Fund’s $600 Million Lost Week Captivates Traders
Decline of Catalyst Hedged Futures Strategy is topic on minds of trading desks
By CHRIS DIETERICH and GUNJAN BANERJI
Feb. 16, 2017 7:40 p.m. ET
It is the buzz of Wall Street: a five-day, 15% plunge in a U.S. mutual fund whose bearish bets were undone by the S&P 500’s latest run to fresh records.
The decline of Catalyst Hedged Futures Strategy fund, a $3.4 billion fund employing complex derivatives, is topic du jour on trading desks fixated on the surprising resilience of the postelection U.S. stock rally and the long decline of volatility, or price swings.
Many investors have been surprised by the S&P 500’s 9.7% run-up following the Nov. 8 election of Donald Trump as president. The Catalyst fund typically uses options positions in a configuration that seeks to maximize gains from stable or gently rising markets, or else shield investors from sudden declines.
Its weak spot, badly exposed in recent weeks, is a fast-rising market that punishes the portion of the strategy that is effectively a wager against the market.
U.S. stocks carry lofty valuations, and trading has been unusually placid, even as high-profile investors warn that rapid shifts in the political environment will likely add to investment risks.
“We’ve had a pretty unprecedented market run here, and the volatility is at record lows,” said Jerry Szilagyi, chief executive of the fund’s adviser, Catalyst Capital Advisors. “This is the type of market that is the worst type of environment for the fund.”
Here’s how Catalyst got into trouble: The Catalyst fund’s strategy uses options on the S&P 500 index, contracts that allow investors to buy or sell at set prices over fixed time frames. In this case, the fund employed a “butterfly spread” that benefits the fund if the market remains stable, rises slightly or declines in any magnitude.
The fund’s manager, Edward Walczak, said that a portion of the fund’s portfolio set up before the rally was effectively left “short” versus the S&P 500 after the market burst higher over the past week.
Losses accelerated in recent days because the options were set to expire Friday, meaning there was little time for the market to reverse and return the bet to profitability.
Declines became so extensive that the firm chose to unwind its money-losing bets, Mr. Szilagyi and Mr. Walczak said. The fund lost $600 million in assets in the week ended Thursday, Morningstar Inc. data show.
“We took them off of the books over the past few days,” Mr. Szilagyi said. “We weren’t forced to sell. We have certain tolerances for losses and we decided to take off the positions.”
This week, volatility rose even as stocks rallied, an unusual juxtaposition that prompted some traders to speculate that the fund’s efforts to extricate itself were rippling through the market. Others noted that the CBOE Volatility Index readings, in the low double digits, have recently been so low as to make large upward moves more likely in the event of any unusual market action, some analysts say.
Some analysts said they believed the Catalyst fund’s efforts to rapidly wind down bets against the S&P 500 helped fuel the index’s rise this week to fresh records. Before Thursday, the S&P 500 rose for five straight days— gaining 2.5% over that span—and 10 days out of 11. The index dropped 0.1% Thursday.
Mr. Walczak has for more than a decade used combinations of options with the aim of riding modest stock gains while profiting from regular fits of volatility. The methodology has generated more than 9% a year for investors over the past decade, about two percentage points a year above the S&P 500, according to Morningstar.
Catalyst didn’t explicitly wager on the election’s outcome, but its expectations for relatively flat or declining markets echo concerns voiced by other high-profile investors since the election. Seth Klarman of Baupost Group and Paul Singer of Elliott Management Corp. are among those to warn of deep political uncertainties that could derail the market at any time.
Christopher Cole at Artemis Capital Management noticed the spike in the VIX on Wednesday. He said significant dislocations in the options market have the potential to cause waves in the S&P 500 futures market and spill over into the regular market.
He said he was “suspicious that there was a liquidity event going on,” in which order imbalances cause prices to swoon and surge, rather than a fundamental movement reflecting expected changes in prices and economic conditions.
A liquidity squeeze can happen when dealers are forced to buy S&P 500 futures contracts and options to offset the risk taken by closing out a fund’s positions, traders said.
Chatter about the fund’s troubles was heavy on Twitter Wednesday, highlighting investor anxiety over the idea that some trigger, however minute, could shatter the market’s recent calm.
For example, “if there is an incremental bad data point, it’s not going to take a lot for the market to start selling” said Amy Wu Silverman, equity derivatives strategist at RBC Capital Markets.
But the fund manager, Mr. Walczak, said that he thought it was unlikely that his fund played a role. The S&P 500 is near $20 trillion in market value and the futures markets host billions of dollars in trades every day.
Looking at that backdrop, he said, “I’m hard pressed to imagine that a $4 billion fund is moving the entire market.”
Mr. Walczak moved up the timing of a conference call with clients originally set up for next week to help explain the rough patch of performance. And he doesn’t anticipate making major changes to the strategy that has served him well.
“These aren’t circumstances that happen very often,” he said. “It’s not what you’d like to happen certainly, but as a manager you exit the positions, you reassess and move on.”
https://www.wsj.com/articles/funds-600-million-lost-week-captivates-traders-1487292045
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Don, the unwinding of the funds position quite likely impacted the options market and the VIX. The fund states that they are using futures in addition to the use of options. I notice in the comments section that a couple of people stated that the fund could not have been using a butterfly spread. I suspect that the fund was using multiple options strategies as well as combined complex options and futures strategy..... that obviously did not work well with the market not having a 1% move in 49 days.... with not declines to help get the VIX implied volatility up.
John
below is some additional info that goes to underscore how complicated options strategies are .... and from what I have been told these types of firms end up with an overlay of multiple variations of "positions or exposures" where they could have a 3 month long butterfly that they put on this week, next week a combination of options premiums and market outlook can have the firm added money to a short butterfly or an iron condor...
or a strangle that are placed at different points of in time and are pulled off as conditions and market expectations change. And there complex positions can closed out or "legged out of " not all at once, but over a period of time a
while other parts are being offered at limit prices and the risk of the unbalanced position is covered with a futures position.
When it is done and profits are made... that is where so called value has been added or "Alpha Captured"
When done at a lose...... no added value has been created.
theoptionsguide.com
theoptionsguide.com
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Options Trading: A Brief Discussion of Butterfly Spreads
By J. W. Jones Jan 11, 2012 1:00 pm
There are several points of emphasis regarding butterflies that are essential in order to understand their behavior.
"I only ask to be free. The butterflies are free."
-- Charles Dickens
My last few postings have served to introduce certain families of option trades. I find it helpful to embrace the concept of various families sharing certain and specific characteristics. In doing so, it serves to help avoid the chaos of considering whether each possible option trades as its own unique individual with its own unique set of defining characteristics. Grouping these trades into families reduces the number of specific variances the trader must consider in each particular case.
While in the process of defining our families of trades and the specific cast of characters to whom we will return regularly, I want to remind readers that there will be the occasional unique trade structure that we might use to take advantage of a certain situation.
A specific example included among this cast of unusual characters is the ratio back spread. When presented with the appropriate situation, this trade construction can deliver outstanding profit opportunities with low levels of associated risk. Remember the term ratio back spread as we may look to that type of spread in order to profit from a particular scenario in the future.
For now, let us continue our study of the various families of option trades. It is the individual members of these families which we will utilize in the majority of option trades that we undertake.
Today we will begin introductions of the members of the incredibly useful family of "winged spreads." Specific members of this family include butterflies, iron butterflies, condors, and iron condors. These trade structures are built by combining vertical spreads in several specific combinations.
This family shares several important characteristics among the various individual members. These individual characteristics vary somewhat from one type of trade structure to another, but the family identity is quite clear. The similarities are best viewed in the P&L chart of a frequently used trade structure known as a call butterfly spread.
There are several points of emphasis regarding butterflies that are essential in order to understand their behavior. As regards their structure, put and call butterflies always are built from options in the ratio 1 / -2 / 1 with equal price differences in the strike prices between the central short positions and the long "wings" on either side. An example using IBM (IBM) is shown below:
Buy to Open 1 February IBM 175 Call
Sell to Open 2 February IBM 185 Calls
Buy to Open 1 February IBM 195 Call
When considered from another point of view, the trade simply consists of a vertical credit spread and a vertical debit spread which share the same short strike price.
From a functional viewpoint, maximum profit always occurs at expiration when the price of the underlying is at the short strike price. It is this relationship between the short strike and the point of maximum profit that allows the trader to express his view on price action. The short strike can easily be chosen to express a bullish, bearish, or neutral price expectation.
Another characteristic of winged structures is that these positions have a range of profitability with both an upside and downside breakeven point. The range of profitability can be adjusted by varying the width of the "wings" to establish a very tight target zone or a wide zone of profitability.
The width of the zone of profitability is correlated with the risk versus reward characteristics of the trade. The wider the zone of profitability is, the greater the risk / reward of the trade. However, the wider the profitability zone is, the greater the probability of success becomes.
An important point for traders to understand is the change in price sensitivity of the position as time goes by. Go back to the chart above and pay particular attention to the slope of the P&L graph in relation to the price of the underlying.
Note that early in its life, the butterfly responds slightly to price action and only exhibits substantial losses if price moves away from the central point of maximum profitability. However, as time passes, the butterfly becomes increasingly sensitive to price movement.
It is for this reason that most experienced butterfly traders develop a "trigger" to exit these positions as they approach the end of their life. Adverse price movements in the underlying can have significant negative effects on the P&L of the position when dealing with butterflies that are late in their expiration cycles.
There remains one major family member we need to discuss. This is the "iron condor" -- a high probability trade that can deliver profitable results in a number of market scenarios. We will review this particular trade structure next week.
Iron Condors spread--- had not heard of that one.
investopedia.com
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