by Joe Ross.
The markets have changed and are still changing. Whenever I say that, I’m asked: “How have they changed? In what ways have they changed?”
A trader today can trade in a variety of markets and nations and at numerous exchanges.
When I began trading there were only eight to ten truly tradeable futures markets. For me these were in the United States, one of the two nations that actually had futures markets. The others were in the United Kingdom, but I had no access to those markets.
There were just a few thousand traders in the futures markets, and for the most part what I did was called ‘commodity trading’. Furthermore, there were only about 20,000 traders of all kinds in the entire world, including those who ‘traded’ – as opposed to those who invested – in the stock markets.
Today there are hundreds of thousands, perhaps even millions, of traders in all markets, and the number is increasing. The changing composition of the group of traders who are trading the markets is what changes the markets themselves. After all, a market is made up entirely of its participants.
There are also a considerable number of markets from which traders can choose. Markets are no longer limited to consumable commodities. We now have financial markets of all kinds; these include bonds, notes and currencies. Currency trading has become so common that national currencies are now traded via a cyber-world that is called ‘Forex’, a market with no regulated exchange and very few rules.
In addition to financial markets, we now have stock index trading. In fact there are all manner of indexes being actively traded today. Exchange Traded Funds are increasingly popular among traders, as they allow for a trader in one country to trade the best companies in another country using a single index. There are also at least two commodity indexes that are traded: there is growing participation in the CRB and the Goldman Sachs commodity indexes as commodities begin to challenge financial markets as a venue of choice. Recently, Gold Tracks became available, traded under the symbol GLD. It is now possible to trade physical gold in the form of index shares or ‘I-Shares’.
Single Stock Futures are slowly but surely coming to the fore. They promise to replace much stock market trading by making it possible to trade an index of stocks within a certain market sector using the futures markets.
Many commodities have come into being that were not there when I began trading almost 48 years ago: gold, unleaded gas, natural gas, and fertiliser, to name a few. Many nations now have futures markets that never had them before.
To go along with changes in those who participate in markets we have seen changes in the way markets move. Such changes have been caused by:
• traders who use computers and trading models;
• fully-electronic trading platforms;
• day traders.
Computerised trading models
For the most part, the people trading large pools of money are the people who use mechanical trading systems, also known as computer-driven trading models. Trading pools of money using computerised models can cause the markets to explode or melt down rather than to trend. Models are either trend following or value-oriented. There is not much else they can be. Let’s first look at trend-following models.
The problem is that there are only a few variables that can be included in a mechanised mathematical system. How many ways can you combine or evaluate the Open, the High, the Low, and the Close? Will it make a huge difference whether you use simple or complex moving averages of these four variables? Will it matter significantly whether or not you add volume into the equation? Just how many ways are there to determine the trend? Virtually every method for trend finding is based on some sort of moving average of prices, is it not?
All moving averages, when de-trended and presented as oscillators, are an attempt at measuring momentum. Is the market trending up or down? Then which direction best represents the pressure in the market? Is there more buying than selling? If so, prices should be rising. If there is more selling, then prices should be falling.
The net result of all these models attempting to discover trend is that they are all going to find the same trend at approximately the same time, literally within moments of each other. The models are, in fact, correlated.
What takes place when all of the models suddenly discover that prices are trending upward? They all give buy signals. What happens when all the models suddenly discover that prices are trending downward? They all give sell signals. What happens in the market when people who have huge pools of money suddenly decide they need to take action with regard to the current trend? The market begins to trend more steeply. It may even explode upward or melt down, depending on the newly discovered trend.
There is only one factor that can mitigate the absolute dynamics of an explosion or a meltdown. That factor is size.
The trading pools have so much money that they cannot afford to put on their entire position at once. If they do so they will shoot themselves in the foot.
If people in a pool buy too much all at once, they will drive prices substantially higher, thus having to put on their position at an increasingly higher price. They may even cause prices to explode upward. Their buying activity will appear to be real demand, but in fact the demand in the market is partly real and partly false. The false demand is caused because the pool’s computer is indicating that the market is trending and therefore they should buy. But the computer-generated demand is artificial, and may have nothing whatsoever to do with real fundamental demand for the underlying.
The same principles apply to selling. If people in the pools try to sell too much all at once they will drive prices substantially lower, and have to sell at a lower price than they want to. Their selling may even cause a price collapse. Their selling looks like there is too much supply of the underlying, but much of the downtrend will be due to pseudo oversupply, that is, the pool’s computer-generated selling causes the market to go down more steeply and possibly more quickly than would natural market forces.
So, we find the large pools having to ease their position into the market. The result is an enhancement of the trend, but the trend will tend not to last nearly as long as if the pools were not involved. What is really happening is that the real trend, caused by real demand or real oversupply, is now being accentuated by the buying and selling of the trading pools, simply because their computers have told them that the market is trending.
Pools dominate the futures markets
Before there were such things as commodity pools (they should be called futures pools), commercial traders dominated the markets. The commercials knew how to keep a trend going, and milk it for all it was worth. But today the commercials face a serious challenge from the commodity pools as to who will dominate the futures markets. The pools do not have a clue as to how to maintain a trend. They all rush into a perceived trend when their computerised models tell them that there is a trend.
The trading actions of the pools actually kill the trend.
There is another way in which trading pools destroy the trend, with the result that markets trend a lot less and for a shorter period of time than they ever did before.
Many pools use valuation models for trading the markets. The models compare today’s price with what the computer determines is a relatively overvalued or undervalued price. The computer looks back historically over several months or years and comes up with what the price should be. Therefore, when a trend really gets going, and prices are much higher or much lower than the computer thinks they should be, the commodity pool receives a buy or sell signal.
Let’s say that the commercials are very nicely moving prices up. They are in no hurry. All of a sudden the pool computers decide that prices are too high compared with the past. The pool computers issue a sell signal. Being correlated with one another, the pools all begin selling. Prices start to fall, or they stop going up and enter into a trading range top. The reverse is also true when prices are deemed by the computer to be too low. The computer issues a buy signal and a lot of pool buying comes into the market. At that point you will see a 1-2-3 low and possibly a ‘v’ bottom. Usually, there will be a 1-2-3 low and then a trading range.
In either case, the valuation models have killed what was previously a trend. Unless there is either massive buying or selling coming in from the public that might cause the trend to continue, the trend will end.
Day trading history
So far I’ve shown how trend-following models and value models affect the markets. Now let’s take a look at day traders.
Day trading began to be fairly common in about 1980. Most day traders traded the full S&P 500, the currencies, or the bonds. The only decent day trading took place in those three markets, with ‘Swissie’ being called the ‘day trader’s market’, though there were a few who attempted other markets.
When day trading became available to traders who had live data and a computer, the exchanges, along with the brokers, began heavy marketing of the availability of rapid trading, claiming traders could make big money in a matter of minutes. Commission rates dropped dramatically. Word got out and the number of traders attempting to day trade increased rapidly.
Discount brokers sprang up. Discount brokerage firms took out huge ads in The Wall Street Journal and Investor’s Business Daily. They also advertised in a variety of trading magazines. These magazines were full of ads promoting mechanical trading systems, low commission brokerages, day trading software and various data feeds.
As the number of day traders increased, so did the noise in the markets. Short-term trading was all the rage. Intra-day prices chopped up and down as day traders bought and sold for only a few ticks. Markets went mostly sideways until either real supply or demand, or someone with enough clout to move the market came along. What at one time were beautiful intra-day trends gradually became chopping intra-day trading ranges.
During the 1990s currencies lost their attraction for thousands of day traders. At the point that banks were trading over $1.4 trillion daily there were not enough currency traders in the pits to handle the huge currency trades that were needed. For a while the price for a seat at the Chicago Mercantile Exchange (CME) increased geometrically. Entities that needed to hedge in the currency markets were hiring ex-football and basketball players to stand in the pits to trade. Their physical size gave them an advantage in the push and shove of the trading pits. Anyone under 6’ 3” tall was at a disadvantage. Their bids and offers simply could not be seen because of the behemoth-sized ex-athletes standing in front of them. Nevertheless, there were not enough locals and floor brokers in the pit to take the other side of the mega-million currency trades that needed to be made.
Those entities needing to buy or sell huge amounts of currency could not find satisfaction in currency futures. Banks began to call each other and do off-exchange trades. These trades among banks are called ‘currency swaps’. And the environment in which they are made is called ‘Interbank’. Those who didn’t want to bother with making deals directly with other banks chose instead to use Forex brokers to handle their currency trades. In Forex there were no commissions and no fees to be paid. Forex brokers made their money on the spread between the bid and the offer. The result was that there were fewer traders in the currency pits. The volume plunged like a rock. Formerly liquid markets gradually became illiquid. The price of a seat on the Chicago Mercantile Exchange dropped to a quarter of what it had been. Did the drying up of the currency markets affect day traders? It sure did. It sent them scurrying for the bond pits and the S&P.
What happened in the S&P is a story in itself.
To be continued in the Sep/Oct 05 issue of YTE.
This article was originally published in the Jul/Aug 05 issue of YourTradingEdge magazine. All rights reserved. © Copyright 2009, MarketSource International Pty Ltd.
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