Algorithmic and Mechanical Forex Strategies | OneStepRemoved

Keeping up with the humans

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Daniel Fernandez posts a nice summary of some of the problems algorithmic traders have experienced over the past few years. If you’ve been wondering why your expert advisor isn’t making money, well, you’re not alone.

Daniel points out the terrible performance of the Barclays systematic trading index and its nearly three years of continuous losses. Even the pros are losing money consistently.

Tough Times with Algorithmic Trading

Barclays system traders return

The performance of professional systems traders has fallen over the past two years

Key sections:

It is no secret that algorithmic trading had some “golden years” between 2008-2011. Through this period – most notably due to the high directional volatility of the financial crisis – systems based on a wide variety of market characteristics were able to obtain high amounts of profit, with an almost completely negative correlation with equity markets. Among the high-performers found during this period, trend followers were perhaps the most impressive, with some systems achieving returns of more than 100% of capital within this period, with little drawdown whatsoever. During these years everyone trading algorithms was making a killing. Then, change happened.

 

The answer seems to be simple and at the same time incredibly complex: fundamental influence and uncertainty. Algorithmic trading systems are all designed with the idea that some historical assumption will continue to be true in the future. This assumption can be that price tends to break at a certain hour, that momentum created in one direction leads to continuations, that two instruments are co-integrated, etc. When these assumptions break, the algorithms fail because they have no way to know that under current market conditions their assumptions are no longer valid. This “breaking up” of algorithms means that we usually need to take loses to realize that something has changed – to remove or modify our strategy – and this makes us invariably less reactive than human traders. The strength of algorithmic trading, it’s high capacity to exploit structural characteristics, becomes its weakness when the underlying structure changes.

Limit Order Book

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I remember the first time that I really sat down and thought about it. Why exactly does a stock price change? Shrinking the economy and the number of shares helped. Examples starting with 10 oranges together with supply and demand arguments sparked good ideas. But, expanding a simple scenario into a full blown economy with high volumes and different order types never made any sense.

The story is not complete without considering the information contained in a limit order book. It’s the absolute best source for highlighting buying and selling power in a market in real time. The information within the data often results in more desirable entry and exits points.

A simple example of a limit order book

limit order book example

The orange squares represent units of stock that you can buy at market

Suppose that each block represents one share of stock on both the bid and ask side of the market frozen in time. The volume of shares in the above plot are limit orders waiting for execution or cancellation.

Say that Frank comes along and wants to buy 5 shares using a market order. In that case, his order will be filled immediately.

Remarkably, the current quote displayed  of $20,26 is not where Frank can trade- there are no shares available at that price. The quoting convention reflects the spread rather than tradeable prices.

The 5 empty colored squares represents the 5 shares that Frank bought with his market order

The 5 empty colored squares on the right represents the 5 shares that Frank bought with his market order

The order is filled by sellers in a first in, first out (FIFO) process. Those who waited the longest in the order book receive the first execution.

Frank’s market order for 5 shares receives execution at two different prices. The first 2 shares fill at $20.27. The depth of market at that price is only 2 shares, forcing him to sweep the $20.27 price and move on to the next available price at $20.28.

4 total shares are available at $20.28. Because Frank only needs an extra 3 shares, he completes his total order at this level.

The best offer displayed when Frank placed the trade was $20.27, but his average fill is $27.276 (2 * $20.27 + 3 * $20.28). The slightly worse price doesn’t have anything do with slimy brokers. Slippage is the natural result of buying more shares than there are shares available.

Try making Frank a more aggressive buyer. Say he wants nine shares. Large orders receive worse fills because they suck up most of the liquidity on one side of the market.

Why A Spread Exists

Before answering this question, it is first worth understanding the difference between a quote driven and an order driven market.

Order driven market:

• Displays all of the current bids and asks across the market

• Has complete transparency

Quote driven market:

• Displays bid and ask prices from market makers, dealers, or specialists.This is the norm among retail forex brokers

• Often provides a guarantee that an order is filled

A quote driven market has more moving parts and will likely be involved in any market you wish to trade in. Therefore, it is a good idea to think about the existence of a spread in this setting.

When you post an order in a quote driven market, the dealer will either fill it with their own inventory or match you with another market participant. For this reason, part of your transaction cost goes to the dealer who has done this work for you.

In a simple model, the bid ask spread is the price that aggressive traders must pay to have their order immediately filled– think buying and selling the same security at almost the same instant. The spread is the compensation to a dealer for offering that immediacy.

A good way to think about the size of the spread is to consider a market with several competing dealers. In this case, there are two primary scenarios:

1. If the spread is too high, more dealers will enter the market to gain profit from the large bid/ask spread

2. If the spread is too low, dealers will lose money, and exit the market

These two factors ensure that the liquid market dealers make normal profits, and that spreads are of reasonable size.

Supply and Demand

The existence of a spread is quite natural and leads back to the simplicity of supply and demand. Start the argument small and work your way up! I found a great example in an article by Glenn Curtis on August 19 with the following story.

Suppose that a one-of-a-kind diamond is found in the remote countryside of Africa by a miner. An investor hears about the find, phones the miner and offers to buy the diamond for $1 million. The miner says she wants a day or two to think about it. In the interim, newspapers and other investors come forward and show their interest. With other investors apparently interested in the diamond, the miner holds out for $1.1 million and rejects the $1 mil- lion offer. Now suppose two more potential buyers make themselves known and submit bids for $1.2 million and $1.3 million dollars, respectively. The new asking price of that diamond is going to go up. The following day, a miner in Asia uncovers 10 more diamonds exactly like the one found by the miner in Africa. As a result, both the price and demand for the African diamond will drop precipitously because of the sudden abundance of the once- rare diamond.

Imagine the diamond becomes more popular. More buyers want it. More mines open, and more sellers emerge. In a rational setting, this creates a quote driven a bid ask spread. Add enough volume, and before long, you are back to the first example.

What is the yardstick for successful trading?

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Regardless of whether you are trading Forex, stocks, gold or beans, everyone who considers themselves a “trader” wants to be successful. For many, this means fulfilling the goal of replacing their current income with gains made from trading. For others, it might mean reaching levels of wealth and security impossible to reach with their “day job”. In all cases, success means something different to each trader.

So, how can you measure trading success?

I bring this up because there are a lot of unsuccessful traders out there that want to become successful. When they evaluate a mentor, trading system, service or piece of software, they make their determinations based on preconceived notions of success in trading. Too often, the people selling these systems, services or software use these preconceived ideas of success to sell the illusion of success, without any chance of delivering what they promise.

You see, the more contact I have with people trying to learn to be successful traders, the more I feel people are on a journey without end. They have unrealistic goals they think are achievable, but are not. This leads to jumping to the next service, system or software promising huge gains. They’re permanently one step removed (good pun?) from the success they seek.

I thought it would be a good idea to go over some of the most common “measuring sticks” of success in trading, so you can make informed decisions based in reality, and not uninformed decisions based on unrealistic hype. In the end, I want you to figure out how YOU define success. Is this a realistic goal? Is what you propose possible, or only a dream? Only once you have a clear definition of success, can you take steps to achieving your goals.

measure successful trader

Win Rate?

You’ll see a lot of people define success by win rate. When a new system or service becomes available, win rate is often used to show how good it is. You’ll see systems claiming 80%, 90% and even 98% win rate. But does the win rate really mean the system is good and you will be successful trading it?

Even if you can learn a system and get the win rate percentages advertised, this does not necessarily mean you are going to be profitable. Win rate alone is not enough information. You need to know stop loss and take profit levels as well as the money management strategy used to calculate lot size.

What would happen if the system uses a 200 pip stop loss and 2 pip take profit? Think about it. One bad trade would negate 100 winning trades.

Number Of Pips?

Another favorite method for measuring success is number of pips gained in a month. The idea is the higher the number of pips, the better. But again, only knowing the number of pips is not enough information. Here are a couple of things to look out for…

Double Counting Pips: A lot of systems and services use scaling out as part of their exit strategy. For example, they take off half the lot size at 20 pips and the other half at 40 pips. Some people might say this was 60 pips of profit. Where in reality, this is only 30 pips of profit at the original lot size.

High Stop Losses: If you are using a strategy with a high stop loss value, you need to take this into consideration when deciding on the lot size to use. Traditionally, the higher the stop loss, the lower the lot size you should use to not put too much of your account at risk. So, even if the service shows high pip gains, these pips might not mean very much in terms of money earned.

The truth is, the number of pips you need to make to be profitable depends on the system’s characteristics. A lot of people think they need 1000 pips a month in order to be profitable and use this level to define success. But a service making 200 pips a month might be much more profitable when you look at the stop loss size and lot size used.

Money Earned?

A lot of times I see specific dollar amounts being used in promotion. Something like, “X trader made $346,095.00 in six months”. But this does not show how much money YOU would make.

Too many people kid themselves and believe these kinds of gains are achieveable with a starting balance of $500. This is just not the case. It is easy to make $350,000 when you start with a balance of 20 million. So, take these dollar amount statements with a grain of salt.

Percentage Gains?

In my opinion, percentage gains are the best way to measure success in trading. It is just easier to determine what the percentage gains would mean for you, compared to using win rate, pip numbers or money amounts. Here are a couple of things to take into account…

100% monthly gains are not realistic. I know a lot of people who want 100% gains every month. Well, what trader wouldn’t be happy with those numbers? But the truth is, this kind of goal is ridiculous. You might be able to do reach this level once, if you are lucky and use risky money management. But these type of gains are not something you can achieve consistently.

You can create huge wealth with 2% average monthly gains. With compounding and patience, consistent monthly gains can really add up. Throwing away a system or service making 2% monthly gains for the hopes of finding something that gives you 100% monthly gains is a waste of time.

In the end, you need to decide what success looks like. But the best advice I can give is to align your goals with reality. If your trading success goals are outside the possible, you’ll just end up going from one thing to the next, and this is not the way to be successful.

3 Steps to Protect Against a Forex Broker Bankruptcy

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Forex Magnates posted an article on FXGM, a Cyprus based forex broker caught up in that country’s banking debacle. I don’t know any specifics, but it seems likely that FXGM might be forced into bankruptcy. Bankruptcy scenarios usually result in traders receiving pennies on the dollar for their accounts.

My mission – the entire reason that this company exists – is to help traders find an automated edge to exploit around the clock. It’s an extremely challenging goal. It requires my 7 years of education in the school of hard knocks. I might be the world’s leading expert in what doesn’t work in trading.

That goal is so consuming and challenging that we often lose sight of the big picture. When you deposit funds with a broker, everything happens with the pretense that the funds are your money. You believe that you reserve the right to withdraw those funds at will, and that legally, those funds are your money.

I hate to be the Bad News Bear, but that understanding is emphatically incorrect. Deposits at most brokers are unsecured loans to the broker.

I hope you’re aware of this, because it’s the exact same situation with your bank account. The account is “yours” in the sense that it’s “your loan” to the bank. If the bank/forex broker goes belly up, depositors are among the first parties hit with losses (after the deposit insurance ceiling is breached).

A bank run can cause your forex broker to go bankrupt.

A bank run can cause your forex broker to go bankrupt. Image credit: www.thecomingdepression.net.

That generally means that equity takes the first hit, followed by depositors, followed by the bond holders. If you apply that to a forex brokerage, it means that the owners of the brokerage are first in line to lose the value of their holdings. Once those losses exceed the amount of customer funds on deposit, you the Trader take the loss.

Trading is hard enough. Taking losses because a broker went belly up is sickening.

How to protect your trading account from a forex broker bankruptcy

Protecting your initial capital by choosing the right broker(s) is every bit as critical as choosing the right trading strategy to protect and grow the account.

Before we dive into specifics, I want to highlight that there is no fail-safe method to avoid getting caught up in a broker bankruptcy. The best that you can do is to mitigate the risks.

Choose multiple brokers – Don’t put all your eggs in one basket

The simplest tactic involves spreading your funds across multiple forex brokers. If you’re trading a $50,000 account, consider splitting that money between 2-3 different brokers. That may have been inconvenient in the past when everyone traded manually. Most of you use expert advisors today. Is it really that hard to open two copies of MetaTrader and let them run simultaneously?

Even without safety of funds, I encourage you to open multiple forex accounts. Different forex brokers use different liquidity providers.

Most traders get caught in the trap of thinking that the forex market is unified and that there is only one price for the EURUSD. There are hundreds of different prices for the most liquid instrument, EURUSD, around the world. The prices are generally very, very close together, but they are different.

The small differences between forex brokers really adds up for certain strategies. I remember visiting a private fund in Dubai back in 2009. The trader showed me account statements from different brokers running the same expert advisor. Losses of 10% at one broker compared to 50% profits at another broker.

Jurisdiction

Running to the alleged safety of the United States doesn’t make sense anymore. The US government, represented by the not-so-fine folks at the NFA and CFTC, have been asleep at the wheel for decades. Take note of their recent epic failures:

I know several customers that lost six figure accounts dealing with these brokers. The government claims that through its enforcement and regulation, it performs the due diligence that the trader would normally conduct.

The discovery of multiple accounting frauds, all in the hundreds of millions of dollars (MF Global was over 1 billion), exposes the situation for what it is: a farce. The CFTC and NFA are grossly incompetent at evaluating which forex brokerages are safe places to put your money.

That doesn’t mean to run off and put your money with some shoebox broker in Belize, either. The goal is to strike a balance between selecting a location where the rule of law still matters and where the banking system isn’t on the verge of collapse.

The events in Cyprus had absolutely nothing to do with the forex brokerage. The company got caught up in banking events that put the entire system at risk. The bank account (and its location) of your broker is a critical factor in your decision.

Here are some of the jurisdictions that I like for banking and forex brokers:

  • Singapore – no history of banking failures. It probably has something to do with its severe criminal penalties. It’s harsh, but there’s no disputing that the rule of law governs the country. I would be inclined to take Singaporean claims of safety of funds at face value
  • Chile. I’m a huge fan of Sovereign Man. Otherwise, I never would have considered the country were it not for their newsletter. Every report that I’ve read supports the idea of a stable banking system and a government that serves justice blindly.
  • Australia – The government’s debt to GDP ratio is heavy but not impossible to service. Regulation also means something here, even if it’s heavy and burdensome. Pepperstone and Go Markets are two brokers that OneStepRemoved has done work for in the past. AxiTrader also sends us referrals on a consistent basis. ILQ is a true ECN that offers very low spreads to retail traders.

I trade my live accounts at Pepperstone, which I believe is the best endorsement that I can give. My personal money is on deposit with the company. They’re also on my list of recommended forex brokers.

Jurisdictions that I’m ambivalent towards:

  • Switzerland – Yes, there are good banks in Switzerland. There is also the UBS and Credit Suisse crowd that required government bailouts and emergency capital. The Swiss brand is heavily tarnished
  • Finland – the only EU country bent on kicking out the PIIGS from the euro. I wouldn’t want my personal money in any EU bank, but I suppose it’s the best of the worst if you want to trade in Europe. FinFX, a Finnish forex broker, also accepts US customers.
  • New Zealand – a similar case to Australia. New Zealand seems to position itself as a Western safe haven for assets. The Cook Islands, which are known for its trusts, are a protectorate of New Zealand. I don’t know much about the regulatory effectiveness or the stability of its banks.
  • United Kingdom – I honestly don’t like this option very much. The only reason that it makes the list is that the FSA appears to do a good job policing fraud and enforcing segregated accounts. The indebtedness of their banking system makes me extremely wary.

Jurisdictions where you’re nuts to put your money (assuming that you don’t live there). All of them have indebted banking systems up to their eyeballs. You risk getting Cyprused working with a broker here:

  • Cyprus
  • Ireland
  • France
  • Germany
  • Spain
  • Italy
  • Portugal
  • Greece
  • Malta
  • Japan
  • US

Trade on a line of credit

A line of credit is my favorite option. It eliminates most of the risk in a forex broker bankruptcy. Unfortunately, it’s also out of my league.

Starting a line of credit involves selecting a banking partner acceptable to both yourself and your broker. A number of legal agreements go back and forth, requiring time and effort from the broker’s legal team (i.e., it’s expensive).

Most brokers require a starting balance above one million dollars to consider accepting a line of credit from a bank. The time and effort involved with setting up credit lines under that threshold don’t make sense.

A line of credit is secured through a deposit at the bank of your choice. Say that you’re trading 5 million dollars and you believe that HSBC Singapore is a wonderful place to hold your money. You do just that. You open an account directly with the bank and inquire about establishing a line of credit secured through the cash deposit.

HSBC Singapore

HSBC Singapore

When you’re ready to open a new forex account, the broker may require that you deposit 10% with them. The remaining 90% stays at the bank via the line of credit. The bank and its capital assures the broker that any losses you suffer are covered by the bank. The bank then deducts the losses from your available balance.

Profits accrue at the broker. If you want to withdraw them, you simply pull the profits back into your bank account.

The 10/90 ratio is flexible and completely open to negotiation. These things don’t get set up all that often. 10/90 is more of a starting point for the discussion.

If you’re in the admirable situation of trading a million+ dollar account, then you have a tremendous opportunity to safeguard your funds at the bank of your choice anywhere around the world. The country of business where your broker operates becomes largely irrelevant. Contact me directly at info@onestepremoved.com if you would like to arrange a line of credit between yourself and your forex broker.

Conclusion

The rules for safe guarding your forex deposits are simple. There are countless forex brokers to choose from. Instead of risking all of your money in one spot, it’s best to spread it around in countries with strong banks. You might also consider using one of our recommended forex brokers.

You are legally lending money to the forex broker when you open an account. The broker then legally lends your deposit to the bank. You can want to ensure that you’re lending your capital to businesses – the broker and its bank – that are extremely likely to pay you back.

The line of credit is the best option available. Instead of facing two counterparty risks, you largely remove the broker from the equation. You can then focus on your trading and let your broker focus on its primary service of providing excellent execution on your trades.

My live account is at Pepperstone. If you’re interested in trading with them, I’m happy to share my experiences and why I chose them.

Meet real traders in real life

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Polite conversation usually includes the question, “So, what do you for a living?”. It’s a question that I usually dread.

It would be so much easier if I could say doctor or teacher. When I worked as a forex broker five years ago, I managed to squeeze my answer into a 30 second type of elevator pitch.

“You know about day-trading? The guys that sit there all day clicking buy and sell in their brokerage accounts?”

“I work in forex, which is the currency market. You can trade currencies like stocks. My job is like a stockbroker.”

That explanation worked until I started OneStepRemoved. Now I have to explain currency trading and software development at the same time.

People nod like they get it. They don’t. They’re being polite.

Polite response

Most people have no idea what forex trading is. They nod politely while I quickly dodge the question about what I do for a living.

A real traders network

It’s so nice when people understand what you’re saying. Words like pip and EUR/USD don’t sound like an exotic foreign language to other traders.

Those relationships don’t happen by accident. They involve putting yourself in places and situations where you get the opportunity to meet real people.

My forex network happened largely through fate. I started my career in trading. Many of my closest trading buddies are former colleagues.

Most people reading this aren’t lucky enough to get paid while building a network of other traders to share their pain and ideas. It usually takes work to develop something as valuable as a personal network.

Meetup.com

The Meetup group Dallas Algorithmic Trading invited me to give a presentation next week on Thursday, February 21, from 7-9 pm. If you’re in the neighborhood, I’d love to meet you in person.

Meetup.com is a great place to create relationships with other traders. Many of you live in spots with unusual concentrations of forex traders: London, Gold Coast Australia, Singapore, etc. There’s a good chance that you can go meet like minded folks without having to venture too far from home.

The groups are pretty small – usually 10-15 people. You can socialize without having to really throw yourself out there.

Meeting people in person at these type of events are one of the few places where you can naturally speak about your hobby. Everyone that shows up to these things shares the same interest as you.

Trading conferences and expos

Big conferences are also a great place to meet people. But, it does involve more effort to chit chat comfortably with other people. The conferences are usually free or low cost and packed with traders. The Traders Expo in New York, for example, starts in a few days and is free to attend.

If you enjoy traveling, it’s often a good excuse to go somewhere. Depending on your home country and how seriously you trade, it’s also a tax write off.

Online

Last month, two new clients used us for a project that they’ll both use. How did they meet? Virtually!

These guys trade every day together over Skype, but they’ve never met in person. They started talking on an online forum 5 years ago. They’re great friends. They split the costs of their programming projects, share trading ideas and most importantly, they have someone there to help them ride through the ups and downs of trading.

Conclusion

Trading and emotions go hand in hand. People often think of automated trading and EAs as solutions to emotional trading. They aren’t.

If you don’t feel totally confident in your system, you will eventually pull the plug. It might be an EA or your trading altogether.

The best defense against doubt is to bring yourself out of isolation. Go meet people. Share ideas. Talk about markets and trading.

How did you meet your trading buddies? I’d love to hear other ideas in the comments section below.

Fibonacci Fluff

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I read a post on Zero Hedge highlighting an alleged Fibonacci time pattern. The chart shows a convincing countdown between the March 2009 low and an exponentially decreasing time period between market peaks.

ES Daily chart

The ZeroHedge post claims to find a Fibonacci pattern in the ES low going back to 2009.

I would expect the pattern to show up in other instruments if the observation had any merit. It’s well known that the strength or weakness of the US dollar largely drives the price movements in equity indices, especially in the S&P 500.

If it shows up in the SPX ETF, surely a similar patten would appear in EURUSD? It’s the most liquid and actively traded forex pair in the world.

A quick look at the EURUSD doesn’t give any encouragement.

Fibonacci time

A current look at the EURUSD doesn’t show any relationship to the ZeroHedge Fibonacci time observation

I even did some cherry picking in the drawing to get the time span between trends to decrease. My original drawing counted the 128 and 97 day periods as a single group.

A lot of readers out there swear by Fibonacci price movements. I’m not sure how many subscribe to analyzing time with Fibonacci.

Do you think it’s a useful tool? Let me know what you think by leaving comments below.

Forex Liquidity

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Peter from Ireland wrote in asking me to do a piece on liquidity on the forex market. Although the market trades 5 trillion dollars per day in volume, even forex traders face limitations in how much volume they can push through in a short period of time.

A Zero Hedge article on the Reuters 3000 platform outage cited some interesting statistics for the currency markets and where the trading actually occurs. Although I was familiar with Reuters and EBS previously, the Dow Jones article was the first place where I’ve seen volume statistics published. Apparently Reuters, the biggest platform, trades approximately $130 billion dollars in volume per day.

That’s an astronomical amount of money. Intuition makes it feel like hitting the ceiling on executing large transactions might be a problem for only the biggest institutions. Let’s take a look at where we might expect to run into problems.

When I went through broker training at FXCM, the team leader cited the EUR and USD as being involved with 60% of all forex trading volume. That number does not imply how much volume occurs in the specific EURUSD pair. Also, that that was seven years ago. I dug around looking for more up to date numbers. Forex trading volume is notoriously hard to track due to it being an over the counter market. The best proxy that I know of is the FX futures market.

The CME publishes FX futures contracts volume (page 16), which I used to estimate the proportion of the EURUSD pair in relation to all traded volume. FX futures contracts, like their spot counterparts,  are all denominated in different currencies. Except for the e-mini and e-micro contracts, which resemble the mini lots of retail forex trading, the contract size is roughly $150,000. I’m counting contracts rather than actual notional value to speed up the calculations. You can double check my calculations by downloading this spreadsheet. The EURUSD pair represents 33% of all forex trading volume based on my rough estimates.

The EURUSD value traded per day on Reuters is 33% of $130 billion, which is 43.33 billion. The average trading consists of 1,440 minutes per day. 43.33 billion trades per day / 1,440 minutes per day yields an average traded amount of $30,092,592 traded per minute. Again, this is a huge number.

Everyone in forex trades on margin. Institutions traditionally keep their margin very low. Assume that 3:1 is the norm for the big players. That means that the actual funding in the account only needs to be $10 million dollars (30/3). That’s a lot of money, but that is chump change by institutional standards. That’s more on par with a wet behind the ears CTA that launched within the past few years. This scenario is for the most liquid currency pair on the largest currency trading platform in the world.

Dropping down to the retail scenario, the numbers involved get much, much smaller. The Financial Times cites FXCM’s average trading volume as $55 billion per day. This is tens of multiples higher than an average broker’s volume. I picked it because it’s the highest that I know of and I wanted to demonstrate a big scenario. 33% of $55 billion is $18.15 billion traded on the EURUSD. $18.15 billion / 1,440 minutes per day is $12.6 million traded per minute.

Retail traders leverage far higher than institutions. Again, let’s be kind and make the assumption that the average retail trader employes 15:1 leverage on the account (hint: it’s much higher). $12.6 million / 15 implies that it only takes an account balance of $840,277 to trade all of the expected trading volume in an average minute. One trader is unlikely to have a balance that large, but a segment of a broker’s customers most certainly do.

The fragmentation of the market combined with leverage makes it strikingly easy for a group of traders to suck up all of the liquidity available on a given platform. Even though trillions are available across the broader market, the broker or platform where a trader participates is substantially more limited. The scenarios modeled use the EURUSD, the most liquid pair in the world. Liquidity gets exponentially worse when examining exotics or cross currencies. The volumes are far lower, but the available leverage and account balances remain the same.

When too many traders buy the same EA, all orders fire off at the same time. Blockbuster EAs easily reach the combined account equity floor where demand overwhelms supply. Finer details like all of the supply is being one sided make the situation all the worse.

Dark Pools

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I picked up Dark Pools by Scott Paterson on Friday evening and finished Sunday afternoon. That ought to say something for the book’s readability. I recommend it to anyone that trades, especially equities traders.

The structure of the stock market is far more complicated than I ever expected. Trading at Interactive Brokers, I always noticed that the execution venue would vary between different acronyms like ISLAND, ARCA and BATS. I knew that they were ECNs, but I never really understood what linked them together.

The stock market is not an exchange in the sense of a centralized location where all transactions occur. It is more like a listing entity where public companies go to list their shares. Actual trading occurs on any network plugged into the system.
The “exchange” is really a complex network of networks with varying degrees of favoritism shown to high volume clients.

Electronic Communication Networks (ECN) originally started in the mid 1980s with the idealistic goal of eliminating the corrupt practices of the NASDAQ floor specialists and market makers. These guys were notorious (and later heavily fined) for colluding to artificially widen spreads on stocks for their own profits. ECNs would cut out the hated middle man while reducing errors, increasing transparency and dramatically decreasing execution time.

As one can imagine, the ECNs took off rather quickly. Not only did they offer much faster execution, but they were also about 60% cheaper to execute a trade.

They corruption that ECNs sought to eliminate inadvertently replaced one problem with another. Networks looking for liquidity offered trading rebates for limit orders that added orders into the system. The setup, which came to be known as maker-taker, created perverse trading incentives for participants. The more trades executed, the more the profits would add up.

Firms sought to become something like Walmart is to wide screen TVs. The more you sell, the more you make. The liquidity providers started fighting aggressively for inside placement of the spread to facilitate ever more trades.

The system spun out of control in two ways. It created a computing arms race where firms focused on purchasing cutting edge technology that shaves microseconds off of calculation time. Firms with the deepest pockets could literally buy an advantage through their computing hardware over the average Joe.

More importantly, the system itself bred its own corruption. The ECNs grew addicted to the liquidity fees. The more trades that fired off, the more money they made. They naturally started catering to their most important clients.

How they did it, though, is what sickens me as a trader. The ECNs started creating order types that were effectively secret. They allowed high speed firms to jump in line over retail chumps using vanilla limit orders. The ECNs offered colocation access at exorbitant fees to give the machines an edge. They allowed the creation of dark liquidity where some players could literally hide orders for execution while others displayed theirs 100% of the time. It makes a complete mockery of the idea of a level playing field.

Artificial intelligence played a big role in how the algorithms operate. What encouraged me, however, was how Patterson chose to wrap up the book. Many of the funds covered near the end start out as relatively small fish working with various types of AI to build predictive trading systems. Their initial results appear encouraging.

One of our biggest projects here is to use various models of fractal markets to build an automated trading system on behalf of the client that I go visit in Ireland so often. Andy and I meet on a near daily basis to discuss our genetic algorithm and how best to encourage the network to behave as we want it to. We are about a month from running our first predictive tests with our in house model. Reading this book encourages me that we are blazing down the right path.

Forex Market Depth

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Moving from small time retail forex accounts to a serious account size comes with some bumps in the road. Most traders see the prices of forex pairs on the screen and assume that they can buy and sell unlimited quantities at any time. Although the forex market is the largest market of any in the world, making it the most liquid, there is still a limited size to what you can trade at any moment.

Reading Forex Market Depth

NinjaTrader and MB Trading both make market depth information available in their trading screens. It shows where all of the nearby liquidity lies. Say, for example, that you wanted to place a big order for EUR/USD. You can see in the screenshot from MB Trading’s platform that the currency market depth gets bigger as you get further from the price. They call these “Level 2” quotes, which is jargon taken from equities traders.

Market depth of EUR/USD

MB Trading’s Navigator shows the market depth of the EUR/USD. Light colors show the best prices, darker prices indicate distance from the best price.

I took this screenshot in the late afternoon when liquidity is at its worst. The best bid shows a depth of 200, which is measured in mini lots of 10,000. You could sell up to 2 million EUR/USD and get filled at that price. Notice, however, that most of the liquidity is further away. 3 million sits at the next best price and another 3 million even further from that. The net available liquidity is 8 million on the short side and 6 million on the long side for a total of 14 million.

The FX Pro screen in NinjaTrader makes it even clearer. I took this screenshot several minutes later, which is why liquidity numbers are different. One thing I really like about this screen is that NinjaTrader converts the currency market depth into more tangible numbers. The formatting makes more sense to me. Plus, it’s much easier to keep track of the varying spread.

FX Pro screen in NinjaTrader

The FX Pro screen in NinjaTrader

What you learned in economics doesn’t apply to trading. Dealing in bulk actually leads to worse pricing instead of improved pricing. The reason is that forex instruments are so standardized that there’s effectively never a lack of customers. It’s really an issue of getting how much much you want at a certain speed.

Only a fool would hit the market with 20M EURUSD instantaneously unless you’re desperate to exit a position. If you push a market order judging solely from the quote on the screen, you may get 2-8 million filled at the displayed price. But, the rest of the order will get filled at progressively worse prices. The traders making a market want their pound of flesh for letting someone into the market so quickly.

Traders cannot see the liquidity depth of most brokers because they elect not to show it. Their platforms encourage the buy this, buy that psychology. The more information that they broadcast, the more bandwidth that’s required, which means that better servers are required.

The EURUSD is the most liquid forex pair in the world. This varies largely by broker, but at any given time you should be able to trade 20-30 million EUR/USD. That doesn’t mean that you’ll get filled at the price on the screen. What that means is that that is the sum quantity available at any given moment.

Some brokers hide their quantity. It’s not like the stock market where if there are 15,000 shares of Microsoft ready to trade at any given moment, you can see 100% of the liquidity available. In forex, as an OTC market, the broker may wish to restrict the viewable book for a few reasons.

If you offer markets from say 5 banks, it’s very rare for the broker to feed the best competitive price and to let the banks fight it out? Why? Because the broker also needs the banks to stick around when nobody wants to trade.

It’s an informal agreement that if I’m retail broker A and UBS is my main liquidity feed, I go out of my way to give UBS the good flow. My customers expect to trade during NFP and other volatile markets (although they really shouldn’t!). If the brokerage simply lets the banks fight it out, then the banks have every reason to let the brokerage rot on the vine when their customers want to trade but it’s bad for the banks. The banks certainly don’t want to take positions in volatile markets. Their only incentive for doing so is if the “good flow” that the forex broker sends during normal markets incentivizes them to accept the risk of losing more than they care to during NFP.

News traders are the most likely to try trading during a thin market. They are also the most likely to complain about not being able to trade. These are the arguments to which I’m least sympathetic. If you’re trading the news, you are overwhelmingly likely to have less than one year of trading experience. The decision has nothing to do with researching systems or evaluating whether or not it’s a good idea. It has everything to do with gambling.

Retail traders are the most likely to trade during volatile events, not just news but really any type of momentum. Almost everyone follows a breakout or momentum strategy. It has everything to do with what traders perceive as the most likely outcome. When the market explodes in one direction, it takes nerves of steel to stand in front of the freight train. Therefore, it’s probably a good idea because it’s counter-intuitive.

Trends happen so slowly that they don’t excite the gambling buzz that most retail forex traders are after. My friend Afshin in Dublin fell victim to this last week. He saw the EUR/USD rising day after day after day. He felt like it was simply overdue for a correction. The urge to participate, rather than coming from a desire for a quick hit, instead came from a desire to be right before there was any clear indication of the opportunity to be right. The point is that what feels natural to do is often precisely the wrong thing to do. It feels natural to every other trader, too.

Market Depth and Direction

One research project that I’d eventually love to do is to study how market depth on any given side of a market affects direction. Some traders run simple liquidity businesses where they receive trading rebates in exchange for accepting the risk of holding a position over the short run. These entities are less likely to concern themselves with picking the direction of the market.

Trading desks that make markets, however, often want the flow so that they can establish a position and earn the spread while doing so. These entities are picking direction – and they are backed by very intelligent math geeks with PhDs and a lot of time on their hands. If those desks make a visibly deep market and it’s sufficiently one sided, then it’s probably safe to assume that they expect to the market to move in the opposite direction.

When you’re buying a forex pair, the bank is selling it to you. So if everyone stacks the liquidity so that you can buy but the liquidity is thin on the short side, it should be telling you that the smart money wants to go short right now.

Ten heresies of finance

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I set a reading list for new programming hires before they ever interact with customers. OneStepRemoved’s newest programmer, Jon Rackley, comes with an outstanding background in programming, but almost no market knowledge. Jon is under my wing for the next few months. My goal is to fully indoctrinate him on my market views.

One of the most useful, high level overview of trading dynamics is Benoit Mandelbrot’s The (Mis)behavior of Markets. My philosophy is that before you attack a problem, you first need to understand the problem. Building trading robots is the problem that our customers face every day. One reason that many would-be automated traders fail is that they understand very little about how markets function. They try to solve a problem that they don’t understand very well.

Mandelbot’s “10 heresies of finance” sums up my view of markets quite well. I made Jon read the book as part of his job training because has no trading experience. If you’re relatively new to markets or think it’s time to step back and re-evaluate your approach, then I highly recommend this book.

The 10 heresies of finance

  1. Markets are turbulent.
  2. Markets are far more risky than the standard theories imagine. Mandelbrot does do a very good job throughout his book explaining how unpredictable and complex market behavior really is.
  3. Market timing matters greatly. Big gains and losses concentrate into small packages of time. He calls this trading time.
  4. Prices often leap, not glide. That adds to the risk.
  5. Time is flexible. Some times of day are more important than others
  6. Markets in all places and ages work alike. Human behavior never changes, even if the mood does
  7. Markets are inherently uncertain. Bubbles are inevitable. We will always be greedy
  8. Markets are deceptive.
  9. Forecasting prices may be perilous, but you can estimate the odds of future volatility
  10. In financial markets, the idea of “value” has limited value.

Jon found Mandelbrot’s comparison between wind turbulence and market dynamics the most compelling part of his argument. It’s conceptually difficult to accept the idea of human behavior acting like the wind. The math of the two behaviors is identical, which is somewhat difficult to accept emotionally. What I like about the argument is that it makes for a beautiful metaphor.

When a storm comes up, it’s noteworthy. The average wind speed picks up. People notice that part. What everyone really notices and gossips about are the wind gusts. Staring out the window and watching the family oak tree bend a quarter way to the ground makes an impression.

Wind gusts are essentially market volatility. Events like a collapse of the euro or a surprise NFP number are the violent gusts of wind that make the jaws of traders everywhere drop to the ground. One gust begets another gust, packing themselves densely in time. Mandelbrot would reference the
increase in gusts as trading time speeding up.

If you enjoy these types of ideas, you might find our free resetting moving average indicator useful. It builds on Mandelbrot’s fractal approach to markets, negating the idea of a true average. The resetting moving average tries to act as a minimum reference point by changing its period in step with market volatility.