Anyone trading natural gas before, during and after Hurricane Katrina knows how brutally volatile natural gas prices can be. This market can be subject to wild fluctuations.
In my article, "What Determines U.S. Natural Gas Prices? A Modeler's Perspective," I discussed the factors determining natural gas prices. I ended by stating that price forecasts are incomplete for specifying a trading strategy. To successfully trade natural gas, two other components need to be taken into account: risk management and market behavior. I discuss those below.
In The Intelligent Investor, Benjamin Graham states, "the essence of investment management is the management of risks, not the management of returns." At the heart of this approach is loss minimization, deliberately protecting oneself against serious losses. Warren Buffett described this book as "by far the best on investing ever written."
My philosophy is that the best strategy is one in which a participant will not abandon in down-markets but also provides opportunities for long-term capital appreciation in rising markets. This is best accomplished by focusing on the management of downside risk for participants.
In the algorithm discussed below, I have built in risk management features to limit the maximum likely drawdown, which I consider to be the most important risk measure. It measures the maximum difference between the peak in total return and the trough.
In the 1970s, the efficient markets theory reached its peak of acceptance. The idea was that asset prices, such as equities, always incorporate the best information about fundamental values and that price changes are rational due to "new" news.
In the 1980s, researchers, such as future Nobel Laureate Robert J. Shiller, demonstrated that prices changed much more than the fundamentals they are supposed to reflect. He termed this "excess volatility."
In particular, he described one of the oldest theories about financial markets, which he calls price-to-price feedback theory. Essentially, he argues that the emotions of greed and fear drive market prices far too high on the upside and much too low in downturns. This observation fits with Benjamin Graham's prior description: "The day-to-day market isn't a fundamental analyst; it's a barometer of investor sentiment."
If markets move more by sentiment than by the short-term fundamentals, the trading strategy needs to have a way in which to adjust accordingly. I developed and tested hypotheses to try to quantify conditions that might make investors feel greedy and fearful. And it turns out that the size of market gains and losses, combined with the speed, does a pretty good job in determining when to be long, when to be short and when to be out.
My approach, which I call Vertical Risk Management (VRM), is to separate emotions from investment decisions by running an algorithm that provides systematic, quantitative signals. I first developed this particular model about seven years ago and have applied it to different markets, such as crude oil and equities.
BRS Natural Gas Index
By applying the same VRM algorithm systematically from 2000 through 2013, the "In-Sample" period, I created the BRS Natural Gas Index (BRS stands for Boslego Risk Services). This version of the Index is "long only." Note: All of the SEC disclaimers at the end of this article are important to read about any such Index applied retroactively over historical data.
The "In-Sample" period refers to the period in which the algorithm parameters may be adjusted to achieve different levels of risk and return. In the "Out-of-Sample" period, the same parameters that were set in the "In-Sample" period must be used.
The total return of the Index during the "In-Sample" period was 144%, with a maximum drawdown from peak of 31%. This compares to the total return from a buy-and-roll position of 28% with a maximum drawdown of 50%.
I calculated the Index for the "Out-of-Sample" period, January 1, 2014, through March 18, 2016. The Index gained 15%, and the maximum drawdown from peak was 15%. That compares to a loss 55% from the buy-and-roll strategy and a maximum drawdown from peak of 42%.
During this heating season, natural gas prices have been in a downturn with occasional recoveries. This long-only index methodology gained about 10% in a mostly declining market.
The BRS Natural Gas Index (long-only) has three positions: 0% long (in cash), 50% long and 100% long. The percent applies to a maximize position size. The positions are signaled daily by three signal lights: red (0%), yellow (50%) and green (100%).
The Red signal on Friday, March 18, 2016:
The natural gas market can be highly volatile. Trades that may seem to make sense may go the other way due to behavioral factors. That's why it is important to control risk and be conservative in this market.
Important SEC Disclosures
This material is provided for limited purposes. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice. The opinions expressed in this article represent the current, good-faith views of the author(s) at the time of publication. The views are provided for informational purposes only and are subject to change. This material does not take into account any investor's particular investment objectives, strategies, tax status, or investment horizon. Investors should consult a financial advisor for advice suited to their individual financial needs. The author cannot guarantee the accuracy or completeness of any statements or data contained in the article. Predictions, opinions, and other information contained in this article are subject to change. Any forward-looking statements speak only as of the date they are made, and the author assumes no duty to update them. Forward-looking statements are subject to numerous assumptions, risks, and uncertainties. Actual results could differ materially from those anticipated. Past performance is not a guarantee of future results. As with any investment, there is a potential for profit as well as the possibility of loss.
The information presented in this paper relates to the creation and testing of investment models and the use of backtested performance data. Back-tested results are calculated by the retroactive application of a model constructed on the basis of historical data and based on assumptions integral to the model which may or may not be testable and are subject to losses. Hypothetical performance results have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. In fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular trading program. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. Back-testing allows the security selection methodology to be adjusted until past returns are maximized. In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk in actual trading. For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses are material points which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results and all of which can adversely affect actual trading results.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.