Twenty Reasons to

Invest in
Asymmetric
Strategies
"Finding Alpha through State of the Art Risk
Management"

Asymmetric funds are the closest thing to the original Hedge Fund intent. They
provide for upside gains while limiting quantifiable losses to the downside.
 Twenty Reasons to Invest in Asymmetric Strategies

Twenty Reasons to
Invest in Asymmetric Alpha is an

Strategies Option

We firmly believe in
"Finding Alpha through State of the Art Risk active management or
Management" more precisely "active
risk management."
(1). Asymmetric funds are the closest thing to the
Market participants
original Hedge Fund intent. Intelligent investments and
have different objectives,
intelligently controlled risk is the way to build wealth.
time horizons, skill and
Asymmetric Investing is the combination of smart
other risk constraints
investing through prudent risk management policies and
that can produce
derivative instruments
inefficiencies.

When Sid Bass wanted to rebuild his family's wealth he brought in What this means is that
Richard Rainwater. To accomplish this feat, Rainwater's idea was to certain inefficiencies can
re-energize "dormant or dead money" through intelligent investing be exploited by savvy
in a controlled fashion. Asymmetric investing does this through investors who are
prudent risk management policies and derivative instruments. willing to reflect and
reconsider how the
investment process
(2). Asymmetric strategies provide investors with that
works.
unique ability to participate in as much of the upside
gains as possible while limiting the downside. We believe options can
provide investors with a
Most psychologists suggest that most investors feel that a 1% move tool that is flexible, self-
either to the upside or to the downside does not have the same adjusting, and can be
affect / utility to an investor. Losses are considered to be twice as tailored to any investor's
bad. We try and therefore manage two types of capital - our individual risk appetite.
monetary and mental capital. Getting mentally beat up can hurt an
investment manager in such a way so as to tilt an investment
manager leading to a major blow up.

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 Twenty Reasons to Invest in Asymmetric Strategies

(3). Various Financial Models that were established in the

1950s are showing their age. A review of their relevance
is needed in context with today's environment
Investment
Modern Portfolio Theory (MPT) and other theories of that era Management:
suggest that an investor is rationale and is only looking at a Science or
Mean-Variance Optimization. This means that an investor only an Art?
looks at the historic average return on a particular asset and its
deviation / variance from that average return. From there, the More than sixty years
rationale investor will optimize a portfolio of risk- adjusted ago we saw the
preferences. This isn't true as the two other Moments of a founding of the basic
Distribution aren't considered in the investment process. tenets of Modern
Investors need to weigh the Skew and the Kurtosis as well to Finance. From the
beginning of our careers
make good investing decisions. We also see from Behavioral
we have questioned
Finance Theory how financial markets are impacted by human
those assumptions and
psychology and groupthink.
theories.
Harry Markowitz in his seminal paper (1952) on MPT didn't
We believe the prudent
have access to computers to back-test the data back then. If he thing to do is for the rest
did, he would have found that the distributions of various of the investment
historic prices weren't all normal bell shaped curves. Instead a community to open their
lot of them have big fat tails and large skews. In addition, minds and question the
Markowitz didn't have options to use in his construction of veracity of some of these
portfolios. Equity options weren't available until 1973 at the assumptions in light of
CBOE. So in essence MPT is vastly outdated to today's all that has happened
over the last six decades.
environment. See CFA article titled, Investment Management:
A Science to Teach or an Art to Learn We believe there is a
better way to manage
(4). Cash can be a very useful asset and diversifier in a investments and risk.
portfolio Our way challenges
current thinking but the
logic is sound and
Warren Buffett can get a better return than most because he has proven.
Cash available when it's needed most by other individuals. He
gets a sweetheart deal for being a "lender of last resort". Usually

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 Twenty Reasons to Invest in Asymmetric Strategies

there are better investment choices available after you have

invested your last Dollar, Yen, Euro or whatever. So holding
back some cash shouldn't be a big worry especially for
absolute return managers with the ability to leverage with Leverage is a
options. Don't forget the leverage of options can allow us to Beautiful Thing
replicate a normal portfolio using less money or it can allow
us to diversify more with more positions while still keeping Options provide a
our money management rules intact. In this way, we are source of leverage
better able to reflect today's environment without the concern because they are cheaper
of correlations reverting to one. than buying the actual
stock. Your leverage can
(5). Leverage with an option is a beautiful thing be 2, 3, 5, or 10 times
more than the actual
underlying asset or
Why do so many people want to buy short-dated options? stock.
Because of the bang they get for the dollar. The problem is
It means you can sit and
that they have no system to evaluate the environment in
be patient, knowing that
which they are in as well as they have no concept of how the
you are really not giving
options Greeks can impact their investment and returns.
up a lot of return by
Matching the option to the (the Macro as well as the sitting and waiting for
Volatility) environment is the key. opportunities to line up.

Understanding option probabilities and leverage are other key Putting less money to
components to successfully investing in option long positions. work on an individual
Also, don't forget buying options has a cost - the Theta - time idea then allows you to
decay. Thus we need to manage the time decay with another spread your investable
option or other options strategy. Managing an options funds over other worthy
ideas giving you a wider
portfolio has its own unique risks - learn those risks.
selection. This is done ,
while still keeping your
(6). Diversification - We are not strict believers in
money management/
diversification as most people use it.
risk rules intact.

Warren Buffett has three quotes that we like (1)

Diversification may preserve wealth but concentration builds
it. (2) Risk comes from not knowing what you're doing. (3)

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 Twenty Reasons to Invest in Asymmetric Strategies

Diversification is protection against ignorance. It makes little

sense if you know what you are doing".

Our addition to this is they we don't pretend to be the smartest

folks in the room but the asymmetric option strategies that we
Diversification
employ allow us more room for our intellectual thoughts and is Protection
strategies to work their way through because they are more from Ignorance
Who are we to argue
robust and flexible than most investment strategies. Too much
with Warren Buffett?
needless diversification can saddle you with too many losers
that are an anchor on your returns. See Dr. Henrik We believe that
Bessembinder's paper titled, "Can Stocks Outperform Treasury diversification and
Bills?" correlation go hand-in-
hand with most
investors.
(7). Correlations - We are not big believers in correlations
We think adding
anything that doesn't
Correlations as we view it, are used by long term equity holders
add value is "dead
to identify targets for diversification purposes. They use it as a
wood." Therefore, there
way of dampening volatility and smoothing out returns over
is no use carrying it
longer economic cycles. The problem that we have with that is around.
two-fold. (1) Correlations have a remarkable ability to revert to
one just when you need them the most. So we see no real Dr. Henrik
Bessembinder's paper
benefit from this perspective and see it instead as a cost and as a
basically supports our
dampener of our potential returns. (2) It goes against our
idea that the bulk of
shorter investment time horizons and limited risk perspectives.
stocks don't add value.
Instead, we try to play in that "Knowledge Cone" and stay
away from the longer term unknowns that can hurt our What really happens
portfolios. when you combine
stocks into a portfolio is
that they diffuse the
(8). Asset Managers and the Prisoner's Dilemma
skew (our upside) that
we are trying to capture.
Peer comparisons and misaligned incentives cause asset
managers to follow the herd even to the detriment of asset
owners, according to the Bank of Englands Thomas Belsham.

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 Twenty Reasons to Invest in Asymmetric Strategies

Why do asset managers sell when prices are falling? The answer might be found in a classic
game theory example, suggests one Bank of England staffer. In a new blog post, Thomas
Belsham compared the incentives faced by asset managers to those faced by the convicts in
Albert Tuckers Prisoners Dilemma.

In the thought experiment, two prisoners face a two-year conviction for a crime, but are
suspected of a more serious offense. Each is offered a deal: snitch on your partner and you can
go free, but your partner gets seven years. If both snitch, each gets five years in jail.

Although keeping quiet seems like the obvious choice, game theorists argue that a rational
thinker would snitch: No matter what the other person does, the snitch would face a better
outcome (zero jail time instead of two years; five years instead of seven years). The Nash
equilibrium, or game theory solution, is for both prisoners to snitch.

Asset managers face a similar dilemma, argued Belsham.

In a period of financial stress, when there are concerns about falls in asset prices, rather than
hold ones nerve and stand pat, individual asset managers might reason that it is preferable to
sell instead, he wrote. If all asset managers reason thus, the resulting rush for the exitand
downward pressure on asset pricescould result in considerably bigger losses for everyone,
than if asset managers had coalesced on the cooperative outcome.

For asset owners, there are two preferable outcomes: Either all asset managers hold on to their
assetsor, if some managers have already sold, other managers should not follow suit. In both
scenarios, potential losses are limited.

But asset managers dont face the same incentives as asset owners, Belsham argued. For
managers, performance in and of itself isnt the most important considerationwhat matters
most is how they perform compared to their peers.

No matter what other managers do, its in an individual asset managers best interest to sell
if they sell and others dont, the holders incur the losses; if everyone sells, everyone loses.
Either way, the manager performs at least as well, if not better, than its peers.

It becomes in an individual asset managers best interest to minimize deviation from the rest
of the packbecause his or her reputation and ability to raise a new fund and operate
henceforth are a function of relative performance, he wrote.

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 Twenty Reasons to Invest in Asymmetric Strategies

So how can manager incentives be better aligned with those of

the investor? Belsham suggested making selling more difficult
or making peer comparisons less importantby emphasizing
absolute return over benchmark performance, for example.
Unified System
Alternatively, we could all take a cue from game theorists.
that Combines
Multi-functions
Our view is that an option may not always be the absolute best
strategy but it won't be the worst. The Option allows us to We believe we have
predefine our maximum loss. So we are able to manage our developed a unique
investments without undue pressure. And over time, we'll get a system that combines
few big wins that will offset those smaller failures. many separate functions
into one nice, neat
system.
(9). Technical Analysis combined with fundamental
analysis We have blended
fundamental and
technical analysis with
Our Commodities Corp. training taught us to combine and
risk management and
understand both types of analysis. Fundamentals can give you
derivatives trading to
the big picture that can possibly last a long time. However, it is
form a state-of- the-art
the technical analysis side that will get you in or out at the right
process for managing
price and at the right time. money and risk.

If you are really trying to compound your capital then the best The process is logical
way is to buy low and sell high within a certain time and dovetails nicely
perspective. Over the years of sitting on investment committee with the "real-world" of
meetings and listening to many equity managers make their investment and risk
pitches I have seen too many state "we sell when the investment management.
is fully valued." We rarely see anyone talk about price entries or Investors want
price exits. It is our belief getting in at the right level is a major something that aligns
component of whether an investment will be a winner or a loser their interests. They
and whether you will compound your capital. want something that
makes sense and that
(10). Equity factor investing they can utilize over the
long term, given any
type of market that may
Equity factor investing concentrates on such factors as Value, arise.
Low Size, Low Volatility, High Yield, Quality and Momentum.

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 Twenty Reasons to Invest in Asymmetric Strategies

Asymmetric investing can apply these same factors along with

others that apply to currencies, bonds and commodities in their
own special way to create meaningful asymmetric strategies.
We are particular keen on "Value and Momentum" aspects of Idiosyncratic
asymmetric trading. versus Systemic
Risk
(11). Global Macro/ top-down macro analysis and its
Systemic impact on markets. With options you are not
so worried about
Here's another key point of differentiation for us. We see most idiosyncratic risk -
individual firm risk. The
equity analysts looking at firms from a bottom-up approach.
option premium that
They look at hundreds of firms and do due diligence trips
you pay limits your risk.
talking to senior executives. The executive teams are always
optimistic so nothing is gained from our perspective other than Instead we are focused
a waste of time. The bottom-up analysts then combine other on big trends that
bottom-up investments together to reduce or diversify their impact the total equity

idiosyncratic risk - individual firm risk. space. We find it

provides us with more
Meanwhile they are still exposed to the Systemic Risk which "margin of safety."
can't be diversified away and impacts the market as a whole. We
The premise behind our
on the other hand, study the big global macro factors that
investment philosophy
impact the markets. We pick out the individual sectors that are is that we want our
the most affected and try to align ourselves and ride a bigger decision-making to be as
and more powerful trend. The "Margin of Safety" is bigger and "robust" as possible.
better for this type of investor. See Seth Klarman for additional
When your process is
material on "Margin of Safety."
"robust" then you have
Traditionally long-only equity investors are generally most leeway. You don't have
concerned with the ability of the firm to grow its earnings over to have precise entry

time; corporate debt investors are more interested in the and exit points. In
addition, you don't have
strength of the firms balance sheet and its capacity to repay its
to pick the exact winner.
debts.
We just have to get
We at Lone Wolf Asymmetric are concerned with the Systemic close. The idea is that
factors that impact global markets or at least country markets you give your intellect
room to be right and not
perfect.
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 Twenty Reasons to Invest in Asymmetric Strategies

and see opportunities from shifting among them. We believe that understanding and
following these monster tides ensures a better probability of success than some individual
factor related to a particular company or industry. We believe that understanding where those
factors impact the most generates more profitable and more stable returns.

(12). Option Greek Management

Most folks treat options as mini- equities. They don't understand the Greeks and their impact
on the options price and return. It is important that if you run a portfolio of options that you
know how to manage a portfolio of Greek risks. We have numerous mathematical formulas
that allow us to manage the risks or structure the option strategies appropriately

(13). Volatility

Volatility - As an example, back in 1987 when the US stock market crashed I had a currency
position that was the wrong way. Nevertheless, the stock market volatility was so great that it
drove my currency volatility higher as well. However, I actually turned a profit even though I
had a completely wrong directional position. Nowhere else but in options can a thing like that

160
140
120
100
Upside Vol
80
Downside Vol
60
Price Trend
40
20
0
1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55

Managing Option Risk is done by managing their Greek derivatives. Managing
Direction alone isn't enough to keep portfolios profitable.

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 Twenty Reasons to Invest in Asymmetric Strategies

happen. Volatility cuts both ways but in our case it's a major benefit when markets are
disruptive and volatility spikes. You can get a double benefit. It's the equivalent of owning a
foreign stock or bond and then seeing the underlying currency go your way as well.
Therefore, you can get a double bonus from the combination of Price/ Yield and Currency
appreciation.

(14). Time is a Precious Asset that we should not Waste

Time can never be regained. Once it's lost, it's gone for good. Therefore, the prudent investor
and manager must look to see if their funds are being managed in a thoughtful way. Investors
can not waste time by tying up their funds in lingering and unproductive investments. Your
money / investments should work as hard as you and as long as you. We need to have an

Starting Value Time (Years) Needed

100 Return needed to to Recover to 100
Percent Loss Value After Loss get back to even Assume 8% per year
10.00% (10) 90 11.11% 1.369
20.00% (20) 80 25.00% 2.899
30.00% (30) 70 42.86% 4.634
40.00% (40) 60 66.67% 6.637
50.00% (50) 50 100.00% 9.006
60.00% (60) 40 150.00% 11.906
70.00% (70) 30 233.33% 15.644
80.00% (80) 20 400.00% 20.912
90.00% (90) 10 900.00% 29.919
100.00% 0 100

Keeping Losses to a Minimum is Essential if you want to Compound

your Growth over the Long-Term

investment philosophy in which our money should be as productive as possible in the time
that we have it and exposed to limited downside fluctuations. Because we don't know exactly
how much time we'll Starting
have toValue Time (Years)
build our nest eggs and exactly when our money andNeeded
100 Return needed to to Recover to 100
investments will be needed. The vast majority of us can't be like Warren Buffett. We just don't
Percent Loss Value After Loss get back to even Assume 8% per year
have endless streams of cash
10.00% (10)for investments
90 that never get disrupted and are 1.369
11.11% allowed to
compound20.00%
endlessly. (20) 80 25.00% 2.899
30.00% (30) 70 42.86% 4.634
40.00% (40) 60 66.67% 6.637
50.00%
Lone Wolf Asymmetric (50) Reasons 50
- Twenty 100.00% 9.006 Page 9
60.00% (60) 40 150.00% 11.906
70.00% (70) 30 233.33% 15.644
80.00% (80) 20 400.00% 20.912
 Twenty Reasons to Invest in Asymmetric Strategies

Instead most of us have real lives with real factors (births, deaths, sickness, marriages,
divorces, educational bills, home purchases, job losses, etc) that impact our investments.
Therefore, your money should be as productive as it can be while you have it. Accordingly, it
should be able to pickup right were you left off when you return to investing. If you're sitting
waiting several months to several years for an undervalued move to occur that's lost time that
you can never recover. Instead your money could have been working on some other more
time favorable opportunities. Investors should be trying to get out of life and their
investments as much as they can everyday. Remember you can always find another
investment opportunity but you can never find more time.

(15). Compounding and its Magic to a Portfolio

Einstein says its the eighth wonder of the world. Limiting losses and working your trading
edge allows you to compound growth at a much faster rate than sitting and waiting for a
single investment to return a 100% gain. The key is to grind it out (our methodology and
edge) and keeping losses
small. So that even if we
don't have the best return
that year, over the long
haul we'll produce a
Volatility Matters -When a Correction
better compounded rate
Occurs and How Deep - Impacts Your
of return. Ultimate Outcome

(16). Investment 250

Horizon
200

Sure you can have a long- 150 Series1

term investment horizon Series2
but you need to be 100
Series3
worried about short-term
50
volatility. As Alexander
Ineichen states in his book
Asymmetric Returns, "Volatility Matters." Holding an investment like Buffett sounds great but
it usually doesn't work that way. Most of us are normal human beings that have normal

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 Twenty Reasons to Invest in Asymmetric Strategies

inflows and outflows that need to be addressed from time to time. We all are exposed to such
things as marriages, divorces, children births, education, weddings, travel, sickness, death etc.
which can all have a major impact on our financial health if the timing of those events hits at
the wrong time.

Waiting and waiting for that particular stock to prove its worth just when you need to fund
some major event doesn't help one bit. Our money and investments need to be working hard
all the time and available /liquid in a rather reasonable time period. Seeing a major hit to the
portfolio doesn't help one bit as there may not be enough time to recoup those losses thus
impacting the lifestyle that we anticipated prior to retiring. CAGR versus IRR what you see is
what you get.

(17). The Knowledge Cone

The Knowledge Cone of the "known knowns," "known unknowns" and the "unknown
unknowns". Black Swan type events. We like to trade in what we call the knowledge zone. It
is the time frame in which most planned economic events and expected releases are forecasted.

This is usually somewhere between three to six months. Going beyond that time frame falls
into the nebulous world of "Black Swans" or as Donald Rumsfield would say, "Unknown
Unknowns.

We believe you cannot forecast with certainty beyond a certain time period. There are just too
many factors that can disrupt your forecasts. Instead, we believe you manage your
investments in increments of three to six month intervals and reassess the environment
periodically to better reflect what is going on and to check our investments. Having a way or a
strategy that measures our performance with the trend helps to keep us on the right path to
investment success.

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The Knowledge Cone

Knowledge Cone
250

200

150

100

50

0
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55
-50

Lower Band Price Upper Band

(18). Timing the Markets

People argue that you can't time the markets. However, Paul Tudor Jones and I had this
conversation awhile back and we both believe that you can do it. Usually we both give
ourselves at least three chances to call the turns and are quick to reverse if wrong.

The key to this is having some solid technical indicators that give clear indications of when a
turn is imminent. Then you need to quantify/modify your technical indicators so that you
know when and at what level is the best time to pull the trigger on the trade. Timing a trade at
the right level has many benefits. Usually you are at the ground floor of a major move or at
least a nice size correction that can add to your returns. In addition, if done correctly you will
usually see a major range expansion that can give you a cushion on the trade. Again this helps
your mental as well as monetary capital. See below for further clarification.

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 Twenty Reasons to Invest in Asymmetric Strategies

"If you can

(19). Trading as Close to the Danger Point as Possible
think it, it can
happen!"
This is another one of Commodities Corp.'s lessons that I
learned. The idea is to put on a position as close to the stop-out We pride ourselves on
point as possible. This has several benefits. From a psychological the idea of being open-
point a small loss shouldn't hurt us mentally. We should accept minded on a variety of
small losses and follow the signals as given by the system. In subjects and matters.
other words, "See the signal, Follow the Signal, and Feel good We aren't afraid to go
about the Signal". From a risk/reward perspective, we can back and retest ideas.
leverage up more and still stay within our money/ position limit Nor are we afraid to test
rules while avoiding catastrophic losses. This is in contrast to ideas that are not
other trend followers/investors who invest at the mid-point of a conventional. We
trend then see a reversal. understand that change
occurs and we must
adapt to the times.
(20. Trade both sides of the Market
We hope that we have
established a process
Understanding how to trade from the long side as well as the
that is adaptable to a
short side develops flexible thinking and allows for minds to be
variety of environments
open to new ideas. Flexibility in thinking is another one of the
and can provide a
Commodities Corp ideas that has carried over to Lone Wolf framework for the long-
Asymmetric. As a friend mine always says, "If you can think it, it term.
can happen." Again the price distributions that we have seen in
Our whole investment
the various markets that we trade suggests that the tails are fat
process tries to
and that they can occur more frequently than most folks would
understand the current
assume.
environment and
position ourselves not as
bulls or bears but
instead as realists.

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