The Hidden Cost of Volatility Drag

Managing Risk in Commodity Markets

The exponential growth of commodity index funds has been a cause for great consternation among investors. However, from a traders perspective, the changes in the nature of commodity markets, particularly in spreads, have provided great opportunity.

As Emil van Essen, front running specialist at Futures Magazine, explains, "I looked at how we could take advantage of their behavior and their size. We were looking at how they rolled their positions and also how a lot of participants were front running the roll of the index funds and trying to get in front of that whole wall of money, essentially we were [front running] the front runners."

Van Essen's program is more complex than simply placing bear spreads in front of the Goldman roll. He modeled every aspect of commodity spreads and found multiple ways to exploit anomalies in that relationship.

Modeling Spread Markets

Spreads are much more consistent in their behavior and it is a lot easier to take advantage of the nuances of spread markets, according to van Essen. "Our ability to capture alpha in this market became a combination of getting an edge by front running the front runners in the index funds and also being able to model the markets to take advantage of price movements."

The Importance of Front Running

Front running is a strategy where individuals or groups buy securities at a low price before they are sold at a higher price. In commodity markets, this can be particularly effective.

Van Essen notes that spreads are much more consistent in their behavior and it is a lot easier to take advantage of the nuances of spread markets. "Spreads are much more consistent in their behavior and it is a lot easier to take advantage of the nuances of spread markets," he says.

Exploiting Market Behavior

Van Essen's program exploited market behavior by identifying patterns in how commodity spreads were being traded. By modeling every aspect of commodity spreads, van Essen was able to identify multiple ways to exploit anomalies in that relationship.

Profiting from Volatility

One of the key benefits of front running is that it allows individuals or groups to profit long before a major index roll occurs. This can be particularly effective in volatile markets where prices may spike and then revert back to the mean.

Van Essen notes that "a lot of markets that have a lot of noise end up spiking and then reverting back to the mean." This allowed van Essen to profit long before the major index rolls and, at times, exploit one roll period multiple times. "If we know that a market is mean reverting we can sell the spread on a spike and then if it gets back to the mean just take a profit and wait for another spike."

Managing Leverage

Van Essen's program was able to manage leverage effectively by using approximately one third of the original amount of leverage. This allowed him to amplify his profits without risking too much.

Deleveraging the Program

The 2009 return is based on using approximately one third of the leverage of when he started in 2007. Van Essen is also adding an additional risk overlay that will take small offsetting futures positions in case of a sharp rally. "We found that all of our drawdowns were the results of spikes in the [front month] market," van Essen says.

What the Data Actually Shows

Constantly updating research is important because contango markets and front running bear spreaders create a drag on the performance of the index funds and indexers are looking for ways to alter their indexes to reduce these headwinds. But van Essen is not worried it will affect his program. "I love when these guys do this because they are still rolling in a kind of dumb way. They have a standard way of operating and the more they try and change it, we will know exactly what they are doing and we will just be in front of them."

Conclusion

Van Essen's program is an example of how traders can profit from market behavior by exploiting anomalies in spread markets. By managing risk effectively and using leverage strategically, individuals or groups can amplify their profits and reduce the impact of volatility on their portfolios.