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Assessing Market Reality

Trading looks easier than it is. Think of how clear the trends and pat­ terns seem on an old chart of the DOW, or gold, or bonds. The reces­sion that started in 1990-1991 was severe and prolonged, and it caused bond prices to move steadily higher for three years. It is perfectly clear that interest rates could do nothing other than decline. But how many "traders" just held bonds rather than bought and sold throughout the whole period? Not many. Whether people are trading stocks or selling crops, they usually buy and sell when they are forced to, or when they can no longer stand the stress of holding the position.

Change is difficult. We tend to be resistant, slow to recognize change, and often slower to react. Awareness of change often comes when it becomes obvious that the old way doesn't work anymore. Only then do we look for new solutions. This chapter looks at changes in the market structure, its participants, and in the way we use the new tools. Recognizing the problems can be a convincing argument for changing some of your trading methods.

The Screen Is History

Prices that appear on the quote screen are already part of history. In a fast futures market, the price you see may have traded 5 minutes ago. At any time, the market is more likely to be trading at a price that is differ­ ent from the one you see on the screen. The screen shows where the price traded last, not where it's going to trade next. When execution timing is critical, you cannot wait for a screen price. The screen is not the market. It lags the market in the same way a trend lags actual price movement.

That's not to say that you always get a poor execution price. There are those times when, because you were too slow, you got in at a bet­ter price later. But they are exceptions. Even when you can make the entry gracefully, exiting a trade can be a rushed event. Use of sponta­neous judgment only gives you the opportunity to delay the exit, hold onto that losing trade, and wait for a worse price to come along.

The screen is a poor substitute for a resting order, which gets execut­ ed immediately. Unfortunately, Stops and Limit orders only work for small lots. However, anticipating a trade, whether a computerized or intuitive system, will improve the ability to get a target price for small­ er, individual traders as well as institutions. The importance of antici­pation will be discussed later in this chapter.

Nonexistent Spread Profits

During the trading day, screens often show prices within a single mar­ ket, such as crude oil, that appear out of line. Or, a part of the yield curve, such as the 10-year note, may be too high with regard to the 5- and 20-year instruments. Box 2-1 shows the prices as they might appear at midday , with the November quote clearly out of line with respect to other delivery months.

If you try to spread those markets, to profit by selling the apparent distortion, you find that the bid-asked is perfectly in line with the other months, although the screen price only reflects the last trade. The price was higher or lower on the screen simply because one for­ ward month had not traded while activity in the neighboring delivery months had moved those prices lower.

In general, spreads that are constructed by matching two separate price series will suffer the same problem. The traded spread price is not often saved as historic data because it seems easy enough to create a spread once you have the prices for each of the components. It sim­ply involves getting the prices at the same time.

Frequently, two markets do not trade at exactly the same time. The spread will appear to move in and out based entirely on one market trading while the other remains quiet. This is especially the case for a nearby versus deferred delivery of the same futures market. In reality, the spread price (the difference between the two months) may have remained unchanged during the entire time.

Sep Oct Nov Dec Jan Feb Mar

Futures Contract Delivery Month

Figure 2-1. Distortion in crude oil forward prices. A relative price distor­ tion is shown for the November contract.

The November quote of 18.70 should be closer to 18.45 if the carrying charge pattern is to remain uniform. A butterfly spread that buys one Oct and one Dec and sells two Nov would capture certain profits. When the spread prices are quoted, however, you find that Nov is bid at the equivalent of 18.45. The distortion only exists on the screen because Nov has not traded in 5 minutes while the other delivery months were more active.

Closing Prices

It is more common to use the closing prices to generate a spread. For financial markets that close at the same time, these prices can be reasonable, if you consider the slightly higher transaction costs of executing a spread. However, creating a spread from the closing prices of two mar­kets that did not close at the same time (and at the same exchange) cre­ ates an unrealistic spread price. If you trade only the IMM (International Monetary Market) currencies and the Swiss franc closes 5 minutes after the Deutsche mark, then the spread may appear to widen or narrow during those 5 minutes. The Deutsche mark will remain aligned with the Swiss franc in the cash market, and open the next day at the spread price that existed 5 minutes before the Swiss closed, when both markets were open. A trading signal based on prices quoted at different times could easily have been an error.

Execution Problems and Performance

Brokerage fees are often only a small part of transaction costs. Slippage, the difference between the price you wanted and the price you got, is a costly component in trading. This ignores the fact that some trades don't get filled at all. Unables, the trades that don't get executed, are the biggest problem and the greatest cost for large traders.

You can get filled on any trade if you must be in or out of the mar­ket. By placing an order "at the market," it will be filled; or, you can take the bid or asked price in the cash market, regardless of the amount. But most traders won't take any price; systematic trading generally requires a price relatively close to the signal or target price to produce profits.

"Unables"

Unables are usually orders that were canceled because the market moved too fast and too far. This applies to entering new positions much more than getting out of existing ones. Entering a position allows more selectivity; exiting a trade always seems to be an urgent matter.

Experience shows that a fast trend-following or breakout system can miss nearly all profitable trades under poor market conditions, and up to 30 percent of all profitable trades during a volatile 1-month period.

Intraday breakout systems show the typical problems. Buying a breakout that occurs during the trading day may not be possible. When government reports are released just after the opening of the U.S. financial markets, prices can leap to new levels. Only a few con­tracts in total may be executed during the price move that lasts only a few seconds. You can't expect to be filled by being fast or using a Stop order. You can only buy the top or not buy at all.

An individual with a small order may be pleasantly surprised once in a while, by getting an execution somewhere before the market reaches its extreme. If you trade larger lots, say 100 or more futures contracts, and limit the slippage that you will accept (by using Limit orders or waiting for a specific price level), expect that 5 percent to 30 percent of your trading volume won't be filled over the long term. Many times all of an order will be filled, other times very little.

Who Is Likely to Have Execution Problems?

Not all traders have difficulty getting fills. The worst performance comes from a combination of five features:

•  High-volume traders, such as fund managers and institutions. Large
orders mean pushing the price, especially if you are exiting a posi­
tion. It means that it may take from 10 minutes to 3 days to execute
an order. It's difficult to get a specific price under those conditions.

•  Short-term traders, holding positions for less than two days. Fast trading
keeps both profits and losses small. Slippage can take a large per­
centage from profits, in addition to increasing the size of each loss.

•  Trend-followers, buying and selling in the direction of the price move.
Buying when the market is rising always results in sizable slip­
page, and occasionally an unpleasant surprise when prices jump.
Good news is rare.

•  Intraday traders, executing orders between the open and close. Volume
drops sharply between the open and close of an foreign exchange trading
session, and between traditional business hours in interbank mar­
kets. It is not always easy to find someone to take the trade, or the
bid-asked moves to an unacceptable spread.

•  Traders who use limit orders, such as "Or Better." Rather than using
"At the Market orders," professionals try to execute at a price. They
can find themselves chasing the market more often than they
expect. At some point, the price becomes unacceptable.

An institutional trader, such as a fund, using a short-term breakout system (considered to be trend-following) in which signals occur at any time during the day, would have the largest slippage and the most unables. Few traders and methods are immune from unables.

Only the Profits Don't Get Filled

It is easy to see that the unfilled positions would have all been profits. If prices had reversed after a breakout or trend signal, there would have been an opportunity to enter the whole trade. Therefore, it is the profitable move—where prices keep going (or pull back only a small amount)—that does not get executed. The losing trades are always filled and you miss only the winners.

Can you make money trading a system where 5 percent to 30 per­ cent of the profitable positions aren't filled or when you must excecute in a fast market? Box 2-2 shows that a single unexpected price jump

Example 1: Impact of normal slippage

A trend-following program has an average profit of $500, an aver­ age loss of $150, and is profitable 40 percent of the time, netting an average combined profit of $110 per trade after commissions, with­ out slippage. Trades in the Deutsche mark, entered as Stop orders, are typically filled 4 pips from the signal price, but no less than 2 pips. For a Chicago International Monetary Market contract, traded in 8ths of a million, that means a cost of no less than $25, but nor­ mally at least $50 of added cost for each entry and exit. That leaves only $10 per trade as an expected profit!

Example 2: Impact of slippage in a fast market

The importance of slippage can be reduced by increasing the expected profits per trade. Using a slower trend-following approach, with larg­ er profits and fewer trades, the program produces the same $500 average profits, $150 losses, and a 40 percent reliability, but this time net of both fees and normal slippage.

When the IMM Deutsche mark opens at 7:20 a.m. in Chicago , the price is at 58.10. The trend-following system has a buy Stop entered for 20 lots at 58.25. At 7:30 , the U.S. Balance of Trade is released, showing a deficit of $12 billion, unchanged from the previous month, but $4 billion worse than expected. The fills come back from the floor: 2 at 58.30, 5 at 58.60, and 13 at 58.75, averaging 58.667. The total slippage is US$521 per contract. If this program has one trade per week, the expected returns would be:

21 Profits @ $500 = $10,500

31 Losses @ $150 = (4,650)

52 Trades total $5,850

A single added loss of $521 is 9 percent of the annual returns.

could cost nearly 10 percent of the expected yearly profits. If you do not plan for execution problems during development, most programs will not survive.

Improving Results

The three ways of reducing the unpleasant effects of unables and slip­ page are to seek larger profits per trade, use realistic transaction costs in testing, and anticipate the trading signal (anticipation is discussed in Chapter 11). Larger profits can be accomplished in the following ways:

•  Holding long-term positions. Trading only one to three times per
year, with large expected profits, reduces the importance of slip­
page and allows a longer time to enter and exit a trade. An average
price or a specific entry strategy can work well.

•  Targeting larger profits per trade. When using a faster trading
method, which is a necessity for many foreign exchange operations,
profits per trade can be increased by selecting more volatile markets
or by including a profit-taking strategy. Profit taking will improve
the overall profile of a system and will contribute significantly to
reducing slippage.

Test Criteria

The use of a realistic execution price when simulating a trading strate­ gy can resolve all slippage and profitability problems. You cannot know if a strategy will be profitable unless you assign correct entry and exit prices. The following procedures are advisable:

•  Approximate "normal" slippage. Box 2 - 3 shows that fill prices are
based on a number of factors. The net transaction cost is difficult to
determine in advance. A "worst-case scenario" may be too extreme,
but something less than an optimistic approach is best.

•  Estimate fills for intraday trading. It is safe to assume that you get the
worst price during the 5-15 minutes following your order. That
means taking the worst high or low during the interval, not just the
price at the end of the period.

•  Test for "locked-limit" moves in futures markets. In most cases, you
can't buy if the closing price equals the high of the day; you can't
sell if the close equals the low of the day. The exchange system of
settlement, based on an average of the last one minute of trading,
makes it unlikely that the close will settle at the high or low. Of
course, when the high and low are the same, no trading occurred.

The best estimate comes from monitoring a system that is actually traded, as discussed in Chapter 11. Unfortunately, that does not help at the early stages of development. Previous experience will allow you to estimate the transaction costs for trend-following and other pro­grams, even though those strategies are not identical to the current system.

The following guidelines are for buy orders:

Maximum volume. Assume that an order will not be entirely filled, at any price, if it exceeds 5 percent of the daily volume.

Screen trading execution lag. If Stop orders are not used, traders must assume that prices have moved past their price by the time that price appears on the screen. At best, the screen shows the bid price. The calculations above assume that the time to call the bro­ ker, quote the price, and place one or more orders results in larg­ er slippage.

Small lot Stop orders. Small orders placed as Stops are usually filled at prices showing slippage greater than you would expect from the bid-asked spread. You. often pay a premium for trading small.

Globalization: Simultaneous Absorption

The Nikkei drops 700 points, and the S&P opens 200 lower. The Bundesbank raises the rate on the bund by a half-point, and U.S. bonds drop. The old theories of isolationism no longer exist. Economic events in one financial center affect financial markets everywhere with nearly instant reactions. As Great Britain struggles with its economy, its equity market fails to react to rate changes by the Bank of England. Instead, it is pulled by the more influential trading partners in the European Monetary System.

Portfolio diversification is more difficult when markets are tied together, pulling at each other. Some of the new links between invest­ ments are not yet obvious because they have not been tested. Diversifying a portfolio into 30 percent selected stocks, 30 percent bonds, and 10 percent currencies seems safe until a political crisis sur­faces. Then money runs to the safety of the U.S. dollar. Bonds move sharply higher, stocks move slightly higher, and the dollar gains, post­ing a loss in the Forex holdings. The currency allocation is reduced to compensate for the sudden increase in risk just when the international problems ease. Money flows away from the dollar, bond prices drop, the dollar drops, and stocks drop. Your holdings in currencies are too small to help the portfolio. So much for diversification.

Even though each investment group, individual stock, and commod­ ity is directly affected by its own fundamental factors, the global pic­ ture can overwhelm all of them. The purpose of diversification is, fore­ most, to protect a portfolio from extreme risk. Normally, there is ample time to shift positions and take advantage of changing opportu­ nities. With a crisis or price shock, it is too late. Investors pull funds from entirely unrelated investments to cover losses elsewhere. This causes all markets to reverse at the same time.

Factors That Always Exist Noise

An unusual market move may cause you to forget that many underlying factors still exist. A fast move always includes some noise, which should be no less than in a normal market, perhaps larger. An anticipated price or target level may be over- or understated by the amount of market noise. Profit taking when high volatility has clearly favored your position is a way to take advantage of noise. Waiting to liquidate a position that has taken a bad loss on a price shock shows an understanding of noise.

Inflation

Inflation moves along at a relatively steady rate. If prices do not have an upward bias, then they are going down relative to other products. This relative decline can be confirmed by a long-term drop in volatility and a better return to risk ratio for purchases rather than sales.

Seasonality

A market that does not exhibit known seasonal tendencies is still sea­ sonal. During the prolonged devaluation of the U.S. dollar in the 1980s, grain prices tended to move higher, sometimes during periods when seasonal patterns would have favored lower levels. Attractive exports, combined with price parity (a buyer in any country seeks the cheapest price) causes the price of freely traded commodities to main­ tain a constant world value. Seasonal patterns are overwhelmed by outside interest but still exert their influence on prices. During periods of lower supply, the commodity price will be that much higher to include a supply premium. Because seasonal factors cannot be removed, a period that overwhelms them, causing them to appear ineffective, is even more volatile and more unstable than it might seem.

Change and Evolution

An interesting phenomenon of change is that, when events stabilize, they are never quite the same as they were. Globalization and commu­ nications, broader markets, new technology, and better quote machines and analytic tools mean that markets are evolving. They will never respond to one another in the same way they have in the past.

The European Monetary System tries to regulate the variation (although not the volatility) between member currencies. The entry of Russia and China into the free market system can change both the sup­ply and demand of nearly everything. It increases the chances of short­ age and surplus. U.S. stock prices could double quickly if money could move freely between countries. Or, money could flow to the rapidly expanding Asian economies, shifting the center of finance.

Change means that the past does not help us to forecast the future as much as we would want. Unless you view the past as an evolving process, trading methods that worked in the past may no longer work. If market relationships change, you cannot use old data to forecast the future. You only know that the future is going to be different.

The assumption made by rigid systems, such as trend-following, fixed cycles, or patterns, that the current state of affairs will continue, contradicts reality. We are only passing through the current state. A trend-follower can only hope that unexpected changes do not cause extreme volatility that results in unreasonable losses. It is not the fore­ casting attributes of a trending system that allow profits, it is the risk controls.

To forecast successfully is to accept the inevitability of change and the risks associated with it. You cannot assume that the future will be the same as the past, that the risks and profits and patterns will repeat themselves. We can only try to develop systems that recognize the possibility of change and are flexible enough to profit from it.

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