This is a phenomenal two-month return considering that the average yearly return for the past ten years has been just 4.17%.
Further along in this update we will also discuss and demystify the realities and deceptions of Mark-to-Market reporting.
Compared to the S&P benchmark, Pilot portfolios fared pretty well, mildly underperforming the benchmark by less than 1%.
Our mark-to-market broad market portfolio posted a 2.09% return for the month, while our mark-to-market stock portfolio posted a 4.8% return. Trade in Crude Oil and Apple (AAPL) were our best performing markets, while trade in the Long Bond and Amazon (AMZN) were our worst.
more on the >> The realities and deceptions of Mark-to-Market reporting
Firstly, profits and losses posted in monthly return profiles do not convey actual realized gains or losses (see mark-to-market period-analysis last paragraph). Instead, the monthly performance profiles serve more as an accurate statement of account.
If we ran a hedge fund based upon the above listed portfolio, and we were required to send out monthly account statements to each of our shareholders, mark-to-market accounting would provide the best snapshot of performance from one statement period to the next.
This is a best practice method of reporting even though several positions comprising the portfolio might remain open, or may have been on the books for several months or years.
When reported losses are in fact hidden profits
To help focus your attention once again, we highlight our mark-to-market short-term trading results in the Gold market in order to illuminate precisely how such reported drawdowns might be rather deceiving, and how reported losses may well disguise a simple drawdown of open profits within a given reporting period.
This month, we report a mark-to-market monthly drawdown or LOSS of ($2400) in short-term Gold futures trading accounts however, the reality is that we took no such loss and in fact, at the close of February, our short-term bullish position in Gold was actually in profit by $9,530 dollars per contract.
You might be scratching your head asking how in the world can we close out the month of February with $9,530 in actual open trade profits in this account and report a $2,420 loss for the month. At face value, the numbers simply do not add up.
Enter mark-to-market accounting. This is how it works:
In the above Gold futures example, back on January 6, we established a new position, moving long one contract of nearby Gold futures at an entry price of 1619.60.
At the end of January, Gold closed at 1739.10 leaving us with unrealized open profits of $11,950 dollars per contract. It is from here (the condition of $11,950 in unrealized profits) that we began our reporting baseline for the current “February” period. Are you with us so far? Okay good.
So, by the end of February’s current reporting period, still holding our January 6 long position from 1619.60, Gold settled the February books at a closing price of 1714.90 leaving us with ( 95.30-points x $100 = ) unrealized open trade profits of $9,530 per contract.
Where does that leave us performance wise for February? You got that right, it leaves us with a ($2,420) drawdown or loss for the reporting period, which began the month with $11,950 in unrealized open profit and closed the month with a reduction in open profits.
So, to sum it all up, we started February with $11,950 in unrealized trade profits on the books, and ended February with (-$2,420.) less, or $9,530 in unrealized trade profits on the books.
That is how reported losses may be disguised as hidden profits.
How did this trade resolve?
The trade list below reflects transactions made in short-term trading accounts for nearby Gold futures. We have generated the spreadsheets below from recent activity in our short-term Gold trading accounts.
Below, we have listed four completed trade transactions from 11/17/11 through the last trade referenced above, which elected on 01/06/12 at the $1619.60 entry price.
In the last transaction listed, we closed our long positions on 03/01/12 at a price of $1720.40, which yielded a two-month “REALIZED PROFIT” on the transaction of $10,080 dollars per contract.
Note that the profit and loss amounts reflected under the cumulative net profit column include transaction cost adjustments.
Run-ups and Drawdowns
To wrap up this illustration, we provide you with a few rather interesting mark-to-market related statistics: the run-ups, drawdowns, and total efficiency for each trade transaction.
If we were to evaluate a two month reporting period, we would observe that our January long position in nearby Gold futures had a maximum equity run-up of $16,940 dollars at its peak (a 93.85% efficiency correlation), and a negative equity drawdown of (-$1,110) at the worst point within the trade.
At the end of the day, we achieved a 55.84% total efficiency correlation upon closing out this trade on 03/01/12 with more than a $10,000 dollar PROFIT IN JUST TWO MONTHS.
In closing, we leave you with more background information surrounding the best practice of mark-to-market accounting.
Until next time, Trade Better / Invest Smarter
Mark-to-Market Period Analysis
Mark-to-Market is another term for closing the books at certain time intervals for accurately reporting profit, loss, and performance. When we perform Mark-to-Market on a monthly basis, it means that though various positions may remain open, for periodical reporting purposes, we close the accounting books at the end of each month and thereby mark those positions to market.
Without a Mark-to-Market, it would be impossible to know where to allocate profit or losses within a given period.
For example, say that a trade that begins November 1 and closes January 31 makes 30%. The Mark-to-Market allocates the proper percentages to each month as opposed to the entire amount at the end of the three-month holding period.
History and development
The practice of mark-to-market as an accounting device first developed among traders on futures exchanges in the 20th century. It was not until the 1980’s that the practice spread to big banks and corporations far from the traditional exchange trading pits, and beginning in the 1990’s, mark-to-market accounting began to give rise to scandals.
To understand the original practice, consider that a futures trader, when taking a position, deposits money with the exchange, called a "margin.” This intends to protect the exchange against loss. At the end of every trading day, the contract is marked to its present market value. If the trader is on the winning side of a deal, his contract has increased in value that day, and the exchange pays this profit into his account.
On the other hand, if the market price of his contract has declined, the exchange charges his account that holds the deposited margin. If the balance of these accounts falls below the deposit required to maintain the position, the trader must immediately pay additional margin into the account to maintain his position (a "margin call").
As an example, the Chicago Mercantile Exchange, taking the process one-step further, marks positions to market twice a day, at 10:00 am and 2:00 pm.