Managed Futures Today Magazine

While many newer investors often treat different assets identically — buying the same number of shares of different stocks, for example — one of the distinguishing characteristics of professional portfolio managers is knowing that varying position size is an integral aspect of their business. If a managed futures program is designed to diversify across all liquid U.S. futures, for example, it cannot simply buy or sell the same number of contracts in all markets. Trading one T-bond contract is not the same as trading one natural gas contract.

After all, if a stock portfolio manager wanted equal exposure to two stocks, one trading at $20 and the other trading at $30, he wouldn’t purchase the same number of shares of both of them: he’d by one-and-a-half times as many shares of the $20 stock as the $30 stock, because then he would own equal dollar amounts of both. Other factors, such as the difference in volatility between the two, would also be a factor.

Managed futures programs similarly “weight” positions in different markets based on contract size, price levels, and market environment to make sure risk and profit potential is distributed appropriately across the portfolio. This relatively simple concept, while seemingly removed from the “Xs and Os” of triggering trades, is nonetheless one of the most important risk-control tools managed futures funds have at their disposal.


Comparing markets
Let’s look at three futures markets, crude oil (CL), wheat (W), and the E-Mini S&P 500 (ES). One crude oil contract represents 1,000 barrels of oil (42,000 gallons) and is quoted in dollars per barrel, making a $1.00 change in the price of crude worth $1,000. At a trade price of $75.00, a single contract’s value is $75,000.

One wheat futures contract represent 5,000 bushels of the grain and is quoted in cents per bushel, which means a 1.00-point (1-cent) price change is worth $50. At a trade price of 650 6/8 cents

(650.75) a wheat contract has a value of $32,537.50.

Finally, the E-Mini S&P 500 contract has a value of $50 times the contract’s price, and each 1.00-point move in the contract is worth $50. With the market trading at 1025.00, a contract’s value would be $51,250. Table 1 summarizes these values, along with the value of each contract’s minimum price move (tick).

Let’s say a trading system bought both all three contracts yesterday on the close at these prices, and today these markets all gained .86 percent. The money manager’s trading system is based on the idea that all trade signals are of equal importance and each one should have the same weight in the overall portfolio — a common feature of many long-term managed futures systems. However, because of the differences between the sizes of these contracts, Table 2 shows their dollar gains for the day are very different, even though all of them made the same percentage price gain for the day: The dollar gain for the crude oil trade was almost 50 percent larger than the gain for the E-Mini S&P trade, and more than twice the size of the wheat gain.

To “equalize” the trade signals across markets the manager needs to know how many contracts each of wheat, crude oil, and the E-Mini S&P 500 should be traded to produce equivalent profits. A quick way to do it is to calculate the ratios of the dollar gains in the E-Mini S&P and wheat to the gain in oil, which is used as the baseline contract because it had the largest gain.

Table 3 shows the crude oil gain was 1.47 times the size of the E-Mini S&P gain and 2.31 times the size of the wheat gain, which means the dollar values of the day’s gains would be equalized if the manager traded 2.31 wheat contracts and 1.47 E-Mini S&P contracts for every oil contract. Because that’s impossible, the numbers have to be rounded. Rounding the ratios to the nearest integer would result in buying one E-Mini S&P contract and two wheat contracts for every oil contract. Although the final column in Table 3 shows a reduction in the wide disparity between the between the wheat profit and the other markets’ gains, there is still a relatively significant difference between crude oil and the E-Mini S&P.

The positions can be balanced even more accurately by increasing the number of crude oil contracts traded and further refining the ratios. For example, if the system purchased two oil contracts instead of one, the profit the next day would have doubled to $1,300. Table 4 shows nearly the same dollar profit would have been achieved by trading 2.95 E-Mini contracts and 4.62 wheat contracts —double the ratios from Table 3. Because these new ratios are much closer to whole numbers, when rounded the result of trading five wheat contracts and three E-Mini S&P contracts for every two crude oil contracts results in fairly comparable dollar results between the different markets, as shown in the final two columns. The balance between markets could be further refined by continuing this process, depending on the how much capital the manager has to allocate.


Factoring in volatility
The previous example showed how positions in different futures markets could be made more comparable based on one day’s trading activity and identical percentage moves in the three markets. Of course, in reality market conditions are constantly changing and trades are being opened and closed at different times, which makes the position-balancing process much more dynamic.

Although related futures contracts (such as different stock indices) may often make similar-sized moves from day to day or week to week, most markets have different volatility levels, which means position sizes will need to be adjusted on a regular basis as market conditions change. For example, a manager could use the average daily percentage change over a certain period (for example, 20 days) as a simple volatility measure and adjust the number of contracts traded as this figure changes.

Instead of showing the percentage price change for a single day, Table 5 shows the average daily change for the past 20 days. (Note: The absolute value of price changes would be used, since we are concerned with the total amount of price movement, not its direction.) In this case, the markets’ different volatilities would result in different average dollar gains than those from Table 1. Here, the ratios between the crude oil, E-Mini S&P, and wheat contracts become 1 to 2.14 to 6.87 or, when rounded, 1 to 2 to 7. The final column shows trading seven wheat contracts and two E-Mini S&P 500 contracts for every crude oil contract produces fairly comparable dollar results. As in the previous example, the contract ratios could be refined further as desired.


Consistency and risk management
Although position balancing might seem like a relatively unimportant aspect of trading, it is actually an integral part of any futures portfolio manager’s risk-control process: Managing the size and volatility differences between different futures contracts creates a stable trading framework and more-consistent and predictable performance results.