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How much Capital is enough for your Managed Futures/System Portfolio?
November 26, 2007
You've done your research, and think you have found the right match of lowly correlated trading systems and CTAs to put in a portfolio. You're ready to begin trading, but now comes the hard part....deciding how much capital to allocate to that portfolio.
It seems this should be pretty straightforward, with each of the trading systems and CTAs you plan on investing in having minimum investment amounts. To arrive at a sum for a portfolio with 3 CTAs with $100K minimums and 2 trading systems with $50K minimums, you would merely sum the minimums and arrive at a total of $400K.
But if there is any diversification benefit at all, if there is any lowering of drawdowns by combining non correlated programs, and a smoothing of the equity curves as we desire from putting different programs together - won't the sum of all the minimums be too much? Wouldn't using the sum of the minimums possibly be an inefficient use of the capital? Couldn't a sophisticated investor utilize the "whole is greater than the sum of the parts" logic and invest based on the portfolio - not the components themselves?
That sophisticated investor sure could use some "whole is greater than the sum" logic, and in fact can find a starting equity amount which best matches his or her risk/reward tolerances. It doesn't make a lot of sense to most people that an investor can choose their own starting equity amount for a portfolio of futures investments, and the ability to do this is one of the unique features of a futures investment. .
How can you invest less than the minimum?
The ability to use less than the recommended minimum account size is a function of the margin amount needed to place trades, or what we refer to as the amount technically needed to place trades. In stock trading, or real estate, or just about any other investment, really - this doesn't exist. In those investments, the amount technically needed is the same as the minimum investment amount. You have to invest as much as it costs to invest. Sure, you can borrow money to invest (margin trades, mortgages, etc.) but between the borrowed amount and amount you put up - you have to cover the whole amount of the minimum.
It's different in futures investments, as in futures - the amount technically needed to place trades can differ (and usually does) from the minimum investment amount. This technical amount needed to place the trade 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.
So why do trading systems and CTAs have their minimum investment amounts set above this technical amount needed to trade. Two reasons - 1. the technical amount is roughly equal to the amount a position could lose in a single day, so a system or CTA needs more room than this to let trades work, not get stopped out, forced out, etc. They need to have more than the technical minimum on hand to withstand losing periods. 2. Systems and CTAs are in the business of attracting investors, and put their minimums at high enough levels where the drawdowns do not appear too large to the average investor.
Picking a capitalization level that's right for you:
In deciding on a starting capital amount for your portfolio of systems and CTAs, you will need to choose a capitalization level somewhere between the margin, or technically required amount (absolute minimum) and the sum of the minimums of each program (a maximum of sorts).
Of course, if you use the absolute minimum amount and only capitalize your account with just enough to meet the margin requirements, you will have no room for error whatsoever. The program(s) will not be able to suffer even one losing trade/day without you going on margin call. For this reason, the true absolute minimum for a trading system or CTA needs to include the maximum drawdown in addiution to the technically required amount (margin).
The maximum drawdown is the worst losing period the program has had in the past, and represents a sort of worst case sceario for investors, as that is the amount their account would have gone down before rebounding if they started at the exact worst time in the past.
So if you had started your new portfolio at a time when it goes straight into a drawdown, you of course would need enough capital to cover that drawdown, but you will also need enough money to cover the maximum amount of margin the portfolio could use, so that you are not forced to add money to continue the prorgam or stop the program by not having the technically required amount.
To insure you will be properly capitalized to endure the future drawdowns in your portfolio of systems and CTAs, you will need to find out a few numbers from the programs you intend to trade. You'll need to know the maximum margin use the programs could use, the average amount of margin used, and the past historical drawdown of the portfolio as a whole. And you'll need to convert each of those to a dollar figure.
The ideal level for each investor will depend on how conservative or aggressive that investor wants to be in terms of 1. the percentgae drawdown amount they can emotionally handle, and 2. the possibility and frequency of margin calls.
A Conservative and Aggressive Approach:
A more conservative funding approach is to take the sum of the estimated maximum margin use for each program in the portfolio, PLUS the maximum drawdown of the portfolio as a whole multiplied by 1.5 to 2. We use 1.5 to 2 times the max DD because we always expect the largest drawdown of a program to be in the future, and prudent modeling plans for that future event. We also look at the maxium margin used instead of the average margin, because in our experience - programs tend to see their maximum margin usage during new max drawdowns. This more conservative approach will lead to smaller drawdowns and few if any margin calls (as compared to the aggressive method following)
A more aggressive funding approach generates a starting capital amount by multiplying the estimated average margin use for the portfolio as a whole by 1.5 to 2 . This approach works best for investors working with multiple CTA’s that are not just statistically non correlated, but are also not using similar strategies. The different approaches make it very unlikely a market event which causes a margin spike for one program will do so for the others in the portfolio, while the multiplying of the average margin by 1.5 to 2 builds in a further cushion and acts as the DD componeent. Calculating the portfolio's average margin can be tough to do, at times, given the possibility of positions from one system or manager offsetting those of another (thereby reducing margin), and the sum of the average margin for each manager can by used without much of a sacrifice.
This aggressive approach will lead to higher drawdowns (in percentage terms), and will almost certainly lead to some margin calls which require you to add money to continue with the portfolio. For that reason, we would recommend the aggressive approach only to the most seasoned and professional of invetsors. It is extremely difficult to be in teh midst of a drawdown, and then have the guts to meet a mrgin call. Most investors simply stop tarding rather than meet the margin call for fear of the drawdown continuing, and unfortunately end up getting out at or near the bottom.
Please note that the aggressive formula does NOT work for all investors' portfolios, and in particular may be far too aggressive for short Index option selling investors as margins can spike aggressively in one day’s time. For portfolios with short option selling exposure, nearly full funding is recommended.
It is also important to note that we have italicized the word estimated above, to highlight that the margin numbers you get will always be only estimates. Margin use is a moving target with a lot of variables which can and do change (i.e. the exchange can increase margins overnight or how leveraged a CTA is today may not be indicative of how aggressive he will be in the future). .
Adding allocations when profitable:
The discussion above has centered on arriving at a starting capital level, but investors can revisit the capitalization level when and if they build up profits also. An aggressive method of compounding returns 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.
So, if a CTA you have on your watchlist trades with about $50K in margin on average, once your total portfolio has gained profits equal to that $50K amount, the investor can use those profits to add another allocation, as they will have the technical amount to trade covered by the profits, and won't have to deposit any additional funds.
In an ideal world, this can go on indefinitely, with new profits enabling new allocations, and so on to create exponential growth due to compounding. Aggressive investors who utilize this method try to maximize their margin use, and will monitor their margin excess regularly, making sure that amount never gets too big by adding allocations when they can.
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 how to properly capitalize your system/CTA portfolio please call us at 800.311.1145 or email firstname.lastname@example.org
IMPORTANT RISK DISCLOSURE
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US Stock Indices continued to decline last week as the markets absorbed more sub prime write offs from major banks around the world. Perhaps the saving grace for the markets was the shortened holiday week, that concluded with the traditionally bullish Friday after Thanksgiving trading day that saw SP futures climb +1.70%. For the week all the major indexes were down with SP futures falling -1.25% followed by NASDAQ futures at -1.11% and Dow futures at -1.55%. Smallcaps also traded lower with Russell 2000 futures (-1.55%) and SP Midcap 400 futures (-2.09%) finishing the week in the red.
The sub prime mess continued it’s assault on the US Dollar as well with the US Dollar Index futures losing -1.02% for the week as the Euro (+1.18%), Swiss Franc (+1.35%) and Japanese Yen (+2.22%) all traded higher against the greenback. US Bond yields also continued their free fall as most investors and analysts are expecting the Fed to cut the overnight lending rate again in December. For the week US bond futures were up +1.14% and 10 year note futures climbed +0.89%.
In commodity trading the energy markets continue to be the focal point of media around the world as Crude Oil futures trade near the historic high of $100 per barrel. Last week “black gold” futures were up +4.62% while RBOB Gas (+4.03%) and Heating Oil (+4.50%) moved higher as well. Natural Gas futures headed in the other direction losing -4.04% for the week.
Elsewhere in commodity trading, Metals continue to be very active with Gold (+4.79%), Silver (+1.53%) and Platinum (+1.88%) futures all trading higher while Copper (-5.30%) and Palladium (-1.21%) moved lower last week. In the grains Corn (+2.33%), Soybeans (+2.09%) and Wheat (+9.73%) futures all moved higher causing Lean Hogs (+4.01%) and Live Cattle (+0.82%) futures to trade higher as well. Finally Coffee futures were down -1.90% last week.
. ***Commodity Trading Advisors (CTAs)***
Despite the holiday, there was plenty of market activity to keep CTA’s on their toes last week. With most of the activity coming in the US stock indices many of the index options sellers were working to position and reposition their trades throughout the week. Now that the VIX is trading up near 28 (vs 10 earlier this year) we are seeing managers like Ace, Ascendant, Zenith, and others able to bring in more premium for their sold options - causing them to begin their December option cycles with a bang.
Elsewhere, FCI continues to be on the mend, and is setting up to push into the black for the month this week. They have had quite a comeback from their drawdown lows at the onset of the month.
On the flip side, the sell off in Coffee and the Dollar last week brough the Dighton program to a loss of about 10% for the month, which represents a 35% drawdown from their October equity high based on a fixed 100k investment. The last time Dighton hit a 35% drawdown, we suggested that some contrarian style investors get ivolved at the "lows" – and Dighton went on to new equity highs. While past performance is not indicative of future results, the time is now for another opportunity to jump on board with the program during a dip. Here is a link to the article we wrote back in September on the topic: http://www.attaincapital.com/alternatives/alt_sep1007.htm#Topic.
***Day & Swing Trading***
The shortened week due to the Thanksgiving holiday made for fairly slow trading conditions despite some increased volatility in stock and bond markets. Stocks were hit particularly hard on Wednesday ahead of the holiday but rebounded on Friday to limit the losses for the week. Bond markets continued to press higher and are now on pace to break two-year highs made in June of 2005. Swing systems that were short equities or long treasuries tacked on weekly gains while day trading systems underperformed as a whole due to several intraday reversals.
Starting with the swing systems, Signum TY and EBL were the top performers with gains of +$1,000 and +$976.80 respectively per contract. Both systems are holding long on half of their original positions after previously reaching profit targets. Tzar ES continues to hold short and tacked on +$912.50 in open trade equity. Ultramini ES had a similar gain of +$657.50 but on one closed out trade from Tuesday. Tzar NQ continues to hold short and added +$455 in open trade equity.
On the losing side, Ultramini YM lost -$695 on one losing trade from Tuesday but entered long on Fri and made back some of the losses in open trade equity. Seasonal ST ES and eRL continues to hold long and dropped -$912.50 and -$1,170 respectively but will look for a rebound in both markets. Mesa Notes has been hanging on to its short trade by a thread and is nearing a full stop-out as the Ten-Year Note continues to rally. Tzar eRL lost -$2,000 last week and finally bailed on its long trade at the end of the week.
BetaCon 4/1 ESX was the only day trading system to turn a profit with a gain of +$148.38. OPXP eRL had two near breakeven trades for a small loss of -$4.67. Compass SP had two trades for a small loss of -$137.50. Bounce eMD had one trade on Friday for a loss of -$211.15. RT Viper YM was active with four trades for a loss of -$360. Rayo Plus Dax lost -$679.48 while Waugh eRL lost -$1,023.34.
Major foreign currencies bullied the U.S. Dollar as the greenback again scored new historical lows in most cases. The Dollar continues to be dogged by the rally in inflation sensitive instruments like energies, metals and soft commodities with many either scoring or nearing highs not seen in the recent past. Long term trend followers continue to have a negative bias toward the U.S. Dollar as Aberration is currently short DXZ currently making +$4180.00 (open trade). Relativity booked profits in Short DXZ +$3640.00, but exited the Long ADZ losing -$800.00.
The strong uptrend in rate futures continued last week as the majority of the sector moved to levels not seen since 2005. Long term trend followers continue to have an upside bias as Aberration is currently long TYZ with a current gain of +$4171.00 (open trade). Aberration also entered into a Long Bund position recently with gains of +E450.00 (open trade)
Soft commodities were again a hot spot last week led by the alternative fuel aspirations in the grains/oilseeds which followed the energy market lead higher. Soybeans and the grain sector continued to find support from the ongoing rally in inflationary sectors like metals/energy. The sector also found support on news of possible crop problems in South America especially in the wheat were a hard frost in Argentina sparked ideas that a portion of their crop was in peril. The livestock and meat sector posted a turn around on news that China was interested in buying more U.S. pork with added support coming from the end of the year meat purchases in the U.S. by end users and retailers. Aberration is currently long BOF with a gain of $4234.00 (open trade), and long corn losing -$87.50 (open trade). Relativity is currently long SMH making $3510.00 (open trade), short LCG losing -$280.00 (open trade), and Long Jan Robusta coffee losing -$390.00 (open trade).
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.