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Trading with "Imaginary Money"; Understanding Notional Funds
November 27, 2006
We touched on one of the main benefits of managed future and trading system investment in our newsletter last week explaining hedge funds, mentioning that an issue with hedge funds is the inability for investors to use notional funds when investing in them. But as my old history professor would say - 'that begs the question' - What are notional funds?
Notional funds, or notional funding, is in its simplest terms, the ability to use "imaginary money" to fund an investment in a CTA program or trading system investment. Whether there was some legal issue way back when, or whether the term "imaginary money" didn't sit well with most people - the term "notional funds" is commonly used in its place to describe this practice.
What do we mean by imaginary money. Well, a quick example is probably the easiest way to describe it. Say you have a CTA program which has a minimum investment amount of $1,000,000 in its disclosure document. An investor does not actually have to have all $1,000,000 in her account in order to trade the program. Levels of notional funding vary between managers, but for this example, we'll assume this hypothetical manager allows clients to use 50% notional funding.
That means the investor only has to have $500,000 in her account, and can meet the minimum investment amount by pledging an additional, "imaginary" amount of $500,000. The actual cash balance plus the "imaginary", or notional, balance equals the required minimum investment amount of $1,000,000. Another way to think of how this works is to imagine having that $500,000 account, but telling the manager to trade is as if it was $1,000,000. That is in effect what an investor is doing with notional funding.
If you're not asking "how in the heck can you use imaginary money" right about now - go ahead and ask it - because we're going to answer it.
To understand how an investor can use these imaginary, notional funds, we must first back up a step and understand how an advisor's minimum investment amount is arrived at. Minimum investments could, or perhaps should, be further split up into three distinct levels, specified as
- the technical minimum amount needed to actually place the trades on the exchanges
- the amount for an investor to withstand any eventual drawdown of the investment
- the amount to make the percentage returns fit into generally accepted levels
1. Technical Amount: The first part of the minimum investment amount - the amount technically needed to place trades - is what the exchanges and clearing firms refer to as the margin requirement. Any account which wishes to trade a futures contract on a regulated futures exchange like the Chicago Mercantile Exchange must first have enough money in the account to cover the performance bond requirement of the exchange (the margin) This insures that the exchange can make the trader who takes the other side of the trade good should the trade go against the account. Margins can sort of be thought of as the amount of money which could be lost on that position in a single day - and the exchanges and clearing firms make sure each account has that much money - or else the whole system doesn't work. If this wasn't in place, where would a winner get her winnings from - the loser could disappear.
2. Drawdown Amount: The second part of the minimum investment amount - the amount an investor needs to withstand any eventual drawdown - is another technical level of sorts, on that we must have at least that amount in order to stay above zero. If the investment has the possibility of losing $150,000, for example, in the normal course of operation - than an investor better have at least that amount in order to proceed. If they didn't, they would have to get out of the investment during the normal ups and downs of the investment. Think of it like a tank of gas. If your driving 100 miles and need 5 gallons of gas to get there - you better have at least 5 gallons of gas in the car - or else you'll never get there.
3. Window Dressing Amount: The third part of the minimum investment amount - the amount needed to make the percentages appealing to potential investors, or "window dressing" amount - is simply a subjective amount the advisor computes in order for the average returns and risk of his or her program to come out "nicely", for lack of a better term. Imagine an advisor with average annual returns of $100,000 and drawdowns of $50,000. If that advisor sets his minimum at $100,000 - the average annual return in percentage terms is 100% with a 50% drawdown; while if the advisor sets his minimum at $1,000,000 - the average annual return in percentage terms is 10% with a 5% drawdown. While the returns in dollars are exactly the same, the advisor may want to use the $1 Million minimum amount because he finds the 5% drawdown number catches peoples attention more. The difference between the desired minimum and the minimums needed for margin and drawdown is the window dressing amount, and it is often this amount which can be "notionallized".
If we look at Attain Portfolio Advisor's main CTA program, the Strategic Diversification program as an example, those levels would be:
|Technical Amount (Margin)||$150,000|
|Window Dressing Amount||$700,000|
|Total (minimum investment)||$1,000,000|
So, getting back to how you an use an imaginary, notional balance when investing in a CTA program - the answer lies in the "window dressing" amount defined above. It should be clear that an investor actually needs both the 'technical amount' for margins and 'drawdown amount' to stay alive, and that if that amount is truly there for little more than window dressing, we don't necessarily need it as an investor if we can realize and handle the larger percentage gains and losses.
Sophisticated investors who can handle having 3 to 4 times the percentage gains and losses ask what the margin to equity ratio is (a ratio of the technical margin requirement to minimum required capital) to back out the technical amount needed, than look at the worst max DD to come up with the bare bones minim um they need to invest in a program. The advisors also provide this number, however, in their D-Docs, defining what notional levels they will accept. Notional levels of funding usually range from 25% to 75%.
Now come the fun part. The cost of doing this is zero. There is no interest rate charged on the notional amount like you have in the stock market when buying shares on margin or when buying a house with less money down. One "cost" is that the fees charged by the manager are on the notional amount, not the cash balance in the account. So if the program you're participating in has a 2% management fee, that will balloon to an 8% annual fee if funding at just 25%. Likewise, commissions will have a much bigger impact on the account in percentage terms. The last negatives to consider are the mental anguish you may go through seeing percentage drawdowns 4 times those that are reported (but you're still losing the same amount of dollars) and the nervousness you may encounter when/if the a drawdown takes the account down to within a few hundred dollars of a margin call.
Leveraging your leverage:
A neat method several clients at Attain use to further leverage their leveraged, notionally funded CTA investments is to add new CTA programs, or additional allocations to the same CTA program, as they gain enough profits to cover the minimum technical amount to trade - the margin requirement.
Using the Attain program as an example again, suppose an investor who funds the account at 25% by depositing $250,000 to trade a notional account of $1 Million, gains $150,000 with the program. With an average margin requirement of about $150,000, that investor has now gained enough money to cover the technical bare bones minimum for that investment.
Once a manager has gained profits for an investor equal to their average margin to equity ratio - the investor is now playing with the house's money, so to speak. The gains allow the investment to "run by itself", and in doing so frees up the original capital outlay for another investment.
The downside of all of this is the possibility that an investor adds additional programs or allocations and spreads herself too thin, with the bare bones minimum amount allocated to several managers. If each of those managers goes into a drawdown at the same time, the outcome would likely be a margin call or two - leaving the investor with the unattractive choices of either investing more money or suspending the trading of one of the managers.
For more on the benefits and risks involved with notionally funding a CTA account, please call us at 800.311.1145 or email firstname.lastname@example.org
- Walter Gallwas
IMPORTANT RISK DISCLOSURE
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Feature | Week In Review: Mostly Slow during Holiday Weekend, but Currencies Pick up Steam: | Chart of the Week
US Stocks enjoyed a fairly quiet week of trading last week due to Thursday’s Thanksgiving holiday. Some stock traders (and most of the big players) take full advantage of the slow trading conditions by taking a week off work before heading into the last month of the year. Trading conditions were therefore slow and thin for the most part. SP futures closed out the week down 1.90 points while NASDAQ futures climb slightly higher gaining +0.74%. Smallcaps also finished in the red with Russell 2000 futures losing -0.90 points and SP Midcap 400 futures closing -2.04 points lower.
However foreign currency traders were able to pick up most of the slack left over by stock traders. As US investors enjoyed their Thanksgiving dinners on Thursday night the US Dollar was getting hammered by Asian and European traders. Speculation by European analysts that the US economy might not be as as it seems led to big gains for the Euro +2.10%, Swiss Franc +2.91%, and Japanese Yen +1.60%, while the US Dollar Index fell -1.98%.
Energies were also mixed with Natural Gas remaining volatile and losing -5.52% for the week. Most of the decline in prices in Natural Gas can be attributed to the warm temperatures seen across the US last week. Crude Oil trading was very choppy and there is a sense that we may have seen the near term bottom of the market as trading has been range bound for most of the past two weeks. For the week Crude Oil futures gained +0.45%, Heating Oil futures were unchanged, and RBOB Gas futures rallied +1.71% higher ahead of the big travel weekend.
Commodity trading was mixed for the week with several markets seeing robust trading conditions while others seemed to crawl the entire week. Grains were once again the biggest movers with Wheat futures climbing +5.06%, Corn futures were up +4.18%, and Soybean futures gaining +3.60%. The tropical markets were also with Coffee futures gaining +1.87%, Cotton futures gained +1.90%, while Sugar futures were up +1.06% for the week. In the meats Lean Hogs looked last week gaining +3.08%.
Last week was a lackluster week for most CTA’s as low volatility conditions and limited market ranges limited the opportunities. Such weeks are typically welcomed by the option selling strategies as the time value of teh options they sell depreciates daily. Last week was no exception as Zephyr brought their monthly return up to +2.36% in the Moderate program and +2.72% in the Aggressive, World Capital is now earning aprox 5%, and Zenith initiated several new December positions and is now ahead slightly for the month.
With today’s down move, we can expect to see several new positions in several of the above strategies. Outside of the index markets the energy markets Phoenix Energy gave back some of its prior week’s gains. The strategy is currently up aprox +2.23% for the month. Based on today’s new positions (long CL) the program will be looking for a short term rise is energies to start out this week’s activity.
***Day & Swing Trading***
The currencies are usually the domain of trend followers only, but swing trading investors were also able to profit from last week’s explosion in foreign currencies by being involved with Forex systems. SC Forex GBPUSD exited a long trade on Monday from the week prior and then wisely re-entered long two contracts ultimately reaching its profit objective by the end of the week. The system made +$4,030 for the week after a bumpy start to the month. Following a similar path, Delphi EURUSD rode a long position in the Euro to the profit objective which was good for +$2,440 on the closed out trade. The Pound and Euro continued to trend higher following the system exits so both will look for a correction for the downside to re-enter long or establish new short positions.
Swing systems trading stock index futures didn’t see the same kind of movement as the currency programs. As is often the case, a shortened week ahead of the holiday kept the stock market in check and did not offer much opportunity in the way of profits for swing traders. Swing systems are mostly long with Spartan ES, Seasonal ST ES/eRL and Tzar eRL all holding long positions while Tzar ES/NQ were short heading into the weekend. Long ES positions were down -$87.50 for the week while long eRL positions were down -$90 and vice versa for the shorts.
On the day trading front, systems that found the most success were those that stayed out of the market last week. Two exceptions were Rayo Plus which made +$212.62 on two trades in the Dax and Tanker CL which had one trade on Tuesday for +$200 in profits.
Moderate gains were posted in the interest rate sector during the past week as the bias continued to favor the upside on ideas of a cooling economy in the coming months keeping prices supported. The upcoming slate of economic reports next week did keep a cap on late week activity after scoring new near 1-year highs early, but with the market keeping a keen eye on the upcoming housing reports a new leg up might be in the offing. Long term systems continue to have an upside bias with long positions held by Andromeda +$3,790.63 (open trade), Vivaldi +$2,137.50 (open trade), Pegasus +$543.75 (open trade) and Trend Simplicity entering a new Long position with -$50.00 (open trade) in USZ. Axiom LT is Long TYZ with open trade equity of +$590.63 as is Pegasus with +$309.38 (open trade). Trend simplicity entered into a new long position with -$175.00 (open Trade). Aberration is long TUZ with open trade equity of -$125.00.
Major foreign currencies posted gains during the past week led by the Euro which rallied to highs not seen since June on ideas that interest rates in Europe will rise faster than those in the U.S. and Japan. Strength was also garnered by worries that the U.S. economy is nearing a slowdown phase. The move higher caused several long term systems to exit short positions. Aberration -$4,437.50 and Andromeda -262.50 were short SFZ and stopped out. Andromeda was also stopped out of the Short JYZ +$5,393.75. Systems with short positions in DXZ include Axiom LT +$1400.00 per contract (open trade) and Trend Simplicity +$1,280.00 per contract (open trade). Trend Simplicity is long ECZ with an open trade profit +$3,362.00 with Andromeda +$87.50 (open trade), Pegasus +$87.50 (open trade) and Vivaldi +$125.00 (open trade) aligning long during the past week.
The energy sector remained fixed in the sideways/ lower channel it has navigated for quite some time as the market continues to be burdened by heavy near-term supply and a lack of confidence the recent OPEC production cuts have in fact been followed. News of a possible change in U.S. weather to cooler temps for the coming week did keep the sector from heavy selling. Long term systems continue to have a downside bias with short Crude oil positions in Pegasus making $+17,820.00 per contract (open trade) and Trend Simplicity making +$16,260.00 (open trade). Systems with short mini-crude positions are Aberration making +$7,192.50 (open trade) and Vivaldi making $+2,005.00 (open trade).
Grains and Oilseeds posted gains last week on ideas the falling U.S. dollar would spark export demand as the rally pushed Corn and Wheat to 10-year highs. The grains continue to find support from world wide tightening of supplies as well, which has been very impressive considering the U.S. has just reaped corn and soybean crops within the top 3 production figures of all-time. Systems with long corn positions include Aberration making +$4,025.00 (open trade), Andromeda +$3,337.50 (open trade), Axiom LT +$4,962.50 (open trade), and Trend Simplicity +$3,225.00 (open trade). Vivaldi currently is long Soybeans making +$3,687.50 (open trade). Systems with short cotton positions are Andromeda +$1,695.00 (open trade), Axiom LT +$6,730.00 (open trade) and Vivaldi +$3,835.00 (open trade).
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IMPORTANT RISK DISCLOSURE
Futures based investments are often complex and can carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading losses are material points which can adversely affect investor returns.
Past performance is not necessarily indicative of future results. The performance data for the various Commodity Trading Advisor ("CTA") and Managed Forex programs listed above are compiled from various sources, including Barclay Hedge, Attain Capital Management, LLC's ("Attain") own estimates of performance based on account managed by advisors on its books, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.
The dollar based performance data for the various trading systems listed above represent the actual profits and losses achieved on a single contract basis in client accounts, and are inclusive of a $50 per round turn commission ($30 per e-mini contracts). Except where noted, the gains/losses are for closed out trades. The actual percentage gains/losses experienced by investors will vary depending on many factors, including, but not limited to: starting account balances, market behavior, the duration and extent of investor's participation (whether or not all signals are taken) in the specified system and money management techniques. Because of this, actual percentage gains/losses experienced by investors may be materially different than the percentage gains/losses as presented on this website.
Please read carefully the CFTC required disclaimer regarding hypothetical results below.
HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN; IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK OF ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL WHICH CAN ADVERSELY AFFECT TRADING RESULTS.