Ep. #4: Trading Naked

New CTAs often trade for their customers without a written agreement. This is called “Trading Naked” and it presents a profitability problem for CTAs. One reason is because it can hurt your track record. Listen to this episode to find out how, and what you can do about it.

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 trading naked. And here I’m not talking about what you wear when you trade. That’s entirely up to you. What I’m talking about is trading for anyone other than yourself without a good agreement.

Why is trading naked such a big problem for CTA profitability? It’s not because I’m a lawyer and I think you’re going to get sued, although a good agreement can certainly help prevent that or mitigate the fallout of a lawsuit in the rare event that one happens. The reason that trading naked is a huge problem for CTA profitability is because, when you do it, you put your track record at risk in ways that most would-be CTAs don’t even think about.

And CTAs live and die by their track records, so as you’re starting out, it’s critically important to know that there are things other than trading losses that can mess up your track record, and for the most part, these things eliminated by a good agreement. So today we’re briefly going to touch on exactly what a track record is, and then we’ll talk about one very common way that not having a good agreement can screw yours up. I’m only going to talk about one. I could talk about this topic forever. There are so many ways that not having a good agreement can mess up your track record, I probably couldn’t even list them all, but today I’m going to talk about just one really common one.

What is a CTA track record?

So to start off, what is a CTA track record? It is simply the monthly rates of return that you generate in trading an account. If it’s your own account, this monthly return stream is called a proprietary track record. If it’s a customer’s account, the monthly rates of return that come out of that account is called a customer track record.

Now some CTAs prepare hypothetical track records based on back-testing a trading idea or algorithm, or paper-trading in real-time, but that’s not the kind of thing we’re talking about in today’s episode. We’re just talking about the rates of return that come from actually trading an account, and how things go awry if you don’t have a good agreement, and you’re trading naked.

One way trading naked can hurt your track record:

The most common way, perhaps, that that trading naked hurts your track record comes up with cash withdrawals so that’s what I selected to talk about for this episode. Let’s say you start out trading your first account without an agreement, as many new CTAs do, and the account has $100,000 cash in it, and in the first month you earn $2,000 in trading profits, after all the commissions and transaction fees, and whatever you’re being paid as your compensation, have been deducted. And this means that you post a 2% return for the first month in your customer track record. That’s $2,000 in net trading profits divided by the $100,000 in the account.

Then let’s imagine that this 2% profit continues for the next two months. You have a remarkably consistent track record of 2%, and 2%, and 2%. This, by the way, is a great start for any CTA. Consistency is generally far more impressive to prospective customers than big returns.

But in any case, let’s go back to our example. Then what happens? Let’s say we get to the last day of month three. Your customer is happy with the returns so far, but he’s been looking at his account statements and he sees that you are not even using $20,000 of his cash. The bulk of his money, over $80,000, is sitting there unused. And this is typical, by the way. Most CTAs employ a margin-to-equity ratio of 20% or less.

And so what does your customer do when he sees this? He calls you up and tells you, “Keep doing what you’re doing. Trade exactly as you have been, but I’m going to pull $80,000 of my original cash, plus my profits, out of my account and put it somewhere else. I’ll keep $20,000 in the account as margin, but I want you to continue with the same position size as always.”

This is not unusual, by the way. This type of conversation happens all the time.

So then what happens? You start out the fourth month with only $20k in the account, but you’re trading the same size as you were before. And here’s where the problem comes up. Inevitably, the month where the customer yanks the cash is the month when you lose money. Let’s say in month four, you give back all the profits that you earned in the first three months. You  lose $6,000 after all commissions, transaction charges, and whatever your fees are.

So the customer is even. He hasn’t made any money, nor has he lost any money.

But month four of your track record doesn’t show that. It shows he’s down. And not just down. WAY down. Why does it show this? Because he started month four with only $20k in his account. so that means you must calculate your month four return as -6,000 divided by $20,000. That’s a 30% loss.

Now your track record looks like you don’t have a clue what you’re doing. In the good months, you make a little bit of money, and in the bad months, you get your hat handed to you and suffer you double-digit losses. No customer wants that. The returns don’t come close to justifying the risk.

So what can you do to prevent this? You could try to strong-arm your customer into leaving the cash that’s not being used in his account. This is what struggling CTAs do, and it isn’t a great idea because good customers don’t just fall out of the sky. You want to keep your customer happy, and if you try to force your customer to keep the money in the account when he doesn’t want to leave it there, he’s going to be unhappy. If he is looking at his statements, he knows that all that money doesn’t need to be there for you to trade. If he’s smart, he also knows that this account is uninsured, so there’s risk to him for keeping the excess cash there. And if he’s really smart, he knows that you have no ability to try to force him to keep the cash there. NFA and the CFTC won’t allow CTAs to restrict their customers from moving cash.

And, even if you could set a restriction like that, do you really want to be in a business where your customer wants to do something with his own money and you’re standing there telling him that he can’t? That’s not a fun position to be in, and the great news for this episode is that a good agreement will keep you out of that position.

And here’s how it will work: before you begin trading for the customer, you have an agreement that says the account is valued at $100,000 regardless of how much cash he keeps in the account. This will allow your customer the flexibility to move excess cash out of his account without bothering you or your track record, and it will allow your track record to develop in a manner that isn’t at the mercy of your customer’s cash management decisions.

If you’re new to the CTA business, it seems impossible that it could be this easy, but that’s the exactly way it works because of a concept called notional funding. With a notional funding mechanism in your agreement, you are trading a $100,000 account whether the cash is in there or not. The trading level of the account, regardless of the cash level, is $100,000 and so that is the value that you will use to determine the position size you trade, the rate of return for that account, and your management fee, if you charge one.

So why is this concept called notional funding? If your customer has $20,000 in an account with a $100,000 trading level, $80,000 of the account’s trading level is a notion in our minds, hence the name.

And this is the way that my most profitable CTA clients structure their customer relationships, and there are many reasons they do this, but to summarize the primary reasons we’ve discussed today, there are two:

  • Your track record when you use a notional funding mechanism in your agreement is no longer at the whim of your customer’s cash management decisions, and
  • You don’t have to go nose to nose and fight with your customer when he wants to move excess cash out of his account. A good agreement will preserve the relationship, and your track record.

So that’s what I have for you today. If you want to avoid the problems of trading naked—there are many more but the biggie for this episode is protecting your track record from the whims of your customers’ cash management decisions—have a good agreement that insulates your track record from the effects of your customers’ cash additions and withdrawals.

Before I close for today, I want to tell you that many CTAs, particularly many struggling CTAs, get antsy and very concerned about “allowing” their customers to use notional funding, so in the next episode, we’re going to talk about why this concern is misplaced. You don’t have to worry about it, so please join me for that.

And I’d also like to clarify that I’m an attorney so 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 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 and 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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