Identifying the Risks Involved With Managed Futures Investing
With all the furor lately regarding Managed Futures programs investors more and more are assessing risk to determine the real prospect for portfolio growth and asset protection.
Paramount to this assessment is a real understanding of the factors that may not be immediately apparent but can be critically important.
The idea that futures investing, of any variety, can involve substantial risks should be ingrained in the minds of any investor considering the venture.
If your prospective broker does not give you an unbiased explanation of the risk involved along with his profit potential presentation hang up the phone!Run, don't walk!Avoid the guy.
He's probably not too honorable!While professionally managed futures money managers purport to approach commodity trading with an eye toward mitigating or minimizing the substantial risk involved, the risk is still very real and one should examine some very important factors to determine if the CTA has a proper approach both for the market(s) he intends to trade and for your own personal risk tolerance.
Just like trading in equities, futures investing is a speculative activity.
Depending on the markets traded and some other inherent factors the level of volatility can he quite high.
This can be one of those trick areas.
Some money managers seek to take advantage of periods of increased volatility.
Quite a few are quite good at it!Option sellers are principally volatility traders.
However, even option sellers can be victimized when volatility whipsaws or spikes inordinately due to influences beyond their understanding or control.
Among the factors that can greatly affect volatility are:
Governments have the capacity, and in some instances, the sovereign obligation, to influence prices.
Their action can be performed by direct action or investment or tacitly by regulation.
Such intervention can cause rapid spikes in price with resultant changes in the dynamics of the markets.
Commodity markets can be, at times, illiquid.
This illiquidity can prohibit entry or exit at desired prices, and can be attributable to a number of factors.
Certain conditions on the exchanges can precipitate preemptive closure or "time out".
Also, almost every market has a daily price move limitations.
In any given trading day if prices move either up or down to a certain set limit U.
S.
commodity exchanges will literally cease trading activity.
Absolutely no trades will be executed and the market will take a breather.
Certain markets have been known to lock limit for several consecutive days at a stretch.
Managed Futures money managers might not be able to favorable execute trades at desired prices if trading volume is small or non-existent.
Remember, commodity trading is "zero-sum".
There is always someone (either individual or entity) on the other side of every trade.
If there are no takers for what you're offering you're left with your offer.
This is especially true for options on futures.
For a CTA price execution is paramount.
He as an absolute obligation to give fair and equitable pricing for each participant in a particular program at all times.
In instances where the pricing can be the same for all he must make up the difference.
Options can also be subject to restriction if the underlying futures contract has been in any manner suspended.
Counterparty risk, while relevant, is not as big a factor as it once was.
This is truly a case where one must do in depth due diligence on the trader and the markets he intends to trade.
Counterparty risk occurs when a managed futures manager trades in an over-the-counter instrument or contract with an individual counterparty as opposed to on an open outcry exchange.
While it obviously can exist, in reality, most managers today, if for no other reason but increased liquidity, will limit their trading to the normal exchanges and vehicles therein.
It would serve well to read the CTA's federally required Disclosure Document carefully, paying special attention to any entries regarding "forward contracts".
In the past forward contract dealers have quoted especially wide spreads between bid and ask prices to limit movement or effect inordinately favorable conditions for themselves when few other options exists for unwitting traders.
Dealers have also outright refused to make markets or quote prices for forward contracts leaving holders in extremely adverse situations requiring them to liquidate at severe losses if not done with due haste.
It's a jungle out there! Leverage is the double-edged sword of commodity trading.
Successful managers employ varying degrees of leverage in numerous forms almost consistently.
But, leverage, improperly employed, could increase incurred losses by an order of magnitude.
Many brokers presenting individual, broker-assisted trading will almost always give you the upside of the leverage story.
The story can take on one of a few forms.
For example: A contract of Sugar is 112,000 pounds.
A one-cent move in your favor in the price of sugar can put $1120.
00 in your pocket for each contract you control.
(One cent (.
01) X 112,000 = $1120.
00) What the broker may carefully leave out is that that same leverage can work against you to the same degree (amount) or more!Obviously, that occurs if the contract price moves opposite your desired direction and you don't have exit order(s) or other protection mechanism in place.
Because most trading is done on margin an extremely high degree of leverage can be permitted with small deposit amounts in play.
Relatively small movements in price can amount to quite substantial gains or losses in the value of your investment.
Another mechanism of leverage that is occasionally employed but seldom fully understood is notional trading.
Notional trading (or, notional funding) is, in a nutshell, utilizing a degree of leverage to increase the actual trading value of an account.
Clear as mud, right?Well, in plain English notional funding is trading at a level that is over and above the amount of funding in your account.
It could at a rate that is doubled, tripled, quadrupled or even quintupled!Conceivably you could deposit $50,000 in a notionally funded account and the money manager will trade it as though it were $150,000 in a 3-to-1 notional arrangement.
The upside is that if the manager gets it right you'll enjoy three times the profit.
But, the other side is he can be three times as wrong with you account suffering three times the hit! There is a presumption that Managed Futures Managers will maintain better controls with respect to leverage.
Many tout eligibility to manage tax-qualified accounts (IRA's, 401k's, SEP's, KEOUGHS).
Part and parcel to this eligibility is proper risk controls with respect to margin and leverage.
In most instances money managers will never over-leverage your account with respect to trading volume and/or number of contracts traded.
As one of the most attractive features of Managed Futures investing is the absolute transparency, an account holder will be able to determine the level of leverage employed and the margin exposure at any given time.
Most enjoy 100% liquidity with no lock-down or redemption periods to assessment and exit are always available options if the levels are outside the managers stated aims or your risk tolerance parameters.
Finally, Managed Futures CTA's base their trading decisions on trends and/or technical analysis.
As there are many different styles and approaches to trading the types of analysis can vary significantly, with none being absolute.
To say that any one particular style or methodology is right or wrong would be egregious and irresponsible.
However, it is incumbent on a potential investor to get a proper understanding of what the particular manager's approach will be.
Also, assess what his performance has been over a period of time, especially during and immediately after periods of extreme market stress.
This can give you a better sense of the manager's ability to react to adversity and recover from loss.
My grandfather used to say, "It's not how many times you get knocked down but how many times you get up that bespeaks your character.
"And so it goes with Managed Futures CTA's! Investment in futures can involve substantial risk, and is not suitable for every investor.
Only truly risk capital should be used for futures investing.
Past performance is not necessarily indicative of future results.
Paramount to this assessment is a real understanding of the factors that may not be immediately apparent but can be critically important.
The idea that futures investing, of any variety, can involve substantial risks should be ingrained in the minds of any investor considering the venture.
If your prospective broker does not give you an unbiased explanation of the risk involved along with his profit potential presentation hang up the phone!Run, don't walk!Avoid the guy.
He's probably not too honorable!While professionally managed futures money managers purport to approach commodity trading with an eye toward mitigating or minimizing the substantial risk involved, the risk is still very real and one should examine some very important factors to determine if the CTA has a proper approach both for the market(s) he intends to trade and for your own personal risk tolerance.
Just like trading in equities, futures investing is a speculative activity.
Depending on the markets traded and some other inherent factors the level of volatility can he quite high.
This can be one of those trick areas.
Some money managers seek to take advantage of periods of increased volatility.
Quite a few are quite good at it!Option sellers are principally volatility traders.
However, even option sellers can be victimized when volatility whipsaws or spikes inordinately due to influences beyond their understanding or control.
Among the factors that can greatly affect volatility are:
- Central bank policy decisions both foreign and domestic
- Political or civil unrest
- Geopolitically ignominious events (i.
e.
terrorist attacks, etc.
) - Large scale national and international economic events
- Major change in climate and weather dynamics
- Trade policy changes or disruptions
- Fiscal, monetary or currency exchange rate changes
- Changes in interest rates, or sentiment thereon
- Changes in interrelated markets philosophies, emotions and pricing
Governments have the capacity, and in some instances, the sovereign obligation, to influence prices.
Their action can be performed by direct action or investment or tacitly by regulation.
Such intervention can cause rapid spikes in price with resultant changes in the dynamics of the markets.
Commodity markets can be, at times, illiquid.
This illiquidity can prohibit entry or exit at desired prices, and can be attributable to a number of factors.
Certain conditions on the exchanges can precipitate preemptive closure or "time out".
Also, almost every market has a daily price move limitations.
In any given trading day if prices move either up or down to a certain set limit U.
S.
commodity exchanges will literally cease trading activity.
Absolutely no trades will be executed and the market will take a breather.
Certain markets have been known to lock limit for several consecutive days at a stretch.
Managed Futures money managers might not be able to favorable execute trades at desired prices if trading volume is small or non-existent.
Remember, commodity trading is "zero-sum".
There is always someone (either individual or entity) on the other side of every trade.
If there are no takers for what you're offering you're left with your offer.
This is especially true for options on futures.
For a CTA price execution is paramount.
He as an absolute obligation to give fair and equitable pricing for each participant in a particular program at all times.
In instances where the pricing can be the same for all he must make up the difference.
Options can also be subject to restriction if the underlying futures contract has been in any manner suspended.
Counterparty risk, while relevant, is not as big a factor as it once was.
This is truly a case where one must do in depth due diligence on the trader and the markets he intends to trade.
Counterparty risk occurs when a managed futures manager trades in an over-the-counter instrument or contract with an individual counterparty as opposed to on an open outcry exchange.
While it obviously can exist, in reality, most managers today, if for no other reason but increased liquidity, will limit their trading to the normal exchanges and vehicles therein.
It would serve well to read the CTA's federally required Disclosure Document carefully, paying special attention to any entries regarding "forward contracts".
In the past forward contract dealers have quoted especially wide spreads between bid and ask prices to limit movement or effect inordinately favorable conditions for themselves when few other options exists for unwitting traders.
Dealers have also outright refused to make markets or quote prices for forward contracts leaving holders in extremely adverse situations requiring them to liquidate at severe losses if not done with due haste.
It's a jungle out there! Leverage is the double-edged sword of commodity trading.
Successful managers employ varying degrees of leverage in numerous forms almost consistently.
But, leverage, improperly employed, could increase incurred losses by an order of magnitude.
Many brokers presenting individual, broker-assisted trading will almost always give you the upside of the leverage story.
The story can take on one of a few forms.
For example: A contract of Sugar is 112,000 pounds.
A one-cent move in your favor in the price of sugar can put $1120.
00 in your pocket for each contract you control.
(One cent (.
01) X 112,000 = $1120.
00) What the broker may carefully leave out is that that same leverage can work against you to the same degree (amount) or more!Obviously, that occurs if the contract price moves opposite your desired direction and you don't have exit order(s) or other protection mechanism in place.
Because most trading is done on margin an extremely high degree of leverage can be permitted with small deposit amounts in play.
Relatively small movements in price can amount to quite substantial gains or losses in the value of your investment.
Another mechanism of leverage that is occasionally employed but seldom fully understood is notional trading.
Notional trading (or, notional funding) is, in a nutshell, utilizing a degree of leverage to increase the actual trading value of an account.
Clear as mud, right?Well, in plain English notional funding is trading at a level that is over and above the amount of funding in your account.
It could at a rate that is doubled, tripled, quadrupled or even quintupled!Conceivably you could deposit $50,000 in a notionally funded account and the money manager will trade it as though it were $150,000 in a 3-to-1 notional arrangement.
The upside is that if the manager gets it right you'll enjoy three times the profit.
But, the other side is he can be three times as wrong with you account suffering three times the hit! There is a presumption that Managed Futures Managers will maintain better controls with respect to leverage.
Many tout eligibility to manage tax-qualified accounts (IRA's, 401k's, SEP's, KEOUGHS).
Part and parcel to this eligibility is proper risk controls with respect to margin and leverage.
In most instances money managers will never over-leverage your account with respect to trading volume and/or number of contracts traded.
As one of the most attractive features of Managed Futures investing is the absolute transparency, an account holder will be able to determine the level of leverage employed and the margin exposure at any given time.
Most enjoy 100% liquidity with no lock-down or redemption periods to assessment and exit are always available options if the levels are outside the managers stated aims or your risk tolerance parameters.
Finally, Managed Futures CTA's base their trading decisions on trends and/or technical analysis.
As there are many different styles and approaches to trading the types of analysis can vary significantly, with none being absolute.
To say that any one particular style or methodology is right or wrong would be egregious and irresponsible.
However, it is incumbent on a potential investor to get a proper understanding of what the particular manager's approach will be.
Also, assess what his performance has been over a period of time, especially during and immediately after periods of extreme market stress.
This can give you a better sense of the manager's ability to react to adversity and recover from loss.
My grandfather used to say, "It's not how many times you get knocked down but how many times you get up that bespeaks your character.
"And so it goes with Managed Futures CTA's! Investment in futures can involve substantial risk, and is not suitable for every investor.
Only truly risk capital should be used for futures investing.
Past performance is not necessarily indicative of future results.
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