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Creating a Futures Portfolio

August 29, 2011 | By

At the end of the day, most traders and investors are searching for something that works. For them, this involves ways to limit risk while trying to extrapolate upside opportunities. But, the question remains: how can we find simple and effective ways to do this? Let’s follow Brian, who wants to allocate $20,000 towards a portfolio of futures. He works full-time during the week so he doesn’t want to day-trade but simply wants to participate in the futures and commodities market as a longer term investor. Let’s see the process of how Brain evaluates and chooses his portfolio.

Any trades are educational examples only. They do not include commissions and fees.

1. Determine Your General Outlook

Brian writes down his general outlook on the world for the next 3-6 months: this is his “macro” outlook. He breaks this into these categories:

  • Stocks: do you believe stocks move higher quickly in a volatile market or in a sideways, range-bound, quiet market?
  • Energy: do you believe geopolitical risk could bring oil prices sharply higher toward $100 per barrel or will prices drift lower given a global economic slowdown?
  • Currencies: do you believe the U.S. dollar will weaken or strengthen? Are you worried about Europe and think the Euro could weaken as well, thus driving up the value of the U.S. dollar?

Once Brian has identified his “bias” toward the previous questions about the world, he can take some positions on these opinions. This is when the real portfolio construction begins.

2. Decide Which Sectors to Follow

Brian wants to follow several market sectors that he is comfortable with:

  • Stocks
  • Grains
  • Metals
  • Currencies
  • Energies

3. Evalute Contract Value Controlled/Leverage Ratio

Brian knows that given his $20,000 account, he never wants to get too “leveraged” since that is the number one reason for failure. Given his risk tolerance, he’s comfortable keeping his maximum account to leverage ratio at 6:1. Thus, he can control a total of $120,000 in contract value in his portfolio ($20,000 x 6 = $120,000). 

4. Establish Maximum Risk Allocation per Position

Brian decides that he will risk a maximum of $500 per position, or 2.5% of the current portfolio value. Thus, if he decides to have five positions on at once, he will be risking $2,500 at any one time, or 12.5% of the portfolio. It’s very important to know your total risk amount at any given time.

5. Determine Correlation to the U.S. Dollar

Given the correlation of markets today, it is very important to understand your net position correlation vs. the U.S. dollar. If you have five positions in your portfolio that are all short the U.S. dollar, you are essentially creating one giant position against the U.S. dollar. This is an important concept to understand because the vast majority of commodities are priced in U.S. dollars. So, even if there is no fundamental data to make a commodity market move, the U.S. dollar could simply rally causing a price decline in that commodity. For example, Brian’s corn position could go down when the US dollar is rallying, even though there is no data to adversely affect the price of corn. Being aware of these intricacies separates the experienced commodity trader from the new commodities trader.

Any trades are educational examples only. They do not include commissions and fees.

6. Establish Portfolio Positions

Stocks: No position

Grains: Long 1 December Mini Corn

  • Reasoning: Strong demand, low corn yields and low storage should push prices higher
  • Controls: $7,000 of corn ($7.00/bushel x 1,000 bu.)
  • Risking: $500 or $0.50/bu.
  • Correlation: Short U.S. dollar

Metals: Long 1 December Micro Gold

  • Reasoning: General move into real-assets by investors should be beneficial for prices
  • Controls: $18,000 of gold ($1,800/ounce x 20/oz.)
  • Risking: $500 or $50/oz. per contract
  • Correlation: Short US dollar

Currencies 1: Short 1 September Micro Euro

  • Reasoning: European problems may be expressed by a weakening Euro
  • Controls: $17,500 of Euros ($1.40 x $12,500)
  • Risking: $500 or $4.00 per contract
  • Correlation: Long U.S. dollar

Currencies 2: Long 1 September Micro Australian Dollar

  • Reasoning: Large interest rate differential between the U.S. and Australia and strong exports should support prices
  • Controls: $14,000 of Australian Dollars ($1.04 x $10,000)
  • Risking: $500 or $5.00 per contract
  • Correlation: Short U.S. dollar

Energy: Long 1 October Mini WTI Crude Oil

  • Reasoning: Low, but positive world growth and geopolitical risk may contribute to higher prices
  • Controls: $40,000 in oil
  • Risking: $500 or $1.00 per contract
  • Correlation: Short U.S. dollar

7. Summary of Final Portfolio

Total Contract Value Controlled: $ 96,500 (maximum amount is $120,000)

Total Risk in Portfolio: $2,500.00 (Five positions with a maximum of $500 initial risk)

Correlation: .22 (contract value long U.S. dollar/contract value short U.S. dollar) ($17,500 / $79,000). A correlation of 1.00 means you are equal parts long/short the U.S. dollar. Less than 1.00 means you are net short the U.S. dollar, and over 1.00 means you are net long the U.S. dollar.

Brian realizes the portfolio has a strong short U.S. dollar position, so if the U.S. dollar begins to rally the portfolio will likely come under pressure. However, each position has the following important trading questions answered:

  • Reasoning behind the trade
  • Contract Value Controlled/Leverage Ratio
  • Maximum risk defined before the trade is executed
  • Correlation to the US dollar

If you can employ a blueprint similar to what Brian uses, you can simplify your approach and manage your downside risk effectively while trying to take advantage of world trends.

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