ot depend on the long-term return in underlying traditional stock, bond, or currency markets.
Ability to Profit in Any Economic EnvironmentCTAs are positioned to take advantage of a myriad of economic situations in thefutures markets not only because of the mix of market participants but also because they have the ability to buy futures and/or options on futures when pricesare rising and to sell when prices are falling. Many CTA programs have the abilityto profit in flat to neutral markets by using various combinations of futures and/oroptions on futures.
Opportunity to Participate Easily in Global MarketsThe establishment of global futures markets and the accompanying increase intrader participation have provided the means for CTAs to diversify their programseven further. The relatively low cost of trading commodity futures and options andthe proliferation of mini-contracts in many market sectors have contributed to theenticing ease and potential for profit that these markets have to offer.
WHERE DO YOU START?The first challenge you face if you decide to put money into a managed futuresprogram is to find a program that fits your own personal risk/reward criteria. With
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more than 400 CTAs each offering different programs, that task can be daunting.This is where a brokerage firm with a division specializing in managed futures canprovide invaluable assistance to a client, not only in matching a managed futuresprogram to a client’s investment style but also in helping the client get into and outof the program and with everything else in between.Even though each CTA has a uniquely different method and style of trading,within the CTA universe there are only two broad categories of programs—systematic or discretionary.Systematic programs trade with a predetermined systematic trading modelthat has a rigid set of rules and rarely deviates from those rules. Most systematicprograms are trend-following. The system can be geared to long-term, intermediate-term, or short-term trading or any combination of the three.Discretionary programs may also be based on a predetermined systematictrading model. However, the operational word here is discretionary, meaning thatthe individual CTA has discretion as to how to interpret the data. DiscretionaryCTAs may also incorporate fundamental data and other information into theirtrading decisions.When you review a list of managed futures programs, you will find that severalsuccessful programs are closed to new investment or have minimums in the millions of dollars. Several other programs have peak-to-trough drawdowns that areabove 50 percent. Even though many of these volatile programs make money inthe long run, most participants find that kind of volatility too much to handle. Amanaged futures broker can help you sort out the trade-offs between potentialprofits and volatility.Of course, no matter how profitable the CTAs and their programs are, almostall programs experience volatility. Therefore, in addition to producing profits, another important quality that CTAs must possess is excellent risk-managementskills. Some programs automatically set a level of risk per position or per trade.When this level of risk is hit, then the unprofitable trade is closed out, if possible.Of course, having a predetermined guideline for each trade in no way guaranteesthe trader will or can exit at that point.The market is not going to cooperate with the trader or system all the time.This is when the sound risk-management skills of the CTAs that you choose comeinto play. Good risk-management skills will minimize your equity loss until themarkets do cooperate.Risk management is as important as rate of return. Experience has alsoshown that, to execute sound risk management, a CTA must have a very specificrisk-management plan, not just say something like, “My program handles different market situations in different ways; sometimes I use a stop-loss order andsometimes I use a market order.” No CTA is likely to fully disclose the actual trading techniques that have made a particular program successful, but that type ofresponse is not specific enough and may indicate that the CTA does not have anysolid risk-management plan in place.Although choosing a program that is at or near its average rate of return might
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seem like a good idea, that may not be the best choice. It is often much smarter toenter a program that is well off of its average highs. It is also smart to look for programs that have rates of return at least two times the highest peak-to-valley drawdown, discounting any huge drawdowns the program may have had when it begantrading. Many CTAs experience high volatility in starting a program and then makeadjustments to improve the program’s risk/reward parameters over time.Most CTAs manage their programs and client accounts full-time, so they andtheir programs are always searching for opportunities that the part-time tradermay never see.
EVALUATING TRADING PROGRAMSWhen researching managed futures, it is important to become familiar with somekey measurements that allow you to compare money managers. The best way todo this is to look at a typical performance report and interpret the data publishedfor each CTA (see Figure 4.1).
FIGURE 4.1 Meyer Capital Management performance report. The CTA Rankings Sitecontains performance information provided by Daniel B. Stark & Company, a third-partyprovider of CTA performance data. (Source: Lind-Waldock. Reprinted with permission ofDaniel B. Stark & Company, 619–702–1230.)
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Average Annual ReturnThe return on investment using the minimum account size of $1,000,000. Resultsare shown in both percentage and dollar returns, net of fees and commissions.
Maximum DrawdownThe maximum peak-to-trough decline during a specific period of the stated managed futures program, given in percent and in dollars. In this example, the figure isshown on a monthly basis, using only a month-end quote. Larger drawdownsmight have been experienced within the month.
Average MarginThe average amount of money used as margin on positions at any given time during the period of the track record, shown in both percent and dollars.
Maximum MarginThe maximum margin amount in dollar terms that this trader has used historically,quoted as a percentage of the minimum account size.
Avg Annual Ret/Avg MarginA ratio that compares the average annual return to the average margin figures.
Return/Max DrawA ratio that compares the rate of return to the maximum loss, calculated in thesame way as the preceding ratio of annual return to margin. Investors use this asone means of comparing a CTA with other CTAs.
Trades/Million/YrApproximate number of round-turn trades in a managed futures program based ona $1,000,000 account. For example, if the number of round-turn trades per millionwere 1,000 per year and your account size were $100,000, then the average numberof round-turn trades based on historical data would be 100 per year.
Management FeeA fixed fee that a CTA charges investors for its services. This percentage is basedon the assets of the account. If your assets are $100,000 and the management fee is
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2 percent, then you will pay $2,000 a year to the trader for handling your account.This fee is usually charged in quarterly installments.
Incentive FeeA type of fee expressed in percentage terms rewarding CTAs for profitable performance. This fee is based on new profits only for gains above the last high-watermark for the life of the account. Again, it is usually charged on a quarterly basis.
Technical %Percentage of trades on average conducted in a managed futures program basedon preset parameters. The system generates the trades and, therefore, eliminatesany emotion from the trading.
Discretionary %Percentage of trades conducted in a managed futures program based on the CTA’sdiscretionary analysis.
Futures %Average percentage of managed futures account traded in futures, which arefinancial instruments or physical commodities for future delivery on a futuresexchange.
Interbank %Percentage of managed account traded in the interbank cash currency marketsand not on an exchange.
Annual Sharpe RatioA ratio that represents a rate of return adjusted for risk. It also considers standarddeviation, which is the distance of observations from the mean or average. Thismeasure is often expressed as a percentage on an annualized basis.Annual rate of return – Risk-free rate of returnAnnualized standard deviationIt is important when investing to take the CTA’s Sharpe ratio and compare it toother relevant investment benchmarks such as cash. The Sharpe ratio gives the expected added return per unit of added risk. It is a convenient summary of two im-
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portant aspects of any strategy involving the difference between the return of aninvestment and that of a relevant benchmark (usually cash).Although the Sharpe ratio is a common measure often used to compare CTAperformance, it does not take into consideration correlation. It would be prudentto also do some correlation analysis relative to your other investments and toother managed futures accounts you may have.
Annual Standard DeviationA measure of the distribution of a set of data from its average and/or mean on anannual basis. The more spread apart the data is, the higher the deviation.
% of Positive MonthsPercentage of months where the value of the managed futures account wasgreater in market value than the previous month’s value. This is not as importantas many of the other statistics because a CTA may have a very acceptable annualrate of return, yet be profitable in very few months.
Monthly PerformanceA series of percentage figures that reflect how much the value of the CTA’s managed futures accounts changed from their previous month-end balance. This isbased on a composite of all accounts traded by the CTA, so any one particular account may be slightly different than the composite.
Notional Funding on Account SizeMany clients notionally fund their managed accounts to some degree. The grid onthe Meyer Capital Management profile illustrates the annual return and maximumdrawdown based on the percentage of the minimum account size that is depositedin cash. Notionally funding the account can increase the probability of receiving amargin call for additional funds. However, for clients with a higher risk tolerance,this allows them a more efficient use of their investment capital.
Largest Drawdowns and Recovery PeriodThis series shows the largest percentage drawdowns the CTA has suffered duringthe period of analysis, how many months it took to go from peak to trough, andhow many months it took the account to accumulate profits to recover from thetrough back to the previous peak. These figures provide a test of your willingnessto stick with the CTA’s program—how many down months in a row could you handle, especially at the beginning of your trading program? This gives you an idea ofwhat you might have to endure, based on historical data.
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INVESTING IN MANAGED FUTURESInvesting in managed futures is done in one of two ways:1. Opening an individual managed futures account, where the power of attorney
is given to the CTA to trade the money.2. Participating in a pooled account, which is very similar in concept to a mutual
fund in that money from a number of investors is placed into one accountmanaged by the CTA. Some funds require the investor to meet certain established financial criteria in order to invest in the fund.Either account can be opened through a futures commission merchant (FCM).CTAs do not hold money for individual accounts, and funds are placed with anFCM for each account.Table 4.4 compares some features of the two ways clients can be involved ina managed futures program. Comparing the two investment options, individualaccounts are much more liquid than pools, giving investors the ability to canceltheir account at any point and have their money returned within a few days. Onedisadvantage with pooled accounts is that investors are generally required to stayin the fund a certain minimum amount of time and after that period can liquidateonly monthly.If you open a managed account, you have full transparency of what is happening in the account. Each investor is notified of every trade. A monthly statementfrom the FCM is also sent to investors, and many offer the ability to view the accounts online in real-time format. Pools do not offer this transparency of trading.
TABLE 4.4 Managed Accounts versus PoolsBoth types of accounts offer some of the same beneﬁts compared to trading an individual account onyour own, such as having a professional trade and manage your money. Here are a few distinguishingcharacteristics of these two types of accounts.Managed Account
Pooled Account
Beneﬁts
You can close the account at anytime.There is full transparency in trading;you are notiﬁed about every trade.Current statements are available,often real-time online.
Smaller initial investments areavailable.Risk is clearly deﬁned by the amount ofcapital invested.Diversiﬁcation is obtained if funds areallocated to a number of CTAs.
Drawbacks
Usually a sizable amount of moneyis required to open an account.You may be at risk for more thanthe amount of the initial account.
Often there are limitations on accountwithdrawals.There is no transparency in trading; youget only one ﬁgure every month.
Source: Lind-Waldock.
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Investors receive a monthly statement giving a summary of trading and the netasset value of each share purchased. You will not be able to view the trading of theCTA (or CTAs) involved in the fund.When investors place their money in a pooled account, the money is commingled with other investors’ money and managed by the CTA. The first major advantage of this type of account is that the investor can enter the pool with asignificantly lower amount of money than most CTAs’ minimum account size. Asecond advantage of a fund is that the risk is defined by the amount of overall capital invested. Third, many funds allocate the money to various CTAs so that youare, in effect, not only getting diversified into a number of markets but also are getting a portfolio of CTAs for a relatively small investment.
Managed Futures Account CostsA CTA is compensated in one of two ways. The first is a small management fee,typically 1 to 2 percent of total assets under management. The second way is a performance-based fee that rewards CTAs if they achieve positive returns on theoverall performance of the managed futures program. An FCM is compensated bya specified commission on each trade executed by the CTA for every client account. Also, an FCM may share fees with CTAs. If this is the case, it is disclosed inthe CTA’s disclosure document.
CHAPTER 5
Using anAuto-ExecutingTrading System
Y
ou may have heard the expression, “a nice place to visit but I wouldn’t wantto live there.” You might have a similar impression of futures at this point—agreat idea but you wouldn’t want to trade them yourself.After reading the previous chapters and recognizing that trading successfullyrequires considerable effort, you may be about to conclude that you don’t have thetime . . . or the knowledge . . . or the trading skills . . . or the personality . . . or youhave some other shortcoming that might keep you from venturing into futures. Butyou can still participate in the futures markets and reap the potential benefits bytapping the expertise of experienced traders who have already worked through allthose issues and have developed methods that can help you.One of the emphases in the previous chapters has been having a trading plan before you enter a trade. This plan should be a well-thought-out approach that takesinto account not only when and how to get into or out of a position but also theamount of risk you’ll accept, the size of the position you should be trading, when toincrease or diminish your position, and every other detail of every trade you make.However, you may not have a trading plan or the time and resources to do theresearch to develop one, much less trade it. A solution could be purchasing orleasing a trading system that already has a record of actual trading and can provide you with the trading signals that you don’t have time to discover yourself.However, as you continue reading, you must remember that a trading system doesnot eliminate the risk of loss from futures trading.
WHY AN AUTO-EXECUTING TRADING SYSTEM?A turnkey trading system lets you skip many of the steps it would probably taketo develop your own trading method. Having a broker automatically execute a83
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trading program puts you into the market quickly with a tested approach to trading and may be a good addition to your portfolio, even if you already have a futures trading account. Here are some reasons why you might want to considerbuying or leasing a trading system.
Developed by Professional TradersSuccessful systems usually are offered by traders who have years of experiencewith the market. Although you can learn the basics of futures trading ratherquickly, it might take you years of trading to discover all of the parameters andthe details that go into building a successful system. By the time you finally findone that does work—if you ever reach that point—you may have devoted notonly hours of research but also thousands of dollars to systems that didn’t perform well.
May Save on Costs of TradingYou usually do have to pay a one-time charge up front or an ongoing fee for tradingsystem software, so there is some additional expense to use someone else’s system. But, depending on the type of system you get, you may not have to pay for adata feed, analytical software, programming fees, or some of the other costlyitems that most traders need in order to develop their own trading method. Youalso may not have to pay management fees or incentive fees associated with amanaged account arrangement. And, theoretically at least, the added benefits youreceive from trading a program, over and above what you could do on your own,should help pay for the system.
May Reduce ErrorsA broker usually has multiple, redundant data feeds that can catch errors inprice quotes and prevent a system trading on your behalf from taking a positionon a faulty signal. As an individual trader trading your own account, you morethan likely will have only one data feed. If your vendor transmits an erroneousprice quote, it could trigger an entry signal that gets you into an unwanted position or an exit signal that takes you out of a favorable position before a correction is made.
Eliminates EmotionOne of the main reasons traders lose money is not because they don’t know howto trade or don’t have a sound trading method but because they let emotions takecontrol of their trading. A mechanical trading system completely takes away theemotional aspect of trading and eliminates those decisions that may be inspiredby fear or greed. It follows precise trading rules without second-guessing itself or
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deciding that a price move is impossible. When it gets a signal, it makes the trade.This style of trading may take some of the excitement out of trading, but yourgoal should be making money and not producing excitement, anyway.
ConsistencyBy taking all trading signals, a trading system provides a consistent approach totrading rather than an erratic trade selection process where you try to pick andchoose which signals you’ll take—or not take.
Risk ManagementBy definition, a trading system usually includes some stringent limits about howmuch risk to accept and what should happen when the risk parameters arereached. This should be part of everyone’s trading plan, but traders without a system sometimes let a bad trade go because they “know a market will come back.” Asystem employing rigid risk-management provisions won’t let one big losing tradejeopardize an account.
Supplements Your Own Trading DecisionsEven if you already know how to trade futures and have an active account, buying or leasing a trading system can be a smart move. The most convincing evidence is that even some professional traders place some of their money withother systems or with other money managers. Whatever type of system you get,you now have a second opinion about a potential trade you want to make. Someone else’s system may give you more confidence to make the trades that yourown system is signaling when you know the other system has performed well inthe past with similar signals.
DiversificationAs suggested in the previous item, a trading system you purchase may even be thebasis for a separate account that provides diversification to your portfolio—different markets, different methods, different time frames. The system may provideyou with something you might never be able to do on your own.
LOOK AT YOURSELF FIRSTMany of the issues related to selecting a trading system come back to who you areand what your goals as a trader are. Dozens of trading systems and advisory services are being offered today. If you decide to use a system, your challenge is to
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find one that fits what you want to accomplish. Here are some questions you mightask yourself:• Will you be able to evaluate the various trading systems yourself, or will youneed assistance to help you make the right choice for you?• How much risk tolerance do you have? Are you a nervous Nellie or a laid-backLarry? Can you live with the size of drawdowns the trading system has experienced in the past?• Do you want to be aggressive or conservative as an investor? It’s not unlikechoosing a mutual fund for growth or income or for some other goal. You haveto go with a style you like.• How much money will you be trading with the system? It won’t do much goodto look at systems that trade a broad array of markets or a large number ofcontracts per trade if you have only a small amount of money to trade, because you won’t be able to take advantage of the benefits of diversification orsize in those kinds of systems.• What time frame are you comfortable trading—short-term, intermediate-term,or long-term? The shorter the term, the more trades and the smaller return pertrade you will usually have. You need to realize how many trades you mightexpect to see in your account in a given time period so you aren’t surprised bythe amount of trading activity.
WHAT TO LOOK FOR IN A TRADING SYSTEMOnce you have an idea what you will bring to a trading system, it’s time to beginscrutinizing the systems themselves. Many of the things you should evaluate in asystem are the same things you would look for if you were selecting a managed futures account, as you will note by comparing the performance report for theTrendchannel system in Figure 5.1 with the report on managed futures accountsexplained in Chapter 4. Rather than duplicating explanations of all the details on aperformance report, we’ll refer you to the managed futures account chapter formuch of that information.However, there are some definite differences between selecting a managed futures account and a trading system. With a managed account, a professionalmoney manager trades your money, and you pay a management fee based on assets under management, an incentive fee based on the amount of profits, if any,that the manager produces, and commissions. With a trading system, you pay forthe system, either outright or on a monthly lease basis, and then pay the brokercommissions for making the trades automatically based on the system’s signals.The net profits, if any, from the trading system you select are all yours.You won’t get a disclosure document with a trading system, as you generallyget if you choose a registered commodity trading advisor to manage your futures
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FIGURE 5.1 Trendchannel CapitalFlow track record demonstrates this system’sperformance as of a particular point in time. (Source: John Tolan, Trendchanneldeveloper; reprinted with permission of Trendchannel.)
account. However, just as in selecting a commodity trading advisor, you shouldask to see key numbers such as net return, drawdowns, number of trades, percentage of winning trades, Sharpe ratios, and so on when picking a trading system. Youshould study the system’s trade-by-trade track record carefully and ask some ofthese questions:• Is the performance based on hypothetical results or actual trading results?There may be quite a difference between the two, just as there can be betweenpaper trading and real trading.• What data was used to produce the trading results? Was a separate set ofout-of-sample data used to produce the system’s results after the systemwas developed on another set of data?• How volatile are the system’s results? Is the equity curve a relatively smoothline moving ever higher, or is it a choppy path higher with sharp gains andlosses from one month to the next?• How large are the drawdowns from peak to valley, not only in dollars butalso in time? A system should have guidelines about what to do in the event
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of dollar losses, but what about time? Can you live with a system that maybe losing money for several months in a row, based on its historical record?• What markets does the system trade? Is the track record based on the samemarkets you want to trade, or does it include results from big moves in thinlytraded markets chosen after the trading had occurred? You may want a welldiversified portfolio but not one that includes illiquid markets.• Do the system’s parameters do well in all markets, or are different parametersapplied to each market?• Have the system’s parameters been overoptimized and curve-fitted in an effortto show the best results? If the performance of a system with a moving average for 10 periods is significantly different from that of the same system with amoving average for nine periods, you may have an overoptimized system. Or ifa system with a $500 stop shows much different returns than the same systemwith a $600 stop, it may be overoptimized. Ask the developer for results of thesystem’s signals applied over a range of parameters to see if the performanceis consistent.• What time period does the track record cover? Selectively choosing a timeperiod after the trading has occurred may be one of the most misleading factors in a system’s track record. Starting at a point right after the systemwould have made a bad trade—or ending the trading period right before abad trade—may not provide a true picture of what the system will do in actual trading in the future. A track record based on the bullish trends of thestock market of the late 1990s may look much different than the track recordduring the sideways market a couple of years later. Look carefully at the timeperiod of the track record.• How far back does the system’s track record go, both in terms of time andin number of trades? Is that enough statistically to give a good feel for whatcould happen in the future?• Does the track record include all trades for a period? Or does it overlook a selected bad trade or two that might skew the results? Ask for a system’s tradeby-trade listing and then compare the list with a price chart. If it seems that atrade should have been on the list based on the system’s rules but is not, findout why the developer excluded it.• Is much of the system’s profit for a given period based on one or two big winning trades? If one trade accounts for most of the system’s gains, think abouthow the system would have performed if you had missed that one trade.
WHY “SUCCESSFUL” SYSTEMS MAY FAILA system that performs admirably on past data may not do so well in the future. Itmay not have anything to do with the system’s design, although much of the blamecan probably be placed on overoptimization or on presenting the results for only
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those periods when the system did well. And, as you might expect, some tradingsystem performance results may sound appealing but may be misrepresented toentice traders to buy the system.Still, even the best systems may fail over the longer run. Here are some reasons why:• The current market environment may be different than when the system wasdeveloped or when the track record was compiled. However well the system’sparameters may have done in the past, the current price action may not be agood fit for those parameters.• Some of the most profitable systems may also produce the most volatile results. Traders may not be able to take the drawdowns, either in dollars or inlength of time, and they give up—more than likely, when system performanceis at a low point and just before it turns upward.• Where traders have control over the system’s trades, they may cherry-pick thesignals they want, sometimes leading to disastrous trades, while ignoring signalsthat turn out to be the biggest winning trades. Letting a broker automatically execute the system’s signals takes you out of the emotional decision-making loopand increases your odds for success—assuming, of course, you have sufficientfunds to trade the system as it was designed to be traded.
SUMMING UP SYSTEMSThe system-assisted approach to trading is a viable and cost-effective way to participate in trading futures. Programs have been created for a wide variety of markets and time frames. Whether you are a seasoned trader or a green newcomer tofutures, there is a trading program that will complement your existing strategy orhelp you get started trading.
CHAPTER 6
Resources forthe Self-DirectedTrader
I
f you decide to be a self-directed trader making your own trading decisions andentering your own orders, you undoubtedly will need to rely on some resourcesto help you in that process.What you need and where you will get it depends to a great extent on the typeof trader you want to be, the trading style you believe will be most suited to yourpersonality, and the amount of money and time you have to devote to trading.Do you want to be a day trader, moving in and out of positions intraday andwinding up with no positions overnight? Or would you prefer to be a longer-termtrader, taking positions that you might hold for days or weeks in an attempt tocatch bigger price moves? Would you be most comfortable trading spreads? Orwould you be better off in the options on futures market?Whatever type of trader you choose to be will have some bearing on the resources you need. Years ago all you might have needed to trade was a phone andan idea, but the resources you almost certainly need in today’s trading include apersonal computer and an Internet connection to link you to the marketplace—plus the plain old telephone service of the past as a backup. Beyond that, you maybe able to get everything you need from a brokerage firm. Or you may want to supplement what a brokerage firm offers by subscribing to some of the many specialized services available, especially if you are looking for a particular type ofanalysis offered by a software program or an advisory service.
BROKERAGE FIRM CHOICEEven if you plan to handle all of your trading details yourself, you still have to gothrough a brokerage firm to execute your trades. Selecting a broker is covered in91
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Chapter 3 of this book, but because the brokerage firm is such an important resource for your trading, there are several overall matters you should consider before making this choice.
Operations SupportTrading online is great, but sometimes you do need to speak with someone whenplacing an order or checking a balance or just trying to find an answer to a question. The resources a firm offers may be great, but they won’t do you much good ifyou can’t access them when you need them the most.Find out how much staff a firm employs in its client call center operations.Will you always be speaking with the same dedicated team of people or will you beshuffled around to someone new each time you call? Also, ask if the call center isopen 24 hours a day during the trading week and what type of assistance you canexpect from the center’s professionals.Does the firm have redundant facilities in place in case there is some disruption in its connections to exchanges or in its ability to communicate withyou?
Product OfferingMany people come to realize that an investment in futures can form an importantpart of their overall investment portfolio. However, some just don’t have the time,experience, or inclination to trade the markets on their own. Many also realizethat they like both the hands-on and hands-off approach to investing in futuresand opt for multiple accounts.Your firm should offer a full range of services in case you decide to shift or addto your style of trading. It should include a managed accounts division, whichdeals with professional futures managers; an auto-execute division, which can access systems where trading signals can be executed automatically; and a brokerassisted division that can match you with a broker who helps you when you haveyour own ideas but wish to work with a professional to assist in implementingyour trading plan.In trading, nothing beats experience, and these divisions can put that experience to work on your behalf.
Accurate AccountingYou may be focused on trading, but you should also expect all of your trading results to be recorded quickly and accurately and reported to you in a timely manner. You will want to monitor the status of your account daily, and your statementsare your scorecard that reflects how you are doing.
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TRADING PLATFORMSelecting the firm and a trading platform is an important decision because youmay find that the broker’s trading platform includes most of the features youneed