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Some of the worst market analysis ever!

I came across an article the other day which got my blood boiling a bit. It basically talks about trading the “spread” between the S&P 500 and EUR/JPY forex cross rate. The author was quite happy with himself for calling the spread being exceedingly wide and recommending a spread narrowing trade. He went so far as to say “Selling ES and going long EURJPY is now pretty much risk free.” I don’t know what anyone else’s definition of “risk free” is, but this trade certainly isn’t mine.

I don’t have any problem with the general idea underlying the trade that stocks and the EUR/JPY rate tend to trade in tandem. It’s been the case for quite a while now that when the market’s are feeling good and buying stocks EUR/JPY (and really all the JPY pairs) will rally, but when the markets are nervous and shifting into a risk aversion mode both the exchange rate and the stock market falls.

My issue with this analysis is this. The author is using a dual-axis plot of the S&P and EUR/JPY (meaning two price plots with different y-axis) to determine the “spread”. When there’s a gap between the lines there’s a spread. When there isn’t, the spread is zero. That would all be just fine if the S&P 500 and EUR/JPY were even close in price, which they aren’t.  At this writing the mini S&P contract is at about 1066 while EUR/JPY is right around 110. Notice how they are not anywhere close to zero?

This has got to be some of the worst analysis I’ve ever seen. Please, please, please don’t every employ this methodology – if you can even call it that.

And calling or implying this trade is some kind of arbitrage is even worse. There is absolutely no mathematical or other direct linkage between the S&P and EUR/JPY. That means no arbitrage, just a coincident relationship. It just so happens that in this market cycle they are trading based on the same main drivers. That could change at any time. That means you most definitely have risk.

Again, I’m not necessarily arguing against the idea of the trade (stocks and cross get back in line). I’m just saying the analysis used to get there is severely flawed and dangerous.

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Stock Trading is Not Zero Sum

I recently got a zero sum question in regards to the stock market.

The one question I cannot seem to find the definitive answer to is this:

Is the Stock Market a “zero sum” entity?

I have done a lot of online research the last week or so trying to answer this question. Unfortunately, there are too many differing views on this subject and I have not yet found confirmation.

I’ve addressed the general zero sum question previously in the post The Zero Sum Game. Let me tackle stocks specifically here, however.

First, a zero some game is one in which there must be an equal loser for each winner. Basically, it’s a matched pair where there can never be any net gain or loss in value in the aggregate because increases in value for one side are offset by decrease in value on the other side.

Think of it like this. Billy and Bobby each have 5 balls for a total of 10. They are in an enclosed space, so no new balls can be introduced and no balls removed. In order for Billy to have 6 balls, one must be taken away from Bobby, who will be left with 4.

In trading terms, zero sum mean that there is a short for every long. The futures market is a perfect example of this. Futures are contracts for an exchange to take place at a later date. There are two sides to each contract – a long and a short. The long benefits from an increase in the value of the contract, and suffers from a decrease. It’s vice versa for the short, on a dollar for dollar basis. What the long gains comes from the losses of the short.

In asset markets, however, there isn’t necessarily a short on the other side of a long position. In fact, in most cases there isn’t. That means generally speaking, someone who owns the stock will be the sole winner or loser should the value of the stock change. No one else is mirroring that performance on the other side. It’s like owning a house. There’s no short on the other side of a home purchase, so the home owner is the only one impacted by changing values in the property.

I have heard some contend that the seller of the stock (or house) is in fact like a short because of the forgone gains or losses. That’s an opportunity cost argument, though, and one which really cannot be pursued in any reasonable fashion for the simple reason that we don’t know what the seller is doing with the funds, nor do we know if the buyer is actually making the best investment with her/his money.

Others might contend that if you only look at “trading” then stocks are zero sum. Again, since there doesn’t have to be a short on the other side of a stock long then it’s not really zero sum. Besides, traders buy stocks from investors and investors buy stocks from traders, so you cannot look at the groups in isolation.

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Trader Resources Trading Tips

Watching Positioning Figures for Biases and Changes

As you may have gathered from some of my prior posts (like
Using COT data to spot potential big moves), I keep an eye on the weekly Commitment of Traders data to see if there have been any big shifts in trader positioning. A big part of that is tracking how  the small speculators are positioned in the mini S&P 500 futures. There it’s about looking to play against the herd when they are strongly positioned. As of last Tuesday they were 68% short the market, which keeps me suspecting that more upside is probably coming in stocks.

I also watch the COT data for currencies to see what the big players are doing. Now, this isn’t the same as seeing positioning data in the spot market, but it does at least hint at things. In particular, it’s worth noting when the are very strongly biased positions on, and when they change. We’ve seen both recently in a couple currencies.

Take a look at the tables on the left. Notice what has happened in the last few weeks with the way the Large Speculators have been positioned and how that’s changed over time. In most cases that means reducing previous large long positions.

For example, in the euro they were about 60% long and now are nearly 60% short. There wasn’t a switch in the pound, but traders have certainly gotten much more short than they were. This is from the dumping of longs, though, not the increase in shorts.

Things get really interesting when looking at the yen. The large players were 83% long just a few weeks ago. Now they are much closer to being neutral, though remain a bit long thanks to a combination of long reductions and short expansions.

Things are even more dramatic in the Swiss franc. There the large players reached almost 90% long about a month ago. Now they are almost right on the flat line thanks to a combination of both a major cut in long and a 3-fold or so increase in shorts.

If you compare these changes in COT positioning data to the price action of the last few weeks you can clearly see how things have been playing out. GBP/USD has traded down from near 1.69. EUR/USD has given up about 800 pips since the early-December highs. USD/JPY is up nearly 600 pips from its lows (meaning yen losses). USD/CHF has risen more than 500 pip from it’s lows (again, swissy losses).

Now, much of the action these last few weeks has put the market more toward a neutral position. The one exception is in the pound, where traders have been getting more short. That is going to be worth watching.

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Trading Tips

Looking at Stock Market Internals for Confirmation

While I’m no longer a stock market analyst (I’m focused on forex these days), I still keep my eye on what’s happening in equities. It is, after all, a big inter-linked financial world.

One of the things I watch when looking at the big stock market picture is the Advance/Decline line. Basically, that’s a measure of how many stocks have risen vs. how many have fallen on a given day. Because there can be big swings day to day based whether the market is up or down, most A/D lines do something to produce a smoothed out reading. Some are cummulative figures. Others, like the one I like to look at, is average-based.

You can see it plotted at the bottom of this chart.

SP500-103009
To be specific, the plotted A/D line above (blue line) is the 13-period exponential moving average of the difference between NYSE advancers and decliners.

I look at the A/D line as a confirming or diverging indicator. When the market is making new highs and the A/D is making new highs, you have a confirming indication. When, however, you have the market rising and the A/D line is falling you have a divergence. As you can see (highlighted by the red lines), that’s been the case recently. The market has been making higher highs and higher lows, but of late the A/D line has made a lower high and a lower low.

Divergences are warning signs. They indicate that something may not be quite right, but they don’t automatically mean the market is going to reverse. I have seen divergences persist for long periods before the market finally does change course. Also, sometimes they just don’t work out, like earlier this year. Notice how the market made a higher high in August, but the A/D line failed to do so. That divergence didn’t result in a turn down. Instead the market ended up taking off on another strong run.

Still, when you see a divergence in the A/D line, or any other type of “internals” indication, it gives you reason to be cautious. I certainly am that right now where the stock market is concerned. The recent A/D action has been very, very poor. This week’s low is below any since since the bottom in March. I would not be surprised at all to see the next rally up, if it comes, fall well short of the latest highs.

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The Relationship Between Stocks and Forex

I was asked a question by someone on my mailing list yesterday about the relationship between the forex and stock markets. Normally I include the text of the person’s question, but in this case English is not the person’s first language and the inquiry is fairly lengthy, so I’ll skip that in this particular instance. The bottom line is that like many folks this individual is wondering about why the dollar falls when stocks rally, and vice versa.

Following the Patterns and Relationships
As a professional forex market analyst I spend my days watching the all markets (not just forex) and seeing the various interactions between them. Some are subtle, fleeting, and likely only to be spotted by those looking specifically for them. Others are broad and obvious that anyone can see. The whole stocks up/dollar down pattern we’ve seen for some time now is definitely in the latter camp. Even the media is aware of it. 🙂

Back in June I did a presentation on cross-market analysis and trading at the L.A. Traders Expo. I was asked the question then what market tends to lead the rest. My answer was that it varies from day to day, and sometimes even hour to hour (for example the bond market has been tipping off dollar moves the last couple days), but in very general terms it tends to be the forex market which moves first, fixed income (interest rates) which follows second, and equities bringing up the rear (commodities probably falls in the fixed income area on the timeline, but they vary).

Risk Aversion and Carry Trade
The relationships between the markets varies considerably, though, so don’t make the assumption that what’s going on now will persist. Right now we have a situation where a couple of things are contributing to the inverse relationship between the dollar and stocks. One is the general risk aversion/flight to quality trade in which nervous market participants will tend to move money into the dollar for safety.  This isn’t as dominant a theme as it was a few months back, but is still a factor.

The other is the fact that the dollar has to a certain degree supplanted the yen as the carry trade short currency of choice (meaning the one that gets borrowed to be converted into a higher interest bearing currency). The carry trade is a highly risk sensitive position. Those trades will be closed when people are worried about the global economy partly on a safety basis and partly on the view that the higher rates could come down.

Seasonal Patterns in Action
Also keep in mind that so called “seasonal” patterns can influence things. This time of year has generally been a bearish one for stocks, but it has also been that way for the dollar (see Opportunities in Forex Calendar Trading Patterns). That creates an interesting conflict between the usual patterns. So far in September the dollar pattern, because of the inverse relationship, has cancelled out the usual bearish action we’d expect in stocks this month.

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Scalping Individual Stocks

What is the best way to approach trading only 1 stock over and over during the trading day? I know scalpers that take up to 100 trades a day and trade only 1 stock

I got that question the other day. This is one of those times where I have to admit I have no idea. I don’t scalp, have never scalped, and have no plans on scalping individual stocks. I have no desire to be that fixated on the price action day-in and day-out. I’d probably go crazy.

That’s just me, though. I know there are folks out there who scalp and do it successfully. For the sake of the asker of the question above, I encourage any reader who has experience in that area to share their thoughts on the matter.

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Where does forex leverage come from?

A question was posted on BabyPips which occurred to me as being something readers here might wonder about as well.

I understand that it comes from other people’s deposits and from the broker’s capital. However, where is the limit? I understand that with stocks, its basically a loan from a bank, i.e., you will pay interest if you hold it for any appreciable amount of time.

Forex has only the interest rates on the currency themselves. But, there has to be limit, right? To do a crazy example, let’s say you dumped $10mil cash in a forex account. At 1:400, that would be $4 billion. That makes no sense since most brokers don’t have nearly that amount of capital – even if they did, it would leave no capital left for other traders to use.

So where exactly does the money come from? Most offer high leverage in comparison to stocks, or certain other instruments, so I’m just wondering how this is possible. I’m aware that not everyone will be using 100% leverage 100% of the time, but there still has to be limits.

The question comes from what would seem to be an incorrect mental point of reference where the forex market is concerned. The poster is expressing things in terms of stocks where actual ownership of an asset takes place. This is erroneous. Spot forex is akin to the futures market where traders are exchanging agreements, not ownership.

Forex = Futures
In the futures market when a trader goes long gold, for example, what’s happening is that they are agreeing to buy gold at a defined price at some specified time in the future. They aren’t buying the gold now, just agreeing to so it in the future – thus the term “futures”. The value of their position is based on the fact that their agreement is at a fixed price, while market prices are changing, potentially giving them a chance to sell that gold (were they to take delivery) at a higher price than where they bought it. Of course they do not have to hold the futures position through until delivery. They can simply enter into an offsetting agreement and thereby get flat.

Spot forex is basically a 2-day futures contract (technically a forward, but they are essentially the same thing). That means when a trader goes long EUR/USD, for example, they have entered into an agreement to provide USD in exchange for receiving EUR. When the trader wants to close out that position they enter into an offsetting agreement (call it going short if you like). If the trader holds a position overnight, the broker basically offsets the open trade at the end of the current day and then opens a new one at the start of the new day. That’s the roll. Depending on the broker that is either obvious or transparent.

Margin is Surety, Not Down Payment
With forex being an agreement based market, not an ownership market, the capital requirements of the liquidity providers are much lower relative to the size of the trading volumes than would otherwise be the case. This is because margin in forex (and futures) is a surety for the broker (and the system as a whole) to make sure there is coverage for any variation in the value of the future/forward contract the trader might experience. This is different from in stocks where a trader operating on margin is actually borrowing money to be able to purchase (thus own) more stock than they could have otherwise, much like a home-buyer takes out a mortgage. The stock margin is basically a collateralized loan.

No Ownership Means Lower Capital Requirements
Since a forex broker isn”t actually exchanging EUR for USD when a customer goes long a lot of EUR/USD, it doesn’t need to have 100,000 EUR on-hand (putting aside the whole matching up of customer positions brokers do on the back end). It’s not like a stock dealer which actually has to have the capital (or sufficient lines of credit) to own the shares it’s making a market in.

That’s why forex brokers can offer such high leverage ratios.