A 2X program happens when a customer wants to double his position size, but he doesn’t want to increase his trading level. Listen to this episode to find out why this kind of customization presents profitability problems for CTAs, and how to give your customer the increased exposure he wants without experiencing these problems.
Welcome to The Profitable CTA, the only podcast that helps commodity trading advisors grow their businesses and boost their bottom lines. I’m Kelly Hollingsworth and I’m very glad you’re here because CTA profitability is suffering, and in this show we talk about how to fix that.
In every episode, we discuss a common problem that undermines CTA profitability, and the problem for today is 2X Programs. The first thing we’ll discuss today is, how things typically go in CTA programs. Then we’ll talk about exactly what is a 2X program? How is it different? And then we’ll discuss how 2X programs harm CTA profitability. And how to give your customer double exposure they want, without suffering the ill effects that typically arise with 2X programs.
Typically, all CTA accounts are traded at the same margin-to-equity ratio
When CTAs offer a trading program, they know the position size they will take in an account of a certain size. Let’s say they’re trading an account with a $100,000 trading level, and they’ve decided that in an account of that size, they will trade 1 contract.
If the margin on the contract is $10,000, we say that this CTA employs a 10% margin-to-equity ratio. Notice that the margin-to-equity ratio is always based on the trading level of the account, not on the actual equity in the account. In other words, not on the cash in the account. If this account with a $100,000 trading level had only $20,000 cash in it, it would still have a margin-to-equity ratio of 10% (that’s $10,000 in margin divided by the $100,000 trading level). It would not be called a margin-to-equity ratio of 50%, meaning $10,000 in margin over the $20,000 in cash. The customer could think of it that way if he wanted to, but the CTA wouldn’t think of it that way.
A very important thing for CTAs to do is trade every account within the same trading program at the same margin-to-equity ratio. If the CTA in this example has three customers, each with a $100,000 account, meaning, each with an account having a $100,000 trading level, each customer would get a single contract. This is true no matter how much cash is in each customer’s account. If one customer has zero cash, and one customer has $20,000 cash, and one customer has $50,000 cash, but they all have $100,000 trading levels, each customer will get one contract, because this CTA has determined to trade at a 10% margin-to-equity ratio.
Why does this matter to CTAs? Why do CTAs operate this way, with each account having the same margin-to-equity ratio? It matters because then each of the three customers will experience the same rate of return, or very similar rates of return, with minor differences for things like different commission rates, or split fills that may come up from time to time.
And here I should clarify: when I say that each of these customers experiences the same rate of return, what I mean is, in the CTA’s eyes, the rates of return on these accounts are the same because they’re all expressed based on trading level. If the customer wants to consider the rate of return he’s experiencing based on cash, that’s up to him. But the way the regs go, for CTAs and their performance calculations, is that the CTAs always express their rates of return based on profits in the account divided by trading level of the account.
The reason CTAs do this is because they want their customers to experience similar or identical rates of return, because when the rates of return of their various customers are similar or identical, the CTA can then combine the customer returns into a single composite track record. If the returns are very different, the CTA has to present a separate track record for each separate account the CTA manages. That’s a mess.
CTAs want a single composite track record, because consider the alternative. As I just said, if the returns are very different, you can’t combine them into a single track record. You have multiple track records, which doesn’t make sense because the trading decisions are the same for each account. When trading decisions are the same, why would there be multiple track records? That’s a confusing mess.
For example, if you use different margin-to-equity ratios for each customer, their returns are going to look very different. Some CTAs do things like trade 1 contract for a $50,000 account, and 1 contract for a $100,000 account, and 1 contract for a $200,000 account. Initially, this kind of thing makes sense to them because the customers want to customize things, and they want to keep their customers happy. Or maybe the CTA thinks that some customers can afford more risk in a smaller account, but other customers have to get less risk. So this is the way they want to do this, until they see the track record implications that results from this kind of customization for each different customer. When CTAs have this kind of thing going on, they are very unhappy to find that every account they trade kicks out a materially different return stream, and they have to disclose the track record for each account separately. They can’t be combined, and this becomes an administrative and marketing nightmare.
Just imagine this happening to you. You are living in this administrative and marketing nightmare. How does it play out? You’re talking to your prospective customers about what you’re doing, and ask them if they want in to your trading program. And then, instead of showing them a single track record, one page with your monthly rates of return on it, you have pages and pages and pages of track record for them to consider, all with very different rates of monthly return. And this doesn’t make any sense to them, because each customer is getting the same trades based on the same trading decisions. The only reason the returns are different is because you didn’t use the same margin-to-equity ratio in determining the position size that was going to go into each account. And when this happens, your prospective customers are going to be very confused.
When your prospective customers are confused, you lose. To avoid confusion, it’s far better to have a single track record. Then you can say, “Here are the rates of return for this trading program. Everyone in this program has experienced these rates of return, and if you would have been in this trading program during the same time period covered by this track record, this would have been your experience, too.”
When you say this, then your customers aren’t confused, and they’re much more likely to hire you to trade their account.
This is the ideal way to go. The way to really monkey this up is to offer a 2X program, or some other form of customization where different customers have different margin-to-equity ratios, and therefore different returns, and therefore materially different track records.
What is a 2X Program?
Let’s go back to our example. Three customers, each with trading levels of $100,000, they could have different amounts of cash in their accounts, but the trading level is what matters, and each of them gets one contract. One is really impressed with your performance, and wants more of a good thing. So what can he do to get it? There are two options.
He can send you an email and say, “Dial up my trading level to $200,000.” This would get him 2 contracts instead of one, and it would give you double the assets under management—always a good thing–and double the management fee, if you charge a management fee, because it’s always assessed based on the trading level. And this only makes sense that you would get double the management fee, because you’re giving him twice as much of a good thing, so of course you should get twice as much in management fee.
That’s the ideal way to do it. The other options is the dreaded 2X program. With this option, the customer who wants more of a good thing doesn’t increase his trading level, but he still gets twice the position size. The customer in this option says, “Give me a 2-lot, but keep my trading level at $100,000.” Or sometimes, the customer doesn’t ask for this. for some well-meaning but misguided reason, the CTA offers it.
Either way, the 2X program is a profitability problem because it creates a second track record. It sets the CTA on a path for this administrative and marketing mess I’ve been speaking of, when you have multiple track records for a single trading program.
The other two customers are experiencing the same rates of return as each other, because they’re’ still getting one contract per $100,000, but this customer who’s now in the 2x program is getting double the rate of return, because he’s getting two contracts per $100,000. That’s a separate track record any way you slice it, and that’s the administrative and marketing problem for you. On top of that, it cuts your assets under management. This isn’t terribly important in your early years, but AUM history is going to matter later on, so it’s not a great thing for you that your customer gets double the exposure but you don’t get double the AUM. And the cherry on the cake of these problems is that it actually cuts your compensation, if you charge a management fee, because now he’s getting twice as much of a good thing, just at half price. A 2% management fee effectively turns into a 1% management fee the moment this customer starts participating in a 2x program.
How to prevent these problems
The way you prevent problems like this, is you give your customers more size or less size through exactly one mechanism: they dial their trading level up when they want a bigger position size, and they dial their trading level down when they want a smaller position size. Of course, for this to happen, you have to have an advisory agreement that says the trading level of their account is independent of the cash in it. But when you have this, if they want more of a good thing, they just send you an email that says, take my $100,000 trading level up to $200,000, and then you give them a 2-lot. If they want to dial their risk down and get a smaller position size, the way they do that is reduce their trading level. They can just send you an email that says, “Effective as of today, take my trading level down to $100,000 (if it was $200,000.” And you keep everyone’s margin-to-equity ratio the same.
Then, each account that’s participating in the same trading decision, in other words, in the same trading program, will have the same rates of return based on trading level. You’ll have one track record for that trading program, not multiple track records, and that will mean it will be very simple to explain to your prospective customers how that trading program has performed in the past.
If your customers get squirrely about this, if they want $100,000 traded at 2x, the way they get that is not by monkeying with your margin-to-equity ratio and creating an additional track record for you. They can get a higher-octane experience by reducing the cash in their accounts.
If it’s not about the leverage, if the reason they want a 2x program is to get twice the size at half the management fee, still have them dial their trading level up. Just cut the management fee percentage in half. And then you won’t have track record problems on top of the reduced fee. In other words, if you’re going to give a customer a break on management fees, fine. Just do it with your eyes open, and in a manner that doesn’t affect your track record, too. This will give him the fee break he’s looking for, without creating an extra track record for you to worry about.
I hope this helps you avoid the profitability problems that go along with 2X track records. But if you have questions or need some help with your CTA, you can reach me at email@example.com.
Thanks for joining me. Before I close, I’d like to clarify that I’m an attorney so this podcast may constitute attorney advertising. Also, although we discuss general principles against a legal backdrop, you shouldn’t take anything I say here as legal advice that’s applicable to your situation unless you actually hire me as your attorney. If you want to talk to me about doing that, email me at firstname.lastname@example.org, or go to profitablecta.com where you can access my calendar and schedule a free call with me. Thanks and I look forward to speaking with you if you need some help with your CTA, and I look forward to connecting with you in the next episode.