We’ve talked a few times this week about how managed futures are long volatility investment which tends to do well in a crisis because they have a fixed risk, yet can make as much as the market offers up when volatility expands; but we haven’t touched on the seemingly simpler reason managed futures can do well in a crisis. And that is – because they can go short.

We highlighted back in March what a classic trend following breakout looks like in Crude Oil as it broke out to the upside following the unrest in the Middle East, then updated you on that ‘trade’ when it was stopped out in May.  Well, here we are in August, just a little over 2.5 months later – and many trend following models are back at it in the Crude, but this time on the short side – providing a good example of how (and why) systematic managers engage the market on the short side [quick reminder – going short is a bet on prices going lower, where you sell first, then buy back later].

While there are hundreds of different ways to do trend following, the general idea is to bracket the market with volatility adjusted bands, and when the market ‘breaks out’ above those bands, go long – when breaking out below the lower band – go short.  Systematic managers have therefore gone short Crude Oil not because they think the global economy is weakening and there will be a dent in demand, but simply because prices have broken out below their bands to the low side.  Prices are indicating the start of a new trend lower.

To show this, we have used rather standard 80 day averages and standard deviation lookbacks to create the bands in the chart below, showing that Crude Oil broke out to the downside on 8/04.  The classic trend following trade is to go short (sell) on the open following that breakout, which was last Friday’s open of 86.50 and risk up to the 60-100 day moving average.  In our example, we’re using the 80 day moving average (the lighter orange line), which sat $13.92 away from the entry at 100.42 on 8/05, representing $13,920 of risk on the entry day.

Moving forward, the classic trend following model hopes prices will remain below the moving average long enough to pull that average down below the entry price, thereby locking in a gain. If prices rise before the moving average has come down, the trade will lose the difference between the entry and wherever the moving average is at the time prices close back above it.

To see why and how trend following, and managed futures in general, are long volatility strategies where profits can be many times the amount risked on a trade – one only need imagine Crude Oil going to $40 on the back of a second recession in the U.S. or more Eurozone worries.  In such a case, the trade could make $40+ ($40,000) on the same initial risk of just $13,920, for a risk/reward payoff of nearly 3 to 1.   Conversely, if we get a drastic rally back up over $120 in Crude Oil on renewed violence in the Middle East or similar, you still only lose the $13,920 (ignoring slippage and the possibility you could be locked limit down and unable to get out).

This ability to make a great deal more than you risk when volatility explodes is the classic trend following model’s calling card. And, in truth, the models don’t care whether it is a long or a short trade. All they want is a breakout in a direction and some follow through for that move. Whether it is up or down, it doesn’t matter. The downsides, 1. only a small percentage of such breakouts may succeed and 2. Crude may go way down, and then all the way back up before you get out.

We’ll see how this breakout to the downside fares for those with exposure to the energy markets via trend following. This is one of the riskier trades we’ve analyzed, with the breakout coming from an already elevated level of volatility, when many models prefer breakouts to come from levels of compacted volatility.