Managed futures carry a high degree of risk. Simply put, an equal possibility exists that large profits or large losses may be realized. This is due mainly to two major factors within the futures and commodities markets. The first factor that may affect profit or loss in a significant way is volatility. Volatility is a measure of price change within a certain period of time. Futures trading involving currencies commonly referred to as forex (foreign exchange) and commodities may experience dramatic and unexpected price fluctuations. Secondly, futures and commodities trading generally involve a high degree of leverage when compared to stocks or bonds. Leverage or margin allows a trader to purchase, sell or control more of the traded instrument with less money. Let's look at the following example of how leverage works in stocks and futures trading:
Effects of Leverage
- 10 shares of stock at $10 per share=$100 worth of stock
- Leverage for stock purchase is 3:1, so an investor needs to deposit $33.33 to buy the stock
- Stock moves $1 (up or down) results in a $10 (gain or loss): 10 shares x $1 = $10
- Your stock price changed by only 10%, but the gain or loss on your investment ($33.33) is 30%. That is due to the multiplier effect of leverage
Consider that futures leverage in the U.S can be as high as 50:1 and you can see how even small price movements can have a profound effect on an investor's profitability. Combine that leverage with volatility and you can begin to see how futures trading can be either very profitable or very costly. Using an appropriate amount of leverage and managing risk due to volatility is a critical aspect of a CTA's responsibility.
A determination must be made as to a particular investor´s suitability, the investor should be provided with all of the necessary information to make sure he or she understands both the risks and possible rewards of this type of investment. In addition to having the required risk capital, an investor needs to have realistic expectations about returns on investment and tolerance to drawdowns that may occur with managed futures products. The risk of loss always exists in futures trading no matter how skilled a trader an individual CTA may be.
There are several sites that offer investors access to well-organized databases of Managed futures programs, where you can rank performance, look at best and worst performances by a money manager and compare them to others. One company offering a database of more than 120 managed investments providers is IBTRADE (www.ibtrade.com). There are several company offering similar type databases, however, the IBTRADE CTA database is free.