Chapter 17

Trading with a Plan Today So You Can Do It Again Tomorrow

In This Chapter

bullet Coming up with the cash to trade

bullet Choosing who you want to do the trading

bullet Selecting a CTA

bullet Bonding with a broker

In this chapter I help you decide whether you or someone else will do your trading, and I explain how you can go about setting up your trading infrastructure.

Deciding just who will do your trading is as important a decision as you can make because your success or failure, or how fast you get to your goals, can depend on how you decide to make your trades. Each side of the aisle has advantages and disadvantages, and much of deciding whether to trade for yourself or have someone do it for you depends on your personality, how much hand-holding you need, and what your expectations are.

If you decide to make your own trades, you must fully commit your time and efforts to the enterprise. In a very real sense, you’re starting a new business, and any casual notion you have that becoming a trader will be an easy, effortless road to riches is the way to disaster.

The decisions you make have a direct and usually quick bearing on how much money you make or lose while trading.

Financing Your Habit

The most difficult question that you must answer about trading has to do with where you’re going to get the money to trade futures.

A simple rule: If you have to borrow money, you shouldn’t trade futures or anything else. Money for trading needs to be money that you can afford to lose, period.

You may have to develop a savings plan over several years to finance your new endeavor. As a result, you may need to make changes in your spending habits, such as missing a vacation, driving a more modest car, or eating at less fancy restaurants.

Regardless of how you do it, the best way to trade futures is with your own money. When it’s your money that you’re trading, you’re more likely to be extremely careful about what you do with it.

Although most discount brokers enable you to open a self-managed futures trading account for $5,000, most Certified Trading Advisors (CTAs) require a minimum of $50,000, with the range usually being anywhere from $25,000 up to several million dollars. See the next section for more details about choosing a broker or CTA.

Deciding Who’s Going to Do the Trading

After you’ve made up your mind to trade futures, you need to decide who’s going to do the actual trading. The choice is pretty simple; either you or someone else will do it, but that also means you have to decide whether to use an advisor, a broker, or a managed account.

Choosing has its subtleties. Keep in mind that when a broker is doing your trading — depending on your agreement — he or she may have to call you and ask your permission to trade on your behalf. That can delay your ability to make short-term profits. Conversely, you may choose to give your broker full trading authority and discretion to make trades for you. If you do, then you have to abide by the results of the broker’s decisions, which means you may face some conflict down the line if your broker is either unscrupulous or not very talented.

A managed account is akin to a mutual fund. It is a pooled amount of money that is managed by an individual or a group. Those managers don’t have to ask for permission to trade your money because they trade the entire pool simultaneously, and shareholders make or lose money depending on the results of the pool’s trades and the number of shares they respectively hold.

The main advantage of letting someone else do the trading is that you can spend time finding out how to trade while your account grows, assuming that you find a good firm or broker to manage your account. The main disadvantage is that you have little control of your money. If you need control, you’ll probably be miserable.

Here are your basic trading options:

bullet Manage the account yourself based on your own analysis.

bullet Manage the account yourself based on advice from newsletters, publications, or even a broker.

bullet Have a CTA manage the account.

bullet Buy an interest in a limited-partnership pool managed by a professional CTA. Limited-partnership pools also are known as futures funds.

Other advantages of managed futures, either individual accounts or trading pools, are as follows:

bullet Good CTAs have more experience than novice traders and therefore have a better chance of making money.

bullet Trading pools have more money to invest than individuals and thus can establish better positions in the market.

bullet Trading pools can pay lower commissions when they trade and thus save you money on costs.

bullet Trading pools are structured as limited partnerships or LLCs, entities that limit your risk. They spread risk across all the partners, with the managing partner or the manager/management firm assuming the largest part of the risk. You’re liable only for losses or any required restitution for fraud and so on, and your liability is limited to the percentage of the partnership that you own. So if you own 2 percent of the shares, and the partnership goes belly up, you’re at risk of losing only an amount commensurate with what you put in.

Some managed futures funds guarantee the return of your initial investment if you remain with the fund for a set number of years. The disadvantages of that option are that your return from these funds may be lower, and you usually must hold the fund until maturity, so your money’s tied up in the fund, regardless of how well it’s doing.

The disadvantages of managed futures accounts are

bullet Higher fees, loss of control of your money, and the general illiquidity associated with them.

bullet The fact that you have to part with (or give up control of) your money for an extended period of time and be willing to weather some volatility during that holding period.

The Commodity Futures Trading Commission (CFTC) provides an excellent summary of what a CTA is and how the commodities trading system functions at www.cftc.gov/opa/backgrounder/opacpocta.htm.

Choosing a CTA

A CTA is a professional money manager who must register with the CFTC and undergo a rigorous FBI background check before being allowed to trade other people’s money. A knowledgeable CTA can manage your futures trades. You can find a CTA either through a broker or by subscribing to services such as Managed Accounts Reports (MAR; www.marhedge.com), which can become expensive.

Reviewing the CTA’s track record

After you get a few names of potential CTAs, review their disclosure documents, which by law have to present all their vital information and their track records. Track records (also by law) have to be presented in a way that is easy enough for you to understand, regardless of whether the advisor has made money. They include comparisons with benchmarks such as the S&P 500 and the Lehman Brothers Long-Term Government Bond Index.

The track record also has to show

bullet How much money was being managed

bullet How much money per month came from trading

bullet How much came from new deposits or was lost to withdrawals from the fund

bullet Amounts of fees charged by the fund

bullet Amounts of fees paid by the fund

bullet Earnings from interest

bullet Net return on investment after all fees and trading were taken into account

Be careful in how you look at the posted returns of CTA candidates. Here’s an example: Suppose you have two advisors, X and Y, and advisor X’s three years of returns are +10 percent, +40 percent, and –20 percent, while advisor Y’s returns for the same three years are +15 percent, +10 percent, and + percent. At first glance, you’re probably inclined to think that X is the better of the two, but if you do the math, you’ll see that if you gave them each $1,000, after three years, X would have $1,232, while Y would have $1,328.

Other CTA characteristics to watch for

Use this checklist to make your best choice of CTAs. Above all, make sure that you match the CTA to your risk tolerance.

bullet Check how long the CTA has been in business. The longer the advisor has been in business, the better he is likely to be, because he’s a survivor.

bullet Find the CTA’s largest drawdown or the biggest loss he’s ever had. The two important things to find out are how bad the loss was and how long it took the CTA to get the money back after the loss.

bullet Evaluate the returns of prospective CTAs based on risk. The CTA who has a lower return but took less risk may be a better choice because he or she is likely to provide more stable returns, and you may sleep better.

bullet Check out the stability of the business. Make sure that plenty of signs point to the CTA having a stable business and a stable methodology. Look for consistent, but not necessarily high, returns.

bullet Ask about risk management. Look for reasonable answers with regard to money management and risk aversion.

bullet Look for conflicts of interest. Is the CTA getting paid by certain brokers to use their services? Is that costing you money? What kind of fees is the CTA collecting from other sources as fees and commissions?

Considering a trading manager

Another possible suggestion is employing a trading manager or a middleman when you’re trying to choose a CTA. If you’re overwhelmed by the thought of having to plow through hundreds of documents while screening your list of potential CTAs, managed funds, and trading pools, a trading manager can act as an investment counselor, serving as an independent resource who can sift through the jungle of paperwork to help you evaluate CTAs, funds, and managers.

Trading managers collect a fee for doing your legwork, and they get a percentage of your profits, which turns out to be a good incentive for them to find someone who is good for your money. Large investors usually employ trading managers.

Choosing a Broker

If you decide to trade for yourself, you need to choose between a full-service broker and a discount broker. A full-service broker charges you a larger commission but is expected to provide you with good advice about your trades. Some also serve as middlemen between you and CTAs.

Be careful whenever you deal with brokers, CTAs, mutual funds, annuities, and so on because brokers and advisors sometimes earn large incentives for steering you in certain directions, regardless of whether taking those directions with your money is in your best interest.

Look for full access to the following when you open an account:

bullet All markets: Even if you’re interested in only a handful of markets right now, you may want to consider expanding your horizons in the future, so choosing a broker who can give you all the choices under one roof is best.

bullet Research: Some brokers offer discounts to newsletters and Web sites, while others offer direct access to their own research departments. Some offer live broadcasts from the trading pits.

bullet The full gamut of technical tools: You really want an opportunity to get as fancy with your trading as you want to in the future, including having the ability to run multiple real-time charts with oscillators and indicators and receive intermarket analysis.

bullet Intelligent software: Some brokers offer you access to software and charting packages that enable you to back test, or review, the results of your trading strategies and indicators.

bullet Forward testing your strategy: Nothing guarantees that you’ll match the results predicted by the software, but the ability to forward test your trading strategies is a nice tool to have. Back testing shows you how your trades would have worked based on historical data. Forward testing is based on the probability of certain conditions occurring in the future and is more related to how much money you’d make if certain things happened; however, it’s a useful tool only in hypothetical settings.

Follow these suggestions when boiling down your choices between brokers:

bullet Test more than one trading platform. Most brokers will offer you a trial of their software and trading platforms if you register on their Web sites.

bullet Make sure that the broker offers a 24-hour customer-service line. This line of communication is crucial if you decide to exit a position overnight in the face of events that are costing you money. If you have to wait until the morning, your losses can be larger than you’d expect. The 24-hour nature of futures trading is another reason to use stop-loss orders.

bullet Make sure that you have the choice of entering trades via the Internet or phone. If phone lines are busy and you have to make a trade, you want access. If your Internet connection and your backup connection are down, you’d like to have phone access to either check your positions or make trades.

bullet Check all potential trading fees before you sign up and make a trade. Check all fees, including whether all the trading bells and whistles are included in the commission or whether extra charges or conditions must be met, such as a minimum number of trades to qualify for certain services.

bullet Open an account with a well-known firm. Going with an established broker can be a good idea, at least when you’re getting started. If you try to save a few bucks with a smaller firm, you may be sorry later on, especially if you’re concerned about order execution, software glitches, and hidden fees. Large firms are not exempt from fraud but, because of their size, information about their practices is more readily available.

bullet Check for current trading scams: Look on the CFTC’s Web site (www.cftc.gov) under the “Consumer Protection” heading for current trading scams and for disciplinary actions taken against firms and brokers. You’ll find important bulletins and helpful Web links to important information about general rules and recent enforcement actions. On the National Futures Association’s (NFA) Web site (www.nfa.futures.org/basicnet), you can search for brokers, trading pools, and CTAs.

Falling in the pit of full service

Some of the same criteria that apply for choosing a CTA can be used for choosing a full-service broker (see the earlier sections on “Reviewing the CTA’s track record” and “Other CTA characteristics to watch for”). Especially important is whether you’re dealing with an experienced broker, who earns his or her keep.

With brokerage firms, many times you meet the lead guy once, but you never see him again. You’re left dealing with underlings, and that can be just like Russian roulette. If you get a good one, you’ll be mostly okay, if you can handle the larger fees. Much of the time, especially when you have a smaller account, you’re relegated to someone just starting out with the firm, and that may or may not be in your best interest.

Choosing a futures discount broker

Going the route of the discount broker may be a better alternative if you’re adventurous and do your homework, which includes practice trading in simulated accounts.

A large number of discount brokers operate in the futures markets, and you can find most of them by using your favorite search engine on the Internet or looking at advertisements in Futures, Active Trader, the Wall Street Journal, and other publications.

Aside from the important aspects, such as service in general, availability of 24-hour service, commissions, and ease of access to the trading desk, discount brokers offer online trading services. You want to make sure that the trading platform the discount broker provides is easy to use and that the orders you place online are executed in a reasonable amount of time.