Utilizing Added Leverage With A Managed Futures Investment
When an investor looks at the performance of a trading system or Commodity Trading Advisor
, one of the most essential statistics is what the needed minimum account size is. It makes no sense considering trading systems or managed futures that have $100,000 minimums if the investor only has $50,000 to invest.
Though, it is beneficial to know that frequently the investor can start with less than the minimum through notional funding. For instance, an investor could notionally fund a managed futures or trading systems account at the $50,000 amount but tell the manager to trade at a nominal $100,000 amount. In other words, the account will trade as though there were $100,000 in it even though there is not. The investor is merely making use of added leverage.
In the prior example this means that the account will be trading at 2-to-1 leverage. Meaning the investor will have gains and losses at twice the amount. Had the investor only put up a third of the nominal amount minimum then he would see gains and losses at 3 times the level and so on.
Notional funding can be an effective use of funds, because often a trading system or managed futures account will not come anywhere near to using all the money in the account. For instance, in Hoffman Asset Management's case we have a margin-to-equity ratio of typically less than 10%. What this means is that for every $100,000 invested, generally speaking, we will be utilizing less than $10,000 at any given moment for margin. The remaining $90,000 rests on the sidelines stagnant. While it is true that interest on those unused funds can be earned, most investor's feel they could do better investing those funds elsewhere. Often time's high net worth individuals or corporations will even put NOTHING in their accounts and trade 100% notionally. The question for traders should be how can I determine a realistic notional level to invest at.
We think the answer to that question is one that can be computed based on a number of statistics. Specifically, what is the maximum drawdown expected and what is the highest margin that might be needed. For example, Hoffman Asset Management (as of this writing) has had a maximum drawdown of about 17% on a $125,000 nominal account size. This means a $21,250 drawdown in cash terms. The maximum margin usage is about 15% on $125,000 or, about $18,750 in cash terms.
To compute a notional investment amount, we suggest that an investor add the maximum expected drawdown and the maximum expected margin usage. This figure would give the investor the absolute minimum they could invest in the account without having a margin call.
In the previous example, if an investor had began on the worst possible day, and had a $21,250 drawdown, and at the same time experienced the maximum margin usage of $18,750, he would have required $40,000 of cash in the account to fund that $125,000 nominal account size. Once again, some organizations and individuals who are not concerned about margin calls might actually decide to fund the account with less than that (or zero).
This enables the smaller, but more aggressive trader to participate in the program without needing to tie up the whole amount in cash. This will amplify their gains and losses at the additional leverage level they are utilizing. If, for example, the manager made a 30% return with a 17% drawdown, then the investor at 2-to-1 leverage should have experienced 60% gains with a 34% drawdown.
Once again, this is a more aggressive approach, and we suggest this only for investors who completely understand the benefits and risks of notional funding. However, for the right trader, this can be a beneficial tool to have in his or her arsenal.
Dean Hoffman - DH Trading Systems
by: Dean Hoffman
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