LIM Pursues the Science of History

Date: Thursday, April 10, 2008
Author: Jacob Bunge, Financial Correspondent, Hedgeworld.com

CHICAGO (HedgeWorld.com)—There is a day, usually in April, when the price of natural gas contracts rises more than 3%, heating oil rises more than 1% and unleaded gasoline rises more than 1%. On this day, if a trader buys crude oil and holds it for 60 days, 91% of the time he or she will see the position gain an average of 14% as the summer driving season approaches.

So says history, anyway—the above-mentioned phenomenon has occurred 12 times in the past 16 years, and every year running since 2002. This sort of thing—identifying the magic day in the second quarter mentioned above, or what happens to live cattle futures in advance of snowstorms in Texas and Oklahoma—is the specialty of Chicago-based Logical Information Machines Inc. It's a company that provides commodity traders, hedge funds and others with a crystal ball that looks into the past, or a magic eight ball that spits out statistics in less time than it takes that ghostly blue triangle to appear.

LIM's service centers on its Market Information Machine, a system that combines its time-series database of historical pricing information going as far back as the 1800s with the firm's patented query software. Market data from commodities and equities exchanges to weather information are fed into LIM's aggregation process, where the numbers and dates are checked and put into a standardized format. At that point the information is entered into the firm's data warehouse and uploaded to clients' onsite MIM servers, where it becomes searchable. Depending on the information, getting it into the system can take anywhere from a few seconds for a short set of numbers to a few minutes for a lengthy document, according to LIM officials.

The service is used by money managers like CTAs who want to know what happens to corn futures when no rain has fallen in the Midwest for two weeks, as well as big companies like General Electric, which uses the service to analyze temperature readings on nuclear turbines. Some clients spend 10 to 12 hours per day running queries, designing intricate searches that reach two to three pages in length, whereas other users may run queries only three or four times per week.

Product of the Pits

LIM was born of a particular sort of frustration native to Chicago's trading floors. Anthony Kolton, a trader at the Chicago Board of Trade, found himself with an idea about a trade, but he wanted to back test it, and by the time he got an answer several days had passed—an eternity, in other words. Mr. Kolton talked with several programmers about creating a database of historical pricing information, but none of them could produce what he was looking for until a friend at Bell Laboratories showed him some new database technology he'd developed. It did the trick—delivering an instant answer for whatever historical query Mr. Kolton could come up with—and it formed the base of the Market Information Machine.

Right away, Mr. Kolton said, he knew it was a project with legs. Plus, he was tired of toiling in the pits. "I went through the stock market crash in 1987, and 1988 was a very boring, very tough year after 1987," he said. "I decided I was going to retire from the trading floor. I made a lot of money in 1987—I was short IBM." Leaving the CBOE was difficult, he said, but he knew his friend was a genius, "and I'd had enough yelling and screaming after five years."

Mr. Kolton's trading floor cohorts were supportive of his new venture; the president of the clearing firm he traded with investing money in LIM. After launching in 1988, LIM did $300,000 in sales in its second year, and $600,000 in its third; now going into its 20th year, the company serves about 150 clients, including some of the biggest names in the hedge fund and investment banking industries. Its client base mainly includes hedge funds, CTAs and mutual funds, with CTAs making up the biggest constituency. LIM got its start focusing on the futures markets, and today, Mr. Kolton said, the biggest area of interest is energy.

That's largely due to one of its former customers—Enron Corp., which at one point was LIM's biggest client. It wasn't exactly a good day for LIM when Enron went down the tubes, as the company had bought around 2,000 MIM units after first signing on as a client in July 1997. But many Enron employees found their way to other energy-trading firms and convinced their new bosses to sign up new MIM units, and LIM saw its client base grow.

LIM currently operates offices in Chicago; New York; and Austin, Texas. The latter serves as the location of LIM's data warehouse, where a 100-man team is charged with error-checking data as it comes in, organizing it and putting it into a standardized format. Last year, LIM estimated that its data warehouse distributed around 50 million data points per week, gleaned from around 250 vendors of market data. The firm maintains two separate facilities for data storage, for disaster recovery purposes. Most client firms keep a MIM server onsite, which is updated with new market data throughout the day as fresh information becomes available.

Idea Generation

According to Travis Nadelhoffer, financial analyst with LIM, most traders use the searches as part of the decision-making process when evaluating a possible trade. They may start with a gut feeling that, say, crude oil will go up or down, and the MIM system lets them see whether that gut feeling has been borne out in the past—how crude has moved in similar market conditions, what generally happens afterward, and how often.

Mr. Kolton described it as a third branch of science. "You have fundamental analysis and technical analysis, and this is historical," he said.

While MIM units are used by both discretionary and systematic traders, Mr. Kolton estimated that about 70% of users want to see the data before entering a trade based on a query. "People want to be able to see the data, feel the data," he said, although firms trading systematic programs have the option of hooking their trading models directly into the MIM unit.

Hands-on users are able to save queries as "jobs" and can get a basket of custom queries they've written delivered to their email as often as they choose. LIM staff members also use the system to sift through the markets and come up with a handful of trading ideas, usually eight to 15 per day, which are written up and distributed to clients in a newsletter.

Some clients, particularly those trading on systematic models, need real-time market data incorporated into the database, so their queries can take into account up-to-the-minute market movements. Last year LIM introduced a new module that takes a real-time market information feed and directs it to a separate database, housed within the client's office, which is searchable alongside the standard MIM unit.

Many hedge funds and CTAs also want to incorporate their own internal data and models into the database to compare their profit and loss against the historical performance of, for example, the Standard & Poor's 500 stock index. LIM is able to route these firms' performance data into their on-site MIM units, so the information never leaves the firm's walls, according to Mr. Nadelhoffer.

New for 2008 is an options module, a four-years-in-the-making product that LIM plans to introduce in May. It will allow clients to back-test options performance, and Mr. Kolton said that development was difficult because of the multitude of strike prices involved. For this reason, LIM's options module doesn't require users to set a strike price—instead they input parameters for "moneyness," as in how far in the money or out of the money a strike price may be, or if it will come in right at the money.

With little constant but volatility in most markets over the past few months, Mr. Kolton said that the historical perspective provided by LIM can serve as a road map, because even though 2008 appears to be a strange new world, many of these movements have happened before.

"I think it's very important to realize that nothing lasts forever," said Mr. Kolton. "In the history of the world there's never been a commodity, be it pork bellies, sugar or whatever, where the price hasn't risen to a certain point where it doesn't come back down. The laws of gravity have not been disproven."

But what of those "black swans" we heard so much about last year—those hitherto unthinkable events that confounded trading models time and time again? Mr. Nadelhoffer granted that there are events that cannot be predicted, such as the terrorist attacks of Sept. 11, 2001, but he argued that it's always possible to find some kind of equivalent.

"With 9/11, you look at what happened after Pearl Harbor," he said. "There's always the human element there."

JBunge@HedgeWorld.com