“My CTA is beating the world!” That naturally is our goal when we select and invest in a professional futures trader, be he our spouse’s favorite nephew or someone of the stature of George Soros.

In the securities market, measuring success appears to be reasonably easy. Most advisors evaluate their performance against the Dow Jones averages. Since beating the Dow has been the yardstick for trading success in the stock market just about from its first publication in 1884, let’s examine it briefly and then see if there are comparable indexes available for the futures markets. But first, we need to understand the composition of the Dow so we can evaluate futures indexes.

How the Dow Is Calculated

Originally, the Dow was computed as a simple average—total up the prices of the stocks included in the index and divide by the number of stocks. Naturally, this system gave more weight to the higher- priced stock. Therefore, a major advance in a low-priced stock is diluted by a modest loss in a high-priced issue.

As the 1920s roared to a close, the stock markets were having a heyday. Prices were soaring and just about everyone in the country was buying on the cuff. To keep skyrocketing prices of hot securities within the price range of the majority of investors, many issues split, which caused some special problems for the Dow. For example, if one of the stocks included in the Dow was priced at $40 and split two for one, the day after the split it would be worth $20. The Dow would be artificially down. For this reason, the analysts over at Dow Jones introduced a flexible divisor, which is adjusted whenever an event (split, merger, major dividend) occurs that distorts the normal calculation by 10 percent or more. With the flexible divisor also came the concept of measuring the Dow in points, rather than dollars.

The key point of this discussion is that the Dow has been carefully modified, fine-tuned over the years so it can be used to measure the magnitude and direction of price movement over just about any period of time. Its weakness may still be the fact that, despite the flexible divisor, it is still price-weighted and can, therefore, give false signals.

There are many other stock indexes, some of which were developed to overcome the price weighting drawback. Take the Standard & Poor’s Index as an example. To compute the S&P, you multiply the stock price of each underlying company by the number of shares outstanding. Then divide the total by the aggregate market value of all S&P stock from the base period (1941-43). The computation is then multiplied by 10 to get the index price at a specific time.

Stock gurus also have the Value Line, NASDAQ Composite Index, Wilshire 5000 Equity Index, New York Stock Exchange Composite Index, Amex Major Market Index, Amex Market Value Index, Russell 3000 Index, Russell 2000 Small Stock Index, and others as a baseline for measuring success. It’s interesting to note that while short-term fluctuations often occur among the many stock indexes, the overall long-term trends are usually in sync.

The reason for this is that when we think of the stock market we generally measure success in terms of continuous price appreciation. Sure, one can sell stocks short, but it is not the common practice. The stock trader’s mindset is to purchase a stock, hold it until it gains in value, and then sell—buy * hold * sell!

There are as many technical and fundamental approaches to stock picking as there are to selecting suitable futures trades, but the most basic is that the underlying company represented by the stock is making money. The more money it makes, the better managed, more competitive, faster growing, and more resistant to external factors it is, and the greater the dividend expected. Therefore, investors believe the Dow should continually rise. We measure our trading success against the rising tide of stock prices. Our expectation is for each company we invest in to become wealthier over time.

Futures contracts and futures trading are a horse of a different breed. For the most part, the commodities underlying the futures markets are simply entities. Grains, precious metals, petroleum products, food, fiber, money, etc.—they are stored or produced in anticipation of use. Prices are influenced by the ever changing supply-demand equation and the inflation rate. A commodity does not perform a service or produce a product that can be sold for a profit as does a corporation that underlies a stock, but the futures markets of the world nevertheless perform a valuable service for which they are paid.

Futures and options-on-futures exchanges sell price insurance, more commonly referred to as hedging. Producers and consumers of commodities can go to the futures markets and sell the risk of price increases and decreases to speculators.

Here are a few simple examples: A farmer plants a field of corn. He calculates his per-bushel cost—including seed, fertilizers, insecticides, herbicides, interest, labor, land charges, etc.—at just under $2.00 per bushel. At some point during the summer, the price of the December futures contract trades at $2.50 per bushel. The farmer is satisfied with a net before-tax profit of 50 cents per bushel, or 25 percent, on at least a part of his crop. He sells two 5,000-bushel contracts on the Chicago Board of Trade for delivery at a predetermined grain elevator in December. At this point in time, the farmer has locked in a 50 cents per bushel profit on 10,000 bushels of corn. He is long corn in the sense that he owns it because it is currently growing in his fields. And he is short, since he sold corn on the futures market. His only worry is not being able to deliver it when the futures contract comes due in December.

Or consider an inventory manager working for an electrical manufacturer whose bonus is based on buying silver at $5.00 per ounce or less. He needs silver, which makes him short the market. If silver is trading below $5.00/ounce, the inventory manager can go long the futures market and assure himself a bonus. He even has the option of accepting delivery of the physical commodity when the contract expires. Or he could offset on the futures position and buy locally on the spot or cash market. If silver prices go up, the profit from the futures offsets the higher cost in the cash market. If prices go down, the inventory managers lose in the futures market, but the cash market will be lower. The cost of his price insurance (the loss in the futures market plus the expenses involved in trading) would be compensated for by a lower per ounce silver price in the cash market.

Possibly related posts: (automatically generated)
Selecting a Baseline Measurement for CTA Success Part 1

• Common Terms Used in Measurement of Futures Funds
• Performance Measurement
• Selecting a Baseline Measurement for CTA Success Part 3
• Selecting a Baseline Measurement for CTA Success Part 2
• THE REPORTING AND PERFORMANCE MEASUREMENT OF FINANCIAL FUTURES AND OPTIONS IN INVESTMENT PORTFOLIOS IN THE UK
• Performance Measurement—The Issues
• Finding and Evaluating Trading Advisers Part 2
• European Performance
• The Simple Managed Futures Trading Regulatory Recourse
• Evaluating Shorter Trader