- Speaker #0
Hello and welcome back to Papers with Backtest podcast. Today we're diving into another algo trading research paper. This one is called Return Asymmetry in Commodity Futures. It's all about how you might be able to make money not just by predicting if commodity prices will rise or fall, but by understanding how they move in those directions. Okay. It's a bit of a mind twister,
- Speaker #1
right? It is. It is. The paper uses this term return asymmetry and it's a concept that might make you rethink how you view. market movements.
- Speaker #0
Okay, so can you break this down for me? What exactly is return asymmetry? And why should I as a trader even care about it?
- Speaker #1
So think about it this way. Some assets tend to have these sharp, sudden price increases. But when they fall, they do so more gradually. Others might be prone to sudden crashes, but their rises are slower and steadier. That's what we're talking about here. The difference in the way prices move up versus down.
- Speaker #0
I see. So it's not just about if a price goes up or down. Right. But about the shape of that move. I'm starting to get it. But honestly, I used to think, hey, a profit is a profit, right? Why should I care if a commodity just skyrockets versus slowly climbing as long as I'm on the right side of the trade?
- Speaker #1
Well, that's where it gets really interesting. The authors of this paper believe that this difference in price movements, this asymmetry can actually create opportunities for traders. OK. They even have a specific way to measure it, which they call IE. Think of IE as a way to rank commodities. by how likely they are to make those huge sudden jumps.
- Speaker #0
So IE is almost like a measure of a commodity's potential for dramatic price swings. Yeah. Yeah. That makes sense. But how do they actually use this IE metric to create a trading strategy?
- Speaker #1
The strategy they propose is surprisingly simple. Each month you calculate the IE for 22 different commodity futures. Things like soybean oil, corn, gold, and so on. Then you rank them from lowest to highest, i.e.
- Speaker #0
Okay, I'm following so far. We've got our commodities ranked by their potential for these big price swings. What's the next step?
- Speaker #1
This is where the trading comes in. You go long, meaning you buy the seven commodities with the lowest IE scores. Remember, a low IE suggests a lower probability of those sudden upward jumps than you go short, meaning you bet against the seven commodities with the highest IE scores. These are the ones that might be primed for a sudden drop. Gotcha. Finally, you rebalance this portfolio every month, recalculating IE. and adjusting your positions accordingly. It's a systematic approach to identifying and exploiting potential mispricings caused by return asymmetry.
- Speaker #0
It almost sounds too simple, but I know better than to underestimate simple strategies in the market. Right. The question is, does it actually work?
- Speaker #1
Well, according to their back tests, this strategy using this specific set of rules generated an annualized return of 4.36% from 1991 to 2021.
- Speaker #0
Hold on. a 4.36% return per year, consistently for over three decades. That's pretty remarkable for such a straightforward approach.
- Speaker #1
It is quite impressive, but it's important to remember that any backtest, especially one covering such a long period, is based on historical data. It can give us insights, but it's not a crystal ball.
- Speaker #0
Of course, past performance doesn't guarantee future results.
- Speaker #1
Exactly. But it's still a fascinating finding, especially when you consider that this strategy might also offer some protection. against stock market downturn. Interesting. We'll dive into that more later. All right.
- Speaker #0
So we've got a strategy that's easy to understand, has promising historical performance, and might even act as a hedge against a falling stock market. I'm definitely intrigued. But before we move on, I want to make sure I fully grasp this IE concept. Can you give me a quick real world example of how IE might differ between two commodities? Sure.
- Speaker #1
Let's imagine we're comparing gold and crude oil. Gold is often seen as a safe haven asset. tending to hold its value or even rise during times of uncertainty, its price movements, while they can be significant, are often more gradual. On the other hand, crude oil is known for its price volatility with the potential for sudden spikes or plunges based on global events, supply disruptions, or changes in demand. In this scenario, gold might have a relatively low, i.e., reflecting its tendency for smoother price movements. Crude oil with its potential for sharp, unexpected swings. could have a much higher IE.
- Speaker #0
Okay. That analogy really clarifies things for me. So the IE is essentially reflecting how jumpy a commodity's price is likely to be. Now this whole strategy hinges on the idea that investors might be mispricing commodities based on this. Asymmetry. Right. Could you elaborate on that a bit?
- Speaker #1
Of course. Imagine two commodities with the same expected return over the long term, but one has a high IE, meaning it's prone to those occasional big jumps, while the other has a low IE indicating steadier movements. Now, some investors might be drawn to the commodity with the high IE, even if those big jumps are just as likely to be down as they are up. They might be willing to pay a premium. for that chance of a sudden outsized gain, even if it means accepting a greater risk of losses on the flip side.
- Speaker #0
So it's almost like some investors are subconsciously drawn to those lottery ticket commodities, the ones with a low chance of winning big, but the potential is exciting.
- Speaker #1
That's a great way to put it. And this paper suggests that this kind of investor behavior could actually lead to certain commodities becoming overvalued, while others with less dramatic price action. Might be undervalued. That's where the trading opportunity lies.
- Speaker #0
I'm starting to see the logic here. By focusing on commodities with low IE scores, you're essentially betting on those steady, eddy assets. That might be overlooked by investors chasing those potentially bigger but riskier gains.
- Speaker #1
Precisely. And by shorting those high IE commodities, you're taking advantage of the potential for those overvalued assets to correct themselves.
- Speaker #0
I think I have a good grasp of the basic premise of this strategy. and how it leverages the concept of return asymmetry. But now I'm really curious to see how it actually performed during different market conditions, especially during stock market downturns. Shall we dive into that in the next part?
- Speaker #1
Absolutely. That's where it gets really interesting.
- Speaker #0
All right. So we've established that this strategy of going long on low IE commodities and shorting high IE ones has shown some promising historical returns. But let's be honest, what really matters is how it performs when things get a bit rough, right? Yeah. Like how does it hold up during a stock market downturn? After all, isn't the whole point of diversifying? To have something that zigs when the market zags?
- Speaker #1
You're absolutely right. Anyone can design a strategy that makes money in a bull market. But the real test is how it handles those inevitable dips. Right. The researchers behind this paper actually addressed that specific question. They looked at how this strategy performed during periods when the S&P 500, which, you know, is the benchmark for the U.S. stock market, is having a bad month.
- Speaker #0
I love your guess. During those stock market dips, did this strategy just fall apart like a house of cards? Or did it actually provide some sort of cushion?
- Speaker #1
Well, it seems like it held up rather well. Remember, we're talking about times when the S&P 500 was down. On average, 3.5% in a month. That's a pretty significant drop. But during those same periods, this commodity strategy actually managed a small positive return. Averaging about half a percent.
- Speaker #0
Wait, so while stocks were losing money, this strategy was actually making money. That's impressive. I'm really curious, how does that even work? I mean, aren't commodities supposed to be risky assets too?
- Speaker #1
That's where the dynamics of different asset classes come into play. The researchers found that the returns of this asymmetry-based commodity strategy actually have a negative correlation with the S&P 500. In simpler terms, when stocks go down, these commodities tend to go up, or at least they don't fall as hard. It's like they're marching to the beat of a different drummer.
- Speaker #0
I see. So even though this strategy involves commodities, Which can be volatile on their own, the way it's constructed. By taking advantage of this return asymmetry, seems to create a sort of natural hedge against stock market declines.
- Speaker #1
Exactly. It's not a perfect inverse relationship, meaning they won't always move in the opposite direction. But the negative correlation suggests that incorporating this strategy could add some stability to a portfolio that's heavily weighted towards stocks.
- Speaker #0
All right. So now I'm starting to see the real potential of this approach. Yeah. Not only does it offer... potentially attractive returns on its own, but it could also smooth out the bumps in the road. When the stock market hits a rough patch, it's like having a built-in shock absorber for your portfolio.
- Speaker #1
That's a great analogy. It's all about diversification and finding those assets that don't all move in the same direction at the same time.
- Speaker #0
Speaking of diversification, this paper specifically mentions a portfolio they call Portfolio 7, which seemed to perform particularly well. So special about Portfolio 7.
- Speaker #1
Portfolio 7 is essentially the embodiment of the strategy we've been discussing. Remember how we talked about going long on the seven commodities with the lowest IE? Yeah. And shorting the seven with the highest? Right. Well, that's exactly what Portfolio 7 does. Aha.
- Speaker #0
So it's not just about randomly picking commodities. There's a specific method to this madness. And out of all the possible combinations, Portfolio 7 seems to be the sweet spot.
- Speaker #1
Precisely. The researchers tested different portfolio configurations, but Portfolio 7 consistently stood out. delivering the most compelling results.
- Speaker #0
So remind me again, what were those impressive results from Portfolio 7? I want to make sure I have the numbers straight.
- Speaker #1
Over that 30-year period, from 1991 to 2021, Portfolio 7 boasted an average monthly return of 0.38%, which translates to an annualized return of 4.36%. And remember, this was achieved while also exhibiting a negative correlation with the S&P 500, suggesting potential hedging benefits during market downturns.
- Speaker #0
Those are some pretty solid numbers, especially considering the strategy's simplicity and potential hedging benefits. It's not about getting rich quick, but it's about consistent long-term growth.
- Speaker #1
Absolutely. It highlights the power of understanding subtle market dynamics and how they can be leveraged to potentially enhance returns and manage RIP.
- Speaker #0
But of course, with any investment strategy, there are always risks involved. We talked earlier about maximum drawdown, which is essentially the biggest potential dip you could experience. What was the maximum drawdown for this impressive portfolio seven?
- Speaker #1
The maximum drawdown for portfolio seven was negative twenty nine point zero three percent. So while it has shown resilience during stock market downturns, it's not immune to losses. It's crucial to remember that no strategy can eliminate risk entirely.
- Speaker #0
Right. No risk, no reward. But a potential drop of nearly 30 percent is. definitely something to consider carefully. I guess it underscores the importance of not putting all your eggs in one basket, even if that basket is a seemingly well-diversified, cleverly constructed portfolio like this one.
- Speaker #1
You're spot on. It's all about managing expectations, understanding the potential risks, and making informed decisions based on your own investment goals and risk tolerance.
- Speaker #0
Okay. I think we've covered the nuts and bolts of this strategy and its performance quite thoroughly. But before we wrap things up, I want to zoom out a bit. And talk about the bigger picture. What are some of the key takeaways for our listeners? Who might be interested in incorporating these ideas into their own trading?
- Speaker #1
I think there are a few key points worth emphasizing. First, this research suggests that focusing solely on whether a price goes up or down might be missing part of the picture. Understanding the dynamics of how prices move, this concept of asymmetry could open up new possibilities for traders.
- Speaker #0
That's like saying, don't just follow the herd. chasing the latest hot stock tip. There's a whole other layer of market dynamics at play that could give you an edge.
- Speaker #1
Exactly. And second, the simplicity of this proposed trading strategy is appealing. It's not overly complicated, which makes it potentially accessible for a wider range of traders, not just those with sophisticated quantitative models.
- Speaker #0
Yeah, sometimes the most elegant solutions are the most effective. Yeah. It's a good reminder that you don't need a PhD in rocket science to potentially profit from the markets. What else?
- Speaker #1
Third. While we always have to be Ausha about extrapolating past performance into the future, the long-term returns and the potential hedging benefits of Portfolio 7 are definitely intriguing and worth further exploration.
- Speaker #0
I agree. It's not a magic bullet, but it's a thought-provoking approach that could potentially enhance returns and mitigate risk. But as always, do your own research and due diligence before implementing any trading strategy.
- Speaker #1
I completely agree. It's crucial to thoroughly understand any strategy before putting your hard-earned money on the line.
- Speaker #0
Okay, now I'm wondering, this whole paper focuses on identifying commodities that might be overvalued because of this asymmetry effect. But could there be a flip side to this coin? Could there be opportunities in identifying commodities that are undervalued because investors are too focused on avoiding potential losses?
- Speaker #1
That's an excellent question. It's a reminder that understanding market psychology and investor behavior can be just as important as crunching numbers. and analyzing charts.
- Speaker #0
Absolutely. Sometimes the biggest opportunities are found where conventional wisdom falls short.
- Speaker #1
Well, I think this has been a fascinating discussion. We've covered a lot of ground. But before we wrap things up completely, I want to make sure our listeners know where they can find more information about this research and other interesting trading strategies. You know where I'm going with this, right?
- Speaker #0
Of course. For more in-depth analyses and backtests of trading strategies, be sure to check out Papers with Backtest. You can find us at http://https.com.
- Speaker #1
papers with backtest.com. We have a whole library of fascinating research papers and backtests just waiting to be explored.
- Speaker #0
And if this episode has sparked your curiosity about return asymmetry and its potential impact on commodity markets, you'll definitely find a lot more to dig into on the site. So as always, I encourage everyone to check it out and continue exploring these intriguing market dynamics. Now, before we wrap up this deep dive, I want to circle back to something you mentioned earlier about this strategy's potential. to act as a hedge against stock market volatility.
- Speaker #1
Knowing our listeners, they probably want to understand exactly how they could potentially incorporate this into their own portfolio.
- Speaker #0
That's a great point. It's one thing to understand the theory, but it's another to actually put it into practice. Right. Now, I have to offer the standard disclaimer that I'm not a financial advisor, and this is some personalized investment advice, right? Of course. But speaking generally, the idea is that this commodity strategy, specifically Portfolio 7, could be used as a sort of counterbalance to a stock heavy portfolio.
- Speaker #1
So let's say someone has, I don't know, 70% of their investments in stocks. Could they potentially allocate, say, 10% to this portfolio seven strategy as a way to smooth out the ride during those inevitable market dips? That's the general concept. By having a portion of your portfolio invested in a strategy that tends to perform well when stocks are struggling, you're essentially creating a built-in buffer against those downturns, of course, the specific allocation, would depend on individual risk tolerance, investment goals, and all those other factors that make personal finance, well,
- Speaker #0
It's not a one size fits all approach. Yeah. But the key takeaway here is that this strategy isn't just about trying to beat the market. It's also about potentially reducing overall portfolio volatility and preserving capital during those times when the stock market takes a tumble.
- Speaker #1
Exactly. And that peace of mind can be invaluable, especially for those who are approaching retirement or have a lower risk tolerance.
- Speaker #0
Now, one last thought before we sign off. We've talked a lot about how the strategy leverages a quantitative measure, this IE score. to identify potential mispricings. But I think there's also a qualitative element to this whole concept of asymmetry.
- Speaker #1
I'm intrigued. Tell me more.
- Speaker #0
Well, I'm thinking about how understanding return asymmetry could also help us make better decisions about individual stocks or even entire sectors, for example. Knowing that a particular company or industry tends to have more dramatic price swings on the downside could make us more Ausha about our position sizing or even avoid it altogether. If it doesn't align with our risk profile. Does that make sense?
- Speaker #1
That's a really insightful observation. It's like saying that even if you're not implementing the specific commodity strategy, the underlying principle of recognizing and accounting for return asymmetry can be applied across different asset classes and investment approaches.
- Speaker #0
Exactly. It's about being aware of the potential for those outsized moves, both positive and negative, and adjusting our strategies accordingly.
- Speaker #1
It's about incorporating that awareness. into your decision-making process.
- Speaker #0
Well, on that note, I think we've given our listeners a lot to chew on today, from the technical details of this commodity strategy to the broader implications of return asymmetry for investors of all types.
- Speaker #1
I agree. It's been a fascinating discussion.
- Speaker #0
Thank you for tuning in to Papers with Backtest podcast. We hope today's episode gave you useful insights. Join us next time as we break down more research. And for more papers and backtests, find us at https.paperswithbacktest.com. Happy trading.
