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I attended the X-Fund seminar the CBOT put on yesterday in their 5th floor
auditorium. Therefore, before I go any further I must disclose that I was
the recipient of an X-Fund tie (a $15 value), as were all the other
attendees. Now you might think that a $15 tie is not a big deal and will
not sway my opinion of the CBOT and their new product to be launched on Feb.
1. However this is not the first gift I have received from the CBOT. I am
also the proud owner of a small leather portfolio (which comes in very handy
for taking notes at seminars), which I think I received for criticizing the
CBOT in a previous email. Is that positive or negative reinforcement?
Anyway, the real value is the X-Fund tie.
As a tie challenged individual with a chronic case of STS, or Short Tie
Syndrome, I find it important to wear silly or funny ties that attract
attention by their silliness or their funniness. Therefore that fact that my
tie is consistently 2 buttons short of my belt is overlooked because, hey,
that is a funny tie. The idea is that the tie is supposed to elicit a
response and deflect attention from the STS. Being a tall person with a
long waist, I believe STS is genetic in nature. I had gone so far as to
construct several web pages on the Price Group Electronic Trading Division
web site about an UGLY tie contest. The idea behind the contest was that as
electronic trading took over from open outcry, one of the industries most
apt to be impacted was the distributors of the ugly ties worn on the trading
floor.
This led to months of people asking me if the ties I had one was one of the
ones from the ugly tie contest despite the fact they were fairly normal
ties. Thus the attention was deflected from the STS. So yes, I received a
free tie from the CBOT and I will cherish it always, or until it stops
deflecting attention away from the STS. On to the seminar.
*******
If the success of the X-Fund contract was correlated to the confident,
intelligent, pointed and thought provoking manner in which CBOT marketing
staff member Bob Hutchings presented the case for the X-Fund, then this
product will be a huge success. I can't tell you how impressed I was with
the case that Bob made, but of course I will anyway.
The X-Funds represent a new type of futures contract which borrows liquidity
from existing liquid futures contracts, therefore giving it deep and
persistent liquidity due to the arbitrageurs in place. The X-Fund
represents a futures contract which is not a competitive threat with other
exchanges' products or confrontational, but rather will attract trading
volume to those pits or matching engines.
The X-Funds represent a product which could benefit every pit broker working
in the pit or ring of one of the 35 contracts which qualify for selection
for the X-Fund components. The X-Fund also represents a contract that could
benefit every trader in the pits of those same contracts. And, the X-Fund
represents a contract that could benefit each and every brokerage firm in
the industry.
THERE IS SIMPLY NO OTHER FUTURES CONTRACT OR FUTURES PRODUCT WHICH DOES ALL
THIS.
The combinations of ways to trade X-Funds is extensive and already some of
the proprietary trading firms are constructing models to take advantage of
the underlying movements of the X-Funds and the built in arbitrage potential
for the contract.
The CBOT has been running a trading simulation for the X-Funds and has 100
traders participating. This is a tremendous turnout. Firms are putting in
electronic order routing capabilities to just be able to manage the
arbitrage trades for the X-Funds, according to a CBOT staff member. The
interest is there and the infrastructure is being put in place to make this
work.
Without sounding too much like a hometown fan, this is just the type of
innovation, creativity and deep liquid local participation that makes the
Chicago futures community the unique cradle of market innovation that it is.
The fact that the X-Funds will be pit traded, in the face of the trend
towards electronic trading, speaks to the strength of that innovation and
creativity. This is a new market that will have instant liquidity because it
takes advantage of what many local traders do best; lay off trades on
other bidders or sellers, spread trades against related markets and scalp
the markets. There will be plenty of trading opportunities for the local
traders, not because of a huge buzz of trading activity in the X-Fund pit,
but rather because of the trading and price movement in the underlying
component contracts.
The CBOT has also been running some simulated X-Funds prior to launch, just
as my newsletter has been monitoring a group of shadow X-Fund managers.
Despite expectations for positive cash flow and market appreciation for the
first two simulated X-Funds, both settled with losses.
As many of you know who have been following my X-Fund writing, I have a
problem with the concept that these X-Funds can somehow be designed to have
consistent expiration by expiration price appreciation. The regulatory
mantra of the managed money industry is that past performance is not
necessarily indicative of future results. Thus, I can't sell the idea that
these X-Funds have a tendency to appreciate over time because I have no way
of proving that until I have a statistically significant sample of X-Fund
performances. That will take at least a year of 2 week expiration X-Funds
before that is possible.
That is one reason I proposed the shadow X-Fund/O-Fund exercise, to measure
the performance of the X-Fund managers versus the O-Fund managers, including
my own random O-Fund picks. If the X-Funds will have a positive cash flow
record, they should outshine the O-Funds. If there is some special skill or
tool that can be used to derive consistently profitable X-Funds, then that
will be represented in the X-Fund traders and not the O-Fund traders.
The O-Funds are also meant to make money for the CBOT and the X-Fund
managers. There is a standard $1.00 per round turn exchange fee on the
X-Fund trades, but there is also a $7.00 per side surcharge for non-members
trading X-Fund contracts. Although this seems like a lot of money in fees,
this is actually a savings versus trading 26 weeks of the four component
contracts, according to the CBOT examples. The X-Fund managers participate
in the surcharge in some manner.
There are a couple other aspects of the X-Funds that I think could be
improved, which I have written about in the past. First is the accumulated
appreciation or depreciation of the $100,000 starting value with each week's
expiration. There is very little chance that any trader will consistently
return the same amount as the implied return of the X-Fund. The reason for
this is the 2 week expiration schedule and the fact that no one can buy and
hold the contracts over time, because the contracts components change and
they cash settle.
Thus, I believe that referencing the price of a particular X-Fund over time
is somewhat misleading if it is used to imply some implicit return on
investment. It would make far more practical sense to me to reset the X-Fund
to $100,000 for each 2 week expiration. The net bi-weekly movement could
still be reported by the CBOT, along with the composite and individual
component movements.
If it is not expectations of upward sloping price movements that attracts
traders to X-Funds, then what will it be? Volatility, capital efficiency
and the inherent arbitrage opportunities is my answer. One CBOT staff member
said that any X-Fund will be shut down if it expires below a value of
$50,000. This is related to the fact that quote vendors don't have the broad
based capability to trade negative prices. But I anticipate that should an
X-Fund fall below that amount, but is the most actively traded X-Fund
series, then the CBOT will simply adjust or reset the underlying index to
allow for continued trading by the manager.
There is no economic impact to any traders, investors or arbitrageurs to
resetting the X-Funds to $100,000 each two week expiration and re-launch.
Thus, the value of the index should not be the overriding consideration for
what X-Fund managers to continue using. The consideration should be the
volume the X-Fund managers attract and the results achieved by the
individual exchange members trading those X-Fund managers portfolios.
There are many unknowns about the X-Funds simply because nothing like this
has been offered before in the futures industry. I could be dead wrong about
my conclusions. The CBOT could be wrong about the retail public's acceptance
of a $100 tick size. Market tendencies highlighted by X-Fund performance
could be identified by large quantitative oriented firms trading firms and
the opportunities and tendencies could be crowded out. Expiration related
volatility in component contracts, as arbitraged X-Fund positions were
unwound, could create market movement and market noise which could affect
the analysis of the markets for future X-Fund picks.
I think the CBOT has something very special here in the X-Fund. If the CBOT
were publicly traded I would have gone out and bought some shares in the
exchange the first chance I had after the seminar. And that is despite my
misgivings about the ability of the X-Fund managers to create these baskets
to go up more than they go down.
Actually, I think the key to attempting this neat trick is to pick markets
which are severely overbought or oversold and bunch them together in a fund.
The proponents of the X-Funds have repeatedly said that the X-Funds will
either go up or they will go down. If the go down right off the launch,
don't buy them we are told. To me this indicates the the
overbought/oversold conditions will be persisting in an even more dramatic
fashion. Thus, it is best to not buy the X-Funds in such cases.
However, markets don't just go up or down, sometimes they go up-down-up-down
and so on. It is called chop. It is called noise. It can happen any time.
Never say never. Never say the market can't or won't do that. Because
sometimes they will and do.
The CBOT may think they bought my favoritism with the $15 tie, but that is
not true. I was an X-Fund enthusiast before I walked in the door. And I
have publicly proclaimed that if you want to buy my good will, all it takes
is Chicago Cubs World Series tickets. That is my price.
Actually, I am thinking of giving out free O-Fund boxer shorts to the shadow
O-Fund traders, including myself. But I will be wearing my O-Fund boxers on
the outside. I bet no one will notice or mention my Short Tie problem then.
:-)
Regards,
John J. Lothian
Disclosure: Futures trading involves financial risk, lots of it! John J.
Lothian is the President of the Electronic Trading Division of The Price
Futures Group, Inc., an Introducing Broker.
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