Lowering the Cost of being Long Commodities ft. Hari Krishnan

[00:00:00] Intro

You’re about to join Niels Kaastrup-Larsen on a raw and honest journey into the world of systematic investing and learn about the most dependable and consistent yet often overlooked investment strategy. Welcome to the Systematic Investor series.

[00:00:22] Niels

Welcome and welcome back to this week’s edition of the Systematic Investor series with Hari Krishnan and I, Niels Kaastrup Larsen, where each week we take the pulse of the global markets through the lens of a rules-based investor.

Hari, it is wonderful to have you back on the show. It’s been a while since we last had you on. How are you doing?

[00:00:41] Hari

I’ve missed you, Niels. Let me start with that. I’m very happy to be back and I’m sure we will have lots to discuss.

[00:00:48] Niels

Absolutely. Now, we are going to be talking about a slightly different topic I think this week, courtesy of you, mainly because you’ve had a real deep dive into a different asset class compared to what most people will know you for, namely, volatility. But before we dive into all of that, what I always am curious about is what you’re keeping an eye on at the moment, not related to what we’re going to be talking about today, but what you find interesting going on in the world, in the markets right now.

[00:01:26] Hari

Somewhat surprisingly, I’ve been very interested in zero day to expiration options recently. People used to contact me about them because I’d written quite extensively about weekly options in “The Second Leg Down” book that I wrote in 2017. But then I kind of lost interest because the prices of the stuff that I was buying for protection seem to be going up, at least in equity land.

There are good reasons for that. A lot of portfolio managers who trade volatility as an asset class, who do relative value trades and so on, have strict limits that they have to adhere to at the end of the day. The zero day to expiration tools were great for blocking out risk. What I started to see, and I’m sure many others know this, is a strangely shaped term structure of volatility where very short-dated protection was quite expensive. There was a quick dip down as you went two or three days out, and then everything normalized.

So there was a strange spike at the short end. So what I’ve seen recently is a proliferation of articles and blog posts and so on about selling the zero day to expiration options, especially in equity land. That has been a very good strategy since 2022, but a lot of the data is restricted. It only goes back two or three years. You can try it interpolate the surface before then, but the dynamics were different.

So I’ve seen a lot of press recently about how these are the greatest things in the world to sell, selling straddles every day on 0DTE. I would be worried about this because as soon as this sort of idea catches fire, or wildfire, there tends to be distortions in the market. I’ve tested this stuff as well. It does look very attractive over the past two or three years. You can generate a Sharpe ratio well over 1 or 1.5 doing this. But we haven’t seen a major event, or major volatility spike, in equity land or in equity index land since 2022.

I know 2022 was a fairly bad year for international stocks or international indices, but it wasn’t a very volatile year. So I see something brewing in the horizon in 0DTE land, I’m just curious to see what happens.

[00:03:57] Niels

It’s kind of interesting you chose that topic. I did not expect you to pick volatility.

[00:04:02] Hari

I didn’t give you any advance warning.

[00:04:04] Niels

No. But it’s funny because I had written down that I wanted to ask you about volatility because I’ve had so many conversations with our mutual friend Cem about things and some of the things that he’s seeing. Actually, he thinks, generally speaking, and he was mentioning this last week when we did our conversation, that he has a little bit of fear about what’s happening right these days, May 1st through whatever, 5th or whatever it was.

He thought that was a pretty important time. But in any event, you chose volatility, and you chose something that is interesting and the changes that you know the zero day options have had on the volatility space I imagine so.

[00:04:50] Hari

Well, the open interest has soared at the very short end. I used to call these things gamma plucks. You could fill the holes in your portfolio by buying these things at fixed cost and blocking out extreme downside scenarios for a short time. So they were great, but maybe the pendulum has swung a bit too far.

[00:05:12] Niels

It’s funny, we argue so much on this podcast about the importance of being long-term, and a lot of these popular strategies, be it zero-day options and meme stocks and all that, are so focused on the short term. But anyways, another thing that actually is kind of interesting this week from my perspective, that certainly caught my radar, was some of the statements coming out of the Fed this week.

I think they’re finding it very difficult to navigate this narrow path between wanting to give markets hope about rate cuts but running into a brick wall every time the inflation number comes out. I think he came out saying this week that there’s not likely to be a rate hike. The next move from the central bank is unlikely to be a rate hike. It just feels like they’re putting themselves a little bit into a corner like they did with this transitory narrative where they already decided what they wanted to do and not actually looking at what the data was showing them, even though they say of course that they are data-driven.

Then he got this question I think as well about stagflation, and Powell pointed out that by some measures at least, the economy is growing at least 3% and inflation is below 3%. So he didn’t see “stag” nor “flation” anywhere.

[00:06:42] Hari

Didn’t Janet Yellen say something about how inflation was quite moderate, except for a collection of prices that were immoderately going up?

[00:06:50] Niels

As she’ll probably exclude from the calculations at some point.

Anyways, we’re just starting out the month of May. That means April just came to an end. So I thought I would just summarize a little bit the month of April, which, despite offering intervention in the Japanese yen, also a pretty meaningful sell-off in the last few days in cocoa, which has been a great trend for trend followers, and some meaningful weakness in equities, trend following models are still positioned kind of risk-on when you look at the signals we have on at the moment.

That’s obviously as we head into the summer months, where sometimes we do see some decent moves. Although April may also have been a month where some trend followers took a little bit of risk off the table given some of these reversals. Of course, it is interesting that all of this is happening at the same time as we are seeing these dynamic shifts in the US economy marked by of course the robust employment numbers we’re getting, persistent inflation, and as I mentioned before, this evolving Fed policy that we are witnessing every time there’s someone speaking from the Fed.

Now, the other thing that’s happening at the moment of course, which is interesting from a trend following perspective, is this divergence in central bank policy. We haven’t seen that for a long, long time. It started a little while ago, but it’s becoming clearer and clearer. Maybe even the ECB will do something different next month compared to the Fed. But it is giving some interesting opportunities in sectors that we haven’t seen moving for a while, which is currencies.

I think trend followers benefited from that as well, certainly from the yen, but also Mexican peso and I’m sure a lot of other things. But in any event, at the end of April, my Trend Barometer finished at 45, which is a neutral level. I think that’s probably fair enough. I expect a lot of managers will come in plus/minus 2% or 3%, maybe more of them on the plus side for the month of April.

Certainly when I look at the initial indications, the BTOP 50 finished or is looking to finish at up 1.65% for the month, up 11.14% for the year. SocGen CTA Index up 1.82% for the month, up 11.65% for the year. The Trend Index doing well, up 1.65% for the month of April, up 14% and change for the year. The winner of this month was the Short-Term Traders Index. They enjoyed some of that volatility. Up 2.4%, which is great for them, up 3.73% for the year.

That of course comes in light of the fact that traditional markets were down. MSCI World down 3.85%, still up 4.25% for the year. World Government Bonds down another 1.77% in April, and the S&P 500 Total Return index up 4.08% and up 6.04% for the year. So interesting times. I know we’re not going to be talking about trend following, but I know you follow trend following.

[00:10:05] Hari

No pun intended.

[00:10:06] Niels

You have a hidden trend follower in you, Hari. Exactly.

[00:10:09] Hari

Waiting to come out. Itching to come out.

[00:10:14] Niels

Any thoughts on that space since we haven’t spoken for a while?

[00:10:20] Hari

Well, we did offline. We talked about cocoa. Cocoa was a phenomenal market in so many ways. One is that it had long periods where it hadn’t trended. So I’m quite sure that some trend followers didn’t even put it in their basket. It’s not particularly liquid. It’s not as liquid as many other commodity markets such as oil.

The other thing is that when looking at the Commitment of Traders report, which is always a mysterious thing to try and interprate, cocoa seemed to be one of the markets where managed money was as large, in terms of open interest, as commercial hedging activity was both for producers and end users. That’s quite unusual. That suggests to me that there was a major piling into that trade on the trend following side, because managed money typically correlates to trend in most markets.

So I presume it was to a very large extent a technical affair once the poor production numbers came out from Africa. But that all has changed abruptly as you well know in the past week or two, I’d say two weeks, partly as a function of higher risk requirements or margin requirements set by exchanges. One can debate to what extent this is a factor, because if you have a trade that’s heavily on site, you’re not desperate to get out too quickly. But it’s a good topic for today.

[00:11:52] Niels

Yeah. Cocoa is interesting. Firstly, I don’t follow the Commitments of Traders report. But I will say, from a trend following perspective, I think it is important to say that we, and I speak for the longer-term trend follows I guess here, we were not buying it much past the second half of last year. All the interest signals really started in January 2023. Depending on your timescale, it takes a little while to get into a full position.

But I don’t think that trend followers, interestingly enough, really had much to do with cocoa once it became a parabolic trade. I commented on that with one of the other co-hosts, I can’t remember who it was, that recently, there was an article out that one of these big oil traders, I forget his name but he’s quite famous I think, was getting into cocoa suddenly this year and it had gone up 60% alone in March and all that good stuff.

So I think, personally, that it is participants, certainly speculators, that have certainly moved the markets higher in the very end, but I just don’t think it’s trend followers, frankly. As I also have commented on, trend followers, in general, who use dynamic position sizing would have been selling cocoa all of this year because of the increased volatility. In fact, we’ve been going in the opposite direction in 2024. But these are more technical points and I’m sure the headlines will say it differently once it gets to the press.

[00:13:36] Hari

Well, that bears itself out in the Commitment of Traders report as well. You see a lower number of contracts on the long side for managed money this year.

[00:13:46] Niels

But if another hedge fund bought those contracts, you wouldn’t see it, right? Am I correct in that?

[00:13:51] Hari

You wouldn’t. They would be blurred.

[00:13:52] Niels

Yeah, that’s what I’m thinking. Anyways, thanks for the little cocoa introduction because you knew I was going to bring that up I’m sure, because we are moving into the world of commodities. I will also say that in addition to this margin requirement going up, and maybe that’s the cause of this 35% plunge in cocoa for the last two weeks, there was also news out that Nigeria is coming out with a better harvest. So maybe that good news had something to do with it. We’ll see.

Before we dive into your topics, and I’ve already revealed now we’re going to be talking about commodities, which is not a topic you and I normally talk about. The interest in commodities, how did that show up in your life? Because it’s a little bit different than volatility, I imagine.

[00:14:47] Hari

Well, just to go on the record, I have not stopped with long volatility. That’s still a big part of what I do. It’s a big part of my knowledge base, hopefully. It’s just that that’s a highly cyclical business in terms of interest. When things are going very bad, I tend to get tons of requests and a lot more business opportunities flow in. But there are long stagnant periods where it’s hard to raise money, frankly.

I know as a trend follower, if I were a trend follower, I would be well aware of the cyclicality of interest in the area. The same is true here. So I was interested in commodities just from a political standpoint as an outsider, but I started examining some things that I knew and I wondered if I could reengineer them. The first thing was an analogy that I had, which is that the VIX and natural gas or electricity are quite similar.

It’s hard to replicate the VIX. It’s very hard to store natural gas unless you liquefy it, electricity is even worse. So now you have these commodities which have futures term structures and options dynamics which look very similar to stuff that I know. So you get severe contango in the term structure where the front month trades at a significant discount to the further out months. You get low prices and heavy roll-down.

So longer-term trend followers let’s say are typically short most of the time in these markets, and you get sporadic mega spikes when there are supply shortages in the case of commodities or risk off mega events in the case of the VIX. So the same sort of structures seem to apply. So I put all this stuff into my backtesting engine, and I found that the same sorts of trades seemed to be working.

Then I compared that to other commodities markets which actually behaved like the S&P, and I’ll give you some examples there. For the S&P, at least in my opinion, somewhat out of the money puts, somewhat out of the money insurance tends to be expensive. So let’s say three months to maturity, S&P puts that are 10% out of the money tend to be quite pricey because institutions like to buy them.

Whether it’s the well-known and well-broadcasted products that the banks sell, the caller to equity index products, or it’s simply the mindset of institutions that want to hedge against moderate downside scenarios, those things tend to be rich. So you can build a lot of hedging strategies around selling those and buying a lot of other stuff, whether it’s out the money, far out of the money, or whatever.

In the same way, I found that in the commodities markets such as oil or corn, soybeans and so on, out-of-the-money call options, which are trading on the other side of the distribution, tend to be expensive. So that led me into a nine-month rabbit hole of trying to figure out why, and then constructing trades that would allow me to monetize increases in commodity prices, especially from a low level.

[00:18:12] Niels

Over the years, we’ve had a number of commodity specialists on the podcast. I’m not even including Shawn Hackett that you spoke to because I can’t remember exactly what he said. But some of the other ones have certainly been of this opinion that we’re heading into this commodity supercycle bull market. So why don’t we start with that?

[00:18:33] Hari

Yes. Well, there are many good reasons to believe that commodity prices will go up in the medium term, and I’ll give a few. One of them is political. We’re going into an environment where deglobalization seems to be coming into vogue, where countries are worried about food security, about energy security, about being able to produce what they need internally.

Now, this requires more infrastructure. To increase agricultural production internally requires more infrastructure. But it also creates frictions in the global trade for commodities, which could put upward pressure on prices. Moving along, we can go into the Green Revolution, which as it progresses at whatever pace, will require large amounts of industrial metals such as copper. You need a lot of copper to rebuild the grid.

We’re also in an environment where weather volatility seems to be picking up. Now, I’m not going to take a strong political stance here, but there have been greater extremes in temperature and precipitation in areas like Brazil as the rainforest has been cut down significantly to increase agricultural production that do seem to have destabilizing effects at least on the prices of certain grains and other commodities in the long term, or in the medium to long term.

So we’re kind of in an environment where the ease of transporting commodities across national borders is decreasing, where countries are trying to, God forbid, re-militarize, which requires a lot more metal and energy inputs, requires a lot more of those. We also have an environment where weather could become more volatile going forward, which will lead to greater volatility in prices.

[00:20:37] Niels

I’m going to interrupt you again here just with a question. I remember very clearly that after the Russian-Ukrainian conflict broke out, we did see a lot of commodities spike higher. Those were the exact reasons that the people would say, right?

[00:20:59] Hari

I think so, yeah.

[00:21:02] Niels

But to many people’s surprise, actually…

[00:21:05] Hari

They came right back down.

[00:21:06] Niels

They’ve been selling off for two years. I know as a general case, some commodities are cheap and so on and so forth, and therefore, they could go into a bull market. But is there anything that you’ve noticed in your research that kind of says, yeah, there’s a reason why it didn’t happen two years ago but now things are different? Even though they’re not really different, because the same problems are here today than they were maybe a couple of years ago.

[00:21:35] Hari

Again, I don’t want to go too heavily into geopolitics. I think if you go back over time, in World War One and World War Two, the price of wheat tripled. It went up three to four times in each case, and these were sustained movements. I do accept that technology and the improved supply chains from 50 years ago or 75 years ago are creating a bit of a downward pressure on grains for the time being, but being able to own stuff that’s cheap seems to be immensely valuable.

It’s a really interesting topic for me because in the same way that hedging is an attempt to provide the biggest payout you can given an equity market decline, a severe equity market decline, with the lowest cost of carry, buying depressed commodities, if you believe in the commodities bull market story, is a question of being able to buy using financial instruments, being able to buy and hold, in other words, virtually warehouse cheap commodities with low bleed but with significant participation should prices rise.

[00:22:53] Niels

So let’s imagine I buy into that. I don’t know if you’re thinking about specific commodities or all commodities, but as you rightly indicate, a lot of investors can’t just buy the stuff and put it in a warehouse. So how does someone like you, me, a lot of the people listening to our podcast today, how would we go about thinking about this differently from what you’ve put together?

[00:23:23] Hari

That’s an excellent lead-in. So if I were a physical supplier or a physical storage operator, I think the cost of storing or warehousing a cheap commodity actually goes down at bit as the price goes down. My insurance costs go down, my depreciation costs go down a little bit. Also, there’s less incentive for me, let’s say if I’m a farmer, and corn is at $3, to sell corn into the market to pay off my loan because I don’t get as many dollars out of that transaction as when corn is at $6. So I do get paid a bit more implicitly to weights.

[00:24:03] Niels

Sorry to interrupt you again, Hari, because I’m really curious to understand this. It’s a little bit outside my normal expertise. We saw a couple of years ago that prices moved down in oil back to a negative, but that was not a time where storage became cheaper, so to speak. I guess it went down because of storage costs. So is this what you just mentioned? Is that sort of generalized? Where do the difference lie in terms of that?

[00:24:38] Hari

Let me make a less bold claim just to make my point clear. Let’s say that I were in the steel business and the price of steel went down. I would go out and buy some scrap and then stick it in a warehouse somewhere and wait for the price to go up. The cost of my renting that warehouse space is insensitive in dollar terms to the price of steel. So I’m not paying more to hold steel in the warehouse when it’s trading at a low price than when it’s trading at a high price.

By contrast, if I were to go into the futures markets and buy and roll coil steel futures or any commodity futures, on average, the cost of buying and rolling a long position goes up quite dramatically as the price goes down, and that’s a function of curve effects. So my goal in this endeavor was to demonstrate that it could be done.

Well, what’s it? That it would be possible to manage the costs of virtually warehousing a position using listed financial instruments by combining cleverly chosen futures and options to manage the carry.

I’m happy to give you the back of the envelope description of that. So in the hedging world, for long-dated options, you can sometimes pay for time decay using forward curve dynamics. I’ll give you an example. This isn’t the case now, but let’s say that interest rates were lower than the dividend yield for the S&P 500. If the forward curve rolled, so if nothing happens and you were at a point on the term structure and you rolled down the curve, that roll down can pay for the cost of holding an option from one day to the next.

So you can pay for theta with a roll. So strike out the example. Just think of it in those terms. In the virtual warehousing world, the problem is similar but almost the other way around. You pay for a roll down with theta. There are structural imbalances in the commodities world that are extremely interesting, and I’d like to go into them. Some of them may seem a bit strange to a trend follower but I’ll try and explain them, and I’ll start with corn.

It seems to me, based on the detailed research that we’ve done, that when corn prices rise, producers (producers meaning farmers and storage operators, elevator operators) are highly incentivized to sell futures to lock in gains. So as the price goes up, these commercial hedgers tend to be net sellers of futures. The same is true in copper and many other markets.

So they’re not thinking about capturing the right tail or even a significant amount of the right side of the distribution the way we long vol guys do or you trend followers do. They want to stay in business. They want to make sure that they can pay their employees, they can buy new equipment, keep the ball rolling, so to speak. So you see a strong tendency for that to occur, which leads to the stylized fact that most uptrends do not accelerate in markets where commercial hedgers are selling into rallies.

So the moderate trends don’t go ballistic most of the time. What that implies in the options space is that somewhat out-of-the-money call options which are providing insurance against moderate outcomes, moderate increases tend to be overpriced. You can demonstrate that using backtesting or more sophisticated statistical analysis, but generally backtesting.

So being a seller of these moderately out-of-the-money options can be very profitable if you can buy other options around it. So things like buying out-of-the-money calls, overselling out-of-the-money calls and then hedging the extreme can be a very attractive strategy from a P&L standpoint. From a time decay management standpoint, it allows you to pay for some of the carry costs in buying the futures.

So the virtual warehousing idea is basically a combination of buying futures, targeting cheaper points on the curve to manage roll costs, and then paying for those roll costs by identifying structural imbalances in the options markets that create both attractive time decay properties with bounded risk, but also capture some edge in such a way that the cost of holding a position in a flat market for the underlying commodity is virtually zero.

That’s a big mouthful that I’ve said. There are a number of reasons why out-of-the-money options are expensive but extremely out-of-the-money options are not, but we can dig a little deeper as you process this for the listeners.

[00:29:58] Niels

Yes. It sounds to me, and I could be completely wrong here of course, it sounds to me that there’s a little bit of a combination of convergent and divergent type components. How do you balance that profile? I know I shouldn’t assume anything here because I’m really out of my depth here since it’s brand new stuff. Do you want to end up being more divergent than convergent? Let’s phrase it like that.

[00:30:33] Hari

Yes. To be fair, the warehousing works well in conjunction with trend following. The idea is that if I wanted to buy nat gas and it were cheap, which it currently is, at least Henry Hub natural gas is quite cheap. I would want to be a virtual warehouser in the early stages because I don’t want to be short. A trend follower would be short.

If the client or if I believe the gas is going to go higher in the long term, but I don’t know when, and I don’t want to be eaten alive by roll costs along the way, I would be a blend of convergent and divergent strategies; divergent in the futures, hybrid convergent-divergent in the options piece, until the price did go up significantly, at which point I would turn into more of a trend follower.

There are two reasons for turning into a trend follower. The first reason is, I want to be able to capture as much of the upside as I can. But the other thing, as your listeners well know, is that trend following has the marvelous quality of having a risk control mechanism built into it. So I can hold that trend as long as it goes up and doesn’t break, at which point I get out. So my goal is to capture the early stages of a rally where the skewness is most attractive.

That’s one of the advantages of the warehousing idea. If gas is at $1.50, the risk of it going down $1 are far lower than the odds of it going up by an equivalent amount. Whereas if it’s at $6 or $7, the risk becomes more symmetric. So I capture the asymmetry at low cost, or perhaps even zero cost, in the early stages of a rally. But then in order to get the full extent of the move, I want to convert myself into being a trend follower.

[00:32:27] Niels

I’m sure we’re going to go back on some of these details because there’s a lot of things you’re mentioning here. But if I was going to be devil’s advocate a little bit here, I would say it sounds like you want to be a value investor when it’s good to be a value investor and a trend follower when it’s good to be a trend follower. Then that actually means that timing is very important.

I’m not so sure that is important really. I’m just saying that that’s what it sounds like, so to speak, choosing to be the right type of investor at the right time. You’re right in saying that there are definitely some weaknesses with trend following, but I’m sure it’s not all upside approaching it the way you do. So where are some of the main challenges in trying to do what you do now? Because you would think that somewhere, there’s a cost to be paid. It’s almost too good to say, well…

[00:33:29] Hari

There’s always a cost in any options structure. Just as a rule of thumb, the way that this system seems to be working, this virtual storage operation seems to be working, is that if the price of a commodity is low and it drops further, I’ll lose about 25% of the down move. If the price rallies, I’ll capture about two-thirds of the upside. If the price skyrockets in a day, I’ll only capture about 50% of the upside.

So a mega spike from a low level, I’m not making all the money on the upside, and I am exposing the investor to a fraction of the downside. But if the investor believes that the market is already low, flatlining is not an issue. So if the spot price flatlines, the futures will typically drift down but I won’t drift down. I’ll be flatlining.

So there are certain scenarios which aren’t ideal for the strategy. But moderate increases of great, spikes are okay. Big drops will incur losses, but a fraction of the loss, and I could keep playing the game and rolling from one month to the next if nothing happens. So I think it’s a really interesting area. The reason I’m so excited about it is because commodity options markets are driven by necessity as much as they are by arbitrage tied by tiers.

The arbitragers are great. There are some very famous names out there, and very successful ones, but you don’t know which side of the game they’re going to be on at any given point in time. You don’t know if they’re making money on the short side, on the long side, on the relative value side. Maybe they can generate more alpha given their more intricate knowledge of the specifics of a given market.

But what I’m trying to do is deliver that warehouse function at low cost and significant upside capture. That’s where I think the edge in this whole idea lies.

[00:35:43] Niels

You talk about virtual storage, but I was thinking while you were talking from a marketing point of view, it’s very popular to use cloud storage. So maybe it should be cloud storage of commodities. I don’t know, it might help. They might steal that.

But on a serious note (again, we may dive into some more details, but I’m just asking questions as they pop into my head here), when you look at your backtest, because obviously you would have to rely on some kind of backtest to get an idea of how this works, a couple of things.

Have you found, one, that there is a big difference in how an approach like that will do whether we are in a commodity bull market or not? The other thing I was curious about is recently, as more of these exchange-traded funds come along, we see that in equity land where obviously it’s just flows that determine whether there are buyers or sellers, they don’t really look at price. I don’t know how many of them are really in pure commodities yet and how popular they are, how big they are. But obviously, they haven’t been around forever.

So I’m curious to know whether having investors like that who are not so sensitive to price, if we can call it like that, and maybe in the nicest possible way, driven by stories, narrative, and perhaps not professional investors in terms of flows, does that also seem to have an impact on how the strategy reacts or has fared?

[00:37:25] Hari

So many good questions in there. I’ll try and rattle off as many answers as I can. The first thing is that one of the encouraging things about the backtests is that for all storable commodities, or for nearly all storable commodities, the same structures work. So there’s a lot of cross-sectional stability in the analysis, which is very reassuring. It suggests that end users of commodities are either more credit-constrained or less sophisticated than producers.

In the oil markets, to give one example, airlines are major hedgers. Airlines are not that solvent some of the time. It’s not the greatest business to run. So they’re not going to be doing complicated structures that have open-ended risk. They tend to buy call options as a base case in their treasuries to hedge against a rip in the price of oil. So there is that sort of imbalance that occurs in very many markets for slightly different reasons. We’ve analyzed those two.

What regimes are good? In markets where the price is low but the demand for out-of-the-money insurance is high, that’s a good regime for me. There is a little bit more edge in that. Please remember though that I’m covering all the upside, I’m not just selling out-of-the-money options. I’m overbuying deep out-of-the-money options and buying half-the-money ones as well. So it’s a bounded structure that gives upside participation.

But low prices and high demand for hedges are attractive. Higher prices are a little bit less attractive on the call side. Things do normalize, but that’s where the trend component really comes in handy. It’s the same idea as in the hedging world. So I’ve found analogies abounding, I’d say. As a hedger, my idea is to buy volatility when it’s cheap, and then turn into a trend follower if I have to provide protection on the way down once volatility has become rich.

The reason for that is volatility tends to be more cyclical than price. Prices tend to trend a lot more. Why would I want to overpay for insurance when I can get the same protection just by selling into the downside? Now, for equity indices, it’s a bit more challenging actually, because as you know, the signal-to-noise ratio in bear markets tends to be lower than in bull markets because declining markets for equities tend to be choppy. Rallying markets can be a lot more stable.

So there are issues in a pure momentum-based approach in a single market like the NASDAQ or the S&P, but that’s the general theme. The theme applies to the other side of the distribution, meaning for commodities, it applies to upside moves in the sense that the relative value plays tend to be more attractive in financing the cost of carrying a position when prices are low, but investors are worried about upside risk. The attractiveness of some of these structures decreases as prices rise and hedging has already occurred or is being monetized.

So trend following, again, plays a role in this idea of regime-based participation, which is a big part of what I think about. It’s always about regime-based participation for an options guy, namely, in certain regimes, certain spreads or trades tend to work relatively well. In other regimes, they don’t. As soon as you put an options trade on, you’ve already decided what regime you’re hoping for and what you don’t want, because there’s no structure that will do well in every case.

[00:41:13] Niels

So in my world, we have a defined universe of markets. We apply the same risk to all markets. We don’t know where the next big trend is going to be. How does that work in this world?

[00:41:29] Hari

Sadly, it’s more restricted what markets you can trade because the options liquidity is sharply decreasing once you go beyond the biggest 10 commodities markets, let’s say. So cocoa would have been virtually unplayable using this strategy, and other small markets such as milling wheat, soybean oil, all of those, places that I would be curious to participate in are out of reach.

Really, my universe is the biggest 15 options markets in the world. I think it is possible to expand into other markets with a better OTC, a better bank, better bank relationships for things like Nordic power and French power and so on. But in the listed world, I’d say it’s the 10 biggest markets. It’s possible to move beyond that, but I haven’t done so yet. That’s a work in progress. That’s already a restricted universe.

So what I can say is that liquidity and the ability to store the commodity are two drivers in this whole thing. I don’t plan to be providing virtual warehousing of weather derivatives because there is no physical analogy. So I’m guided by that too.

[00:42:49] Niels

As we start to wind down a little bit on this particular topic, Hari, talk a little bit about, I call it cloud storage, but let’s talk about the virtual warehousing of these things. The other thing I wanted to maybe also ask you a little bit about, and that is the consistency of an approach like this. Because we talk a lot about trend following, but we know trend following is not very consistent. It’s, in fact, very unpredictable.

So I’d love to hear a little bit about that side of things when you approach markets like you’ve described. But let’s go to the warehousing first.

[00:43:30] Hari

Well, you’ve had people like Adam Rozencwajg on your show; very well-known, long-term bullish investors in the commodity space, and their horizons are extremely long. They talk about things like uranium and various energies and so on, traditional energies being required over the next 10, 20, 30 years. So this is kind of an attempt to engineer their approach in markets other than the ones they are focused on.

You have various areas where you can get the equivalent of physical storage. Gold ETFs are a good example. There is some physical backing of those. Uranium is claimed to be physically backed, but one can argue as to whether there is any freely available open market in which to sell these claims or these units. So even that becomes a sketchy proposition. I know that Sprott has various ETFs in that space.

And then you quickly dive down into the area of things like the two Korean ETFs, which are blends of futures, and you’ve lost the virtual storage concept immediately. So I’m trying to fill that gap. So if someone watches Adam’s podcast or Adam Rozencwajg’s podcast, or various other supercycle bulls in the commodity space, hopefully this will resonate with them as a way to get positions in place at low prices.

Whether they choose to do it themselves, whether they choose to allocate someone or pick particular markets and build their own virtual silver mine or copper mine, or have it built for them is up to the investor obviously. But I think it’s an intriguing idea because it does allow people to participate at low cost in markets where they have a strong view that there could be a significant long term involvement.

This will not eliminate the volatility along the path, it will just allow them to sit tight, wait, and not bleed so much that their breakevens make the strategy untenable. For example, at $3 a bushel, your breakeven for corn has historically been $4 over a 12-month horizon. It costs $1 to buy and roll the futures, at least from 2000 to the present. You don’t want to have those sort of 30% breakevens every one year. If you can turn that into a 5% breakeven, a 10% breakeven, you can wear a position far longer.

That allows you to express your view without having all the issues of running a physical business, which frankly is untenable for most. So I think that’s the point that I want to get across on the storage idea, even if it means that you visualize the real physical entity in your head and you’re getting delivered very similar returns but without a lot of the logistical difficulties and headaches and barriers to entry.

[00:46:44] Niels

You know, when you speak about these things, I get this picture in my mind where you see nowadays people growing different types of agriculture in big storage houses, in layers where it just looks so different to how we think about crops being grown. Here they’re doing it indoors and all of that.

So one question that springs to mind. Of course, the series we’re on is called the Systematic Investor series. I was curious, because it sounds like a little bit of a complex strategy. How much can be systematized and how much do you have to rely on some kind of manual discretionary input?

[00:47:33] Hari

Well, I’m sad to say that I manually execute trades even in the hedging business. So the execution is manual. Sourcing liquidity is manual. But the structures that I put on are identical conditional on the prevailing regime across all markets. So there’s no thinking about should I be buying a put or put spread today. It’s a standard structure that’s done again and again and again conditional on the regime.

So all the backtesting, and it is backtesting to a large degree. So the viewership needs to be aware of that, but it is conditional as well. The first thing is to come up with unconditional backtests across the market, see how stable the ideas are, identify the possible reasons for the mispricings in the structures that work, or the inefficiencies that make the structures work. But then to identify regimes, whether they’re trend-based or volatility-based, that are particularly attractive for the strategies.

So it is very systematic in terms of there being a template which maps a state of the world onto a trade. Of course, the trend piece is very systematic, but there is discretion in terms of legging up the trade, figuring out the best time of day to do it in, and so forth. So there is a bit of manual intervention in that.

[00:49:02] Niels

It’s been very fascinating to hear about this, Hari. So I do appreciate you coming on and talking about this. As I said in the very beginning, this is very different for me to talk about. So I am sure, absolutely sure, that there are things that I should have asked you that I haven’t done. I’m going to give you a chance maybe to kind of set the record straight about some of the things I left out.

As I said, it’s a mouthful. It’s an interesting way because I think investors, if we just boil it down, I think investors have become more used to thinking about other asset classes away from stocks and bonds. Obviously, we’ve spent the last 10 years trying to get trend following on the radar, and other people have tried to get commodities on the radar, and to some extent, of course, we are successful in introducing new asset classes to portfolios.

I certainly feel, from the beginning of my career, 35 years ago to now, there is a big plate of types of assets and strategies that are very accessible for many investors. We know that. You’re taking it to a new level. You’re sort of saying, okay, well, commodities are interesting, but we know there are challenges, so here’s a way to look at it where we can mitigate, maybe not remove completely, but we can certainly mitigate some of those challenges. So why don’t you round things off maybe…

[00:50:43] Hari

Well, the way I think about it, I hope you would agree, is that every strategy is trying to solve a problem that investors face. So for trend following, it’s I want to participate in large moves that may occur in many, many different markets that I typically don’t have access to whether they’re up or down, what should I do? Well, allocate to a trend follower or perhaps build your own system if you’re able.

For this, I’m trying to solve problems for two different types of investors. One are the types who have bought into this bull market supercycle thesis for commodities, realized that they don’t have access to the physical commodity production or distribution setup, and want to be able to enter at cheap prices without having to pay too much to hold positions. So reducing time and risk, that’s the goal.

The other goal, which is quite interesting, is that for many people who actually are in the business, maybe they’re in the oil services business and they’re worried that the profitability of their business is really just a function of the oil price rather than being a function of how well they can run their business vis-à-vis someone else, that there’s really one major driver, so maybe they want access that way. Or maybe it’s a mining company that realizes that it’s going to take a while to increase production but want exposure in the meantime at a low cost.

So I’m trying to appeal to that crowd in terms of supplying commodity exposure in a timely and low-cost way for people who know that business, who know a specific business, and want that exposure in a liquid and easy-to-access manner, but also people who are very bullish on commodities and don’t want that necessarily corrupted by the sensitivity of commodity shares to say the S&P 500, or the level of diversification of certain businesses that cloud the issue of whether they’re really gaining exposure to what they want.

So, if I invest in a mega food company, I don’t know if the positions are hedged or unhedged, I don’t know whether they’re going to shift from the commodity I’m interested in to a different commodity, and how they’re going to play all of those games. I also don’t know if passive flows or other dynamics are going to drive the prices of those shares more than perhaps the stuff I’m actually interested in investing in on the long side.

So I view this as being a good complement to trend following. In fact, it incorporates trend following in the later stages. But it’s particularly useful for people who have a view and they want the most efficient way to express that view in terms of up capture and low cost. So that’s really the thesis that I’m trying to present.

[00:53:47] Niels

Just to recap, the sectors that this is possible in applying it to?

[00:53:53] Hari

As of now, copper, silver, gold. So those metals. Oil, and to a lesser extent, gas because of its lack of storage. All the grains. In principle, it can be applied to other markets as well. But as of now, it’s seven or eight markets where the systems are up and running.

[00:54:16] Niels

Fantastic. Good stuff. Very much appreciate that, Hari. Super interesting learning something new, for sure. To all of you out there listening, if you enjoy these types of conversations, please go to iTunes, Spotify, Amazon, wherever you get your podcasts and leave a rating and review.

Next week, I’m joined by Nick, who is back from some traveling, for a fun, insightful conversation no doubt. So make sure you send over your questions, and then I’ll do my very best to put them in front of him. info@toptradersunplugged.com is the usual email where you should send them.

From Hari and me, thanks so much for listening. We look forward to being back with you next week. In the meantime, as usual, take care of yourself and take care of each other.

[00:55:06] Ending

Thanks for listening to the Systematic Investor podcast series. If you enjoyed this series, go on over to iTunes and leave an honest rating and review and be sure to listen to all the other episodes from Top Traders Unplugged. If you have questions about systematic investing, send us an email with the word “question” in the subject line to info@toptradersunplugged.com, and we’ll try to get it on the show.

Remember, all the discussion that we have about investment performance is about the past and past performance does not guarantee or even infer anything about future performance. Also understand that there’s a significant risk of financial loss with all investment strategies and you need to request and understand the specific risks from the investment manager about their products before you make investment decisions.

Thanks for spending some of your valuable time with us and we’ll see you on the next episode of the Systematic Investor.