose $31,000.00 in premium (our mark to market risk on the day we closed futures and bought calls) so we do have the luxury of buying more time (if our calls expire worthless and we still wouldn’t have been stopped out of the underlying futures).
A more pleasant problem would be that crude oil continues to rise. If this happens, the delta of our pair of call options will increase from roughly +1.0 to close to +2.0. In this case we could close out fifty percent of our long December ’22 calls and “roll forward” in time, buying twice the amount of at the money June ’23 call options at a significantly higher strike price.
As always, the devil is in the details. When we decide to sell futures and buy at-the-money calls will make a big difference in overall performance. Disclaimers aside, I still feel this is an area of research worth exploring for long-term trend following traders.
The CQG PAC at the bottom of the post will install a page with the volatility study.