ise. Some brokers specialize in a market area;others may focus on a technical or a fundamental approach. You should find a broker who fits your particular style and trading needs. Whatever you need, youshould conduct your broker search just like you would if you were interviewing apotential employee or a partner to handle your money—the broker, in effect, actually is your employee and your partner whom you pay to do a specific job for you.Just as you evaluate the broker, the broker is going to be interviewing you toascertain your level of trading knowledge and experience, your trading goals, yourtolerance for risk, and other factors that will shape what and how you trade andthe relationship with a broker that you will need in order to attain your trading objectives. Following are some examples of issues a broker can help you workthrough as you develop your own trading program.
Trade What You Know, Know What You TradeMarket participants can be split into two camps:1. Hedgers are the producers and users of commodities who have exposure and
vested interest in price movements in certain markets.2. Speculators are the traders who seek to profit from price changes and providethe liquidity that is so vital to a smooth, efficient marketplace.By listening to your trading goals, a broker can quickly identify which groupyou fall into, the first step in determining which markets to trade. Of course, if youare a hedger, you obviously know which markets to trade because you deal/investin the underlying commodity all the time. One of the criteria in your broker searchmight be finding a broker who specializes in the market you trade, is well-versed inthe fundamentals of that market, and understands strategies for hedging.The vast majority of futures traders, however, are speculators and have no interest in taking or making delivery of any particular commodity. When you get tothe point of narrowing down the field of market choices, the broker can guide youto those that best fit your situation. Familiarity should be factored into your decision. Select a market that you know something about when you first begin trading.For example, if you grew up on a farm, consider the agricultural markets; if youare a stock market investor, consider stock index contracts; if you are a salesperson for a mortgage broker, consider the interest rate contracts.
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Take advantage of the market knowledge you already have and leverageyour prior experience/exposure into a market you know so you can concentratemore of your energy on developing trading strategies and making money. Thebroker can give you plenty of information to consider when you are evaluating amarket and trying to find trading opportunities, and you should use any edge youhave. Market familiarity breeds confidence, and confidence begets disciplined,clear thinking.Initially, you should limit the number of futures markets that you follow sothat your focus is not diluted in too many different directions. Ideally, the marketsyou select to review will have a low correlation to one another. For example, youmay want to limit your analysis to only gold, stock indexes, and corn—or someother combination of three or four diverse markets. A broker can help you determine which markets fit you best.Get as much information as you can about the market(s) you’ve selected orthe trading method you plan to use. The more knowledge you acquire in advanceof trading, the less likely an unpleasant surprise will occur while you’re in the market. Printed contract specifications and literature are usually available free ofcharge from the broker or exchanges where the market trades, or you can getmost of the information you need on Internet web sites.You can always explore adding different contracts to your trading account asyour experience and comfort level increase, ultimately allowing you to diversifyinto more areas to take advantage of contracts with low correlation to one anotherto balance your exposure to any one market segment.
Match Markets to Your BudgetOf necessity, the amount of risk capital you are willing to devote to futures tradingwill play a big role in determining which markets are more practical than others.Margin requirements for futures contracts must be considered and should weighheavily in your decision about which contracts to trade. Your broker can explainwhy the market choices available to the speculator with $5,000 will not be thesame as those for the speculator with $50,000 and can outline the consequences ofan adverse move in various markets.Even though you may have adequate funds to cover the margin requirement,you should also pay attention to the average true range or daily trading range of amarket. The average true range study takes the moving average of the true rangeover a specified period.True range = True high – True lowwhere
True high = the greater of the current bar’s high or the close of theprevious barTrue low = the lesser of the current bar’s low or the close of theprevious bar
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63
The E-mini S&P 500 index contract may show an average daily range of approximately 10 to 15 points, which equates to $500 to $750 per contract. A one-daymove could represent a 10 percent drawdown on a $5,000 account balance andmay prove to be too volatile a market, based on your objective and risk tolerance.Your broker can help you stay away from the rookie mistake of committing allavailable capital to cover the margin requirements for open positions. You maythink you have a sure thing, but surprises and drawdowns are inevitable in trading.Avoid placing yourself in a position where a nominal adverse market move forcesyou to liquidate prematurely due to a lack of available cash reserves. A good ruleof thumb is to maintain at least 25 percent of your initial margin requirement ascash reserves to cover potentially adverse price movements.
Time ConstraintsThe stock market offers thousands of individual companies from which the investor can choose. Unfortunately for the investor, each company has its own particular dynamics that need to be evaluated and considered, and the research thatgoes into just the stock selection can take a great deal of time.A distinct advantage for the futures investor is that there are relatively few(approximately eight) major futures market sectors to monitor. Should you desire, you can track nearly every noteworthy economic area by following fewerthan 25 markets.Also, market information on futures contracts is readily available through regularly scheduled government reports and data releases made accessible to thepublic. Best of all, futures traders generally do not have to rely on market information produced by boardroom meetings, management turnover, insider information, officer incentives, and personal or corporate agendas.Even though you have fewer markets to follow in futures, you still need toconsider your own personal limitations regarding your time, one of the most precious of all commodities. Most investors have a day job, and they need to makesure that the markets they decide to follow are a good fit with whatever time constraints they have.That’s when having a broker on your side can be invaluable. The broker keepsa close eye on market developments and can monitor your positions for you orcall you with timely trading opportunities that may arise while you are busy. Withthis arrangement, you can still control all of the trading decisions after getting input from your broker, or you can give a broker some discretion to make decisionsfor you if you and the broker have an understanding about what you want to do.The volatility in one futures contract may be considerably greater than another and, as such, may require more of your attention and resources to monitor.The broker is in a position to see what is happening and can help you arrive at atrading decision at the time when it may be critical to take some action.Compare the dollar value of daily range moves in the S&P 500 and corn futures, for example. A 10-point or $500 change that is a normal daily move in the
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THE COMPLETE GUIDE TO FUTURES TRADING
S&P market will probably require closer attention than a 2-cent or $100 dailychange in corn, which may be a longer-term position requiring less monitoring. Ofcourse, the volatility of any contract can change quickly based on new market information, and a contract that once was considered quiet may now be thought ofas volatile.Don’t spread yourself too thin by trying to follow too many markets. Mosttraders have their hands full keeping abreast of a few markets, even with the assistance of a broker. Day-trading on your own is probably not a good idea if you workduring market hours.
Identify Trading GoalsDefine your objective up front. Be specific and realistic. This is an area where thehelp of a broker can be most useful as you discuss your objectives and how youare prepared to achieve them. Having a realistic goal and trading plan will help youdetermine which markets are more conducive than others to attaining your goal.Start with your initial deposit and quantify what percentage return you’re trying to achieve and what percentage negative return would make you stop trading.You should also identify the time period. It’s unrealistic to just say that you want todouble your money.Let’s say you establish a futures trading account with $10,000 and, after consulting with your broker, set a modest goal of a 25 percent return in one year—inother words, a gain of $2,500. That may not sound like much compared to theflamboyant claims you sometimes hear in marketing literature, but a return of thatkind would exceed the return you can get from many other investments. Achievinga monthly average return of a little over $200 over the next 12 months on a $10,000deposit won’t come easily for a beginning trader, keeping in mind that some tradesyou make will probably lose money.The amount of money you have to trade and your stated goal may narrow yourfield of market choices fairly quickly. Even with a conservative goal, you have toevaluate the current market climate to determine what markets fit best with yourbillfold and your objective. Grain markets may appear to be relatively calm forseveral months, for example, but could be very volatile markets during the criticalplanting and growing seasons.Contracts with high volatility do not necessarily trend strongly up or down.They could simply bounce around within a range-bound band of prices. A brokercan tell you about seasonal patterns and other market nuances with which youmay not be familiar and give you some idea of what to expect, based on markethistory. Several markets present seasonal opportunities and risks, which a brokercan help you evaluate.Also important to remember is that, although large price swings (often associated with volatile markets) offer the potential for larger gains, they also come withthe potential for greater losses, as a good broker is likely to remind you. Remember, leverage can cut both ways. Like any other newfound power, you should fully
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65
comprehend the pros and cons of leverage before wielding this power, and thebroker should indicate the extent of risk you may be taking on with a position.Use a simulated trading account to see if the markets you choose to trade really do match up with your financial objectives. It’s better to figure this out whileyou are using play money. And you could end up saving yourself some real dollarsin the future.
Identify Your Risk ToleranceAs important as it is to identify your objective going into a trade, it is equally important to have a bailout plan and to place a protective stop-loss order wheneverpossible, given exchange order acceptance policies and market liquidity. You maythink you can withstand a big loss on a trade and stick with a trading plan you andyour broker have worked out, but dealing with the loss of real money in real trading may affect your perspective of how much you are willing to risk.Ask yourself, “At what point do I absolutely not want this position anymore?”Call that your doomsday stop, and have it working. If such a stop does get hit, thensomething was probably very wrong with your analysis and trading position. Keepin mind, stops are no guarantee of limited losses—markets can sometimes movequickly through them. Also, remember that stop orders can remain unfilled, suchas in limit moves. In this case, a broker might suggest spreading your risk off in aback-month contract. Picking a place to bail out of a trade is a powerful first steptoward taking control of your trading. Your broker is your best resource for helping you determine where to place stops.If you are new to futures trading, be sure to identify two levels of risk beforeyou start trading. The first is the maximum overall account drawdown you’ll accept before throwing in the towel. The second is the maximum loss target for eachtrade. You should refrain from risking more than 20 percent on any one trade.The same principle used to match markets traded and profit objectives appliesto risk tolerance. You need to make sure the markets selected match your risk appetite. Take into consideration the market’s average daily range or true range, andmake sure the average price swings fit with your risk threshold. The experience ofa broker with an objective view of a position can be a big help to any trader.
OPTIONS VERSUS FUTURESUp to this point, most of the discussion has focused on using futures contracts tohedge or speculate in the markets. You also may want to consider options on futures as an alternative or supplement to futures contracts because options can addflexibility to your trading program.An option is the right but not the obligation to buy or sell a particular futurescontract at a specified price (strike price) at any time during the life of the option.
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The main appeal of buying options is that you can speculate on increasing or decreasing futures prices with a defined and limited risk. The most that the buyer ofan option can lose is the cost of purchasing the option (premium) plus commission and fees.Because options on futures offer defined-risk features, you might think thatthis would be the ideal vehicle for traders new to futures. Although options positions can offer clearly defined risk, they also have more components that need tobe considered.With futures, your trading decisions are pretty straightforward: You buy if youare bullish, and you sell if you are bearish. With options, you not only have to project which way the underlying futures contract is going to move, but you also needto determine which strike price to select and the value of the premium you arewilling to pay. Understanding these concepts is not beyond the novice trader butadds some complexity to the decision-making process.For that reason, you may need to rely on a broker who has a thorough understanding of options, the conditions when they might be most useful, and the strategies for using them. A broker who knows options can provide perspective onvolatility, fair value, liquidity, and other factors involved in options pricing that youmay not be able to get from any other information source.Options may be your best trading choice, but you may not know that withoutgetting some professional help. Used in their most basic form, options may provide traders with unlimited profit potential and clearly defined risk, but may require a significant move for the position to break even or be profitable. Futures, onthe other hand, offer unlimited profit and a direct correlation to price movementbut are coupled with unlimited risk. Options are an effective instrument for situations where you anticipate a large price swing but recognize the potential for pricevolatility and the resulting risk.For a more detailed discussion on options, see Chapter 9. Whether you preferto trade the market directly with futures or indirectly with options on futures depends on your trading style and risk tolerance.
MARKET SHOULD FIT STRATEGYWhen you talk with your broker about the markets you want to trade and the approach you want to use, you may find that your ideas won’t mesh with the realitiesof the marketplace. Different markets lend themselves to different styles of trading. Day traders need volume and liquidity in markets in which they participate sothat they can readily enter and exit a position without being concerned about thebid/ask spread, for example. Less heavily traded contracts may have a widebid/ask spread and, therefore, may not be suitable for day traders, even thoughyou may have decided that’s your preferred style of trading.
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Options on futures have several strike prices for each contract month traded,and trading activity may be scattered over a number of different options positions.Consequently, many of the strike prices may have very little trading activity on anygiven day. Such a market is not a good candidate for a short-term or day-tradingsystem. Also, generally speaking, even the most active futures contracts will seevolume drop off significantly as you look to the further-out contract months.Again, short-term speculating in these contracts is not recommended.Those markets with larger daily trading ranges are usually more conduciveto short-term trading models (assuming there is adequate volume, of course).For mid-term to long-term trading, you still should evaluate a market’s volumeand open interest to get an idea about liquidity. Rather than purchasing a contract 12 months out, you may find it more cost-effective to purchase a contract afew months out and roll the position over every three or four months to remainin liquid contracts. You will incur an additional commission charge for each roll,but that amount can be considerably less than the additional cost of entering andexiting a far-out contract with a wide bid/ask spread. A broker can help you getthat done.In general, most short-term traders or day traders tend to concentrate onfinancial markets for the volume and volatility these markets offer on a regularbasis.
PAPER TRADING, BACK-TESTINGExploring new markets can be an exciting as well as unsettling experience. Thereis no better way to get acclimated to a market than to take it for a test-drive. Use asimulated trading account and test your strategies before implementing them inreal markets with real money. A broker can help you discover flaws that you mightnot have recognized yourself and can help you find remedies to increase yourchances of success.A simulated trading account can also help you determine if the markets youselect to trade really do match up with your financial goal and strategies. Tweaking the contracts you trade is much easier when it’s only play money that’s on theline and may end up saving you real money down the road.Because broker-assisted programs require more of a firm’s resources and services that are personalized, a higher commission rate is generally charged. This, ofcourse, is usually what makes traders hesitate about working with a broker.For a broker-assisted program to make sense, the commission rate has to bereasonable and justified. A general rule of thumb and widely accepted standard isfor the commission rate to be double that of the self-directed rate. The additionalcost helps defray the expense of dedicating broker staff and resources to monitoring the markets and reviewing trading strategies on your behalf.
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Most important, however, is whether the rate is justified. Consider this: If noadditional stipend were charged to work with a broker and the trading results andexperience did not improve, then what have you gained? Conversely, if you use theservices of a broker-assisted program and find that your bottom line improves andthat you grow as a trader because of this broker interaction, the decision to spenda little more on commissions becomes easier to justify.Remember, the ultimate goal of the broker-assisted program is to improveyour bottom-line results. Whether you’re a seasoned trader or a novice, this shouldbe your goal as well!
CHAPTER 4
Letting thePros TradeYour Account
F
or those who would like to take advantage of the benefits that futures provide but don’t want to be involved in trading directly themselves, an alternative is a managed account traded by professional money managers.Managed futures accounts have been used by high-net-worth individuals formore than 25 years as a way to diversify their portfolios and enhance overall ratesof return. The managed futures concept, which has been around since 1970, hasgrown most dramatically in recent years as the number of financial contractsavailable to traders increased and the interest in more traditional investments fluctuated. The total assets under management have risen from almost $26 billion atthe end of 1994 to almost the $120 billion level by the end of 2004, the BarclayTrading Group1 estimates—an increase of more than 450 percent in 10 years!More than 400 managed futures programs are offered by commodity trading advisors (CTAs). The programs are created by individuals or groups of individuals whohave designed a method of trading that historically has had higher profits than losses.Anyone who offers a managed futures program in the United States must beregistered as a CTA or a commodity pool operator (CPO) with the National Futures Association (NFA), the direct operational watchdog of all futures firms andfutures professionals that is itself governed directly by the Commodity FuturesTrading Commission (CFTC), a federal government agency. The CTA must hold aSeries 3 license, the futures industry’s equivalent to the Series 7 license that stockbrokers must have. The Series 3 requirement applies not only to CTAs but also toall futures brokers; to learn more about registration and requirements for CTAs
1
Barclay Trading Group Ltd., 508 North 2nd Street, Fairfield, IA 52556 (www.barclaygrp.com).
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THE COMPLETE GUIDE TO FUTURES TRADING
and their status, see the NFA’s web site at www.nfa.futures.org. A CTA must alsopublish a disclosure document, explaining the program and including the risk disclaimers, which must be filed with the NFA.Holding a managed futures investment in your portfolio is not necessarilymeant to take the place of your own trading account. However, if it can increasean investor’s potential for success, why aren’t managed futures a part of more individual portfolios?The answer could be as simple as the fact that the majority of individual investors lack knowledge and basic understanding of this very specialized area. Ifyou understand how managed futures operate and become confident about thebenefits they can provide, it may be an area you will want to consider adding toyour portfolio.
WHY MANAGED FUTURES?So what can managed futures do for you? Table 4.1 summarizes some of the benefits and drawbacks of managed futures versus trading an individual account. InTABLE 4.1 Going It Alone versus Managed FuturesA beneﬁt for one person may be a drawback for another, so it’s difﬁcult to create a clearpro/con table comparing individual and managed futures accounts. Here are some of themain points distinguishing the two types of accounts. Also, keep in mind that managedaccount programs have their own differences with each other.Individual Trading
Managed Futures
Beneﬁts
You are in full control at alltimes.You can close the account atany time.You can adapt methods tovarious situations.There are no front-end oradministration fees; all proﬁts,if obtained, are yours.
Trading is done by CTA; set rulesmay govern trading in programs.Less day-to-day monitoring isrequired.Professional is in charge of yourtrading.Accounts often are more diversiﬁedand, thus, generally less volatile.Trading costs (software, research,etc.) are spread across many people,particularly for pools.
Drawbacks
You must have time to committo research and trading.No one is to blame for poorresults other than yourself.You have to pay for software,data, and so on yourself.
Some types, especially pools, setlimits on account withdrawals.Manager takes a percentage ofproﬁts, if obtained.
Source: Lind-Waldock.
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71
addition to benefits that futures can provide any investor, following are the majorbenefits of managed futures specifically.
Opportunity for Reduced Portfolio RiskNobel Prize-winning economist Dr. Harry Markowitz, creator of modern portfoliotheory, states that more efficient portfolios can be created by adding managed futures. Whether the CTA that you choose trades specialized markets or trades all ofthe markets, it is far more important to realize that these programs have beengood portfolio diversifiers historically because of their low correlation to conventional holdings of stocks and bonds.The Center for International Securities and Derivatives Markets (CISDM)2notes in a 2003 paper, “The Benefits of Managed Futures,” that CTA programshave often been regarded as high-risk investments. However, over the period1990–2002, the averaged annualized standard deviation of individual CTAs in theCISDM alternative investment database is, on average, lower than the averagedannualized standard deviation of the 30 individual firms in the Dow Jones Industrial Average (see Table 4.2).The CISDM goes on to state that investment theory has shown that the potential benefit of adding an asset to an existing portfolio may be measured by the increase of an existing portfolio’s Sharpe ratio (risk-adjusted rate of return) when amanaged asset is added to an existing portfolio investment (see Table 4.3).The Swiss Alternative Investment Strategies (SAIS) Group3 offers a biggerpicture of the attractiveness of managed futures investments in a portfolio in itsresearch paper, “A New Passive Futures Investment Strategy,” published in December 2002. This paper presents the new passive investment strategy in futures markets based on important economic functions of the actual makeup ofthe market players and what they provide to commercial hedgers in terms ofrisk management.
Potential for Enhanced Portfolio ReturnsThe potential for overall enhanced portfolio returns has been substantiated by awealth of data over the years, including a landmark study conducted by Dr. JohnLintner of Harvard University and reported in 1983.4 In his study, Dr. Lintner
2
The Center for International Securities and Derivatives Markets, Isenberg School of Management, University of Massachusetts, Amherst, MA 01003 (www.cisdm.org).3Swiss Alternative Investment Strategies (SAIS) Group AG, Baarerstrasse 12, CH-6300Zug, Switzerland (www.saisGroup.com).4John Lintner, “The Potential Role of Managed Commodity Financial Futures Accountsin Portfolios of Stocks and Bonds,” Annual Conference of Financial Analysts Federation,May 1983.
72TABLE 4.2 Beneﬁts of Managed Futures, Performance 1990–2002
Annualized ReturnAnnualized StDevSharpe RatioMinimum Monthly ReturnCorrelation with GSCI
Annualized ReturnAnnualized StDevSharpe RatioMinimum Monthly ReturnCorrelation with GSCI
GSCI
EACM 100
S&P 500
Lehman Gov./Corp. Bond
MSCI World
Lehman Global Bond
5.4%18.5%0.03–12.2%
12.9%4.3%1.89–4.4%0.16
9.7%15.3%0.32–14.5%–0.07
8.3%4.2%0.83–2.5%0.02
4.2%15.1%–0.04–13.4%–0.05
7.7%5.0%0.57–3.0%0.08
Portfolio IS&P 500& LehmanBond
Portfolio IIS&P 500,LehmanBond, &GSCI
Portfolio IIIS&P 500,LehmanBond, GSCI,& EACM 100
Portfolio IVMSCI World,Lehman Global
Portfolio VMSCI World,LehmanGlobal,& GSCI
Portfolio VIMSCI World, LehmanGlobal, GSCI, &EACM 100
9.3%8.2%0.55–6.3%–0.06
8.9%7.4%0.55–6.2%0.45
9.5%7.0%0.68–6.0%0.22
6.2%8.4%0.17–5.6%–0.02
6.4%7.6%0.21–5.7%0.47
7.0%7.1%0.31–5.5%0.25
Note:Portfolio I: 50% S&P 500 and 50% Lehman Gov./Corp. Bond.Portfolio II: 40% S&P 500, 40% Lehman Gov./Corp. Bond, and 20% GSCI.Portfolio III: 40% S&P 500, 40% Lehman Gov./Corp. Bond, 10% GSCI, and 10% EACM 100.Portfolio IV: 50% MSCI World and 50% Lehman Global Bond.Portfolio V: 40% MSCI World, 40% Lehman Global Bond, and 20% GSCI.Portfolio VI: 40% MSCI World, 40% Lehman Global Bond, 10% GSCI, and 10% EACM 100.Source: Center for International Securities and Derivatives Markets.
TABLE 4.3 Beneﬁts of Managed Futures, Factor Correlations 1990–2002
GSCIGSCI AgriculturalGSCI EnergyGSCI Industrial MetalsGSCI LivestockGSCI Non-EnergyGSCI Precious MetalsS&P 500Lehman Gov./Corp. BondEACM 100
S&P 500
LehmanBond
Change inCredit Spread(Baa–Aaa)
Changein VIX
Change inTerm Spread
Changein BondVolume
Changein StockVolume
UnexpectedInﬂation
–0.070.17–0.100.200.010.19–0.121.000.16
0.02–0.060.02–0.150.07–0.04–0.020.161.00
–0.060.04–0.06–0.22–0.01–0.040.12–0.13–0.06
0.00–0.200.04–0.14–0.04–0.220.01–0.66–0.04
0.01–0.030.030.11–0.010.020.10–0.03–0.64
–0.020.01–0.010.10–0.05–0.01–0.030.01–0.09
–0.11–0.01–0.07–0.11–0.01–0.08–0.09–0.28–0.04
0.29–0.340.320.29–0.01–0.090.29–0.21–0.26
0.41
0.15
–0.21
–0.22
–0.01
–0.17
–0.32
0.42
Note: Monthly charges in inﬂation beyond one standard deviation of the average are used to proxy for unexpected inﬂation.Source: Center for International Securities and Derivatives Markets.
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THE COMPLETE GUIDE TO FUTURES TRADING
wrote that “the combined portfolios of stocks and/or bonds after including judicious investments . . . in leveraged managed futures accounts show substantiallyless risk at every possible level of expected return than portfolios of stocks andbonds alone.”The SAIS Group’s report cited earlier credits the remarkable growth of totalassets committed to managed futures in recent years in large part to investor perception, as investors have grown to understand that their conventional portfolioswould probably not continue to produce the same level of returns as in the bullishdays of the stock market in the 1990s.It is worth mentioning here that in bear market years the low correlation ofmanaged futures to traditional portfolios of stocks and bonds can even becomenegative, thus providing the possibility of even greater enhanced overall portfolio returns.In addition to being an asset class with a low correlation to most other investments, managed futures bring added value with the CTA’s use of investment strategies based on the unique skill of the CTA or the unique properties of theunderlying systems available to the CTA. In this respect, investments in managedfutures have been described as absolute return strategies because the returns don