Roller Coaster Day for Stocks

I'm seeing a new phenomena over the past few weeks. In the past, when the stock market opened, we would see buying at the open that would drive the market higher. Now, over the past several sessions, we are seeing selling at the open instead.

In this chart, prices chopped higher on thin volume in a melt-up overnight, but sold off at the market open. While the buying is thin, the selling is occurring on heavy volume, which is suggestive of fund selling of all kinds (hedge, pension, mutual funds, etc.). The volume has shifted from bullish to bearish, at least temporarily. The same thing has occurred several times in the past few weeks.

There appears to be a change in the wind, and I suspect that it is because the market is anticipating the end of the Fed's quantitative easing program in June. The nearly infinite liquidity that the Fed has provided will soon come to an end -- for the time being. Of course, anything could change by summer. I'll be anxiously awaiting the Fed's policy statement following its meeting at the end of April.

Liquid Illusion

Here is an excellent article on global central bank attempts to create liquidity, and why it is largely an illusion of liquidity. Delusions of reserve grandeur? Great article by Satyajit Das!

In recent years, there has been speculation about the amount of capital or liquidity available for investment globally. The substantial reserves of central banks and their acolytes, sovereign wealth funds, were frequently cited in support of the case for a large pool of "unleveraged" liquidity − that is, "real" money. In reality, the available pool of money may be more modest than assumed.

Click here for the entire article.

Harvard Endowment Fund Loses Nearly 1/3 of Its Value in 2008

"Harvard officials said they were planning for a decline of 30% in value for the year. Harvard said the school's worst single-year investment loss was 12.2% in 1974, when the endowment stood at less than $1 billion and its funds contributed far less to the school's operations."

Here is the rest of the Wall Street Journal article.

Liquidity matters! When I read this article, I realized that Harvard made investments that were profitable, but which couldn't be sold when they started to lose momentum. This is why I try to concentrate my trading on futures instruments that are liquid. If you can't get rid of it, you can't turn paper profits into real ones! "Honey, Junior's tuition is going to go up!"

Tumbling Treasuries

It appears that with a Fed that, based upon FOMC minutes yesterday, has clearly signaled that they have stopped cutting rates, the best bet now in futures may be to sell treasuries as interest rates begin to rise. This appears to be borne out by the markets this morning, as treasuries are being sold and one one of the solid market movers today. Go where the movement is! That is one of my mottoes.

Treasuries are one of my favorite instruments to trade because they are among the most liquid of all futures and the margin requirements are modest. Treasury futures have margin requirements that are roughly 1/4 those of stock index futures. I can therefore take a larger position in treasury futures than I would ever dream of doing with stock futures.

Execution, Execution, Execution
I am told that the three rules of real estate are location, location, and location. In futures trading, execution is the first law of success. This requires deep, constant liquidity for a trading instrument.

The combined open interest for treasury futures outnumbers the open interest for even the stock index futures. Prices for treasuries also tend to move more gradually than other futures. While I might take 10-20 trades each day for soybeans, I might make only 5-10 trades for treasuries, even though treasury futures trade 3-4 hours longer each day than grains. These factors make treasuries easy to get excellent executions, superb and accurate fills, and to enter and exit easily and quickly. Treasuries are also a good way for new traders to cut their teeth because the charts tend to move more slowly and gradually. They are good for practicing their trading skills.

In contrast, I haven't traded energy futures over the past year (despite the obviously good returns for energy traders who are long) because while crude oil futures are very liquid, they tend to print so rapidly across the screen that I am unable to get good executions at the proper prices for my methodology. Just watching the crude oil futures print across the screen can often be a dizzying exercise. Thus, I stay away from crude oil and other energy futures.

I also tend to stay away from grain futures in the first 5-10 minutes of the day trading session because they move too quickly for me to get accurate executions. I will usually wait for a slightly more subdued market in which trading conditions are more sedate and I can get good executions under more stable conditions.

Tick Bar Adjustments
Likewise, I have found that the Russell 2000 futures, which I used to trade exclusively at one time, tend to print too rapidly for me to be able to get good executions. Even adjusting the number of ticks in a bar for the Russell 2000, I haven't been able to find one that looks clean on the charts. I prefer to trade the Dow mini because the charts tend to trade more cleanly with less market noise. Market noise is, in my humble opinion, deadly for small traders like me. It will drive prices through stops and convince traders to exit prematurely with losses, often just before the market makes a spasm back in the other direction that would have resulted in a profit. I always look for clean charts, and will occasionally adjust my tick bars until they look clean. Only then will I trade them. Anything else has too much market noise. And as I said, market noise is deadly.

Trading Treasuries

One of the nice characteristics of trading treasury futures is a concept that Chick Goslin mentions in his book, Trading Day By Day. He expounds that the larger and more liquid a market is, the more gradually it changes direction. I think he compares it in his book to changing the direction of a large ocean liner versus changing the direction of a speed boat. A speed boat can change direction on a dime, but its movements are therefore more erratic and difficult to anticipate. An ocean liner, on the other hand, can't change direction or stop on a dime. It may take a half mile or more to bring itself to a complete halt. Its volume or mass simply can't be halted quickly. Therefore, its movements can be more easily charted and anticipated. Likewise, the larger the volume and open interest of a particular futures contract, the higher the volume of contracts in the opposing direction are required for that futures vehicle to stop and/or change direction, and the less erratic are its movements.

Stock futures -- at times -- seem to buck this rule for some inexplicable reason. Perhaps this is because they are the first choice of inexperienced traders, thus creating far more market noise and erratic price action. This is just a guess, however. I suppose I should be grateful that they stay in the stock mini's, where their influence is contained, if this is the case. More inexperienced traders in the other futures markets might bring with them this phenomenon of erratic movements and market noise. Who knows? That's just my opinion, and I could be completely wrong about it.

This size-of-market phenomenon can be an advantage to a trader. A small trader can therefore maneuver in these very liquid futures markets, entering and exiting trades several times with small profits or small losses in repeated attempts to accurately position himself/herself in the market to maximum advantage. Imagine a small speed boat (a small trader) racing around an ocean liner, making circles rapidly while the ocean liner slowly attempts to slow down and change direction. This is one of the reasons why tight spreads are so critical to traders. (Take heed of that point, Forex traders!)

Treasury futures are so liquid that even very large individual traders will have minimal impact on the market. I could easily place a position of 300 contracts without affecting prices in the slightest. Now that's liquidity! Using our speed boat analogy, imagine our little speed boat (us, the trader) on the vast Pacific Ocean of the most liquid financial futures. While the Pacific Ocean has the capacity to easily destroy a careless small speed boat, the little boat also has the advantage of adept handling and maneuverability. One must understand both the power of the ocean and the advantages we have as small traders in order to remain safe on that ocean and properly take advantage of it.

Another advantage that this size phenomenon afford to traders is that since the market moves somewhat slower, it makes a good training ground for beginning traders. Beginners can practice and learn how to achieve good and accurate executions, and critical skill to develop.

On the other hand, I could take a position of about 25-30 contracts in soybeans (about 50 in corn) without affecting the market much. When the day arrives that I am trading positions of that size, I will may switch permanently to trading treasuries. At that point, the Law of Large Numbers kicks in. I'm not there yet! I have a long way to go before that occurs. Once I am trading positions of that size, I may remain in the grains markets and just limit myself to trading positions that keep me from the reaching the limitations of the Law of Large Numbers. Even at that level, I can be very satisfied with the income level it will provide to me.

Bombshell: Fed Rescues Bear Stearns

Using its new $200 billion collateral window pre-emptively for mortgage-backed securities, the Fed and JP Morgan Chase has stepped into the financial markets to rescue Bear Stearns from a liquidity crisis. This has turned the positive sentiment following the flat CPI data into a financial crisis literally within less than an hour, and has turned market sentiment once again within an hour. The nagging question hanging over the market now is, "Who else?" What other investment banking firm is going to be faced with a liquidity crisis in the next few days or weeks?

Stock Stampede! Great Legs!

The latest Fed rally today has legs! The Dow closed today higher by more than 400 points, and continues even higher in after-hours futures trading! This one may be just the ticket to put in a firm bottom on the stock market and provide the boost necessary to ensure that the United States economy is able to begin a well-anchored recovery. I am being told by some of my insider friends that by allowing investment bankers to borrow against some of their questionable derivatives and exchanging them for U.S. Treasuries at 28-day intervals, this latest Fed move may be able to provide liquidity to the financial markets without igniting more inflation. This action would provide short-term relief to Wall Street without huge new injections of additional money (emphasis on the word additional). If this move forestalls deeper Fed rate cuts next week, it might work. We shall see!

I'm not that easily convinced. But the rally today in stocks suggests that the financial markets are seeing optimism and a possible end to the quagmire! The charts seem to reflect the stock market optimism today. The only thing that worries me is the possibility that while this action might not increase the money supply, much of that additional liquidity will end up in the commodities markets, kindling still higher prices in energy, metals, and agricultural products and igniting yet higher inflation. Fed Chairmen have admitted that while they can pour money into the markets in an attempt to grease the economic engine, they can't control where that money will go. Again, we shall see!

One thing is for sure:

This was an undeniable stock stampede today!

Commodities Broadly Higher, Primer on Commodity Indexes

Commodities in general are broadly higher today. I have been reading over the weekend about the various different indexes used in creating different commodity indexes. Here is a very good primer on the various different ways that ETF companies calculate and manage the commodities in their indexes. It is published by Deutsche Bank in conjunction with the Proshares ETF family, which it sponsors. Obviously, any ETF provider is going to favor its own methodologies of selecting and managing commodities. In light of this bias, it makes sense for any investor to carefully study the available published material and weight that bias against the available data. However, after reading DB's primer (not light reading, but interesting and educational nonetheless), I admit a bias for the DB/Proshares products myself. They are probably the most liquid of all commodities ETFs, consistently maintain the tightest spreads, and make a very strong case for their methodology being the best for investors. See what you think after reading their brochure regarding the many different commodity indexes. I have also included two links to other index-related materials.

Deutsche Bank Guide to Commodity Indexes

DBLCI - OY: Technology to Tackle Term Structure Dynamics

DBLCI: Less is More

Soybeans: Trades 14-15

Trade 14 was an attempt by the soybean bears to defend resistance at yesterday's settlement price. It barely made a profit. When the Klinger Volume indicator turned bullish and profits were meager, I moved my stop to the top of the previous candle, where price movement took it out.

Trade 15 has proven once again that the soybean bulls are still very firmly in control. Prices have closed up again for the day! I've noticed that the best trades typically take off. This one was a good example of that. I closed it out less than one minute before the end of the trading session.

What a great day for trading. It had all the requirements for good trading, including volatility, solid movements in both directions, and excellent liquidity. What more could I ask for?

Derivatives Trading and Liquidity in Financial Markets

I have been intrigued throughout my trading career with the derivatives markets. The recent subprime credit crisis, and the meltdown thereof, have always been a fascination to me. However, my fascination has been somewhat from a distance.

Derivatives and Liquidity

In the early days of trading in the Forex markets, and as an evolutionary process over the years, I have come to a few decisions regarding my own trading. I realized over time that one of the primary ingredients in effective trading is liquidity.

I can quickly look at a chart and determine by the look of it whether a market or financial instrument is liquid. Which of the two ETF charts in this posting would you rather try to trade? One had volume of 2.7 million shares daily, and the other had only 3,400 shares. The difference is not just easy to see; it is also easy to decide which to trade. Trading a very liquid instrument is a critically-important element of effective trading.

For this reason, I have been distantly fascinated to wonder why anyone would create a plethora of innovative, but illiquid trading instruments that no one truly understands, and that few people even trade. Of what value is an instrument that can not be bought, sold, or traded? It can't even be accurately or honestly priced! It may be cool, or it may be hot, but if it isn't liquid, its value and future is questionable.

Brief History of Futures Markets

The futures markets in agricultural products have been in continuous existence since the 1840's. Before that, when farmers brought their products to markets, buyers were forced to pay premium and sometimes astronomical prices during the winter months when grain products were scarce. On the other hand, during the harvest season, farmers couldn't get a fair price, and stories abound of farmers who would dump their wagon-loads of grain on the streets instead of selling them at a loss, because they couldn't get a sufficient price for their products to cover their production costs and feed their families. The futures markets benefit both producers and buyers of products by evening out the extreme and wild price fluctuations that plagued producers and consumers previously. The futures markets level out and provide stability to prices for everyone.

Over time, as more and more market players have entered the markets, liquidity in the futures markets has increased and improved. Speculative players in the futures markets have made them increasingly liquid and stable. This is a benefit to all who buy and sell futures instruments. One recent example of this phenomenon is that when the softs futures became available for electronic trading, prices became more stable and market noise decreased markedly within a few months. Chart patterns have become much more consistent.

Black-Scholes and the Elimination of Risk

On the other hand, when Black and Scholes developed the models and formulas for eliminating risk in derivatives instruments, they didn't find a formula for insuring against the risk of poor liquidity. These models have, over time, proven themselves deficient and thus, incomplete. Many derivatives outside of futures are highly illiquid. In fact, many are so unique and innovative that there is no market for them. Period. In an environment like this, an new type of risk is introduced: liquidity risk. Without liquidity, prices become increasingly unstable and markets become unreliable. This increases the risk rather than eliminates it. It is simply a new form of risk that is impossible to calculate, let alone eliminate.

Liquidity Beneficial for Traders

That is the reason why I refuse to trade any futures instrument that has open interest of less than 100,000 contracts. My mentor taught me only to trade futures contracts that had at least 10,000 contracts of open interest. However, he personally only trades futures that are much more liquid than that. I have come to the same decision on my own.

Liquidity is important to me because it brings price stability to that instrument, and it reduces market noise. (Volatility is beneficial for traders, but market noise isn't. It is our enemy.) Good liquidity, in turn, allows me to improve my trading win/loss ratio by taking trades that have a higher degree of reliability and chart accuracy. As markets become more liquid, charts patterns, and their predictive capability, also become more accurate and reliable. Bid/ask spreads become concomitantly tighter, and the cost to trade is reduced. It becomes easier and earlier to reach break-even and profitability.

That's why I've always been intrigued with the constant creation of innovative and never-before-heard-of derivatives instruments. The more new and creative they are, the less liquid they become, and the more unreliable become those markets. Liquidity risk increases exponentially with the innovative nature of the derivative instrument. I choose reliability over creativity when it comes to placing my money at risk. Only thus can I reduce that risk. Unfortunately, innovativeness is the enemy of liquidity, and thus, profits, in the world of financial derivatives.

Nice trend today in corn

After its retracement with the other grains today, corn is showing a very nice trend upward. This chart shows all three time frames (15 min, 3 min, 50 tick) of my corn triptych.

So far today, after a sympathy retracement among all the grains (corn, wheat, soybeans), the corn price has recovered and moved higher, wheat prices have continued to sink (poor manic-depressive wheat), and soybeans prices have gone flat. I lost a few points today on soybean trades. The later consolidation became so tight I couldn't even make a few ticks on my trades. I couldn't even break even. If it wasn't for corn, I would have lost money for the day.

Trading other futures

Typically, if my preferred soybeans go flat and consolidate, I will check charts for my other favorite futures until I find one that shows promise. I usually check soybeans first, then wheat, corn, gold, treasuries, and currencies, usually in this order.

When gold is consolidating, as it has been in the past few weeks, it becomes more erratic on the longer-term charts than some other commodities. However, on very short-term charts, it can be very enjoyable to trade, because shorter-term charts for gold have a certain orderliness that some other commodities don't have. I don't know how else to describe it. For example, I enjoy trading gold on CBOT. However, after the European markets close about 12:00 pm EST, gold sometimes can be thinly traded (but not always), so I am reluctant to trade during those post-European hours. I have been trading long enough that now, I can take a quick glance at the charts and decide instantly if it is worth trading.

The key to selecting which futures to trade is to trade ONLY the most liquid ones. Liquidity ensures that spreads are tight, executions are quick, and slippage is minimal. All the financial brains in the investment banks should have know that this is "Derivatives 101". You don't create financial instruments for which there is no market, no market value, and no liquidity. Duh!