Markets change personality depending on the underlying emotions guiding them. At any given time, every single market is doing one of three things: going up in response to greed, going down due to fear or moving sideways due to the lack of an overriding sense of either fear or greed. Since big, market-moving events don’t happen often, most markets move sideways most of the time.
Different trading styles work best with different market conditions. Trading techniques that work well in directional markets tend not to work in sideways markets. The reverse is true as well. This is why knowing a Commodity Trading Advisor’s trading style can be helpful when putting together a managed futures portfolio.
Commodity Trading Advisors (CTAs) can be grouped into four basic categories:
- Trend followers attempt to identify a market trend, trade in the direction of that trend, and then ride it as long as possible. Trend followers do best when the markets they trade are moving in one direction — either up or down. Most trend followers are “technical traders”, which means they rely mostly on charts and the movement of price itself to determine exit and entry levels. Many trend followers are systematic, which may mean trading signals are generated by a formula or computer algorithm.
- Trend faders try to identify market turns, switching bias at support and resistance levels. Trend faders tend do better in sideways markets – jumping in and out of markets as price chops sideways. Like trend followers, trend faders use charts, technical analysis and computer algorithms to generate their signals, but unlike trend followers, are monitoring markets not for trends — but for trend reversals.
- Fundamental / Discretionary traders make trades based on the supply and demand “fundamentals” of the markets they follow and may also incorporate some chart-based analysis as well. Discretionary traders rely more on experience and market knowledge than a systematic approach. They may use systems in their research but the decision to trade comes from the trader – not the system.
Fundamental traders base their trading decisions on supply and demand. Many CTAs specializing in agricultural markets are fundamental traders. Some of the more successful fundamental traders have a background in farming or ranching and have access to information not easily available to those outside the industry.
Fundamental traders are constantly monitoring crop conditions, import and export levels and the weather, among other factors.
Fundamental traders are trend followers when they believe directional price movement is supported by market supply/demand fundamentals, but they can also be trend faders if they think a market is too cheap or too expensive — buying into declines or selling into a rallies as a result.
- Option premium sellers attempt to capitalize on time decay. Options are “wasting assets” that lose value over time. Option sellers are like insurance companies. They are betting on the probability that they will get to keep the vast majority of the premiums they receive for selling options and hoping that the premiums they keep will be enough to cover any losses and generate a profit. Like insurance companies, premium sellers can be on the hook for big losses – especially during “Black Swan” market events.
Since most markets move sideways most of the time, the probability that a call or put with a strike price “out-of-the-money” will expire with no value is relatively high, so it is not surprising that selling option premium tends to work best in markets that are moving sideways or slowly.
Which of these four trading styles has the best overall success rate? It depends… All markets will be either rising, falling or moving sideways at some time during their respective lifecycles.
Successful CTAs make money over the long term no matter what their preferred style. What separates successful CTAs from the rest is not how good they are when the conditions of the markets match their style of trading, but how well these traders manage risk when their trading styles and market conditions don’t match.
That’s why it important to examine a CTA’s track record, paying special attention to the “drawdowns” or losing periods. All traders have losses. It is how these losses are managed that counts. CTA track records can be found in their “Disclosure Documents”, which are similar to stock prospectuses.
Some successful money managers have more losing trades than winning trades but keep the losers small enough in relation to the winners to be successful. This pattern is characteristic of trend followers and some fundamental / discretionary traders. Others have track records showing more (usually smaller) winning trades with a few bigger losing periods mixed in. This pattern is often characteristic of option premium sellers and some trend faders.
Mixing Different Trading Styles
When you add an individually managed futures account to your portfolio, you are not necessarily buying or selling a given market; you are investing in the talent of the money manager you have selected. CTAs with different styles make money under different market conditions. This is why it may make sense to consider building a portfolio of CTAs that employ different trading styles — perhaps matching a successful trend follower with a successful trend fader or combining both with a fundamental/discretionary trader. This can help smooth out overall performance over time.
Check with one of the managed account specialists here at the Rutsen Meier Belmont (RMB) Group and ask them to put together a sample portfolio of CTAs with complementary trading styles for you. Then track the real-time performance of this sample managed futures portfolio on our website, www.rmbgroup.com. This will help you can get a feel for how managed futures can help diversify your stock and bond holdings, without having to commit a single dollar upfront.
Call the RMB Group toll-free at 800-345-7026, direct at 312-373-4970 (country code 001) or send an email to email@example.com, tell us a little about your current investments and one of our managed account specialist will be happy to put together a sample managed futures portfolio for you.
Want to know more about individually managed futures? Click here to download our 30-page booklet, Opportunities Outside the Stock Market, which will teach you all the basics of this fast-growing asset class in an easy-to-read format. There is also a short companion video available as well.