A common complaint of anyone who buys insurance is that it wasn’t needed—the house never burned down, the car never was stolen, etc. But few of us want to assume the risk that nothing unpleasant will ever happen, so we go ahead and buy the insurance.

The same goes for the futures markets. Hedgers buy insurance from speculators. A premium is paid for that insurance, which is the economic raison d’etre of the futures market. We’ll continue this discussion and quantify the amount of premium hedgers pay a little later, when we review the various indexes available to you to evaluate your CTA’s trading performance.

It’s important to note that speculators do not create the price risk. This risk is there. It is real, whether there is a futures market in a particular commodity or not. As a matter of fact, price risk is substantially greater when there isn’t a formal market. Open auctions with competitive bidding fixes prices. All the information—fact or fiction—affecting the perceived value of a commodity is resolved as buyers and sellers bid. This is true for the stock and bond markets as well as the futures markets.

If you ever have something you must desperately sell and there is only one buyer, you’ll learn the hard way how the lack of competitive bidding hurts. For example, a farmer was heard to say at a very well publicized bankruptcy auction: “I’m glad all the sharks are here. Maybe some of them will eat each other as they circle me.”

Now let’s move from a market’s passive economic return on investment—i.e., profits in the case of stocks and insurance premiums for futures—to discuss the concept of active asset management. How much does the skill of the trading advisor add to the return on investment figure? This also brings up the question of the randomness of any kind of price activity.

If the stock market is truly random, you should be able to compare the results of your advisors to those of the Dow or with another stock index that more accurately resembles your portfolio. If all your stocks are over-the-counter, perhaps the NASDAQ Index would be the best match. For portfolios of small stocks, consider the Russell 2000 Small Stocks Index. If your advisor beats the selected index, you should be pleased. If she or he doesn’t, you naturally begin to wonder what you’re paying for. If your advisor took you out of the market in September of 1987, you probably considered sending him or her a bonus as a reward for the skill or experience (or luck) displayed.

This discussion of the random nature of markets leads to a dichotomy: If the markets are random, does active management make any difference? If the markets are not random and there is a master pattern, why hasn’t some extremely wealthy trader revealed the secret on his deathbed?

The discussion of the nature of the markets is as fascinating as the search for the Holy Grail once was. It is the meat and potatoes of the academic world. Open-auction markets result in real-world price discovery. They embody the collective opinions of the value of the stock shares, bond certificates, or futures contracts being traded. Prices mirror the herd psychology of the majority of bidders.

As such, they are sometimes coldly logical. This occurs when the supply-demand equation is clear. If the world is desperately short of oil, gold, money, etc., prices increase. They rise spectacularly fast because there are no sellers, everyone is a buyer. At some point, every commodity becomes too expensive and the bulls exhaust themselves.

Another face of the market is its Mona Lisa look. Is it happy or sad? Yin or yang? Bullish or bearish? The market cannot make up its mind to go up or down. The supply-demand situation is unclear. The supply may be known and adequate, but the demand is weak or coy.

When the market is logical, it is also reasonably easy to trade. The professional trader sells plenty of price insurance without having to pay out any claims. These are the markets friendly to trends- following trading systems. CTAs appeared to be clairvoyant.

The more emotional markets are also the more common. “Buy the rumor; sell the facts” sums them up. Guesses, misstatements, whipsawing price moves are the order of the day. Skill and experience are required to survive. More insurance claims are paid than premiums collected and a good many insurance companies (CTAs) go under.

Investors often ask why traders don’t wait and trade when market activity is in sync with their trading system. Some actually do, but their trading volume is low and their investors become impatient. They want action, profits, above-average returns. It’s not unusual for an investor to coax his CTA into overtrading. CTAs, after all, wish to please their benefactors.

More common are markets that appear to be calmly trending higher or lower one minute, only to be violently moving in the opposite direction the next. These events-driven markets are like shallow lakes hit by violent squalls. The bond markets are good examples because they are so responsive to good or bad economic news. Just a quarter of a point increase or decrease in the interest rates can send them soaring to the sky or down the tubes. The whisper of the word “drought” puts the grains in the stratosphere.

All these twists and turns, ups and downs, are graphically displayed by a variety of indexes. Some just give you the opinion of the majority of traders; others attempt to measure more sophisticated aspects of the futures market and its profitability. We’ll review several of the more useful indexes now. It’s important to understand how they are constructed in order to know how to use them to evaluate potential CTAs.

Possibly related posts: (automatically generated)
Selecting a Baseline Measurement for CTA Success Part 2

• 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
• 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
• How Futures and Options Work Part 2
• Futures Contracts