What changes the market ? - Part 1

J

Joe Ross

Part 1

From time to time I am reminded that the markets have changed and are still changing. Whenever I say that, I’m asked: “How have they changed? In what way?”

The markets have changed in many ways, but the principal change, the one I want to write about today is that of participation. The participants in the markets have changed dramatically.

When I began trading there were perhaps 20-30 thousand traders in the entire world. This was in addition to a very few stock traders (not investors).

Today there are hundreds of thousands, perhaps even millions of traders in futures alone. The changing composition of the group of traders trading the markets is what changes the markets themselves. After all, a market is made up entirely of its participants.

Computerized traders using trading models have changed the way the markets work. Fully electronic trading platforms have changed the way the markets work. Day traders have changed the way the markets work.

I’m going to look at each of these, plus some other ways in which the markets have changed over the years.

I’ll begin with computerized traders using models. For the most part, the people trading large pools of money are the people who use mechanical trading systems, also known as computer driven trading models.

Pools of money using computerized models can cause the markets to explode or melt down rather than trend. Think about it! Models are either trend following or value oriented. There is not much else they can be! Today we are going to look at trend following models.

The problem is that there are only a few variables which can be included in a mechanized system. Ask yourself, how many ways can you combine or evaluate the Open, the High, the Low, and the Close? Will it make a huge difference whether you use simple or complex moving averages of these four variables? Will it matter significantly whether or not you add volume and/or open interest into the equation? Just how many ways are there to determine the trend? Virtually every method for trend finding is based on some sort of moving average of prices, is it not?

All moving averages, when detrended and presented as oscillators are an attempt at measuring momentum – is the market trending up or down – which direction best represents the pressure in the market? Is there more buying than selling? If so prices should be rising. If selling is greater, then prices should be falling.

The net result of all these models attempting to discover trend is that they are all going to find the same trend at the same time, literally within moments of each other. The models are in fact, correlated.

What takes place when all of the models suddenly discover that prices are trending upward? They all give buy signals. What happens when al the models suddenly discover that prices are trending downward? They all give sell signals. What happens in the market when suddenly huge pools of money decide they need to take action with regard to the current trend? The market begins to trend more steeply. It may even explode upward or melt down, depending on the newly discovered trend.

Actually, there is only one essential factor available to mitigate the absolute dynamics of an explosion or a meltdown. That factor is size.

The trading pools have so much money that they cannot afford to put on their entire position at once. If they try to place their whole position into the market all at once, the result will be that they shoot themselves in the foot.

If a pool buys too much all at once, they will drive prices substantially higher, thus having to put on their position at an increasingly higher price. They may even cause prices to explode upward. Their buying activity will appear to be real demand, but in actuality, the demand in the market is partly real and partly false. The false demand is caused because the pool’s computer is telling them that the market is trending and therefore they should buy. But the computer generated demand is artificial, and may have nothing whatsoever to do with real fundamental demand for the underlying. The reverse is true for selling.

If the pools try to sell too much all at once, they will drive prices substantially lower, thereby having to sell at a lower price than they want to. Their selling may even cause a price collapse. Their selling looks like there is too much supply of the underlying, but much of the downtrend will be due to pseudo oversupply, i.e., the pool’s computer generated selling causes the market to go down more steeply and possibly more quickly than would the natural market forces.

So, we find the large pools having to gradually ease their position into the market. The result is an enhancement of the trend, but the trend will tend to not last nearly as long as if the pools were not involved. What is really happening is that the real trend, caused by real demand or real oversupply is now being accentuated by the buying and selling of the trading pools, simply because their computers have told them that the market is trending.

Pools dominate the future markets

Before there were such things as commodity pools (they should be called futures pools), the markets were dominated by the commercial traders. The commercials knew how to keep a trend going, and milk it for all it was worth. But today, the commercials face a serious challenge from the commodity pools for who will dominate the futures markets. The pools do not have a clue as to how to maintain a trend. They all rush into a perceived trend when their computerized models tell them that there is a trend.

The trading actions of the pools actually kill the trend.

I want to show you another way in which the trading pools destroy the trend. The result is that markets trend a lot less and for a shorter period of time than they ever did before.

Many of the pools use valuation models for trading the markets. These models compare today’s price with what the computer determines is a relatively overvalued or undervalued price. The computer looks back historically over several months or years and comes up with what the price should be.

Therefore, when a trend really gets going, and prices are much higher or much lower than what the computer thinks they should be, the commodity pool receives a buy or sell signal.

Let’s say that the commercials are very nicely moving prices up. They are in no hurry. They know how to milk a market. All of a sudden the pool computers decide that prices are too high compared with the past. The pool computers issue a sell signal --- prices are too high. Being correlated to one another, the pools all begin selling. Prices start to fall, or they quit going up and enter into a trading range top. The reverse is also true when prices are deemed by the computer to be too low. The computer issues a buy signal and a lot of pool buying comes into the market. At that point you will see a 1-2-3 low and possibly a vee bottom. Usually, you will get a 1-2-3 low and then a trading range.

In either case, the valuation models have killed what was previously a trend. Unless there is either massive buying or selling coming in from the public that might cause the trend to continue, the trend will end.

......to be continued in Part 2 !

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This article was written and contributed by Joe Ross
 
Part 2

Daytrading history

So far I’ve shown how trend following models and value models affect the markets. Now let’s take a look at day traders.

Daytrading began to be fairly common in about 1980. Most day traders traded either the full S&P 500 (500 times the index), the currencies or the bonds. There were a few who attempted other markets, but the only decent day trading took place in the aforementioned 3 markets.

When day trading became available to traders having live data and a computer, the exchanges along with the brokers began to heavily market the availability of rapid trading, in which traders could make big money in a matter of minutes. Commission rates dropped dramatically. The word got out and the number of traders attempting to day trade increased rapidly.

Discount brokers sprang up all over the place. Discount brokerage firms took out huge ads in the WSJ and the IBD. They also advertised in a variety of trading magazines. These magazines were full of ads promoting mechanical trading systems, low commission brokerages, day trading software, and various data feeds.

As the number of day traders increased, so did the amount of noise in the markets. Short-term trading was all the rage. Intraday prices chopped up and down as day traders bought and sold for only a few ticks. Markets went mostly sideways until someone came along with enough clout to move the market. What at one time were beautiful intraday trends gradually became chopping intraday trading ranges.

During the 1990’s the currencies lost their attraction for thousands of day traders. What happened was this: At the point that banks were trading over $1.4 trillion daily there were not enough currency traders in the pits to handle the huge currency trades that needed to be made. For awhile, the price for a seat at the IMM of the CME increased geometrically in price. Entities that needed to hedge in the currency markets were hiring ex-football and basketball players to stand in the pits and trade. Their physical size gave them an advantage in the push and shove of the trading pits. Any one under 6’ 3” tall was at a disadvantage. Their bids and offers simply could not be seen because of the behemoth-sized ex-athletes standing in front of them. Nevertheless, there were not enough locals and floor brokers in the pit to take the other side of the mega-million currency trades that needed to be made.

Those entities needing to buy or sell huge amounts of currency could not find satisfaction in the currency futures. Banks began to call each other and do off-exchange trades. These trades among banks are called “currency swaps.” And the environment in which they are made is called “Interbank.” Those who didn’t want to bother with making deals directly with other banks, chose instead to use forex brokers to handle their currency trades. In forex, there were no commissions and no fees to be paid. Forex brokers made their money on the spread between the bid and the offer. The result was that traders in the currency pits simply dried up. The volume plunged like a rock. What formerly were among the most liquid markets gradually became illiquid. The price of a seat on the IMM dropped to about 1/4th of what it had been. Did the drying up of the currency markets affect the day traders? It sure did. It sent them scurrying for the bond pits and the S&P.

to be continued in Part 3

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This article was written and contributed by Joe Ross
 
Part 3

What happened in the S&P is a story unto itself.

Story of S&P

We began our story of S&P day trading by looking at how day traders affect the markets. We saw that in the currencies, the market affected the day traders, and eventually drove them out, and volume and liquidity moved to the Interbank and the Forex.

Daytraders were more or less forced to trade the bonds and the S&P 500. There were really no other places to go. I said, “What happened in the S&P is a story unto itself.” Let’s look at that story now.

Day traders formerly trading in the currencies poured into the S&P, along with the ever increasing mob of “get rich quick” day traders who were entering the markets in droves, due to massive marketing campaigns. Over a relatively few years, there were many thousands of people who took a turn at losing their money in the S&P 500. This presented a problem of significant magnitude in an area which you might never have expected. Certainly, the CME exchange did not expect what happened.

This was the situation: Brokers were signing people up to day trade the full S&P 500 contract. Their marketing efforts were paying off handsomely. It was much like what happened in the stock market when electronic Nasdaq trading began about 10 years ago, and what is happening today in the all-electronic day trading of the futures markets, people were pouring in eager to see if they could get rich trading futures.

Discount brokers were competing like crazy for this new business. They were offering $15 (unheard of previously) a round turn to let you day trade the S&P 500. It soon became apparent, that you were virtually doomed to failure if you called your trades in to an upstairs broker. Anything less than a trade desk on the trading floor simply would not suffice. So, in addition to the low commissions, brokers began to advertise, $15 RT plus direct floor access. If you signed up with them, you could call directly to the trading floor, from which your order would supposedly be “arbed” (hand-signaled) directly into the S&P (or bond) trading pit.

If you had a big enough account, and did a lot of trades, it was even possible to have your own person on the trading floor. In other words, you could have called directly to an arb desk which specialized in very fast, very good fills.

In any event, it became possible to bypass the upstairs broker and call directly to the floor. Was there anything wrong with this?? You bet there was, and it almost put the CME out of business. Here is what took place:

1. Margins to trade the S&P were rising. By 1997, they were on the order of $28,000 to hold one S&P contract overnight. Why such high margins? Because in 1997 the bubble market in stocks was in full swing. The June contract of the S&P hit 900. The higher the value of the Index, the higher the margin requirements to trade it. Day traders were putting up 1/4th that amount for day trading, still a lot of money.

2. By bypassing the upstairs broker, there was no way to tell if a trader had sufficient margin to day trade the S&P. If a day trader failed to get out of the market by the Close, he had to have $28,000 in margin for each contract held overnight. The number of margin calls increased dramatically and undisciplined wannabe day traders often forgot to get out of all their contracts.

3. The number of single-contract S&P day traders was multiplying like rabbits. There were literally thousands and thousands of single-contract day traders calling directly to the trading floor.

4. After awhile, there were not enough telephones on the floor at the CME to handle all of the traffic.
5. Large traders were finding that they could not reach the trading floor with their orders, because the phone lines were jammed up with single-contract day traders.

Finally, the CME had to tell all of the brokerage firms that they could no longer give floor access to anyone trading less than a 5 contracts. Can you imagine the chaos this created? All of the discount brokers offering $15/RT and direct floor access now had to call their many, many customers and tell them they could no longer call directly to the floor.

The S&P volume began to dry up. The currencies had already dried up a few years earlier. The CME had only one other liquid major contract, the Eurodollar. But the Eurodollar was no longer growing in volume and all by itself could not make up for the lost currency volume, nor could it carry the overhead of the CME. The CME was beginning to talk merger with the CBOT. They talked about moving over to the CBOT. To add to their problems, the building owner refused to let them out of their long-term lease. By August the S&P was trading at over 950. Margins were approaching $30,000 to hold overnight. It became very expensive for hedgers to hedge in the S&P 500, which in turn further decreased volume. Liquidity dried up to the point where at certain times of the day it was virtually nil.

A minimum price fluctuation in the S&P was $5, but it ticked 5 of these at a time, or $25/tick. One day in August of 1997, the market was so thin that there was an 800 minimum fluctuation drop ($4,000) from one tick to the next. You could hear the screams all the way to the Bahamas where I was then residing at the time. Two weeks later there was a 500 minimum fluctuation move in the S&P, which brought even more screaming.

Backtracking to the month of July, the CME came out with the most confusing announcement I have ever heard. They said they were going to cut the S&P in half and at the same time, create the e-mini S&P. The manner in which the announcement was made was so poorly done, that no one knew exactly what was going to happen. Because the announcement was so confusing, it only added to the diminished liquidity in the S&P. Trading literally dried up. Paper flow into the trading pit was pitiful.

Would you say that day traders affected this market? Can you see that the markets changed because of participants involved in day trading? A market is made up of its participants. The nature of participation due to day trading materially affected all markets.

As an aside to the CME story above, in 1987, when the stock market crashed, margins on the S&P rose to $36,000 contract. Some broker’s margins were even higher, I have heard as high as $48,000 to hold a single contract overnight.

This forced S&P day traders to look elsewhere. Where did they go? Many of them went to the Soybean pit. What happened to them there? They got their rear ends waxed. They had no idea of how to trade soybeans. The locals in the soybean pit had a field day cleaning out the margin accounts of the S&P day traders. Did day trading affect the soybean market?? You bet it did, although the fun lasted only a few weeks.

to be continued in Part 4
 
Part 4

Other changes in markets

There are many ways that markets change. In 1997 the multiplier for the S&P 500 stock index was cut in half. Since then, we have seen the introduction of the e-mini S&P 500, the Nasdaq Index, the e-mini Nasdaq, the e-mini Russell 2000. Along with those changes at the CME, came the introduction of the Dow futures at the CBOT, and now the introduction of a mini Dow.

Each time an exchange introduces a new contract, it ultimately affects the markets because it brings in new participants. If, when, an exchange changes the rules, or even the margin requirement, it has an effect on the price action. Since markets are made up of those who participate in them, we see changes taking place accordingly.

The most recent dynamic change in markets has been the inclusion of markets traded electronically. The mini Nasdaq, and the mini S&P 500 have seen the most dramatic changes of any other markets since the introduction of all-electronic trading. Has all-electronic trading affected the way you trade in the markets?? Absolutely - and in more ways than you might initially suspect.

All-electronic trading in U.S. markets has brought in many new traders both in the U.S. and from overseas. What at one time were prohibitively high telephone expenses are now non-existent because of the ability to enter orders electronically.

If I may digress a moment, consider the following changes in my own trading career.

When I began trading, it was common to pay $100 and more/round turn/ contract to enter an order into a market.

After a long time, I was able to find a “discount broker” who allowed me to trade at $65/round turn/contract. Can you imagine how many traders that kind of commission would eliminate from today’s markets? That would change the participation, wouldn’t it?

Data was available to me in two ways: 1. I could get the prices from the newspaper the following day. 2. I could call the broker and get the prices from him once the markets had closed.

Wanting to be on the cutting edge of technology, I opted to call the broker at the end of trading to get the prices. Big deal! Right?? However, when I began trading it cost $4.85 for the first 3 minutes and then some amount per minute thereafter to call New York, and it cost $4.35/minute to call Chicago. I lived in California at the time, and if all I did was to call Chicago 5 days/week in order to ascertain commodity prices, it could cost me $21.75/week. Based on 4-1/3rd weeks/month that amounted to $92.53/month. Of course, that was if I talked for only 3 minutes to get all of the prices I needed. I can tell you this much for certain: My telephone bill for calling the broker to get prices was well over $125/month. To give you an idea of what that meant, the mortgage payment on the house I lived in after paying it down to $19,250 from $28,500 (4 bedrooms, 2 baths, living room, family room, dining room, kitchen), was only $100/month. In other words I was paying more for data, than I was to live in a lovely new home. If you think the price of data is high today, on an inflation adjusted basis, I was paying far more than you pay today. The lowering of the cost of trading has made it possible for many more traders to consider the markets than ever before. This, too, affects participation.

Getting back to all-electronic trading:

The low cost of data, and the low cost of commissions, and the elimination of long distance telephone fees because of the Internet, has made it possible for people from all over the world to trade in markets they never dreamed of before.

So the number of participants in the markets, especially those trading all-electronically has had a significant impact on the way the markets trade.

Take for instance a recent happening in the markets. In the Fall of 2001, the SEC issued a ruling which stated that unless a trader had a margin account of $25,000 or more, they would be severely limited as to the number of electronic day trades they could make.

Suddenly, thousands of stock market day traders began opening accounts in the futures markets where margins are much lower for trading stock index futures. Not only are margins lower, but so are commissions, and there is no limit on number of trades. These were mostly traders who had been trading the all-electronic Nasdaq stocks. Why they chose to flood into the e-mini S&P is probably because the S&P 500 is more well-known than the mini Nasdaq. In any event, this flood of traders into the e-mini S&P made it almost impossible to trade and win. Why? Because the stock traders were accustomed to making from 80 to 120 trades a day, trading for what they called a “teeny.” A teeny, prior to the decimalization of stock prices was 1/16th of a point (.0625 cents). Can you realize how exciting it was for them to trade at $25/tick?? All they needed was 1 tick, to make money. These ex-stock market traders were in essence scalpers, looking for 1-2 ticks and then out. Suddenly, the e-mini S&P trends simply became corrupted. Risk became very high. Unless you increased your stop size to where it would be uncomfortable for many traders to trade, you stood to lose on most of your trades. When the market moved ahead 3-4 ticks, it suddenly moved back 5-6 ticks. Why? The scalpers were taking profits. Overall, prices would trend, but the trend would be extremely erratic compared with the way it had been in the past.

to be continued in Part 5
 
Part 5

How to deal with change in the markets

Today is an exciting age of unprecedented change. Change presents unique challenges and opportunities. When change brings success, you have to keep your ego from getting out of hand. When change is negative, have both common sense and a sense of humor to get through it. Learn to handle change then take your skills, talents, and abilities to help others change if such is the case that you are involved with others. Here are some ways to enhance your mastery of change.

1. Don’t fight it. The natural tendency is to protect what has become familiar and comfortable. The markets will change with you or without you. You must adapt again, and again. Today changes in the markets are much more frequent than in the past. Your life can be complicated in fighting the change. Change often causes stress, anxiety and sometimes even illness. The old Serenity Prayer says, “God grant me the serenity to accept the things I cannot change and, the courage to change the things I can, and the wisdom to know the difference. In today’s markets there is very little you can do to change things.

2. You don’t have to like the changes you are experiencing. You must come to understand them in order to progress. Study, explore, and read everything you can about current changes affecting your trading and investment. Life, as well as trading, is not always about “liking.” It’s about doing your best with what you have and getting on with it. Do it now!

3. Know what and when to defend against change. Sometimes we should resist change because change is not always better. Change for the sake of change can destroy valuable situations, assets, and relationships. Many values deserved to be defended, like your relationship with a good broker. The two most common destroyers that ruin traders are:

A. not changing and adapting when the market has changed.
B. changing from what was previously working by changing a little here and a little there and actually drifting away from that which was previously successful. Don’t be hasty to make changes that are not needed. Don’t be in a hurry to “fix” what brought you the winners.

4. Common sense and a sense of humor can give a momentary “emotional vacation.” It can conquer pretense, diffuse anger and hostility. A sense of humor can take an impossible situation and change it into an acceptable one. The old axiom, “If you take yourself too seriously, no one else will,” is the key. Effective people are spontaneous and use humor to express their feelings, and to encourage others. Sometimes you have to educate the people you work with. It’s a matter of common sense.

When you become a master of change you will make a difference; but there is no guarantee that it will be easy. Learning about change will enable you to work with others and help them to change where necessary. You can make a difference.

End of article

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written and contributed by Joe Ross
 
Quote from Grob109:

You need to take another lap on this.

Your comments are mistaken and ill founded.
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Agree, how sad that someone "trading" the markets for so long has not figured out that the markets have not changed at all.
 
Quote from EatShootLeave:

Agree, how sad that someone "trading" the markets for so long has not figured out that the markets have not changed at all.
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So you assume the market is exactly the same? What are the odds of this hyphotesis being confirmed ?
 
Don't agree with you. Your take on the FX markets is really quite wrong - interbank dealing has always driven the IMM and the time period you speak of was kinda the "golden age" of FX trading where any moving average would net you about 300 million year in profits. Sorry if you got muscled out by goons, but that kind of person does gravitate to the floor.

Without getting into a long involved rebuttal, I offer only one thing:

1. The more things change, the more they stay the same.

Think that sums it up.
 
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