To thousands of futures and stock traders, Victor Sperandeo, futures trader and author of Trader Vic: Methods of a Wall Street Master and Trader Vic II: Principles of Professional Speculation, two of the most influential books on trading, is known simply as Trader Vic.
For a generation of futures traders, Victor Sperandeo was a trader’s trader, being on the ground floor as options trading was born in the United States, as well as being a pioneer in the trading of the S&P 500 futures. A number of Sperandeo’s trading set-ups – from his 1-2-3 trend reversal to his ever-popular 2B reversals – are now standard parts of the professional trader’s toolkit.
Since his Wall Street Master days, Sperandeo has focused largely on developing his S&P Diversified Trends Indicator (DTI), a system for trading commodities based not on the price action of individual commodities, but on building a core portfolio based on the price behavior of a host of commodities. The result, according to Sperandeo in his most recent book, Trader Vic on Commodities, as well as in this interview we conducted with him in March, has been a consistent above-benchmark return – with less than a third of the volatility.
How does Sperandeo’s Diversified Trend Indicator works and what does it tell us about the price behavior of commodities and financial futures? We’ll find that out as well as Sperandeo’s thoughts on system trading versus discretionary trading, methods for day-trading the S&P futures and his general thoughts on how to get started trading futures. In Part One, we focus on Sperandeo, commodities and the DTI. In Part Two, we talk more specifically about how traders can use these insights – as well as some basic rules – when trading individual futures contracts.
Victor Sperandeo is a principal of Enhanced Alpha Management. We spoke with him by telephone in the first half of March while the bull market in commodities was still in full swing.
Penn: Trader Vic, welcome to the Big Saturday Interview. Tell me what is different about the trader I am speaking with now and the trader thousands of aspiring speculators came to know through your books, Methods of a Wall Street Master and Principles of Professional Speculation?
Sperandeo: In the days of the methods books, in the 1970s and the 1980s, traders like me were purely skills based. We used to come in and take our positions, and you’re either right or wrong.
There is no core return from that kind of style. You have to create the, if you will, returns from pure skill.
Penn: And now?
Sperandeo: The difference in what I’m doing now is that it is more of a concept or strategy that is more portfolio-directed. It uses a core, let’s say a portfolio concept of deriving returns. And then, in some cases, I enhance those returns with trading.
“The portfolio concept is what I really do today. I created a concept that flows off of a core rate of return.”
Penn: What do you mean by a portfolio concept?
Sperandeo: Let’s say you had a traditional mix of stocks and bonds, 60/40 maybe, or even, let’s say 60/35 and 5% T-bills. You wouldn’t have to do anything to that, and you would still make a return.
You would get a return on the stocks depending on the environment at the time. And the bonds would give you the coupon. And you have a core return. If you choose to pick some stocks that are better than others, then you get alpha (i.e., above market returns). And the S&P 500 would be your benchmark.
The portfolio concept is what I really do today because I’m not as young as I used to be. So I, basically, created a concept that flows off of a core rate of return. And then, in the case of my money management, I try to enhance the core returns.
So a big part of my returns are given to me instead of me having to earn every single dime of them. And that’s really the difference. I won’t call myself an old man yet, but it’s an older man’s strategy.
Penn: How does this work with commodities? You talk about the role of cyclicality in your book. Is commodities cyclicality where you derive your core returns from now?
Sperandeo: If you look at any charts, basically, what you’ll see, predominantly speaking, is an up and down cycle. It’s fundamentally built into what they are, commodities, by nature. Regardless of what may occur for certain periods, they will always go up and they will always go down.
I’ll just make one example. Corn, which traded in 1930 at 80 a bushel, today is 5.60 a bushel, depending on which contract. And the return on corn over the period is 2-3-plus percent compounded.
Now if you started to look at corn in 1950, you would – 1960, 1970 I should say, just to take the last 38 years, you’d find that corn now, basically, has a high of $5 and a low of $1.50. And basically it traded at $2.50 a bushel about 85% of the time each year. So within a year, it’s going to trade at $2.50 a bushel. It has for the last 38 years, go back 40 if you like. What does that say? Corn goes up and corn goes down.
Penn: And this is true across the board? And what you base your trading on?
Sperandeo: All of the commodities have that scenario. You can’t get away from the cyclicality. That’s why it is a long/short strategy, which is the trading methodology, and the S&P DTI to take advantage of the nature of those commodities and the interest rates. In the DTI there are no stocks because stocks tend to be secular, and commodities are cyclical.
Penn: Could you talk a little more about what the S&P DTI is actually measuring then?
Sperandeo: It doesn’t measure price – it measures trends. That’s an interesting twist on things. Most indices measure prices. If the prices are up the index is higher. If prices are down, it’s lower. This does not do that. This measures the extent and duration of trends. The greater the trend, up or down, the longer it goes up or down and the more returns are shown from the indicator.
If it doesn’t go up or down, if it goes across the page, i.e. is stable, it doesn’t have returns. It may lose in those environments. The point is that this measures trends.
“The S&P DTI is a very balanced combination of commodities and financial futures. Remember: anything that goes up and down goes in there.”
Penn: What does the S&P DTI consist of? You said no stocks…
Sperandeo: It’s a very balanced combination of commodities and financial futures – except stocks. It has currencies in it, which are a function of short-term interest rates, and other things, but primarily short-term interest rates. It has bonds in it, which basically are a function of interest rates that go up and down. Remember: anything that goes up and down goes in there. And anything that does not go up and down, generally speaking, is not in there.
So that’s why no stocks. The combination of the two different asset classes, if you will, financial futures and commodities are mixed 50/50. And the reason they are mixed 50/50 is to give a certain stability to, let’s call it the portfolio, for the moment. They are not correlated. One part of the portfolio is making money, the other one is not necessarily losing money. It could be making money but, generally, it makes less than it did the year before.
The S&P DTI is designed to be consistent, not to make large returns. It may make large returns, but it isn’t designed that way. It’s designed for consistency within 12 months.
Penn: Can you elaborate?
Sperandeo: Let’s make believe oil was the whole DTI for this example, and oil went from $110 a barrel to $220 a barrel. Well, the DTI would double, right? So if oil did that in a straight line, if oil increased by 100% the DTI would reflect that. It would be up 100%. So the more oil goes up, the greater the returns are reflected in the S&P DTI.
If oil went up only 50 cents from $10, or 5 percent, well the DTI might actually break even, or lose. And if it went down it might get, in this example, it would get flat. And since there’s no movement, it can’t get long and it can’t get short. Energy does not go short in the DTI, so that’s a bad example, but you get the point.
Penn: So to the DTI as a whole, movement is key, regardless of direction.
Sperandeo: The point is, if something is not moving, if things are not volatile, if things are not going up and down, well, then the DTI is going to reflect that. There are no trends. And if something has a trend, and goes in a straight line up or down, and the DTI reflects that, then there is more money. So it measures the aggregate of trends, but not prices.
Let’s take wheat. Let’s say wheat goes from $10 a bushel – it’s a little more than that, but just for this example – and it goes back to $2 in a pretty straight line. When I say “straight line”, I mean a pretty steady, solid movement. Well, wheat declined 80% and the DTI, if wheat was all of DTI, the DTI would make 80%.
The Goldman Sachs Commodity Index would say if you held only wheat, it would lose 80%. So it doesn’t have anything to do with prices because we go long and short. So going down a lot is a good thing, okay? Or going up a lot is a good thing for anybody that’s a holder of the DTI.
Penn: How are the commodities within the S&P DTI weighted?
Sperandeo: The weightings of the commodities are based on production. And again, since it’s all 50% of the pie, it’s basically based on half of what the estimate of production is.
Let me dwell on this to make it clear. There are two major industries that did this work far more extensively than we can do it. And that is the Goldman Sachs Commodity Index and the Dow Jones AIG Commodity Index.
They measured the production of commodities to which ones have more weights than others. What we did when we constructed this is we said, look these two major firms know what they’re doing. We’ll go kind of in the middle of the two. This is not scientific. It’s a back of the envelope concept. And we went in the middle of the two major long-holding commodity industries.
On the other side of the pie, the currency side of the pie, what we did was we took GDP of each of those countries, for example, the U.S. represented the greatest GDP so it got the greatest at 15 percent. Now, again, these are not scientifically derived. They are designed logically to give more weight to the dollars and to this bigger GDP than the euro, which was second with the yen third. And then, the British pound, and so on.
Penn: You talked earlier of the DTI not being designed to make a lot of money. Instead, you have used the term “alpha consistency” as a superior goal. What is alpha consistency and why is its pursuit worthwhile for traders?
Sperandeo: Most commodity-oriented methods are trying to make a lot of money. And, like I say, the DTI is not built that way. It can make a decent amount of money – whatever you want to define that as. But it is not structured to make a lot of money. It is not leveraged, for example. It does things that most commodity programs don’t do. For example, it rebalances monthly, and it takes away from the winners and gives to the losers.
“Commodities that go down are not going to go bankrupt. Corn can’t go bankrupt, so if it goes down, it’s going to come back up and vice versa.”
Penn: How does that work?
Sperandeo: It takes away from the fact that if something is very, very strong and in an uptrend, we capture the profits of that monthly. And, therefore, what are we doing? We are going after consistency. You know that you can make the statement that at some point whatever goes up is going to come down. It’s not going to be taken over. Commodities that go down are not going to go bankrupt. Corn can’t go bankrupt, so if it goes down, it’s going to come back up and vice versa.
That’s what we try to capture, taking incremental profits away from the winners and giving it to the rest of the pie. And in doing that we roll our volatility, okay? That’s another principle. That’s actually one of the main principles, to keep the volatility low, is to not allow it to go up. The Goldman Sachs Commodity Index, for example, has approximately a 20 volatility. The DTI has a 6 volatility.
Penn: A third?
Sperandeo: One-third, right. Now the reason that it does is because it balances the sector weightings and has the financial sector in there, and because it takes away from the profits of the winners and gives it to the things that are down that are ready to come up. And it rebalances that pie, keeps the weightings the same and, therefore, you get this very low volatility, relatively speaking. It’s a low volatility instrument that is gearing itself to make consistent returns.
Click here to read the second part of our conversation with “Trader Vic”. Read what he has to say about the value of trading systems, how to choose which futures to trade, and what it takes today to successfully day-trade the S&P futures market.