Trading Tips

Reaction to the “worst analysis” post

My post from yesterday, Some of the worst market analysis ever!, generated a bit of a response (I’ve also noted that another blog picked up the post to which I was reacting). While my main focus was on showing readers of this blog the sort of analytic pitfalls one can fall into, I’ll admit that picking a bit of a fight with Zero Hedge was on my mind as well. I didn’t really expect a reaction, as I’ve written about the posts there before without any, but this time someone actually made note of what I said in the comment section of a ZH follow-up post on the same subject. That generated a few reactions there.

Actually, one reaction was left as a comment on my post. It was left by someone who apparently is very shy because he/she left no name and a bogus email address. The comment was

“um you trade them in a ratio, the author assumed you would get this.”

I can perhaps understand the commentor’s reluctance to attach their name to this brilliant bit of insight which has absolutely nothing to do with the problem I have with the analysis in question. It speaks not at all to the whole “risk free” question, nor does it address the viewing of converging lines on a dual-scale chart as representing a spread going to zero.

On the ZH site the author left his own reaction to someone named sumo posting my assertion “There is absolutely no mathematical or other direct linkage between the S&P and EUR/JPY.” At least I think it’s the author. As I understand it, several people actually author on ZH under the same nom de plume (that’s pen name), so it could have been someone else on the staff. In any case, the response was:

“I assume the gentleman has never heard of the carry trade and its implications.”

Hah! We’ll leave out a discussion of the fact that I was in the forex market long before “carry trade” became common parlance and focus on the mechanics.

The assumption implied by the above statement is that all carry trading is done through stocks. It most definitely is not. In fact, the simplest and easiest carry trade is to just borrow the low interest rate currency and invest the proceeds in a debt instrument of the higher interest rate one. The carry trade need not have anything at all to do with stocks. That means, as I indicated, there is no direct linkage between the S&P 500 and EUR/JPY, meaning carry trade related movement in the likes of EUR/JPY need have nothing at all to do with the stock market. It can move independently. The current market environment is such that the risk tolerance of traders/investors creates a common driver of action in the forex and equity markets. Were something to happen like a Bank of Japan rate hike, however, there could be a very serious sell-off in EUR/JPY on yen appreciation which probably would have a very minimal impact on US stocks.

I’m not sure whether this comment by aldousd was directed at me:

“it’s ridiculous to say that it isn’t related. it’s been going on all day. I keep reading people saying that it’s a coincidence… a second by second coincidence.”

In case it is, though, I certainly never said anything about “coincidence”. In fact I noted that the drivers for the comparable moves are similar.

There’s another reaction offered up by BeerGoggles to the first comment posted:

He’s going on about zero prices as well and clearly has never looked at the ATRs of EJ and S&P.

I have no idea what this person is going on about. I definitely didn’t say anything about zero prices. Maybe he’s referring to the author, but aside from talking about a zero spread (which I contend is incorrect) I don’t recall him saying anything about zero prices either. For the record, though, as of June 7 the normalized 14-day ATR (meaning ATR expressed as a % of the 14-day average) was about 2.8% for the ES and a touch under 2.5% for EUR/JPY.

Here’s a comedian:

Does he use charts for his trading, or some secret method of essentials we haven’t yet heard of?

Whitty, but the incorrect application of the charts is exactly the problem I have with the analysis. For the record, I use charts all day, every day.

Here’s someone who gets it:

I’m not a trader or an FX expert, but I do know maths and you guys are missing the point.

What the “non-fan” is saying, is that a graph of two variables NOT on drawn on the same scale, is going to lead the observer to false conclusions about trading opportunities when they see a gap. It’s perfectly possible (and in this case highly likely), that you’d loose money by trading ONLY based on the existence of a large gap.

By all means do all the carry trades you wish, but not based solely on this gap information. You need more information to guarantee an easy trade.

Thank you virgule (commentor’s handle)! In case you were wondering, “non-fan” is me. 🙂

As I said in my post yesterday, it’s not about whether doing this kind of pair trade is the right thing. It’s about not employing faulty analytic methods to get there, and not thinking that this is a zero risk arbitrage trade.

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.

The Basics

Looking at Volatility Across Markets

The other day I commented on a post on a personal finance blog. The article was an introduction to forex. I won’t link to it here because it was very poorly done, falling short on many points. One of the things that tripped off alarm bells early on about where the post was going was this statement:

However, it is important to note that forex trading is rather risky, and the currency market is quite volatile.

All trading is rather risky, so I won’t address that particular point. I will, however, speak to the issue of the currency market being quite volatile. Statements about the forex market being more volatile than others are made all the time – almost always by folks who are putting forex trading down in some fashion or another. As I’m going to show you, the numbers make it pretty clear that forex is in fact on the low end of the volatility scale when looking at all markets.

Here is a look at the last year worth of volatility in forex rates

Pair Daily StdDev Avg Daily Rng
EUR/USD 0.93% 1.41%
USD/JPY 0.91% 1.45%
GBP/USD 1.00% 1.65%
USD/CAD 1.02% 1.60%

The first column is the standard deviation (a commonly used volatility metric) of the daily % change for the one-year period beginning November 1, 2008. The second column is the average daily range, with each day’s range being expressed as a % of the prior day’s close ( [H-L]/C ). I went with % changes and ranges to make things directly comparable across markets. So from this data we can see that USD/CAD tends to see the biggest daily changes, though GBP/USD tends to have slightly wider daily ranges.

Now let’s compare that to the major US stock indices.

Index Daily StdDev Avg Daily Rng
Dow 2.01% 2.41%
S&P 500 2.26% 2.60%
NASDAQ 100 2.18% 2.69%
Russell 2000 2.89% 3.28%

Here we can see about what as we would expect in terms of the small cap Russell index being the most volatile in terms of both price changes and ranges.

And how about individual stocks?

Stock Daily StdDev Avg Daily Rng
IBM 2.18% 2.85%
GE 4.20% 5.59%
AAPL 2.66% 3.44%
GOOG 2.51% 3.33%
AMGN 2.33% 3.03%
XOM 5.95% 6.66%
JPM 2.23% 2.88%
KO 1.74% 2.45%

All of the above are clearly large-cap stocks which would generally be expected to show less volatility than mid- or small-cap stocks (as witnessed by the higher volatility in the Russell index). Even still, with the exception of KO, they are all much more volatile than the forex pairs.

So what about commodities?

Commodity Daily StdDev Avg Daily Rng
Gold 1.61% 2.38%
Oil 4.35% 6.01%
Nat Gas 4.91% 6.54%
Corn 2.70% 3.83%

Again, the commodities are clearly much more volatile on a day-to-day basis than are forex rates.

Now to add in a market that’s considered the least risky by many folks – interest rates.

Instrument Daily StdDev Avg Daily Rng
Eurodollar 0.05% 0.06%
2yr Treasury Note 0.13% 0.18%
10yr Treasury Note 0.63% 0.92%
30yr Treasury Bond 0.99% 1.50%

I’m using the futures for the prices above. Finally we have a market where volatility is lower than forex! As you can see, the shorter maturity instruments (Eurodollars are 3mo) are calm compared to the others we’ve looked at here. Bonds, though, are in line with the volatility readings we see for the forex pairs.

So the bottom line is that not only are forex prices NOT the most volatile, they are actually on the lower end of the spectrum when looking at available markets. The numbers demonstrate it pretty clearly, even in a 12-month period which has seen its fair share of volatile trading.

Now granted, the application of leverage in forex creates the opportunity for very high levels of volatility in one’s trading account – but that’s not the market’s fault. Traders don’t need to use leverage. You can trade forex without it.

Reader Questions Answered

Is it possible to trade only on the monthly charts?

In yesterday’s post I started to answer an inquiry which came in from a prospective equity index futures trader over the weekend. Because it covered a few different topics, I elected to split it up into parts to address more specifically. Here’s the second part.

Then there’s the choice of timeframe. Is it possible to have a very long term view of things and concentrate only on the monthly charts? That means following a major trend probably for several years. Is it workable, or would I be better off going for the weekly charts? I know about drawdowns and it’s ok with me.

It is absolutely possible to trade the long-term using monthly charts. I have done it myself on occasion. The problem, of course, is that you can wait a long, long time for the right situation to develop. At the monthly chart time frame you’re probably talking about making one or fewer trades per year – and sometimes none at all for a long period.

Personally, I tend to make weekly charts the longest ones I will actually trade from. They provide many more opportunities and the moves they catch tend to be very meaningful. It also makes it easier to get in on the big trends relatively early. A market can move a huge amount in a month.  Also, weekly time frame price moves often fit better in with the expiration cycles of futures contracts, where you have to deal with rolling forward if you plan on holding a position beyond contract expiration.

That said, however, I often look to the monthly chart for a few on the longer-term underlying trend. It helps me frame the potential for a weekly time frame trade.

Clearly, if you’re playing in the longer-term you have to account for the in-trade volatility – the stuff that produces open equity drawdowns. This is an especially important consideration for futures traders where the leverage amplifies things. That means capitalization is hugely important.

Reader Questions Answered

Which mini equity futures contract is best?

Over the weekend I received from a trader what I feel like is really a three-part inquiry. Rather than create one long multi-subject post, I’m going to split the questions out into three seperate posts to focus on each subject. Here’s the first part.

I am trying to build my trading plan, and I feel I would be comfortable trading index mini futures. I would have to choose among ES, YM and NQ. Which would be more advisable, with an initial account size of $50,000?

With an account of this size, really any of the mini futures are perfectly reasonable. The S&Ps (ES) are by far the most actively traded and liquid. There’s somewhere around 3 million contracts worth of open interest in the mini S&Ps, whereas the mini NASDAQ is more like 400,000.

Liquidity and such aside, it’s important to understand the difference between what the three contracts represent. The YM is the Dow, which is a 30 stocks index of so-called industrial companies. That’s going to generally be a pretty cyclical group. The ES obviously is for the S&P 500, which is meant to be the 500 highest market cap value companies. That is going to be a group which is generally going to do a pretty good job of tracking general economic conditions. Meanwhile, the NASDAQ futures are focused on the often more volatile tech sector.

The point is that each index has a different characteristic. You may find one suits your particular trading style better than the others. It’s worth experimenting.