The March 31, 2018, month-end performance estimate for the Horse Cove Partners Absolute Return Strategy is +3.48% net of fees1. Since the December 2010 inception of trading, the Strategy has achieved a total cumulative return of +270.86%.
Total assets under management as of March 31, 2018 - $125.6 million.
Market Recap and Commentary
S&P 500 Total Return for the month of March was down (2.54%).
Volatility has come roaring back to the equity markets. All of the major stock indexes had over double the 1% swings in the first quarter of 2018 compared with all of 2017. When it comes to more distinct single-day moves, 2018 has already blown last year out of the water. The Dow and the S&P had no session close up or down over 2% in 2017. This year, however, the Dow has had six such sessions (four down, including two at more than 4%), and the S&P has seen seven (one session with a 2% gain and six 2% declines).
Most of these strong moves have been led by the technology sector, which has led (carried) the bull market for the last few years. Fears about inflation have seemed to dull since causing the market rout in February, but have been replaced with political uncertainties - as the markets now seem to be focused on the potential of a “trade war” with China.
Volatility, as measured by the VIX, has come along for the ride. The index has more than doubled so far this year: spending almost all of March over 15, and a good bit over 20. Volatility has experienced six sessions this year with a jump of at least 20%, plus one day that saw a 20% drop. Seven sessions with a 20% move are the most for a calendar year since 2014. Looking solely at the six 20% increases, the total is the most for a calendar year since 2015, when there were also six. Again, all of this has taken place in just the first quarter.
Performance and Trading Update
Horse Cove Partners Absolute Return Strategy composite was up 3.48% net of fees in March.
As we mentioned in last month’s newsletter, large spikes in VIX tend to be followed by a prolonged drift back down. March has proved no exception, with VIX closing the month above its long-term historical average of 20. This higher VIX lends well to our strategy, as our strikes will be further away from the market and the premiums we collect will be significantly stronger. In an effort to take advantage of the dramatic intraday swings in the market, we have begun putting on our positions twice during the day—in the morning and the afternoon. Combined with writing to the three weekly expirations, this gives us 6 bites of the apple during a given week—an approach we think is not only wise from a risk management perspective but one that has also proven to be profitable for the strategy. We continue to write the calls very selectively, carefully weighing the risk/reward at each trade.
Relying on the rules and the math, as well as a little “art”, proved successful for March. Not writing the calls paid off on more than one occasion and we were not “forced” to close any positions. We made a few artful decisions to exit trades that we felt were not going our way, resulting in minimal losses on 1/6th of our trading volume. Overall trading for the month was smooth and, as you can see by the results, profitable.
Here are the composite net returns for the Portfolio Margin accounts for the periods indicated:
Reg. T Update
Here are the composite net returns for the Reg. T accounts for the periods indicated:
IRA accounts must use Reg. T Margin which, means that fewer option contracts can be written than in the “regular” accounts that use Portfolio Margin. Over time, this will result in lower returns when compared to the “regular” accounts.
HC Enhanced Yield Update
We discontinued trading the HC Income Strategy in February 2018. After trading the strategy for over a year, we concluded that it was something the market did not want. The return characteristics were not offering clients real differentiation from the Absolute Return Strategy but were harvesting smaller premiums each week. That meant that the strategy was exposed to similar risk but not similar returns.
As we continued to look at alternative applications of our methodology, we began trading a lower volatility strategy in June of 2017, with a lower expected return. We started with a short-term bond portfolio and then strategically overlaid our strategy to enhance the yield. The goal of the strategy was to target net annual returns in the range of 6-8% per annum, with 1-2% percent coming from the bond portfolio.
To reduce the volatility, we made a number of changes to the Absolute Return Strategy. By writing further away from the market and not holding any positions over the weekend, we sought to measurably reduce the probable loss events as well as their magnitude. We also decided not to sell calls. Targeting a return allows us to decide in advance what premium we aim to collect. In application, this allowed us to move away from the market until we reached the spread that gave us the return we were targeting.
After successfully navigating February 2018, we decided to make the track record available for clients. If you would like to learn more, please contact us.
Nuts and Bolts
This month felt like a good time to review some persistent questions that come up about the Horse Cove Partners trading strategies and reporting.
Mark to market: We refer to “mark to market” from time to time and always get questions about it. Under Generally Accepted Accounting Principles (GAAP), portfolios of securities are valued using mark to market. Simply put, securities are valued as if they had been sold at the end of the day on which they are valued. This raises questions because as the sellers of European style options, the options cannot be called away from us and are cash settled at expiration.
Here is an example: we sell a 2390 put on Friday for the following Friday’s expiration and receive $1.00 in premium. The following Monday the S&P 500 Index drops 50 points. At the end of the day on Monday, the put for Friday is valued at $3.00. Thus, there has been a $2.00 mark to market loss.
On Tuesday the S&P 500 rises 40 points, and at the end of the day the put for Friday is valued at $1.20 so there is a $1.80 gain in mark to market. This continues until Friday when we buy back the option for $0.05. We have realized a gain of $0.95 on the trade for the week. Along the way, however, there are losses and gains that can appear significant as the market value of the options fluctuate, even though they are not bought and resold.
Leverage: We do not borrow to trade options. Under a typical margin loan, funds are loaned from the broker to the client to purchase securities. The broker charges interest to the borrower. We sometimes refer to margin and margin calls—clients even get notices about changes in margin.
The seller of options is collecting a “premium” to take on the obligation (or liability) the options create to the borrower at the point of expiration. That being, to pay the difference between the strike price of the options sold and the index at expiration. If the strike price is 2390 and the market closed at expiration (settlement) at 2380, the seller owes the buyer $10 per contract. If the market closes anywhere above 2390, the seller keeps the premium.
The risk that the seller can meet its obligation is called “counterparty risk.” To minimize that risk, the marketplace requires the seller have enough collateral to pay if called upon at settlement. While it is called margin, it is more correctly thought of as posting collateral.
Under Regulation T., where no leverage is available, the seller is obligated to have as collateral 100% of the obligation for each option sold. If a seller sold the 2400 put and did not buy a long put (known as selling “naked”), the seller would need to have $240,000 dollars of collateral to eliminate counterparty risk. (That assumes the S&P 500 goes to zero and the seller owes $100 for each point the option expired in the money: $100 * 2400 index points = $240,000.)
We always buy a long put or call whenever we sell one, and when we sell a 100-point spread (we sell the 2400 put and buy the 2300 put) the maximum loss is $100 * 100 index points = $10,000.
There is a second collateral system available to us, known as “portfolio margin.” Under this system, the risk of the exposure to the seller and to the buyer needing to be protected is calculated by the exchange and the broker. (It makes sense, as the risk of the S&P 500 going to zero is highly remote.) As you can imagine, that risk needs to constantly be recalculated.
We can typically sell one option with a 100-point spread for each $3,500 of collateral. That means that the exchange and the broker calculate the risk of the market falling all the way through the 100-point spread as being very low.
We do not use all of that capability, instead selling one option for each $7,500 of collateral. When the market moves and volatility changes, the risk is recalculated and the collateral requirements change. They can go from $3,500 to $10,000 in a week’s time, and when that happens, there is a “margin” notice.
Expiration and settlement: Before the days of weekly options there were only the monthly options that expire on the third Friday of the month. Those options stop trading at 4:15 p.m. on Thursday and are priced for settlement at the opening price of the S&P 500 Index on Friday morning. It usually takes no more than an hour for the settlement price to be calculated before the collateral is released for trading. Those options are still traded.
Now there are also weekly options that stop trading and expire at 4:15 p.m. on Monday, Wednesday, Friday and the last day of the month. Those options are settled overnight and the collateral is available at the open of the following trading day.
Except for the third week of the month, we trade the weekly Friday expiration. If we don’t buy them back, they would expire at 4:15 p.m. on Friday evening and the collateral would be available on Monday morning. However, if we did that, we would be missing the time expiration over the weekend. As a result, we buy the weekly Friday expirations back so that we can trade for the following Friday.
Group Trading: Because we are trading separately managed accounts, we cannot place one total trade and have it allocated across all accounts. We can place “like” margin accounts together and trade them as groups. At Horse Cove, we trade 6 groups of accounts. For example, a Reg. T group, a Portfolio Margin group, etc.
Because there can be some pricing differences with how the groups trade, each month we set a hierarchy with the broker and rotate the sequence in which the groups are traded. The group at the top of the list is moved down one position while the group at the bottom advances to the top of the list.
In periods of extreme volatility, such as the week of February 5, 2018, the difference in timing of that priority can result in differences in execution prices.
What we do is simple, but it is not easy.
About Horse Cove Partners LLC
Profiting from the art and science of taking risk.®
Horse Cove Partners was founded by Sam DeKinder and Kevin Ellis in January of 2013 with the commitment to help grow clients’ assets with a highly disciplined investment strategy, replicated weekly, to extract absolute returns from the market by trading short volatility option spreads. The firm was launched after more than two years of trading experience with personal assets that began in December of 2010. The firm is built on the strength of hedge fund trading expertise developed beginning in 2002.
Assets under management at the end of March 2018 were $125.6 million.
“We do not believe we are smarter than the market, nor can we time the market in any given week or month. As a result, we take an investment approach similar to an insurance company in that our investment strategy focuses on probability of success and the management of risk. We believe that it is possible to realize positive returns through disciplined focus on the risk of each trade with a weekly investment horizon, and accepting intelligent losses when risk events occur.”
We thank you for your continued support.
Sincerely,
Sam DeKinder, Kevin Ellis
Greg Brennan
Fiona Dyer
John Monahan
Michael Crissey
Don Trotter
sdekinder@horsecovepartners.com
kellis@horsecovepartners.com
gbrennan@horsecovepartners.com
fdyer@horsecovepartners.com
jmonahan@horsecovepartners.com
mcrissey@horsecovepartners.com
dtrotter@horsecovepartners.com
Horse Cove Partners LLC
1899 Powers Ferry RD SE
Suite 120
Atlanta, GA 30339
678-905-5723 main
1Net estimate on a consolidated basis of similar accounts as of 3.31.2018, which is preliminary and subject to revision. Performance estimate described herein as “YTD” are net of fees and expenses including a 2% per year management fee and 20% incentive fee and also assumes investors have been invested with no withdrawals.
This was prepared by Horse Cove Partners LLC a federally registered investment adviser under the Investment Advisers Act of 1940. Registration as an investment adviser does not imply a certain level of skill or training. The oral and written communications of an adviser provide you with information about which you determine to hire or retain an adviser. Additional information about our firm is also available at www.adviserinfo.sec.gov. You can view the firm’s information on this website by searching by our firm name.
THIS MESSAGE AND ANY FILES TRANSMITTED WITH IT ARE CONFIDENTIAL AND PRIVILEGED. IF YOU ARE NOT THE INTENDED RECIPIENT, PLEASE NOTIFY THE SENDER IMMEDIATELY AT 1 (678) 905-5723. IF YOU ARE NOT THE NAMED ADDRESSEE YOU SHOULD NOT COPY OR DISCLOSE THE CONTENT OF THIS MESSAGE AND OF ANY FILES TRANSMITTED WITH IT TO ANY OTHER PERSON.
Internet communications are not secure and subject to possible data corruption, either accidentally or on purpose, and may contain viruses. The content of this message should not be construed as an investment advice unless explicitly stated as such in the text of this message. Further, this message should not be construed as the solicitation of an offer to purchase or an offer to sell any securities or other financial instruments, including, without limitation, interest in any private investment managed by Horse Cove Partners LLC or any of its affiliated entities.
This material has been prepared solely for informational purposes only. Strategies shown are speculative, involve a high degree of risk and are designed for sophisticated investors.
Past performance is not a guarantee of future results. Investing involves risk, including the possible loss of principal and fluctuation of value. The information herein was obtained from third-party sources. Horse Cove does not guarantee the accuracy or completeness of such information provided by third parties. All information is given as of the date indicated and believed to be reliable. Performance results are estimates pending a verification. The returns are based on the Investment Manager's strategy and the compilation of actual client account trades. The Horse Cove Absolute Return and IRA Return strategies seek to extract absolute returns from the market by trading short volatility option spreads. The Enhanced Yield strategy seeks to achieve a targeted return trading only puts with a high probability of success.
The strategies reflect the deduction of advisory fees and any other expenses that a client would have paid or actually paid. The S&P 500 Index is used for comparative purposes only. The volatility of an index is materially different from that of the model portfolio. The S&P 500 refers to the Standard and Poor's 500 Index which is a capitalization-weighted index of 500 stocks. The index is designed to measure the performance of the broad domestic stock market. The VIX (CBOE volatility index) is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market's expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking and is calculated from both calls and puts. The VIX is a widely used measure of market risk and is often referred to as the "investor fear gauge." Investors cannot invest directly in an index. An index does not charge management fees or brokerage expenses, and no such fees or expenses were deducted from the performance shown. Options trading entails a high level of risk. The models do not include the reinvestment of dividends and capital gains because options don't pay dividends. Please read the Characteristics and Risks of Standardized Options available from the Options Clearing Corporation website: http://www.optionsclearing.com for further details.
IRS CIRCULAR 230 NOTICE. Any advice expressed above as to tax matters was neither written nor intended by the sender or any Horse Cove Partners LLC affiliated entities to be used and cannot be used by any taxpayer for the purpose of avoiding tax penalties that may be imposed under U.S. tax law.
