Ep. 13: Selling Trading Signals vs. Managing Accounts

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Some commodity trading advisors don’t manage accounts for their customers. Rather, they sell trading signals. They tell their customers where to buy, sell, take profits and place stops. In this episode, we discuss why this route is often riskier than many CTAs realize, and why it’s generally an impediment to profitability.

TRANSCRIPT:

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 selling trading signals.

I’m thinking about selling signals today because I received an email from a listener who wondered about the best way to break into the CTA business. He asked if he should begin trading his own account, and then start a signal-selling service, and eventually manage accounts.

To this, my answer is, skip the part about selling trading signals. It’s a huge impediment to profitability, and today I’m going to discuss the reasons for that. But first, I’ll describe what typically goes on in these signal-selling arrangements.

How Does Signal-Selling Work?

Some CTAs don’t manage accounts. They don’t take power of attorney and trade in the customer’s account under this grant of discretionary authority. Rather, they sell trading signals to their customers. The signals generally are where to buy, where to sell, where to take profits, where to place a stop, and then the customers can pull the trigger on the trades, or they can have their broker do it, under a special kind of power of attorney called a letter of direction.

Notice that these signal-selling CTAs are still CTAs, because they still give trading advice. There are two kinds of trading advice: direct and indirect. Indirect trading advice is what signal-sellers provide. The advice is the signal to buy or sell and where. Direct trading advice is what you provide when you manage an account pursuant to a power of attorney and you don’t get specific authorization from the customer for each trade that’s placed in the customer’s account. If you provide either kind of advice, you’re a CTA because you’re providing trading advice. This doesn’t mean you have to register.

Why do some CTAs sell signals rather than manage accounts?

What’s the appeal of being a CTA who doesn’t actually manage accounts, and who only sells trading signals?

Signal-selling CTAs generally avoid registration

One appealing thing to CTAs, one reason they wind up selling signals rather than managing accounts, is because in the USA, signal-selling CTAs generally avoid registration.

It wasn’t always this way. As I said just a second ago, the CFTC considers selling signals as providing advice. If you do it, in their eyes, you’re a CTA, even if the advice is indirect advice, and they used to make you register as a CTA to sell signals.

But then the Constitution came along. The CFTC was going after signal-selling CTAs for failure to register. This was a long time ago when I first started as a compliance auditor at the NFA, I remember this going on, and a couple of courts said, wait a minute. These signal-selling CTAs aren’t interacting with these customers at all. All they’re doing is speaking to their customers. There’s no customization in the advice. They’re not managing the accounts. So forcing these CTAs to register is an imposition on their freedom of speech.

And as you know, freedom of speech is a pretty big deal here in the U.S., so the courts told the CFTC that they couldn’t force these CTAs to register because that was an imposition on their right to speak.

The CFTC never said if they agreed with this thinking or not, but they didn’t fight it. They created a new exemption from registration for signal-selling CTAs. They said, okay CTAs, if you don’t direct client accounts, and you don’t provide customized advice, or in other words, you don’t provide “trading advice based on, or tailored to, the commodity interest or cash market positions or other circumstances or characteristics of particular clients” then you don’t have to register.

In light of this exemption, some CTAs decide that it’s just easier never to register. Instead, they decide that all they will do is sell trading signals.

(Erroneous) Perception of Lower Liability

Another reason CTAs take the signal-selling route is because they perceive that there’s less legal risk in suggesting trades that their customers may or may not take, vs. actually executing the trades on behalf of their customers. I don’t know of anyone who’s actually studied the issue of which type of CTA has the most legal problems, but anecdotally I can tell you that I’m aware of many more legal problems for signal-selling CTAs than I am for CTAs who manage accounts under a power of attorney.

Why is this the case? One contributing factor is that those who are inclined to operate in a shady fashion are naturally going to gravitate to the corners of the industry where there’s no registration requirement whatsoever. Another contributing factor is that even those who are wanting to operate on the up-and-up tend to view signal-selling as less risky from a legal standpoint, they adopt this view erroneously in my mind, but this is the way they see things, and when they see things this way they don’t get any legal or even accounting assistance, and this is a mistake because selling signals is in many ways more risky than managing accounts.

For example, signal-selling CTAs can find themselves in a lot of trouble with their performance claims. Often what happens is they’re touting hypothetical performance without disclosing it as hypothetical, or maybe they disclose that the performance is a result of a back test but they don’t present it in a compliant fashion. For example, they don’t use the required disclaimers. This part may surprise you, but yes, even unregistered CTAs have compliance requirements for their promotional material. If unregistered CTAs who sell signals have actual performance, they often don’t get a track record calculated in a compliant manner that backs up their performance claims. And they don’t use good agreements that explain the deal to the customer and protect the CTA from customer misunderstandings and misimpressions. These kinds of things are always a recipe for legal and regulatory trouble.

Another thing that happens is that signal-selling CTAs often find that that the customers say, “Great, I want in. It looks like this is a great trading program. But I don’t have time to babysit this thing and make sure all these orders get entered. I have a job. I have things to do during the trading day.” And then the unregistered, signal-selling CTAs find themselves in a quandary. The customers, members of the public, want what they do, but since the CTAs aren’t registered, they can’t take power of attorney with these public customers. So they enlist the help of an introducing broker to pull the trigger on the trades pursuant to what’s called a “letter of direction.” A letter of direction is a fancy term for power of attorney, but the person with the authority to place the trades isn’t the CTA. It’s a broker.

And then what happens? The broker and the signal-selling CTA essentially have an arrangement between themselves where the customer is participating in what, in my mind, is essentially a managed account program. There’s someone making trading decisions, it’s not the customer, and someone executing those trading decisions, again, it’s not the customer, but the CTA isn’t registered.

Is this kind of arrangement a problem? It depends on the type of arrangement that exists between the CTA and the broker. If the arrangement is too close, the CFTC can say that it’s tantamount to the CTA managing the account, without registration, and outside the confines of the signal-selling exemption. Every instance of this isn’t a problem. It’s a facts and circumstances test, but it’s a good idea to look at these very closely.

In one instance that the CFTC said was a problem, the signal-selling CTA was also an associated person of the broker—he worked for the broker and he was the guy pulling the trigger on the trades under the letter of direction that the customers signed, giving the broker the authority to do that. And the CFTC said, no way man. This is exactly the kind of arrangement that we were concerned about when we adopted this exemption for signal-sellers. This goes beyond pure speech, because now the CTA isn’t just telling the customer what to do. Now there’s an informal arrangement where the CTA is essentially managing the accounts without registration, and that is a no-go.

What are other examples of problems like this? We don’t have a great deal to go on, and NFA is basically silent on this topic. But every time I see a situation where there’s an unregistered, signal-selling CTA, and a broker who’s pulling the trigger on all the trades, I find myself thinking, wait a minute. This CTA could have gone out and hired someone to place these trades in-house. If he had done that, he’d have to register. No question. But instead he went out and enlisted the help of one guy at one brokerage firm to do exactly the same thing, and now the thinking is that he doesn’t have to register? That doesn’t sit super well with me. It’s one thing if, as a public customer, I buy some signals from an unregistered CTA, and call up my own broker, who’s completely independent of the unregistered CTA, to pull the trigger on these signals for me. In my mind that’s quite a different thing from the unregistered CTA going out and enlisting the help of that broker to do this.

So you have to be careful out there. As I said earlier, what happens with a lot of signal-selling CTAs is that their customers need more than just pure signals. They need help actually placing the trades, and if in the course of trying to provide this help, the CTA winds up in what the CFTC determines is an “informal arrangement” where the CTA is essentially managing the account, but without registration, that could mean trouble. Every arrangement of this type is different, so now you’re in the gray area, and I’m sure I don’t have to tell you that the gray area is where a lot of legal problems arise.

So in a nutshell, in my mind, selling signals to avoid legal risk isn’t a great idea, because CTAs that manage accounts while availing themselves of legal protections (such as a good agreement and a properly calculated track record—let me know if you need help on this)… these CTAs just don’t encounter that much trouble. One of the big messages I want to convey with this show is that it’s not that difficult or complicated to manage money for other people without swimming in a sea of litigation risk. A good agreement and a compliant track record go a long way to keeping you safe where customers aren’t suing you at every turn.

Managing Accounts generates more profits than selling signals

So not only do I think that CTAS who manage accounts avoid legal trouble more easily, I think they also set themselves up to make a lot more money than signal-selling CTAs. Think about that: avoid risk, earn more. That’s a trade you should take every time.

Why do I think that managing accounts generates more profits than selling signals? For a few reasons. Today I’ll discuss three of them.

Managing Accounts Generates Incentive Fees

The first and most obvious consideration is that when you manage an account, you get a percentage of the profits generated in the account. This is your incentive fee, and it starts at around 20% of trading profits. Some CTAs earn 50% of trading profits.

That’s huge upside, and most signal-selling CTAs miss out on this. Why? One reason is, when you sell signals, collecting an incentive fee can be tough to do, even if you try, because you have no idea how big your customer is trading. He could take your signals and generate millions of dollars in an account you don’t know about, and you would therefore lose out on participating in those profits.

Managing Accounts Inspires Customer Confidence

Missing out on this huge upside leads me to the second problem. Everyone knows that there’s huge upside in managing an account, so if you’re not offering to manage accounts, if you’re foregoing the incentive fee because all you’re offering is to sell signals, people are going to wonder why. They’re going to wonder why, if you could collect 20 to 50% of the profits you generate for your customers, you wouldn’t set yourself up to receive it.

And when they wonder about this, they’re going to question the value of your signals. If you have the goose that lays golden eggs, why would you give it away for so little? Asking themselves this question, consciously or subconsciously, will make customers less confident about what you’re doing, and less likely to buy.

Managing Accounts Expresses Your Own Confidence

Another benefit to managing accounts, rather than selling signals, is that it’s an expression of your own confidence. One of the most important things you can do as a CTA is to know and like your reasons for doing everything that you do, and I’ve never met a CTA who was selling signals for reasons that most of us would find particularly likable from a business standpoint.

The reasons for selling signals are generally grounded in fear and limitation. They’re things such as, “I don’t believe anyone will actually give me an account to manage” or “I’m afraid of the risk” or “I’m afraid of the responsibility.”

These thoughts, and others like them that lead CTAs to stay small and sell signals rather than build a business with significant AUM that generates significant incentive fees, are what I call business-blocking thoughts. A business-blocking thought is merely a sentence that runs through your brain that motivates you to play small when you could instead clean up this thinking and go big. Business-blocking thoughts cause tons of damage to your profitability, because they seem like the truth so you believe them, but really, they’re not true. They’re just there, knocking around in your brain, causing trouble. They’re just neurological nonsense that you need to get rid of if you want to be super successful.

We all have this neurological nonsense, by the way. One of the best ways to build wealth is to own your own business, but many people, within and outside of the CTA industry, have a thought knocking around in their heads that goes like this: It’s safer to have a job.

This isn’t the truth. There’s nothing safe about having your head on a guillotine where one person, your boss, can chop it off at any moment. In my mind, it’s safer to have multiple streams of income from multiple clients. That’s why I own my business rather than work for someone else. It’s why my clients have more than one customer.  But this thought about “job=safety” holds so many people back, and the only way forward, the way out of this and to success, is to look at it and recognize that it’s merely neurological junk that was unintentionally programmed into the brain, and then get it out of there so it doesn’t continue to cause trouble.

The same thing happens with the business-blocking thoughts that struggling CTAs think. If you know how to trade, if you have the goose that lays golden eggs, you’re generating profits in your own account, but you’re thinking you’re not ready or up to the task of managing accounts and making big incentive fees, and you’re instead pondering a signal-selling business, please get in touch with me immediately because cleaning out this neurological junk is something I can help you with.

I also want to invite you to view the registration aspect of the business as just math. Too many great CTAs are selling signals because they want to avoid the perceived hassles and complexity of registration, and they’re giving up a ton of upside. If you could be making millions of dollars in incentive fees, and making all those hassles go away with a good lawyer and accountant, that’s a trade you should take every time. It just doesn’t cost that much to get great help to get your business off to a great start. Let me know if I can help you with your business.

Before we close for today. I have to tell you, as if it’s not obvious already, that this podcast may constitute attorney advertising. Also, although we discuss general business 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 and I know what your situation is. If you want to talk to me about doing that, email me at kelly@profitablecta.com, or go to profitablecta.com where you can access my calendar and schedule a call with me. Thanks. I look forward to speaking with you if you’d like some help with your CTA, and I look forward to connecting with you in the next episode.

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