CTA Selection: Portfolio Construction Process

Technical traders use such factors as price, open interest, volume momentum, relative strength and moving averages to predict future price movement. Fundamental traders consider economic analysis, government policy shifts, foreign monetary shifts, industrial production, crop carryover, crop plantings and weather patterns as well as supply and demand factors to predict future price movement and market direction.

There does not appear to be an overwhelming edge to using either technical or fundamental analysis. Many technical traders use fundamental factors to confirm their trade selections and many fundamental traders use technical factors to determine the appropriate time to enter and exit positions.

Systematic traders use technical systems to trade the markets and many of these systems are computerized. These systems generate trading signals that are executed regardless of overriding economic or fundamental factors. Secondary systems may be used to determine the number of contracts to trade and to establish stops and/or profit-taking objectives.

Discretionary traders often use technical indicators, but rely on their trading experience and discretion to determine what and when to trade. An analysis of prior trading experience is extremely important with this approach.

Trend followers trade both rising and falling markets by initiating trades in the direction of the trend. Long positions are usually protected by stops placed below the execution price, while short positions are protected by stops placed above the execution price. Once a position is significantly profitable the initial protective stop is replaced by a trailing stop. Not all CTAs use protective stops and/or trailing stops. In extreme market conditions, there is no guarantee that a stop can be executed at a favorable price. Most trend followers stay with a position until there is a trend reversal and rarely exit at the top of a market. Some trend followers use volatility as a signal for exiting the market as the riskiness of holding a position increases.

Categories include fundamental trading, momentum, countertrend, pattern recognition, spread trading and arbitrage. Momentum traders look for indications that a market is about to break out in one direction on high market volume. Countertrend traders look to take small profits by trading against the trend. Trading is usually more active for countertrend traders as they have a shorter outlook on the markets. Pattern recognition traders look for clearly recognizable patterns that indicate a potential move in the market. Spread traders take advantage of market differentials by being long and short different months of the same contract or by trading the differential between two markets, such as corn vs. wheat or the Japanese yen vs. the U. S. dollar. Spread trading does not limit the potential for loss. Traditional arbitrage trading is the simultaneous buying and selling of the same asset in different markets. The goal is to profit from temporary price differentials.

Option writing has become increasingly popular over the last few years, particularly in stock index futures. Option writers look for opportunities to receive premiums, with the goal of having the options expire worthless, thus retaining the profits from the premium received. Options can be traded outright or as spreads. Purchasers of options have limited risk (the risk of losing the premium). Writers of options have unlimited risk.

Reversal systems are distinctive in nature because the CTA that uses this method attempts to always have a position in the market. Over the last few years, many reversal systems have developed an override that keeps them out of the markets during periods of extreme volatility or choppiness.