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As many of you know, I write a daily futures and security email newsletter
where I offer daily news stories and my own commentary about the changes
going on in the markets and new products being offered by existing and new
exchanges. One of the products that I have written about is the Xfunds,
which are expected to be launched by the CBOT in February.
This is an exciting new product idea that holds tremendous possibilities, and
I am being restrained when I say that. An Xfund is supposed to be a basket
of 4 futures contracts, long and short positions, selected by exchange
specified trading managers which are cash settled every 2 weeks. Then
another basket of contracts is selected by the trading manager and so on.
The Xfunds trade verus a starting index value of $100,000 and fluctuate in
value according to the price movements of the underlying contracts in the
basket.
Lets say for example that an Xfund consisted of long 1 March Soybean, Short 1
March TBond, Long 1 March Fed Fund and short 1 March Dow Jones. The value of
the price movements of these contracts would be netted out and added or
subtracted from the starting value of $100,000. A net gain of $100 would
mean the index was worth $100,100.
The beginning value of the next Xfund would be the ending value of the
previous Xfund from that trading manager.
The CBOT has selected some long time traders to be the initial managers. One
of the selling points for the Xfunds is there is an edge to buying them
because of the value of having these experienced traders pick the basket of
contracts. The public will be willing to pay the offer price in the pit to
get into these products, essentially a sort of short term managed futures
investment without the management and incentive fees. At least that is the
proposition.
Because the public would be willing to pay the offer in this pit traded
contract, that will open up arbitrage opportunities for the pit traders. The
tick size that has been discussed is $100, with an expected 3 ticks between
the bid and the offer. Thus, someone buying the offer would open up the
opportunity for the pit trader to arbitrage the Xfund by using market orders
to lock in the expected profits.
The originator of the Xfund concept is none other than Peter Steidlmayer, the
developer of the popular Market Profile.
I have written about a couple of concerns I have in the design of the Xfund
contracts, or improvements that I suggested. For example, I think the market
should dictate the bid-offer difference and that the $100 tick size is too
big. There is some undefined grand economic reason for the $100 tick size,
but I don't buy it. To me a $300 bid-offer spread cost to get into a trade
is like a bad fill in the big S&Ps, it is something to be avoided. Soybeans
will sometimes trade in penny ($50) increments when trading gets active, but
during slower times the bid-offer spread will narrow back to the exchange
minimum tick size 1/4 cent or $12.50. If there is an economic reason the
Xfund should trade at $300 between the bid and offer, the market will do so.
But if a smaller, say $25 tick, could be facilitated, then the market should
provide the structure for that. I think the $100 tick size would be a turn
off for a large section of the public. Bad marketing can kill good
economics.
The other concern I have is with the basic idea that these contracts can be
constructed by these traders to go up a large percentage of the time. The
figure 90% has been used in closed door gatherings of CBOT members, where I
was present. This claim was never adequately supported to my satisfaction.
Correctly, the CBOT preliminary material promotional material I have seen
does not include this or any similar claims.
Regardless, the idea that something will occur some large percentage of the
time going forward is against the regulatory dogma of the industry. Past
performance is not necessarily indicative of future results is the idea. I
can't see getting the performance percentages into any marketing material and
they are irrelevant anyway because you can't stay long the contracts over
time and could have the basket open at its high and settled at its low, but
still be higher than the previous index value settlement. Thus, the
increasing index value could be construed as misleading because actual
investors could not replicate those results.
The value I see in the Xfunds is being able to see into the minds of some of
the veteran traders who are the managers. Since there are no real funds
being traded by the managers, the CBOT might be able to entice some big names
or some unknown but talented traders to be managers. I had at one time
floated my name for consideration as manager, but did not pursue it because
of the concerns I had about the early designs for the contracts.
The Xfunds also present the opportunity for the CBOT to trade Xfunds based on
the futures contracts of some of the other exchanges. We could add a long
crude oil or a short sugar to the mix, or maybe even a long single stock
future contract to an Xfund. This offers tremendous opportunities for the
CBOT and its traders and could benefit the other exchanges as well by the
increased order flow associated with the hedging arbitrage.
I have suggested that the CBOT perhaps offer some Xfunds that did not change
every 2 weeks, but still do settle then. I have suggested that some of these
Xfunds might have longer maturities, perhaps 4 weeks. How about a yield
curve spread Xfund, or a straight basket of longs in Treasury futures (30,10,
5, 2-years). Having a consistent Xfund basket would give traders the ability
to do longer term studies into the basket's market tendency, rather than
having to do a shorter term study on a new Xfund every two weeks or a 5 new
Xfunds every 2 weeks.
I have suggested that the true performance of the trading managers would not
be able to be assessed until we had at least a year of performance data.
Thus, I think offering some of the static Xfunds would offer a mix that could
be analyzed and traded more immediately.
Anyway, what I would like to do is have 5 volunteers from the Omega List
volunteer to be unofficial Shadow Xfund Trading Managers and offer their own
suggestions for the components and baskets of Xfunds, just like the 5
managers are expected to start doing in February. There is no pay for this,
it is only an academic exercise. The shadow managers would be expected to
post their new Xfund component positions on the Friday night of the
expiration of the previous contracts. The managers could offer regular
updates to the list, but they would have to do so at least every 2 weeks with
the settlement of the Shadow Xfunds. The performance would be very
transparent and easily verified.
One of the unique components of the Xfunds is that they would reward brains
over capital. Many arbitrage trades ultimately offset against each other,
for example a long put versus a shares of the same stock. Thus the profits
you capture have much to do with your capitalization and ability to hold
larger number of arbitraged trades. Xfund arbitrages would have to be
unwound every 2 weeks or less. The cash settled contracts do not erase the
other half of the arb. This could lead to some interesting movements on the
closes of some of the futures contracts. This could in an of itself lead to
some interesting trading opportunities in the underlying components as the
contracts approach their settlement close. There could be some interesting
market activity tendencies to discover after these Xfunds settle.
One of the reasons I think this contract will work is because the trader can
uses the liquid underlying contracts to neutralize the position, take partial
profits or reduce exposure whenever they want. And they can do this as a
much reduced bid-offer spread cost. Even though the Xfunds may not be
heavily traded at the beginning, it is easy to neutralize the position with
the underlying contracts. Thus, the illiquidity of the Xfunds may not be
that much of a factor for those holding positions.
Xfunds could be the next huge success in the futures markets. It will
require some fine tuning of the contracts by the CBOT. I would like to do
this exercise to engage the Omega List in the discussions about this new
contract, calling on its members' wisdom and enterprise. I would think that
this lists members would be among those traders who are able to profit from
including Xfunds in their trading.
If I can get 5 volunteers, I would like to start the project on next Friday
for a trial run. I would propose starting officially when the Xfunds launch
in February, thus coordinating the settlement dates for the real Xfunds and
the Shadow Xfunds.
If you have suggestions or nominations for potential traders, feel free to
email me those privately. I will select the first 5 traders who volunteer or
whose names are volunteered and accept when contacted. I would expect we
would want to run the experiment for several months, depending on the
response to the first real Xfunds and their performance and that of the
Shadow Xfund Managers.
In the name of disclosure, as many of you know, I am a broker and run and
electronic trading operation for The Price Group. I am also involved in the
managed futures area. I am also a candidate for the NFA Board of Directors
representing Guaranteed Introducing Brokers. The suggestion for this
exercise should not be considered a solicitation to buy or sell futures
contracts.
What do you think? Anyone interested in being a Shadow Xfund Manager? One
caveat I have is that the managers should be mostly public traders, not
industry professionals. So I will allot only 2 of the 5 manager slots at
most to be professionals.
Regards,
John J. Lothian
Disclosure: Futures trading involves financial risk, lots of it! Past
performance is not necessarily indicative of future results. John J. Lothian
is the President of the Electronic Trading Division of The Price Futures
Group, Inc., an Introducing Broker.
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