Karen Analysis (Part 2)

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Note from Tim. The following is kindly contributed by Buccaneer. The first part can be read here. I am not sure what preamble is required with respect to what I assume is an ongoing legal case, except to say that the words below are obviously a matter of personal opinion and none of these are offered as fact or conclusive findings: On Karen Bruton the Supertrader (KST) topic here’s my analysis about her case. (Links to SEC PDFs are here and here).

Unfortunately, the market had been moving up, and as you all know the adjustments to the Call side being tested can and do include selling Puts also. This works effectively if the volatility stays low and market keeps moving up or flattens out. But where you run into trouble is when this upward moving market suddenly dips with a big vol increase, which is exactly what happened with the Oct 2014 dip. So now Karen had sold many Puts at low vol in an up market, and they suddenly generated significant paper losses.

In retrospect, it’s clear that Karen did not have adequate risk management in place and you are spot on regarding her not stress testing her position with a vol increase in Analyze tab (or other options software). Quite frankly that’s a rookie mistake.

Remember too that the Karen strategy works least well in up-trending markets and having grown her fund to a large size, she was under pressure from investors to beef up returns (since 2012, 2013 and 2014 were big up years in the market she was basically not generating any alpha i.e. not outperforming the market). So this caused her to take on larger positions than what she was doing in the past being under pressure to generate profits that was harder to do with larger size, and started to deviate from her core strategy.

When the big unrealized losses in October appeared, Karen was faced for the first time with the prospect of no fees coming in. This was also a mistake in how the fund was set up because she should have been charging a base management fee (2%) that would cover her expenses during any down months. However, because her fee structure was incentive only she could not do that.

Therefore, knowing full well how her incentive fee structure was based on realized gains, she engaged in trades that created gains for the month to generate fees. Again, this was not done out of malice or profiteering. Because the idea was that it was temporary since the unrealized losses would be made back. From her perspective, it was incentive fees that would have been charged later anyway, so she was just “spreading them out” and pulling in money to pay her traders, staff etc.

Where things started to fall apart is because these trades took up margin and also had a slippage/tax cost, it started to eat into her profits and prevented her from executing her strategy properly. This is known as “going on tilt” and is common also for many traders. You have a good plan, but once you deviate and things start to fall apart you can’t get back on track.

As of right now there is about $50M in unrealized losses, the fund has not blown up, it is not doing well but it’s not a Ponzi scheme IMO and it will continue to trade. Unfortunately, due to the bad press (The Street) it’s likely that many investors will leave and Karen will end up managing her own money only (as she should have to). There will not be any jail time as nothing criminal was done.

One last thing. The redemption issue that was brought up is really the only big problem here. That is absolutely inexcusable and the attorney that drew up those documents is incompetent because that method of redemption is completely inappropriate (those funds that do use realized p/l for accounting have a redemption structure which incorporates the unrealized gain/loss thus preventing specifically this kind of problem where an investor can over-redeem their account relative to its actual NAV-based value). Likely this is the part that will really get Karen because it will be difficult to defend.

All in all, I think that there are some really useful lessons here for those that are trying to replicate this method.

The method works. Karen successfully used it from 2008 to 2014. A 6 year streak is not dumb luck especially considering 2008/2009 was still very volatile. Those that traded in 2014 and 2015 and now have also seen the concept work well during that time.

Risk management is key. You need to stress your positions on a daily basis at the very least. Be aggressive in your model (i.e. stress test with bigger drops and more vol jump that you want to). A few more contracts won’t make a huge difference in your return, but they can put you under much more quickly.

Know what your position size needs to be and don’t go over it no matter how tempting it is. You might get lucky and the market goes your way, but if it doesn’t you’ll start taking big losses. When Karen said she was at 50% margin in an unstressed market , that was a clue that it was too much. If you thoroughly examine her method and trade her way but keep risk limited based on appropriate stress test parameters, at low vol on TOS you will see that she should have been at 20-30% margin no more.

It is not the Puts that will kill you! It’s the Calls. When market goes up and your call side gets stressed, you have to make up that premium at much lower IV. That means you have to sell a lot more Calls or sell Puts at the worst possible time (market up and low IV) which leaves you extremely vulnerable to a drop, just like what happened to Karen in Oct 2014. The lesson here is Calls don’t generate that much premium anyway, so sell less of them, and be very careful adjusting your position on the Call side.

If you are inclined to manage other people’s money, do not let that pressure make you deviate from your plan. If you have investors not happy with returns, let them leave! With this strategy, you need to accept that in a bull market you will likely not beat the market and may underperform. It’s tough (especially in a long bull like 2011-2014) but that’s the only way you can stay within acceptable risk to avoid getting killed when the market turns. As a former Hedge Fund Manager myself, I always find very difficult to explain to investors what & why, so it is not my forte.

In regards to margin usage, the 20-30% is not a firm figure that you have to cut down from if you reach it. In TOS unlike other brokers the margin is very dynamic. At IB for example the margin is pretty set at about $15K per SPX contract regardless of DTE. With TOS, the margin is much smaller with 50+ DTE but will increase substantially as you get closer.

The key to the risk management though is stress the positions daily with both price move and vol move. The specific numbers is something you have to decide what you’re comfortable with. I will say one good thing though is that the TOS analyze tab overestimates the loss from vol increase, because it uses fixed Vega . But Vega actually also changes by its derivative (Vomma) and decrease with an increase in IV.

In regards to the ethics. There are certainly two ways to think about. One is that you should not be charging fees when the NAV is declining. I do agree with that but remember from Karen’s perspective…she was using the realized p/l method for 5+ years so it’s not like she was going to change it. And, if she showed a realized gain on her statements but did not charge a fee, then her investors would ask questions.

The problem of course becomes that she started to manufacture gains and defer losses. When you are managing money you definitely do not want to tell your investors you have a huge loss one month (especially in October which was unexpected and probably took her by surprise) because there is likely to a be flight of capital (it’s very likely that Karen did not have a gate provision in her fund docs therefore it would have been a real worry).

A 20% gate makes sense for this fund to prevent a flight of capital and having to close down losing positions that were going to recover). So Karen, having traded for several years felt that the positions would recover, and manufactured the gains to make it seem like “everything was ok” with an honest belief that she’d be back to profit quickly.

A 30% loss would take about a year to recover, so just as she was getting back on track Aug hit and she was down again most likely. Then she spent the rest of 2015 and early 2016 recovering from that. That’s why she “would not have earned any fees” since Oct 2014 according to the complaint. It’s not that her strategy completely fell apart, just that she was trying to claw back from Oct 2014 loss and likely Aug 2015 loss.

M2M is typically not good for commodities/futures/index options traders because:

One, It is permanent. Once you elect it, if you want to go back to normal accounting you have to file a process with IRS and get their permission. Or you have to liquidate your fund and start a new one.

Two, The M2M election also converts gains and losses to ordinary income! That’s bad since capital gains income is taxed much lower (and in fact options and futures are 60/40 long term vs short term which means you get a tax benefit trading those even if you don’t hold them for 1+ year). Now it’s true if you have losses in a year, you would benefit from M2M because your losses would be ordinary losses and can be offset against other ordinary income. But obviously the goal is to have gains, and if you do M2M removes a significant advantage of the capital gains vs ordinary income tax treatment. Honestly I don’t know any futures/index options traders who uses M2M because of those two reasons.

A good example is Tony Caine with LJM funds . He’s doing the exact same thing as Karen since 1998 and closed his funds 2 years ago after huge losses. He has two strategies one that is not really hedged and the other where he buys even deeper OTM puts (like 1 delta). Both of those strategies interestingly have returned 20% annualized over their time frame (the unhedged one has returns of like 40-60% per year but then always has 50% drawdown for example in 2008 whereas the hedged one has a smoother equity curve).

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