Taking a break from equities, our interview today is with a systematic futures trader. This trader has developed a system that identifies the beginning or end of a trend. Relying on human biases and/or crowd behaviour, the strategy sniffs out dislocations in the futures markets that arise when human biases and/or crowd behaviour fail to align with existing trends. Utilizing a strict buy and sell discipline, the strategy has not had a losing year since 2003, although 2010 might be a deviation from that trend as the fund was down -11.41% at the end of August. However with plenty of time remaining before the end of the year to erase any losses and rally back into the green, it makes sense (at least to us) to learn a little bit more about systematic trading from someone to who plies their trade better than most.
Note: This interview was conducted on September 15, 2010.
Biography: Christopher Foster is the CEO and Chief Investment Officer of Blackheath Fund Management. Chris received a Bachelor of Arts (Honours) degree from the University of Toronto in 1985. His professional qualifications include the Canadian Futures Exam (Parts I and II) (now the Futures Licensing Course), the Canadian Securities Course, the Canadian Commodity Supervisors Exam, the Canadian Options Exam, the Canadian Investment Management Program (Parts I and II), the F.C.S.I. Designation, and the Partners, Directors and Senior Officers Exam.
Q: How and when did you get involved in futures trading? Did you have a mentor or are you self-taught?
A: I first became interested in commodity markets after seeing a presentation - I think it was from Midland Doherty – on futures trading, back in the early 80’s when I was a student at the University of Toronto. This said, my interest was truly piqued when I was given copies by my father of Albert Friedberg’s old newsletter – about 15 pages of closely-typed and very thoughtful prose on commodity and currency markets. I was hooked! And I ultimately convinced Mr. Friedberg to give me a job at his firm which is where I learned most of what I know today.
Q: For those not familiar with your ESDR (Exploitation of Systematic Deviations from Reality) program, Mr. Foster, can you please summarize your program’s history and general strategy? Can you reveal any of the contrary indicators the ESDR system takes into consideration to make its decision?
A: ESDR is an investment strategy that I developed back in the early 90’s. I was disinclined towards technical analysis, and realized that the global-macro style of trading that I learned under Albert Friedberg was subject to such horrible draw-downs to make it almost unmarketable. I was looking for a way of trading that was not technical, but had strong money management discipline. At Friedberg I had come to be familiar with several sentiment indicators that were used in their trading, and the idea struck me to try to make a sentiment-only trading strategy out of them. After much trial and error, I eventually hit upon a system that identified certain ‘situations’ in the market that our system can exploit. To vastly oversimplify, we look for two basic types of set-ups: One, where a commodity or currency market is so egregiously over-owned or over-sold that our sentiment indicators flash sell or buy signals respectively. Or, second, and more commonly, we identify bull or bear markets that are not being embraced – which makes them, in our view, sustainable trends.
Q: Since the ESDR approach is designed to identify when markets fall into one of two tradable categories, how often are you in the market?
A: We are in the markets quite a bit. Only very rarely will we have no positions. That said, we never have more than 6 futures positions on at any one time.
Q: What is your margin to equity ratio?
A: Our margin to equity ratio is about 12% on average. Our investment strategy has never had a margin call.
Q: Mr. Foster, what proportion of your strategy is systematic and what portion, discretionary? Is the systematic portion responsible for risk management?
A: Our money management is systematic. We never risk more than 3% of our equity on any position, and we always work stop-loss orders 24/7. The trade selection process is more discretionary. While we use a strictly limited number of inputs, distilling them into a decision to buy or sell a particular commodity or currency involves some discretion.
Q: Capital preservation is crucial to any systematic program’s success or failure. How do you control risk and volatility?
A: We control risk by limiting the number of positions in the account and the amount of risk we take per trade. Since we only risk 3% of our portfolio on any one trade, and since we have a maximum of 6 trades on at any one time, we never have more than 18% of our portfolio at risk. More normally, we have 3 positions on , therefore risking normally about 9% of our portfolio at any time. Additionally, we always trade the most liquid futures contracts, and we always stay in the most liquid front-month contracts, thereby improving the liquidity of the portfolio, reducing risk.
Q: Can you describe how you enter and exit the markets? When and what would make you decide to increase or decrease a position?
A: Well, if our inputs start flashing buy or sell, we put a market on watch. If it continues to make good noises, we will initiate a position, usually with a very wide stop. If the market starts moving in the way we anticipate, and our indicators keep giving us positive encouragement, we may add to the position and tighten stops. Exiting is normally a matter of the reverse of our entry method. That is, as our indicators deteriorate, we will lighten up on the position and ultimately exit entirely. Normally, we are in a market for two to three weeks, but we have held some positions for as long as nine months.
Q: In a recent blog entry, you mentioned that you have added to your heating oil position – can you give us your thesis (and any target/exit points you have in mind) for this?
A: We put this position on largely as a proxy for the crude oil market. We viewed the crude oil market as having far too large a short position considering its flat trend, and sentiment was at rock-bottom levels, despite the fact that crude hadn’t really made any downward progress in the past few months. The kicker we liked in heating oil was that the short position in heating oil was even larger than in crude oil, perhaps having to do with the idea that heating oil inventories are at multi-year highs. This gave us the opportunity of capturing a more fierce short-covering rally than we saw happening in crude oil. We recently added to the position as recent evidence has shown that the last rally hasn’t elicited any short covering yet. Unfortunately, so far, the rally has been quite muted. We’re making money, but it hasn’t been the big winner we had hoped for. Initially, our stop-loss order was at around 182 (about 10% below our entry price), but when we added to our position a week or so ago, we tightened the stop.
Q: On a seasonal basis, Mr. Foster, gold is supposed to be strong performer going into the end of the year but it isn’t a position in your fund (from what I could glean from your blog entries) currently – why?
A: Yes, I’m aware of the strong seasonal in gold, but unfortunately we view gold as far too risky and subject to a liquidation move. There is a lot of speculative money long gold, and there is also a great amount of money invested in gold by the public in ETF’s. So, we view the market as far too capable of having a sharp correction. Since we can only risk 3% of our portfolio on any trade, this makes the risk of being stopped out too high. So, while we may be bullish longer term, we have to recognize that sharp counter-trend moves can create significant losses for a program like ours with strict money-management.
Q: What if anything can be inferred from your long December copper position? Are you expecting the emerging markets to put up strong economic numbers going into 2011 or do you think the markets have penalized copper a bit too much given the current economics in the United States and the rest of the world?
A: Interesting question. When I find my program producing long signals in industrial commodities, as it is now, it is usually because the market is holding up even while sentiment is deteriorating and shorts are becoming more aggressive. Sometimes, I think, this means that the real economy isn’t quite as bad as the market thinks it is. How much better the real economy might be is only something that will usually become apparent long after we have exited our trades. That said, 2009 was a terrific year for us because of just this kind of situation: we bought industrial commodities (copper and crude oil) early in the year as everyone thought the economy was going into a global depression. We were fortunate enough to stay long for long enough to see the economy actually launch into a solid expansion.
Q: Finally, what is your best investment idea right now? Why do you like it, what are the risks to your investing thesis and do you have any entry/exit points?
A: Well, right now we’re finding that many agricultural commodities are rallying in a very sustainable fashion, and not all of them have to do with crop problems like we saw with wheat. Even better, the public has been slow to buy into the rallies, leading us to believe that there’s more to come. So, while we have just liquidated our long sugar position, we have recently added soybeans, and we are looking to re-purchase sugar on a correction. The really exciting action could start happening if the recent founding of a corn ETF is followed by ETF’s in other agricultural commodities. That could take total passive commodity investing to a whole new level.
Thank You, Mr. Foster!
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