T he rapid technological progress in information processing technologyis changing every aspect of our lives. The financial markets cannot es-cape this technological impact. Investing and trading has shifted fromthe old paradigm of watching quote screens, calling a broker to place an or-der, and then waiting for a call with the order fill, to a new paradigm, basedon real-time chart displays, electronic screen trading, and direct marketaccess with fast executions.

Equally rapid are the advancements in the quantity and quality of infor-mation available to investors and traders as well as in the software applica-tions for processing and analyzing it. Despite all the advancements made,traders and investors are still faced with the same old dilemma: buy, sell,or hold?

One could also assert that the numerous technological advancements,the abundance of information, and improved means of processing haveincreased the complexity and the difficulty of trading for a profit ratherthan making the life of traders easier. This assertion is partly due to thefact that markets have become more efficient while opportunities arebecoming scarce and increasingly difficult to identify.

More and more,traders report failures of trading systems developed not too long ago,which had produced in the past excellent back testing and actual trad-ing records. There are a few possible causes for these failures: Onecause can be found in the widespread use or popularization if I maycall it that of technical analysisthat is, a method of evaluating mar-ket action that relies primarily on the analysis of price and volume.

Somebelieve that traders using technical methods no longer have a competitiveadvantage. Others believe that the failures are due to the ability of somemarket participants to affect price direction and thus generate false tech-nical signals followed by sudden price reversals. I will not attempt to dis-cuss or investigate such claims here, but there may be some truth hiddenin them. My view is that most trading systems failures are due to a wrong ap-plication of system development and risk management principles. But that is exactly where most technical analy-sis methods have deficiencies.

This deficiency arises because of the timelag between price action and the reaction of technical analysis methods. Specifically, the majority of technical analysis indicators lag price move-ment because they consider only past prices in their calculations, and thisallows fast traders to capitalize on this deficiency, position themselves inthe market early, and then profit by satisfying the demand created by tech-nical traders whose systems respond too late. Thus, use of appropriatemodels and their careful analysis is of paramount importance to the suc-cess of a technical trader trying to survive in a highly competitive tradinggame.

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Profitability and Systematic Trading Book

Download for free Report this document. Embed Size px x x x x There were at least 10 trading sessions that remained locked limit up from the open of the trading session starting on January 25, The rally in lumber prices continued to mid-March of the same year with scattered locked limit up trading sessions. Anyone caught net short Lumber futures on January 25, , could not buy contracts to close open positions until around February 8. Unable to do anything, they watched their trading account equity plummet and even go into the red.

On the other hand, those who were long made windfall profits. Some of the traders who were caught short lumber futures during the specific streak of locked limit up sessions ended up losing a fortune. Bear markets: Futures have bear markets but it is not clear how this affects the profitability of systematic technical trading.

Traders can go long or short futures with the same ease and speed. It has been observed, however, that during bear markets liquidity decreases. It appears, based on experience, that technical trading methods tend to be more effective during bull markets than bear markets and much less effective during sideways-moving or fluctuating markets.

This is a bit paradoxical at first glance since the notion of rising or falling prices is a matter of convention from the point of view of the analysis of price charts. However, it seems that bear markets are less technically driven than bull markets, and this is the fundamental reason for the decrease in the effectiveness of systematic trading methodologies during falling markets. Whereas greed and technical trading dominate a bull market, fear and panic dominate a bear market. Equity trading also suffers from the same effects but this is not the case with forex trading, because with currencies there is no such thing as a bear market.

This means that at any given time, even at every price tick, the sum of profits must be equal to the sum of losses. This means that for a trader to profit in futures trading, some other trader must lose. Since there are no speculators willing to lose money in the futures markets, profitable trading requires a means of making the right predictions about price direction. Those who have no power to affect price direction can rely only on their wisdom to predict the actions of the other participants and benefit from the resulting price moves.

Profitability and Systematic Trading Book | Trade2Win

Equity Markets As in the case of futures markets, similar considerations also hold for equity markets regarding the regulated structure of exchanges, moderate to high liquidity, low commissions, and transaction report availability. A few important characteristics of the equity markets that often play an important role in the development of systematic trading methodologies are: Liquidity, leverage, and bear markets: Some equity markets, such as the over the counter OTC market, may not provide enough liquidity and are not suitable for technical systematic trading.

However, position leveraging via the use of margin is not as attractive a feature as it is in the case of futures and forex trading. Margin requirements are high, short positions can be taken only in selected issues that fulfill certain criteria, and there is extra cost and increased risk involved. Equity markets may exhibit protracted bear markets, where the inability to short some issues virtually diminishes the potential to profit from such moves.

But more importantly, short-covering periods in bear markets are frequent and dominated by violent price moves. This reality of equity markets forces many traders to chase short-term upward price reversals that occur in bear markets, which demands a timing accuracy that is very difficult to get using technical analysis methods.

Equity trading can be halted: The actions of market makers and specialists can affect the direction of the price of a stock during periods of low liquidity. Furthermore, trading of a stock can be halted at any time and without prior warning, and when trading resumes the price may gap up or down significantly, which is something that never occurs in futures or forex markets. The same holds true when unexpected earnings reports are released or other surprising news about a listed company hits the wire.

As an example, the stock of Intel Corp. The risks from such random events are high and can erase profits accumulated over extended periods of trading activity. However, one must also realize that there are those who benefit from such random events—in the specific example just mentioned, short-sellers, call option writers, and put option holders, to name a few—but a systematic approach to take advantage of such random events is, of course, impossible to devise.

The reverse effect that works against traders is when company insiders sell because they need for various reasons to reduce their stake in a company. These insiders profit at the expense of traders and investors. Also, equity trading is not always a zero-sum game during certain periods due to creation or destruction of wealth. These issues will be further discussed in the next chapter, which deals with zero-sum games.

Forex Markets Forex markets facilitate over-the-counter transactions of one currency for another. Unlike futures and equity markets, these markets have no central clearance. Retail forex trading offers very high leverage up to , very high liquidity, hour trading, and a market that is difficult for participants to manipulate, although that seems to be easy to do in the short-term for politicians, central bank officials, and some special-interest groups. Trading currencies is by and large a zero-sum game, and there are no bear markets because quoted currency prices are exchange rates between pairs and a rise in the value of a currency makes sense only in reference to the drop in value of another currency.

More than 75 percent of the daily volume of forex markets is speculative. As such, there is a lot of competition and effort made by its participants to redistribute wealth. Some important aspects of forex trading that can greatly impact profitability are: No commission-free trading: There is a misconception, or maybe misinformation, that commission-free forex trading is possible. Online forex brokers that advertise zero commission rates do this because they need to attract customers in order to pool enough accounts together so they can efficiently and profitably act as market makers.

Traders end up paying commissions in the form of wide bid—ask spreads. In most cases, commissions are added to the order fill price, and when a trader opens a new position it always starts with an open loss. Forex market makers can do this because the market is selfregulated and transactions are over-the-counter. No times and sales report: Note that there is no time and sales report available for the forex market as a whole.

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Price quotes that one trader sees on his computer screen that is linked to one market maker data feed can slightly vary from those another trader sees on her screen that is linked to another market maker data feed. Thus, a limit order placed at a specific price level maybe executed by one market maker but not by another because the specific price level was never reached. Those professional traders have timely access to information about order flow and high-quality market analysis that enables them to always have a competitive advantage over individual traders.

Currencies trend: Due to the fact that currency prices tend to form protracted trends, a retail trader can accumulate profits using trendfollowing techniques provided there is the necessary skill and discipline in place, as will be further discussed in Chapter 3. Prices trended down during and and then went in an uptrend in early Only highly skilled and experienced traders can profit during extended periods of sideways-moving prices in a tight range, and this is always done at the expense of unskilled and inexperienced ones.

But even during trending markets, high volatility can make the task of following a trend very difficult; this will be discussed in Chapter 3 in more detail.

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Mostly a zero-sum game: Although forex trading is a zero-sum game, there are certain very rare occasions when some participants may be willing to lose. This, however, does not change the zero-sum nature of forex trading. An example of such participants are central banks that either intervene in the currency markets in order to stabilize currency exchange rates or slow down the rapid evaluation or devaluation of a currency.

Although it is not very clear whether central banks are net losers or winners over longer time periods not that it really matters , over the short term they may be willing to inject substantial sums into the forex market in order to stabilize currency exchange rates within a target band. Central bank intervention cannot change the longer-term trend of currency exchange rates that is dictated by macroeconomic factors, but any intervention on their part presents traders with an opportunity to profit at their expense.

Experienced forex traders can anticipate interventions and can make fortunes if they are correct in timing them. The answer to the question regarding which of the three markets, futures, equity, or forex, is most suitable to systematic technical trading can be given on a case-to-case basis, and only after considering which market s a trader understands best and feels most comfortable with. All three major trading markets offer opportunities, but also involve risk of total loss of capital.

The most important aspect of trading is not which market one chooses to trade but the effectiveness of the methods used in generating market entry and exit signals and applying risk and money management. One important factor in selecting a market to trade in is experience. Novice traders often concentrate on a single market, but experienced traders will trade anything that presents an opportunity to make a profit.

Equity and futures markets are moving toward a hour market operation structure in order to get a piece of the forex action, especially as trading becomes a global activity with traditionally socialist economies and China adopting capitalism. Eventually, all markets will be based on screen trading, and open outcry will be abolished.

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A transition to hour screen trading poses many challenges to traders but also increased opportunity for profit. One factor that is slowing down the conversion to a global, hour, all-electronic trading market is the time difference in the operation of local banks and clearing members.

Automation technology and the World Wide Web are rapidly changing that as banks and clearing members are linking their databases and automating their back-office operations. Recently, there has been an emergence of online brokerages that offer a single multicurrency account for all three markets, futures, equities, and forex, with direct links to many exchanges worldwide.

This bold step breaks the traditional fragmentation of brokerage services and everyone is now scrambling to implement the new technology to remain competitive. The globalization of brokerage services is in line with the globalization of every other economic activity in the world, and this provides more opportunity for profit but also risk of loss.



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Trading is in principle a zero-sum game, and this will not change irrespective of any technological breakthrough. Therefore, having a competitive advantage is much more important than any technological advance. Systematic trading combined with effective risk and money management can provide this much-needed competitive advantage in the new technological environment of fierce global competition.

At the end of each trading day, losses must equal profits.