We have spent a lot of time in this space, talking about the allure of option selling CTAs, and potential pitfalls which have hit them over the past 18 months as volatility spiked from all time lows. And through all of that, some option “trading” managers have unfairly been lumped in with the option “sellilng” managers – causing them to be tainted in a way. Well, we’re here to say all option trading managers are not option sellers, and don’t necessarily have to carry the stigma that comes with naked option selling.

This month’s CTA Spoltight is on an option “trading” manager, Cervino Capital Management.

Who is the Manager:

Straddling the border of Italy and Switzerland is Monte Cervino, probably the most famous mountain in the European Alps, also known as the Matterhorn. When Davide Accomazzo, who grew up in Italy, and Mack Frankfurter, whose father grew up in Switzerland, founded their CTA in 2005, the name best signified the kind of money management firm they wanted to build—independent and enduring.

Accomazzo and Frankfurter are veterans in the managed futures industry, and have established themselves as erudite practitioners through their “SSRN Top 10” academic working paper, “Is Managed Futures an Asset Class? The Search for the Beta of Commodity Futures” [http://ssrn.com/abstract=1029243].

Accomazzo began his financial career in 1996 at Jefferies & Co. trading Euro-convertible bonds/equities. In 1999 he started Kensington Offshore Ltd, a hedge fund, before launching Kensington Capital Management in 2001, a CTA he ran until 2004. He received a Laurea in Political Sciences and International Relations at Universita’ degli Studi Genova in 1990, and his MBA in Finance at Pepperdine University in June 1996, where he now also serves as an adjunct professor to the Graziadio School of Business and Management.

Frankfurter first became involved in managed futures in 1991 when he joined The Echelon Group, which focused on investing with emerging managers and “incubated” several renowned CTAs including Dreiss Research, Jackson Grain and Range Wise. In fact, Frankfurter’s mentor is said to have been the first client of Richard Dennis who is famous for having trained the “turtles.” In addition, his experience encompasses the institutionalization of viatical settlements, and strategic consulting for various investment banks.

The pair met at UBS in 2005 in Los Angeles and quickly realized that the combination of their background and skills—Accomazzo is the principal trader and Frankfurter oversees operations—was a perfect fit.

Much of the partners’ focus nowadays is on their profession. That said, Accomazzo, who played competitive tennis as a teenager, makes sure to carve out time for physical activities such as tennis, surfing, skiing, etc. Frankfurter enjoys hiking whenever he gets a chance, and plans to get back into sailing and surfing.

How does the program work?

Cervino Capital’s Diversified Options Strategy is focused on providing ‘risk-adjusted returns,’ that elusive quality where positive returns are generated with minimal leverage and volatility, through the trading of options on stock index, currency, and bond futures.

The objective of the Diversified Options Strategy 1X program is to produce an absolute return between 10% and 15% annually, while the 2X version trades twice as many contracts as the 1X program for the same trading level (resulting in an increased potential for higher returns (20% to 30% annually) as well as an increased potential for larger drawdowns.

Cervino Capital’s philosophy recognizes that while mathematical techniques reveal important dynamics within the markets, circular relationships between cause and effect relegate quant models to just an abstraction of reality… ..meaning that expecting these models to be exactly right all of the time is unreasonable.

This viewpoint guides Accomazzo, whose trading considers multiple factors including global macro developments. He understands that investment performance is a function of risk taken, but also that the complexity of human behavior can never be fully modeled. Rather, a discretionary common sense approach is needed—one which balances the quantitative with the qualitative in order to manage the cycles of volatility.

Accomazzo thinks of option trading as a three-dimensional chess game. A major distinguishing feature of his approach is that he considers himself an “options trader,” not an “options writer.” The difference is realized in risk management strategies. Option writers tend to rely on the probability of whether or not an option is going to go into-the-money or not, while an active option trading style recognizes the need to manage the possibility of risk-of-ruin when under extreme circumstances.

A good example of this active management took place on February 27, 2007, when the DJIA dropped 300 points in 30 seconds due to a technical glitch. Rather than suffering the “deer in the headlights” syndrome, Accomazzo covered half his naked put positions that day, and covered the remaining at risk put options the following day.

2007 was generally a very difficult year for option programs due to the transition from low volatility to high volatility. The risks associated with option writing during the 2003-2006 volatility bear/stock market bull was generally misunderstood at the time. On the other hand, Cervino Capital’s concern was documented in a January 2007 article Frankfurter wrote called, “The Mysterious Case of Massive Liquidity.”

For Accomazzo, trading is all about historical perspective, homework, risk management and discipline. He is continuously processing large amounts of seemingly disconnected information, including fundamental, technical, quantitative and behavioral analysis, in order to arrive at a decision, which often is to not put on a trade. Having traded during the 1998 LTCM meltdown, 9/11 WTC attack, as well as the recent credit crisis, Accomazzo has the wisdom to know that trading is not about hot returns, but consistent returns.

Trade Example:

Debit spread: long 2 Sep. S&P 1250 puts / short 2 Sep. S&P 1240 puts

Entry price = $1.60; Price on 5/30 = $1.40

Credit spread: short 1 Jun. S&P 1300 puts / long 1 Jun. S&P 1290 puts

Entry price = $0.85, Price on 5/30 = $0.40

Naked option: short 2 Jun. S&P 1190 puts

Entry price = 8.10 (resulted from lifting the long leg of an earlier debit spread); Price on 5/30 = $0.30

This is an example of the kind of complex option position that Cervino Capital trades. The debit spread “reinsures” the credit spread which is intended to capture premium as time decay accelerates. Each of these spreads have “defined” risk with the short option position “financing” the long option position in the credit spread. The different calendar dates encompasses a diagonal spread option trading technique. The robust nature of the option construct helps to mitigate equity volatility and allows opportunities to “transform” positions as may be required due to extreme volatility in the underlying S&P Index.

Cervino Diversified does trade other markets besides the S&P 500, such as bonds, currencies, and Gold.

Attain Comments:

You don’t usually hear the terms “option selling” and “risk averse” in the same sentence, but Cervino Capital appears to be the exception to that rule (especially when compared with other CTAs in the “Option selling” sub category)y. Perhaps that is because they do not only sell options, but hedge against volatility spikes as well.

While there are no guarantees in investing – there are techniques for limiting risk exposure such as reduced margin use, hedging via long options, and diversifying across multiple lowly correlated markets. Cervino engages in each of the above risk limiting techniques on a regular basis, and in turn has outperformed its option trading peers during a very tough period for option sellers the past 18 months.

While many option sellers were hitting new all time drawdowns, and seeing monthly losses well past their historical DDs, Cervino had a very manageable dip, and came out of it nicely, returning +16.65% over the past 12 months with 11 out of 12 months profitable on their 1x strategy. In addition, they show a very low correlation with the S&P 500 (0.0613), and have a Sharpe ratio among the top 10% of all CTAs in our database.

Despite all these positives, Cervino was having trouble getting investor interest. This is due to two factors in our opinion. One, they were a little unfairly labeled an option seller and thrown in with the others who only do naked short options. Those at Cervino view themselves as “option traders”, not “option sellers”, and don’t strictly sell naked options.

And two, their annual rates of return weren’t too exciting if you looked just at the absolute numbers, and not on a risk adjusted basis. For example, on a risk adjusted basis, an annual return of 30% with a 15% DD is the same thing as an annual return of 10% with a 5% DD, but investors usually pick the higher return investment because of the higher absolute number (30 > 10).

To combat this and appeal to those investors who prefer higher return and risk numbers, Cervino launched its 2x strategy as of Jan. 1, 2008. The 2x strategy has the same trading parameters as the 1x strategy, and will do twice the number of positions as the main program on the same $50,000. Or trade the same number of positions as the main program, but require only $25,000 in capital. The result will be performance and risk twice that of their main program. So far in 2008, the 2x program is up approximately 12% (versus roughly 6% for the main program)

In fact, the 2x program will do better than two times the main program for a limited time, due to Cervino only charging a 2% management fee on the 2x strategy, as opposed to 2x their normal 1.5% management fee (3%).

Mack Frankfurter of Cervino is one of those managers who loves talking with clients, and answering any questions they have, and we encourage people to call him up, ask him his thoughts on Cervino, on whether there is a commodity bubble, or anything else. He’s happy to swap ideas. For quarterly updates on Cervino you can also visit the manger’s Blog at http://cervinocapital.blogspot.com/.