Professional Documents
Culture Documents
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GDP GROWTH AND HOUSING (PERCENT CHANGE YEAR-AGO)
Reproduction or use of the text or pictorial content in any manner without written permission is prohibited.
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www.futuresmag.com | January 2008 25
National Association of Home Builders
(NAHB). NAHB expects home sales
to begin a gradual recovery in the early
part of 2008, but that is predicated on
avoiding recession and an improvement
in the mortgage finance system. He is
calling for at least two more cuts in
short-term interest rates to ensure that
those conditions are met.
Leahey explains that over the last two
years, construction and housing have
fallen by 20% to 25% and account for
5% of the economy, and that the rest of
the economy is growing at 3%, which is
below our historical average (see The
Anchor: housing, left). His primary
concern is that as credit tightens and
home values fall, it will adversely affect
consumer spending. That is the event
that the Fed wants to get in front of,
Leahey says. The Fed is taking out
some recession risk insurance by cutting
rates in advance of a major slowdown in
consumer spending, and because con-
sumer spending accounts for 70% of
GDP, that is not an idle concern.
We will be skating close to a reces-
sion, says Daniel Alan Seiver, San
Diego State University professor of
economics and finance, especially if
we begin to feel poorer because our
wealth, in terms of housing, has
decreased. You throw in $97 per bar-
rel oil and a slowly rising unemploy-
ment rate, thats going to put pressure
on consumption, weakening the econ-
Source: Decision Economics
7
6
5
4
3
2
1
0
OVERSEAS GROWTH BACKDROP
World
U.S.
Excluding U.S.
1989-98 2005 2006 2007 2008
US AGAINST THE WORLD
At 2% GDP growth, the United States lags far behind the G-7. Non-U.S. GDP growth
exceeds 5% annualized, compared to only 3% in the 1990s.
omy in the fourth quarter and into the
first half of 2008. Unlike the financial
markets, which can collapse in a short
period of time and clear out any excess,
housing markets dont work like that,
and given how illiquid housing is, and
the fact that owners can live in the
house, the recovery could stretch
into 2009.
In November, The Conference
Board Consumer Confidence Index
declined to 87.3 from 95.2 in
October. In a press statement, Lynn
Franco, director of The Conference
Board Consumer Research Center,
said the decline reflects consumers
apprehension about the short-term
outlook due to volatility in financial
markets, rising gas prices and likely
higher home heating bills this winter.
In addition, consumers inflation
expectations have surpassed the spike
experienced this spring.
It has been quite impressive how
the authorities have managed to engi-
neer such a rescue, Kefalas says. But
at some point in time in the not-to-
distant future, the housing collapse
will sink the economy in a full-fledged
recession. He will be looking to the
equity market to gauge the Feds suc-
cess and should the S&P 500 break
below 1325 that will be the cue that
authorities have failed to delay the
recession.
FOR SALE BY OWNER
The slowing of the U.S. economy is now
largely a given, and the very weak U.S.
dollar is being openly derided by the
likes of rap star Jay-Z and supermodel
Gisele Bndchen. Now the question is
how the rest of the world will react.
Already the deep discounting of finan-
cial services stocks has resulted in the
Markets continued
T
he U.S. Treasury bond market has been trading
inversely to equities, which are being dragged
lower by subprime lending issues and the related credit
crunch. When the bonds rally as equity markets drop it
is called a flight to quality, when it rallies along with
equities it is believed to be following them. So, how do
we identify market direction for the bond market?
A few useful technical tools are chart patterns,
trendlines (or speedlines), the 200-day moving average
and 50% retracements of important moves.
In Stacking bullish signals, you can see how in
June of 2007 (bottom left corner) bonds put in a low
and then rallied to a high of 114.07 in early September.
The 50% retracement of that rally was 110.15. The sub-
sequent pullback in late September and retest in early
October held above that price. Thats bullish. Now, note
that the pullback and retest also formed three points of a tri-
angle pattern. The sharp one-day rally in mid-October formed
point four of the triangle and pushed bonds away from its
200-day moving average (the green line) that was minimally
breached in the correction and retest of support.
What followed was an upside breakout of the triangle.
Note that the market is stacking bullish information on top of
bullish information:
Held initial 50% retracement
Pushed away sharply off the 200-day moving average
Broke out to the upside of the triangle
The key is to try to stay long in this market.
The market hit a high five days after the triangle breakout,
and then started to sag back. The 50% retracement of the
rally originating on point three of the triangle to that high
was 112.11; note the pullback (October 30) held above that
price. Bonds were still bullish.
The subsequent rally took bonds up through the existing
highs to near 119. The 50% retracement of that rally is
114.14; although that is useful to find direction, its too far
away to be of any order-entry use.
After the extreme volatility of Nov. 28-29, we drew in the
first speedline (off the October low) touching the spike low
made in mid-November and projected out to the current mar-
ket. We drew a second speedline connecting the mid-
November low to the Dec. 2 low. A break of those speedlines
will be our first inkling that the bull run is over.
Jack Broz trades bonds and mini-Dow from the trading floor of the CBOT
where he has been a member since 1996. Through his company, The
Marlin Letter Inc. (www.themarlinletter.com), Jack advises, educates, and
mentors traders. He can be reached at tttdow@themarlinletter.com.
STACKING BULLISH SIGNALS
Jul-07 Sep-07 Oct-07 Nov-07 Dec-07
26 FUTURES | January 2008
Source: Trade Navigator
1 1 9 - 0 0
1 1 8 - 0 0
1 1 7 - 0 0
1 1 6 - 0 0
1 1 5 - 0 0
1 1 4 - 0 0
1 1 3 - 0 0
1 1 2 - 0 0
1 1 1 - 0 0
1 1 0 - 0 0
1 09- 00
1 08- 00
1 07- 00
1 06- 00
1 05- 00
0.5
Tech talk: T-bond analysis
BY J ACK BROZ
0.5
0.5
08/02/2007
109-16
114-07
114-14
112-11
111-26
110-02
104-25
OFF 6/04 LOW 3 PT. NOW
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www.futuresmag.com | January 2008 27
Abu Dhabi Investment Authority buy-
ing a 5% interest in recently distressed
Citigroup Inc. for $7.5 billion; and with
the substantially weakened U.S. dollar,
foreign investors are likely to start buy-
ing up U.S. companies and assets.
Foreign investment in the U.S.
ought to be phenomenal now; and it is
because we are offering a fire sale with
a 20% decline against the euro,
Leahey says. And given that an out-
right diversification of foreign currency
holdings would hurt entities with large
dollar holdings, he expects more direct
investment, but that capital flows will
weaken, as has been reflected in the
Treasury International Capital (TIC)
data. The more subtle part of the ques-
tion is what will happen to other major
economies, such as Japan, Korea and
China as the composition of the U.S.
slowdown targets consumers. (see US
against the World, page 29).
One of the reasons that interest
rates have been trending downward is
we have had the foreign buying of our
Treasury securities, says Ronald J.
Ryan, CEO of Ryan ALM Inc. Its
hard to believe that this trend can con-
tinue forever. Sooner or later they will
diversify; its not that they would dump
U.S. securities, but they could not
grow as much. That has to put pressure
on interest rates. Who is going to buy
our Treasury securities if they continue
to grow in terms of the amount we are
trying to finance?
BUYER BEWARE
While there is little dispute the Fed
will continue to be accommodating to
avoid more spillover from the housing
and subprime problems, the reality is
that cheap money is what got us here.
At some point the Fed is going to
have to disappoint Wall Street and
not cut rates when Wall Street is
screaming for another cut, just to
show that Wall Street doesnt get to
call the tune, Seiver says, and a
tightening of lending standards is
under way, as reported in last months
senior lending officer survey.
I am not sure that rates are going to
go sharply higher over the next couple
of months, as people are going to want
to keep their Treasury holdings close to
them, Rupert says. I am not sure how
much more upside the Treasury market
has. But I dont think that any of these
underlying fears are going away soon.
Its a waiting game: waiting for the other
shoe to drop. And the fear is that its
Imelda Marcos closet.
Visit Your DAILY Futures Resource:
FM
Reproduction or use of the text or pictorial content in any manner without written permission is prohibited.
Copyright 2008 by Futures Magazine Group, 111 W. Jackson Blvd., Suite 2210, Chicago, IL 60604
Reproduction or use of the text or pictorial content in any manner without written permission is prohibited.
Copyright 2008 by Futures Magazine Group, 111 W. Jackson Blvd., Suite 2210, Chicago, IL 60604
I
f 2007 provided any lessons, they were on the emergence
of intermarket relationships. No matter what kind of trad-
er you were, currency movements crossed your radar
screen. The synchronicity of the dollar/yen pair and the Dow
Jones Industrial Average became apparent many times and
the upward moves in crude oil pushed the Canadian dollar to
parity with the U.S. dollar and beyond.
Another force in 2007, one to monitor into 2008, is interest
rate policies of central banks. The U.S. Federal Reserve Bank
began a trend of cutting rates, while most of the rest of the
world stopped raising rates.
Lets explore some forex dimensions and scenarios for 2008
that could help shape forex traders trading plans.
1) Decline of global interest rates
As 2007 ends, the signs are already there for the topping out of
rates and the beginning of a decline in rates. The United
States has been the leader, but the projected slowdown of the
world economy by the Organization of Economic Cooperation
and Development (OECD) and others will lead to an environ-
ment of global rate cutting. The Bank of Canada and Bank of
England both recently cut rates by 25 basis points, and
Germany, Australia and New Zealand will likely cut rates
next. Traders can play these fundamental shifts in interest rate
policies by looking to sell these nations currencies. The unan-
ticipated beneficiary of this scenario is the U.S. dollar. When
currencies weaken due to their weakening economies, they
could very well weaken against the U.S. dollar.
2) China contraction
After the 2008 Olympics in China, forex traders should keep
an eye out for contraction in the Chinese economy. If U.S.
and global growth slows, demand for Chinese exports and ser-
vices will be lower. A slowdown in China, or even a rumor of
a slowdown, can be played by selling Aussie dollars.
3) The rise of the dollar
If global interest rates drop, the dollar will benefit. Lower
interest rates weaken a currency. If the central banks of the
European Union, Great Britain and Canada lower rates, the
U.S. dollar would strengthen in relative terms. And if the Fed
decides that inflation vigilance is still important, that would
help the dollar as well. Breaking the trend (left), shows the
possible beginning of a U.S. dollar recovery in its global Trade
Weighted Index (TWI). If the TWI breaks above its current
downtrend, it may signal a shift toward a stronger dollar.
4) Opportunities to trade non-correlated currencies
The tendency of currency movements to cascade across the
dollar pairs presents a risk because currencies are intercon-
nected. However, data shows that there are variations in
correlations. Superderivatives, a global leader in currency
analytics, generates real-time correlation data that shows
that there are variations in correlations.
For example, one of the most traded
currency pairs is the EUR/USD. The
EUR/USD is 90% negatively correlated
with the USD/CHF (Swiss franc) but only
6% correlated with the EUR/NOK
(Norwegian Kroner). The EUR/USD is
only 0.31% correlated with the
USD/MXN (Mexican Peso) pair. The
Norwegian Kroner, the least correlated currency, is a solid
commodity currency. Currency correlations (left), shows
the various one-month correlations among currency pairs,
which will allow them to trade the fundamentals of a curren-
cy. By using correlation data, the trader can find trades that
minimize exposure to the global emotional contagion in the
dollar pairs and may be a useful strategy in 2008.
Abe Cofnas is president of learn4x.com LLC and author of The Forex
Trading Course: A Self-Study Guide To Becoming a Successful Currency
Trader (Wiley Trading). E-mail: learn4x@earthlink.net.
FX outlook for 2008
BY ABE COFNAS
28 FUTURES | January 2008
Forex Trader
BREAKING THE TREND
Source: iBoxx FX
0
2
-
0
1
-
2
0
0
7
1
3
-
0
3
-
2
0
0
7
2
2
-
0
5
-
2
0
0
7
3
1
-
0
7
-
2
0
0
7
0
9
-
1
0
-
2
0
0
7
1
5
-
1
1
-
2
0
0
7
80.0
78.0
76.0
74.0
72.0
70.0
68.0
66.0
64.0
62.0
60.0
USD TRADE WEIGHTED INDEX
Source: Superderivatives.com
CURRENCY CORRELATIONS
EUR/ USD/ EUR/ GBP/ EUR/ USD/ EUR/ AUD/ EUR/ USD/ EUR/ USD/
USD JPY JPY USD GBP CHF CHF USD AUD CAD CAD SEK
EUR/USD 1 -0.31 0.42 0.68 0.31 -0.9 0.03 0.46 0.22 -0.55 0.14 -0.86
USD/NOK -0.73 0.11 -0.59 -0.54 0.1 0.64 -0.26 -0.36 -0.28 0.67 0.2 0.76
Reproduction or use of the text or pictorial content in any manner without written permission is prohibited.
Copyright 2008 by Futures Magazine Group, 111 W. Jackson Blvd., Suite 2210, Chicago, IL 60604
J
ust as computers forced the
evolution of technical analysis
tools, such as static simple,
moving averages to sophisti-
cated indicators that dynamically
adjust to market conditions, technolo-
gy is again fueling a leap in trading
system capabilities. We can now
develop trading systems that are indi-
vidually tailored to the issues in the
portfolio while maintaining the
robustness of the overall system.
The implication of having a trading
system proven in out-of-sample testing
for each stock is profound. No longer
will portfolio performance depend on
gains elsewhere to offset realized losses.
Rather, stocks can be placed with prej-
udice. We can elect to trade certain
stocks when their performance corre-
lates to the periods when an individual
trading system can be expected to pro-
duce positive returns.
COMPUTER AS ANALYST
This new horizon in system trading is
possible by enabling the computer to
write the system logic instead of just
optimizing a previously established set of
rules. In this process, the computer
begins by evolving a set of rules. Those
rules are then backtested on out-of-sam-
ple data to ensure robustness while
determining the best trading solution for
a given set of input parameters.
From here, the rule set is converted
to a standard trading platform lan-
guage, such as Tradestations
EasyLanguage, to exercise the trades on
real-time data. The complete trading
system development process including
input selection, design, testing and
translation is fully automated and
accomplished quickly.
In essence, we are employing soft-
ware to write software. The complete
process of creating these trading sys-
tems can be accomplished in a little
over one minute on a readily available
Core 2 Duo computer operating with
the Windows XP operating system.
Genetic programming is perhaps
thousands of times faster than other
artificial intelligence algorithms. The
central engine allowing this to happen
is known as Automatic Induction of
Machine Code with Genetic
Programming (AIMGP).
Although technically complex, this
power is available with a few clicks of
your mouse. If you can cut and paste,
you can design a trading system. You
do not need to define a trading system
before the evolution begins because
the engine will sort out the inputs to
form the trading rules. You do not need
to select or develop your inputs unless
you wish to do so. No trading system is
defined at the beginning of a run; in
fact, only raw inputs and operators are
available at the beginning of a run.
The Trading System Lab platform, for
example, uses an input data matrix visu-
alized as 62 columns and a row for each
bar to be used in the back- and forward-
testing. Using at least several years of
daily data is recommended. Although
many data preprocessors exist, the data
in each column can be virtually any-
thing you like. It can be numeric or
Boolean. It can be indicator values, pat-
tern descriptions, intermarket data, etc.
Although 62 columns of data are used
as inputs, the platform typically selects
only a small fraction of them for use in
writing the final evolved trading system.
However, unlike other artificial intelli-
gence approaches, the AIMGP com-
bines the selected inputs using dozens of
other functions, such as addition, sub-
With modern technology, no longer does portfolio performance depend
on the law of large numbers to mediate volatility. Rather, stocks can be
traded according to their individual tendencies, even if they are merely
one piece of a complex puzzle.
BY MI KE BARNA
30 FUTURES | January 2008
Using equity DNA to
improve your portfolio
EQUITY TRADING TECHNIQUES
Reproduction or use of the text or pictorial content in any manner without written permission is prohibited.
Copyright 2008 by Futures Magazine Group, 111 W. Jackson Blvd., Suite 2210, Chicago, IL 60604
traction, trigonometry and exponential
functions.
NOT SO NOISY
Of course, it makes sense to select
inputs that have some logical relation-
ship to reality to avoid a garbage-
in/garbage-out scenario.
One important tangible characteris-
tic of market data that can be mea-
sured is its cyclic content. Well look at
two example trading systems evolved
for the S&P 500 futures contract, trad-
ing both long and short over the past
five years. Although this approach is
demonstrated on the index, as dis-
cussed earlier, one of its best uses is in a
portfolio of individual equities.
We start with a bandpass filter,
developed by John Ehlers of Mesa
Software. The bandpass filter allows
only the signal energy within its
band to get through, rejecting both
higher and lower frequency compo-
nents. Because the passband is rela-
tively narrow, the filter output can be
characterized as:
A*Sin(360*t/Period), where
A is the amplitude of the output
signal, and
Period is the cycle period of the
center frequency to which the filter is
tuned
The first 21 columns of data are the
filter outputs for filters tuned from
eight-bar periods to 48-bar periods in
even increments of two bars. In other
words, the filter channels are tuned to
8-, 10-, 12-, 46-, and 48-bar cycles.
The next 21 columns of data contain
the rate of change of each of the filter
outputs in the first 21 columns. You
may recall from calculus that the rate
of change of a sine wave is a cosine
wave, which leads the sine wave by 90
degrees (characterized as A*Cosine
(360*t/Period)).
As every trader recognizes, having a
leading indicator is crucial to creating
an effective trading system.
The final 20 columns of data com-
prise the sum of the squares of the cor-
responding channels to obtain the
instantaneous signal amplitude at the
output of each filter channel. This is
easily seen from the familiar trigono-
metric relationship.
Therefore we have the complete
phase and amplitude relationship of
each bandpass filter over the range of
periods that we think are applicable for
an effective trading system. Bandpass
code (above) shows the EasyLanguage
code for the bandpass filters to gener-
ate the data matrix used in the evolu-
tion of the example trading systems.
Human logic would lead us to select
the channel having the largest output
the majority of time and then seek the
phase relationship between the sine
and cosine outputs that give the best
trading signals. In fact, this author has
even written trading systems that
dynamically sense the dominant cycle
and change the filter outputs used as a
function of time.
GENETIC PROGRAMMING
PERFORMANCE
Genetic programming automatically
selects the most significant columns of
data and combines them in ingenious
ways that often defy logical description.
The result is an evolved trading system
whose performance best meets the fit-
ness criterion.
In our example, a single contract sys-
tem evolved in four minutes, 20 sec-
onds, evolving and evaluating trading
systems at the rate of 770 systems per
www.futuresmag.com | January 2008 31
Source: Mesa Software. Download for code can be found at futuresmag.com.
BANDPASS CODE
This EasyLanguage code generates a channelized filter data matrix. It was written by John
Ehlers and includes in-phase and quadrature filter outputs for cycle period channels
between eight bars and 42 bars. The sum of the squares of the in-phase and quadrature
components provides the signal amplitude at the output of each channel.
Inputs:
Price(Close),
Delta(.20);
Vars:
Period(0),
gamma(0),
alpha(0),
beta(0),
count(0),
mmf(0);
Arrays:
V4[63](0),
OldV4[21](0),
OlderV4[21](0);
mmf = pricescale;
For count = 1 to 21 Begin
Period = 2*count + 6;
beta = Cosine(360 / Period);
gamma = 1 / Cosine(720*delta /
Period);
alpha = gamma -
SquareRoot(gamma*gamma - 1);
V4[count] = .5*(1 -
alpha)*(Price - Price[2]) + beta*(1 +
alpha)*OldV4[count] -
alpha*OlderV4[count]; //in phase
V4[count + 21] = (Period /
6.28318)*(V4[count] - OldV4[count]);
//quad
V4[count + 42] =
V4[count]*V4[count] + V4[count +
21]*V4[count + 21]; //amp
OlderV4[count] = OldV4[count];
OldV4[count] = V4[count];
End;
if currentbar=1 then
print(file(C:\Program
Files\TSL\Data\datainfo.txt),
numtostr(barinterval, 0), ,
numtostr(bigpointvalue,4), , min-
move:4:4, ,
pricescale:4:4,
,newdate(date):8:0, , newdate(lastcal-
cdate):8:0, ,
getsymbolname, ,descrip-
tion, );
Print(file(C:\Program Files\TSL\Data\allda-
ta62n.txt), {TSL-TC-NUMERIC ONLY}
v4[1]: 8:4, , {1}
v4[2]: 8:4, , {2}
.
.
.
//etcetera for all 62 channels
.
.
.
v4[61]:8:4, , {61}
v4[62]:8:4, , {62}
0.2:1:2 , , {63}
newdate(date[0]):8:0 , , {64}
mmf*open:6:0 , , {65}
mmf*high:6:0 , , {66}
mmf*low:6:0 , , {67}
mmf*close:6:0 ); {68}
second. This is not curve fitting. The
evolution is guided by parsimony pres-
sure, multiple runs, randomization of
parameters and an unbiased input set.
Parsimony pressure forces the genetic
program to use as few input parameters
as possible.
Further, out-of-sample performance
is evaluated and any given system is
discarded if it is not robust in this eval-
uation. Its important to realize, how-
ever, that out-of-sample performance is
not analyzed or used during the evolu-
tion or else it would not be out-of-
sample. In situations where the input
set is poor, the setup parameters are
inefficient or the market is extremely
random, out-of-sample performance
will suffer. This is an important test of
robustness.
For our runs, a total of five years of
data were used, four years as in-sample
development data and one year of data
for out-of-sample performance verifica-
tion. At the end of the evolution, sine
wave channel periods of 14, 16, 32, 34,
36 and 38 bars were used in the exam-
ple trading system. Cosine channel
periods of 22, 34 and 48 bars also were
used. No amplitude data were used,
demonstrating that the phase relation-
ships of the filtered outputs are
crucial for the generation of trade
timing signals.
Which waves? (above) shows the
channel filters that were used by the
platform in relationship to the price
data and the trading signals.
A second trading system was evolved
using the same data, but this time
allowing for a multiple contract trading
system to be developed, using money
management during the development
process. In this case, only the genetic
program determined when and how
many contracts to trade. If a trade were
deemed risky, only one contract was
traded. Multiple contracts, up to a
maximum of five, were traded on the
higher probability trades.
This time, the evolution took only
one minute, 13 seconds. Similar, but
different, channels were used in the
evolved trading system. More interest-
32 FUTURES | January 2008
Equity Trading Techniques continued
OUT-OF-SAMPLE IMPROVEMENT
The first chart shows how out-of-sample profit increased while drawdown stabilized. The
final reward-to-risk ratio was more than 6:1, as measured by the ratio of net profit to
drawdown. Next, we can see how the profit grew steadily over the out-of-sample period.
Source:
4 8 12 16 20
210000
160000
110000
60000
10000
-40000
Min Error Pass out of Sample
P
r
o
f
i
t
a
n
d
D
r
a
w
d
o
w
n
OUT OF SAMPLE EQUITY GROWTH
Source: Tradestation
Aug Sep Oct Nov Dec 07 Feb Mar Apr May Jun Jul Aug
1560.00
1540.00
1520.00
1500.00
1480.00
1460.00
1440.00
1420.00
1400.00
1380.00
1360.00
1340.00
1320.00
1300.00
30.00
20.00
10.00
0.00
-10.00
-20.00
-30.00
Buy
WHICH WAVES?
This shows the channel filters that were used as the trading signals. Sine wave channels are
shown in red and cosine channels are shown in cyan. In retrospect, it is relatively easy to see
how the crossing of these indicators occurred at crucial times for the trading signals.
Short
Short
Short
Short
Short
Short
Short
Short
Short
Short
Short
Short
Buy
Buy
Buy
Buy
Buy
Buy
Buy
Buy
Buy
0 100 200
230000
184000
138000
92000
46000
0
P
r
o
f
i
t
a
n
d
D
r
a
w
d
o
w
n
Bars out of Sample
OUT OF SAMPLE RUN LOG
0
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www.futuresmag.com | January 2008 33
ing, three amplitude channels were
also used. Because a money manage-
ment algorithm needs to respond to
volatility of the underlying market, it
seems natural that the genetic program
chose the more extreme movements
inherent in the amplitude segment of
the input data matrix.
A total of 43,930 trading systems
were examined and only 17 of these
were retained as having better perfor-
mance over the course of the evolu-
tion, although far more systems were
stored in the trading system buffer.
Out-of-sample improvement
(page 34) shows how the out-of-sam-
ple performance improved as the trad-
ing system evolved. Initially the draw-
down (shown in red) increased as the
net profit (shown in blue) was
increased. However, as the trading
system evolved, the out-of-sample net
profit increased and the drawdown
decreased, stabilizing at about
$35,000, an indication of robustness
of an evolved trading system.
The second chart in Out-of-sample
improvement shows the out-of sample
equity growth of the final evolved sys-
tem. A more detailed examination of
the trading system showed it had a
total of 60.9% profitable trades and a
profit factor of 2.47 over the period
from August 2006 to August 2007.
BETTER TRADING WITH TECHNOLOGY
Using modern technology, including
both signal processing and genetic
programming, highly accurate and
robust trading systems can be evolved
in mere minutes. This means that
each stock, exchange-traded fund or
commodity futures contract in a port-
folio can have its own customized
trading system so that each element in
the portfolio is highly profitable in its
own right. Then, correlation between
all the elements in the portfolio can
be accomplished to enable further
reduction in variations of the portfolio
equity growth.
Other implementations of this algo-
rithm are possible in financial analysis
as well as options trading system
design. Here, we used indicators creat-
ed by human knowledge and an evo-
lutionary machine learning algorithm
to automatically write our trading sys-
tem for us, thus demonstrating one
successful cooperation between man
and machine.
Mike Barna is president of Trading System Lab. He
can be reached at mike@tradingsystemlab.com.
Code for Bandpass Code, (page 33), will be
available at futuresmag.com under downloads.
FM
Visit Your DAILY Futures Resource:
A
five-minute E-mini S&P 500
chart provides an incredible
amount of information. But
despite this massive flow of
information, simple analysis of its
price action is all that is needed to
trade successfully. One such strategy is
based on flag formations, and it usual-
ly presents several profitable entries
every day.
A flag formation occurs when the
market forms an area of conges-
tion following a surge of activi-
ty. This indicates that both buy-
ers and sellers are equally active
at the current price. If the previ-
ous surge was upward, the break-
out will usually be to the upside.
However, if the flag extended
far enough to break an up trend-
line, then buyers will be wary
because this is a sign that the
momentum is waning. Many bulls
will scalp out with a small profit
on the breakout to the new swing
high. Also, bears will look for
another opportunity to sell at the
slightly better price that the new
high offers. This often leads to a
reversal that may be either a scalp-
ing opportunity or the start of a pro-
tracted downswing. In either case, it is
a low-risk, high-probability entry.
One of the most reliable entry methods
is on a stop at one tick beyond the prior
bar. If the market is in a bull flag and you
are looking to buy, place a buy stop order
one tick above the high of the prior bar. If
by the time the current bar is complete,
the bar does not extend beyond the high
of the prior bar,
lower the buy stop to
one tick above the current bar that just
completed itself. (Do the opposite when
trying to sell a breakout from a bear flag;
enter it on a sell stop at one tick below
the low of the prior bar).
On a five-minute E-mini S&P 500
chart, if you picked your entry cor-
rectly, an initial four-tick protective
stop works in more than 80% of the
breakouts. If the bars are large or the
flag looks like it has more to go, either
risk six ticks or, even better, wait for a
second entry.
Waiting for a second entry means
that you do not take the initial trade.
Instead of buying the breakout of the
high of the prior bar, wait to see if the
bar after the breakout has a lower high.
If it does, place an order to buy one tick
above its high. (This move represents
the second attempt at a bull breakout.)
In the first chart in When the bear
turns (right), TL1 is a steep down
trendline that is broken by Flag 1. In
general, fading a strong trend is a los-
ing proposition. However, in this par-
ticular case, there were three large bear
bars and the previous two had decent
tails; thus, the bears might be tem-
porarily exhausted. Also, because the
downward trend bars did not close
within a couple ticks of their lows, the
sellers are showing that they are not as
aggressive as they could be.
The next bar is a small bull reversal
bar, with its low below the prior bars
low, and a close above the open and
Some aspects of trading are painfully simple. A technical condition can
be either right or wrong. A reliable pattern in the E-mini S&P 500 futures
market is a flag formation on a five-minute chart. However, its when
they fail that you often have the best chance to profit.
BY AL BROOKS
34 FUTURES | January 2008
Failed flags can lead
to E-mini success
TRADING TECHNIQUES
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above the close of the prior bar. This is
a mark of buying. Also, four of the five
bars of the bear flag had closes above
their opens, again indicating that buy-
ers are active. Once the bear flag broke
to the downside, the breakout bar was
not large. The next bar was even small-
er and its close was near its high. All of
this increases the odds that there will
be at least a second leg up (the bear
flag being the first leg up).
This is a low-risk long entry and it
has a high probability of extending at
least six ticks. A six-tick breakout is a
magical number for E-mini day traders.
Many traders scalp for four ticks and to
do so, the move has to extend six ticks.
Why do you need a six-tick move to
make four ticks? You enter on a stop
that is one tick above the prior bar,
and you are trying to exit at four ticks
above that. Most of the time, a sell
limit order will not be filled unless the
market goes above it by at least one
tick, meaning that a six-tick move is
required to net four ticks on a scalp.
MARKET TURNS
When trading counter trend, it is natu-
ral to be hopeful that the trend has
reversed and that your trade will make a
fortune. The reality is that you just
bought a bear trend and the odds are
high that the bear trend will resume. As
such, it is wise to take profit on most of
your position after just a small up-move.
For example, if you bought three
contracts, you might take profit on two
at four ticks (that is, scalp when trad-
ing counter trend). Then, place a pro-
tective stop at breakeven on the
remaining contract. If a sell signal
develops in the meantime, take the sell
signal and exit your remaining long at
the same time. If it turns out that you
did just buy the low of the next 10
years and you are angry for taking a
scalpers profit instead of holding on
for a fortune, remember that every
strong trend will have plenty of great
entries that you can swing for more
profits. Also, it is important to main-
tain discipline. This is a strategy to
take advantage of short-term correc-
tions and it should be treated as such.
This second leg of the up-move in
the first chart in When the bear
turns formed a bull flag (Flag 2).
There was a small breakout bar (Bar 2)
that failed on the next bar, which had
a low below the low of the breakout
bar. You dont want to buy the break-
out because it follows several small bars
that closed near their open, which
indicates indecision. When bars are
small and closes are near the opens, a
better play is to watch for an entry,
dont take it and then wait for it to fail
and trap one side; enter as the trapped
traders are forced to reverse.
In this example, most bulls would not
have bought at Bar 2 because of the
small sideways bars that made up the
flag. Likewise, bears would be hesitant to
sell on the bar after Bar 2 when the bull
breakout failed, because there was not
enough up momentum to trap many
longs. However, when the market made
a second breakout to the upside at Bar 3,
this is a great long entry, again only for a
scalp because there is no evidence that
the market is in a bull swing.
Flag 3 had two bull breakouts and
both failed. Again, the bars in the flag
were tiny, indicating lack of convic-
tion. However, this second failure of
the bull flag breakout is a great short (a
second entry is almost always a good
trade), especially because the down
momentum of the first 90 minutes of
the day was so strong. Also, three legs
up in a bear often works like a wedge,
resulting in a new low.
Flag 4 broke a steep trendline and
www.futuresmag.com | January 2008 35
WHEN THE BEAR TURNS
We can see several examples where failed flag formations provided short, but high-probability,
trades against the prevailing trends.
Source: Tradestation
4/11 7:00 7:30 8:00 8:30 9:00 9:30 10:00 10:30 11:00 11:30 12:00 12:30 13:00
1,474.00
1,473.00
1,472.00
1,471.00
1,470.00
1,469.00
1,468.00
1,467.00
1,466.00
1,465.00
1,464.00
1,463.00
1,462.00
1,461.00
1,460.00
1,459.00
55,000
25,000
1
2
3
4
5 6
7
Flag 1
TL1
Flag 2
Flag 3
TL4
TL3
TL2
Flag 4
6/11 7:00 7:30 8:00 8:30 9:00 9:30 10:00 10:30 11:00 11:30 12:00 12:30 13:00
1,534.00
1,533.00
1,532.00
1,531.00
1,530.00
1,529.00
1,528.00
1,527.00
1,526.00
1,525.00
1,524.00
1,523.00
1,522.00
1,521.00
1,520.00
1,519.00
1,518.00
1,517.00
1,516.00
35,000
15,000
1
2
3
4
Flag 1
TL1
Flag 2
Flag 3
TL2
Double
Bottom
Reproduction or use of the text or pictorial content in any manner without written permission is prohibited.
Copyright 2008 by Futures Magazine Group, 111 W. Jackson Blvd., Suite 2210, Chicago, IL 60604
reversed the low of earlier in the day
(two of the bars in the flag were above
the highs of the prior bar). When the
market reversed upward again at Bar 7,
it was the second attempt to reverse
after a new low of the day and it also
followed a bear flag breakout. Also,
both the flag and the new low had lots
of tails and the closes were above the
opens, indicating that buyers were
coming into the market by the time
the bars closed. This makes a long at
Bar 7 a high probability long scalp.
The second chart in When the bear
turns shows a bear trendline (TL1)
followed by a small, two-bar bear flag
that broke the trendline. There was a
bear breakout that failed on the next
bar, which was a great long entry.
What made this particularly strong was
that the low of this leg was exactly at
the low price of the opening range, cre-
ating a double bottom. Also, the range
of the day at this point was only about
six points and the average range had
been more than 10 points, indicating
that there would likely be a breakout of
the range either up or down.
Because the market made an exact
test of the low followed by a bear flag
breakout, creating another attempt at a
breakout into a bear swing and a mea-
sured move down, and both attempts
failed, there was a great chance that
the market would attempt an upside
breakout. When an entry has a reason-
able chance of being the low (or high)
of the day, it is best to scalp out only
part and let most of your trade swing.
For example, if you traded three con-
tracts, you might scalp one at four ticks
and hold the other two with a
breakeven stop.
The market formed an extended bull
move to a new high, but Flag 2 broke
below the bull trendline (TL2). After
the bull flag breakout, Bar 3 traded
below the low of the prior bar, provid-
ing a short entry. This entry is against a
strong trend, so you should scalp all or
most of your trade. The market formed
a larger bull flag (Flag 3), which was a
well-shaped bull flag on higher time-
frame charts (such as the 15-minute
chart). Bar 3 was a short entry below
the low of the prior bar, creating a
failed bull flag breakout.
More examples of these formations
are shown in Reading the breakdown
(left). It shows a powerful failed flag at
Bar 1, which was a possible low of the
day (every new low is a possible low of
the day). Flag 2 was protracted and
broke below a bull trendline (TL2).
There was a large breakout bar that
failed on the following bar. The break-
out was so strong and the prior up
move so convincing that you should
not be looking to short here (wait for a
second sell signal). This failure became
just a test of the breakout (a failed
attempt at a failed breakout), and was a
great second-chance long entry.
Bar 2 was a wonderful short entry.
The bull poked above a bull trend chan-
nel line and reversed back down, indi-
cating exhaustion. The move had three
thrusts up, making it a wedge. The
move was basically a measured move up
that tested yesterdays close and imme-
diately reversed down. The entry bar
was a second entry (remember the first
36 FUTURES | January 2008
Trading Techniques continued
READING THE BREAKDOWN
Flag 2 provided second chance at a long entry following the failed attempt at the breakout,
while Bar 2 was an excellent short entry trade.
Source: Tradestation
EASY STREET
There are times when you wont want to play the counter-trend game. Here, conditions
supported a continuation of the larger bear move.
Source: Tradestation
6/11 7:00 7:30 8:00 8:30 9:00 9:30 10:00 10:30 11:00 11:30 12:00 12:30 13:00
1,530.00
1,525.00
1,520.00
1,515.00
1,510.00
1,505.00
70,000
30,000
1
2
Flag 1
TL1
Flag 2
TL2
Trend Channel Line
(Wedge)
7:00 7:30 8:00 8:30 9:00 9:30 10:00 10:30 11:00 11:30 12:00 12:30 13:00 6/8
1,539.00
1,537.00
1,535.00
1,533.00
1,531.00
1,529.00
1,527.00
1,525.00
1,523.00
1,521.00
1,519.00
1,517.00
1,515.00
1,513.00
1,511.00
1,509.00
1,507.00
1,505.00
1,503.00
55,000
25,000
1
2
Flag 1
TL1
Reproduction or use of the text or pictorial content in any manner without written permission is prohibited.
Copyright 2008 by Futures Magazine Group, 111 W. Jackson Blvd., Suite 2210, Chicago, IL 60604
www.futuresmag.com | January 2008 37
entry that occurred on the bar after the
breakout?). A climactic move usually
results in an extended move in the
opposite direction. This is a great short
and you should swing most of your
shorts, expecting at least an hour or so
down and usually at least two clear legs
(here, there was just one extended leg).
GOING WITH THE FLOW
Easy street (page 40) shows when you
should stick with the trend. Bear Flag 1
broke the down trendline (TL1), provid-
ing a great long scalp at Bar 1. Because it
is a counter trend, you should scalp
most or all of your contracts. If you hold
some, you would exit the balance at
breakeven. Following the long entry,
there was a bar that poked above the 20-
period exponential moving average
(EMA) but closed below its midpoint,
indicating that the bears won the bar.
Bar 2 was a second attempt at cross-
ing above the 20-period EMA, and this
time the bar closed near its low and the
range was larger than that of the prior
EMA test bar, showing that the bears
were now even more aggressive. Also,
this leg up had a lower high than the
high of Flag 1 (a bear trend has lower
lows and highs). Finally, this was the
first touch of the 20-period EMA in a
couple hours, indicating that the bears
have been aggressive all day.
When you see this much bear
strength, you need to start looking for
bull set-ups. The reason is each will be
seen as a possible low of the day,
month or even year by lots of generous
traders who will buy, lifting the market
for only a few ticks. When no strong
bull bar forms after their entry, they
will feel trapped with no profit and
likely a one- or two-tick loss that never
seems to go away. They will place their
sell stops to exit at one tick below the
low of the prior bar. They will exit at a
loss and not be eager to buy again until
the next small up-close bar forms.
The most reliable trading opportuni-
ties always occur when someone is
trapped. Each of these small long set-ups
saw weak bulls trapped with losses, with
their protective stops providing the per-
fect area to get short, at one tick below
the low of the prior bar. Because you are
trading with the trend, you should
swing most of your contracts because a
trend will always extend much further
than anyone thinks it should.
Al Brooks stopped practicing medicine 20 years
ago to stay home and raise his kids and has been
day trading for his personal account ever since.
FM
Visit Your DAILY Futures Resource:
Reproduction or use of the text or pictorial content in any manner without written permission is prohibited.
Copyright 2008 by Futures Magazine Group, 111 W. Jackson Blvd., Suite 2210, Chicago, IL 60604
E
lectronic, or automated, trading
of interest rate swaps has cre-
ated an easily accessible
method for controlling inter-
est rate risk as well as for hedging and
speculating on interest rate move-
ments. With increasing volume and
improved trading platforms this mar-
ket is destined to become
more popular for individual
traders along with larger insti-
tutional users.
Over-the-counter (OTC)
plain vanilla swaps allow two
counterparties to exchange
cash flows based on a nominal
amount of principal, in which
one of the parties wishes to
swap fixed interest income for
cash flows generated by float-
ing rate. The fixed rate (the
swap rate) is initially set to
equalize the present values of
fixed and floating cash flows.
Depending on the movement
of the floating rate, cash in
each period may flow in either
direction and by netting the
fixed rate against the floating
rate, only the net amount
needs to be transferred.
The OTC interest rate swaps mar-
ket is known for its large volume of
trading and underlying principal
value. According to the Chicago
Board of Trade (CBOT) the notional
amount of OTC U.S. dollar interest
rate swaps equaled nearly $73 trillion
in 2006. The CBOT instituted swap
futures in 2001, starting with the 10-
year maturity and following with five-
year swap futures in 2002. In March
2007, the exchange added 30-year
swap futures.
MARKET BENEFITS
Advantages of exchange-traded
interest rate swap futures
include standardization and
elimination of most counter-
party credit risk. CBOT swap
futures have prices that are
similar to Treasury note
futures. Both the 10-year and
five-year contracts are based on
a notional $100,000 principal
value with a 6% coupon rate.
Interest is paid semi-annually.
Having the same price base
as CBOT T-note futures per-
mits the notional yield for
interest rate swap futures to be
calculated as the discount rate
that makes the present value
of semi-annual payments of
$3,000 and $100,000 at matu-
rity equal to the current price.
Reversi ng thi s cal cul ati on
As liquidity grows in interest rate swap futures, traders will benefit from
improved hedging and trading possibilities. However, to take advantage of
these markets, you need to understand the relationships among futures on
swaps, T-notes and Eurodollars.
BY PAUL D. CRETI EN
38 FUTURES | January 2008
Smoother way to trade
interest rate swaps
TRADING TECHNIQUES
Reproduction or use of the text or pictorial content in any manner without written permission is prohibited.
Copyright 2008 by Futures Magazine Group, 111 W. Jackson Blvd., Suite 2210, Chicago, IL 60604
al l ows a swap yi el d to be used
i n determi ni ng the pri ce of a
futures contract.
For example, a price for the five-
year interest rate swap listed by the
CBOT as 105-295 (105 points, each
equal to $1,000, plus 29.5 32nds of a
poi nt, whi ch i n dol l ar terms i s
$105, 922) has a rel ated yi el d of
4.66%.
The yield computed for a five-year
interest rate swap is likely to be close
to the yield for Eurodollar futures at
the same maturity of five years. The
reason for this, as pointed out by
Robert W. Kolb in Futures, Options
& Swaps (Blackwell Publishers,
2000), is that a strip of Eurodollar
contracts may be regarded as a substi-
tute for an interest rate swap. Recall
that the Eurodollar yield curve is com-
posed of a series of geometric means,
in which quarterly rates are succes-
sively multiplied and then the nth
root of each product determines the
yield to a specific future quarter.
The yields for five-year interest rate
swaps over the August through October
period in 2007 are compared with the
Eurodollar yields each day on Yield
comparison (right). The chart shows
that the two yields are virtually the
same at the end of each day. During the
trading day, automated computer trad-
ing continuously adjusts the two yields
to stay approximately equal.
A similar chart for 10-year swap
yields vs. Eurodollar yields at the 40th
quarter would show less equality
between the yields. This difference is
probably related to the shortage of
trading volume at the longer maturity
for both the swap futures and the
Eurodollar futures.
Although the yield on a five-year
interest rate swap is essentially equal
to the five-year yield for Eurodollar
futures, the two yields are arrived at
by different routes. As shown above,
the swap yield is related to a 6%
coupon note having semi-annual
interest payments and a notional
maturity value of $100,000. The
Eurodollar yield at the five-year matu-
rity is calculated as the last of 20
yields in a chain of yields based on the
geometric mean through 20 quarterly
rates. When all 40 Eurodollar future
quarters are included, the entire
Eurodollar yield curve is complete.
PARTS OF THE WHOLE
The structure of the Eurodollar yield
at any maturity is composed of three
segments: the U.S. Treasury yield at
that maturity, a credit spread, and a
correction to make up for the lack of
convexity. Price changes for
Eurodollar futures are always $25 per
basis point regardless of movements in
the U.S. Treasury yield.
The yield structure of a five-year
interest rate swap also has three parts,
but it varies from the Eurodollar struc-
ture. The two are mutually dependent
on the U.S. Treasury yield curve as
the base yield. An interest rate swap
also has a credit spread, which may be
www.futuresmag.com | January 2008 39
YIELD COMPARISON
Thanks to automated trading systems that continually arb these markets, swap yields and
their comparable Eurodollar yields move hand in hand.
Source: CBOT, CME
1 6 10 15 20 23 28 31 6 11 14 19 24 27 2 5 11 16 19 24 29
5.40
5.30
5.20
5.10
5.00
4.90
4.80
4.70
4.60
4.50
5-YEAR EURODOLLAR YIELD AND 5-YEAR INTEREST RATE SWAP YIELD
SWAP VS. EURODOLLAR PRICE SPREADS
By selling the swap against Eurodollars, Eurodollar futures can be used to mitigate the
negative effects of a price increase.
Source: CBOT, CME
2 8 13 16 21 24 29 4 7 12 17 20 25 28 3 9 12 17 22 25 30
3000
2500
2000
1500
1000
500
0
-500
C
u
m
u
l
a
t
i
v
e
P
r
i
c
e
s
a
n
d
S
p
r
e
a
d
s
SWAP VS. EURODOLLAR PRICE SPREADS (CUMULATIVE PRICE CHANGES)
Aug Sep Oct
5-year Eurodollar Yield
5-year Swap Yield
5-year Swap
5-year Eurodollar Futures
Spread
Aug Sep Oct
Reproduction or use of the text or pictorial content in any manner without written permission is prohibited.
Copyright 2008 by Futures Magazine Group, 111 W. Jackson Blvd., Suite 2210, Chicago, IL 60604
considered equal to the Eurodollar
credit spread because they both are
based on the London Interbank Offer
Rate (LIBOR), which introduces a
small amount of bank risk.
The third element of the swap
yi el d i s convexi ty. Li ke T-note
futures, interest rate swap futures
have periodic notional coupon cash
flows and principal value at maturity.
Price calculations for interest rate
swaps are also different from prices of
Eurodollar futures. As discussed, the
price of a CBOT interest rate swap
futures contract is the present value of
a 6% coupon notional five-year or 10-
year note. The Eurodollar price for
the same maturity of five years is the
quarterly rate for the 20th quarter sub-
tracted from 100. In effect, there is no
dollar price for the Eurodollar futures
for a specific quarter; there is only an
index equal to 100 minus the quarter-
ly rate. However, the change in the
index from one period to the next
permits a price change to be calculat-
ed at $25 per basis point of change in
the price index.
SPREAD DIFFERENCES
Because of the difference in pricing
there are changes in the spread
between the prices of interest rate
swap futures and Eurodollar futures.
The progression of spreads is shown
on Swap vs. Eurodollar price spreads
(page 43). The chart shows cumula-
tive price changes for the five-year
interest rate swap and the Eurodollar
contract with five-year maturity.
It is expected that the average price
change for an interest rate swap will
exceed the average change in the cor-
responding Eurodollar futures. The
proportional difference between the
two changes may be estimated by
comparing basis point values (BPV),
and by computing the ratio between
average absolute changes over an
extended period.
Selling the swap vs. Eurodollar price
spread implies that the trader believes
interest rates will rise. The chart
shows how the spread changes with
no adjustment for the difference in
comparative price movement. With
this trade, Eurodollar futures are used
to mitigate the negative effects of a
price increase with the swap futures
rising at a faster rate than Eurodollar
prices. The Eurodollar part of the
spread also reduces profitability when
interest rates increase.
While the Eurodollar yield curve is
approxi matel y paral l el to U. S.
Treasury yields, the quarterly rates
that create the yield curve have a
compl etel y separate curve. The
unusual shape is required for succes-
sive quarterly rates to result in the
desired yield curve. This means that
the swap vs. Eurodollar price spread
i s i nf l uenced by changes i n
Eurodollar quarterly rates (and corre-
sponding price changes) that vary at
some distance above the yield curve.
Yield curves (left) shows the
Treasury yields at two-, three-, five-
and 10-year maturities, the curves of
Eurodollar quarterly rates and yields,
and T-note futures yields at two-,
five- and 10-year maturities on Nov.
2, 2007. A si ngl e dot on the
Eurodollar yield curve shows the five-
year swap yield.
The Yield curves chart indicates
the problems that may be encoun-
tered in predicting price changes for
the five-year interest rate swap and
the swap vs. Eurodollar spread. As the
Eurodollar quarterly rate curve bends
to make the Eurodollar yield curve
conform to the Treasury yield curve,
resulting price changes may not follow
usual interest rate/price patterns. As
long as the swap yield follows changes
in the Eurodollar yield curve,
Eurodollar yields (and the underlying
Eurodollar quarterly rates) are impor-
tant price determinants of interest
rate swaps.
Over time, increased trading vol-
ume in all maturities of interest rate
swap futures should result in improved
hedging and trading possibilities. The
relationships among swap futures, T-
note futures, and Eurodollar futures
should continue along the trends
described here with smoother curves
and enhanced predictability as the
exchange-traded market for interest
rate swap futures progresses.
Paul Cretien, CFA, is an investment analyst and
financial case writer. He may be e-mailed at
PaulDCretien@aol.com.
40 FUTURES | January 2008
Trading Techniques continued
FM
YIELD CURVES
When the Eurodollar quarterly rate curve changes so that the Eurodollar yield conforms to
the Treasury yield curve, unexpected price changes may follow.
Source: CBOT, CME, Bloomberg.com
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Visit Your DAILY Futures Resource:
Eurodollar Yields
U.S. Treasury Yields
Eurodollar Quarterly Rates
T-note Futures Yield
5-year Swap Yield
Reproduction or use of the text or pictorial content in any manner without written permission is prohibited.
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T
rading is Darwinian. If you
evolve the qualities needed to
trade profitably consistently,
then you survive. If you do
not evolve these qualities, you
become extinct. The fittest thrive.
When I began my journey to trad-
ing full-time, an opportunity to speak
with an exceptionally successful
investor presented itself. We talked
about several aspects of trading,
including the differences between
long-term investing (his approach)
and short-term trading (my
approach), but it was one of his ques-
tions that was most enlightening.
How do you feel when you make a
good trade? he asked.
Id never thought of this before, and
although my answer was truthful, it
was surprising: When I make a good
trade, I feel nothing.
He said that was good. While we
talked for some time longer, the real-
ization that emotions have no place in
trading, win or lose, was the most
valuable lesson from our conversation.
No matter how well you know how
to trade you may have memorized
the greatest trading strategy ever
devised if you dont keep your
emotions in check, you will never
be successful. Of course, no one
can completely escape their
emotions, but we can
understand and practice
what it means to feel
nothing.
TRADING PITFALLS
Regardless of your trading style, tech-
nique, time frame or market, there are
a number of common traits that can
trip you up. Not all underperforming
trades can be traced to the following
reasons, but in the absence of simply a
bad trading technique, many can:
The tendency to trade impulsively.
The tendency to miss an entry
point, then enter too late.
The tendency to deny a losing posi-
tion.
The tendency to enter a bad period
of trading immediately after a good
period.
Frequently, these pitfalls result in a
condition known as the ugly trader
syndrome. It describes the ability of a
trader to trade just fine to a point.
At that point, seemingly inexplicable
f orces i ntervene to prevent hi s
account from growing further. This is
often defined by a specific dollar
amount.
No matter how much the trader
wins, he loses the gains in a frustrating
win/lose cycle. Or the trader loses a
chunk of money, makes a partial come-
back then finds a new, lower dollar
level blocking any advance.
It is customary to make resolutions for the New Year. In the spirit of
this custom, traders should resolve to avoid common pitfalls that lead
to losing trades. Thankfully, many of these pitfalls can be traced to
one underlying cause: emotional trading.
BY RI CHARD L . MUEHL BERG
Avoiding common
trading pitfalls
TRADING TECHNIQUES
42 FUTURES | January 2008
$
Reproduction or use of the text or pictorial content in any manner without written permission is prohibited.
Copyright 2008 by Futures Magazine Group, 111 W. Jackson Blvd., Suite 2210, Chicago, IL 60604
However, theres no mysterious force
behind this cycle. The trader is at the
root of this, and its up to the trader to
admit that he is the source of it.
The first step in avoiding these
common trading pitfalls is to accept
that you are the cause. And the rea-
son why is at the heart of the human
condition: emotion.
LUCKY OR GOOD
You know the feeling. Youre happy
when you win. You feel excited,
relieved, maybe even bored or
exhausted. Consider these one by one.
If you feel happy and excited, the
psychological translation may be that
you are trading to be happy or excited.
The downside of this is more apparent
when you consider what happens
when you make a bad trade. You can
be tempted to ignore the bad trade
because you dont want to be denied
happiness and excitement. Ignore
enough bad trades and you go broke.
Game over.
You feel powerful when you are
happy and excited. While we general-
ly view happiness as a good thing,
whats wrong with it relative to trad-
ing is that we have no power over the
markets. Feeling powerful can lead
you to assume that any trading deci-
sion you make will be right, that you
do have power over the markets. A
bad trade does not fit with a sense of
power. You may try to use your sense
of power to wish a bad trade away.
Ignoring bad trades is expensive.
Whats wrong about feeling relieved
when you make a good trade is that by
doing so you equate the act of making
trading decisions to a mental pressure
that you want to release in other
words, avoid. You cant expect to
become good at trading if you try to
escape decisions.
Sometimes, you can become bored
after making a good trade. This is nor-
mal. Trading can be an emotional
roller coaster. You can swing between
enthusiasm and depression, and bore-
dom is a stop on the way. You escape
from the swings by seeking a disassoci-
ated mental state.
Exhaustion is another common
result from a good trade. A trading
decision has real consequences. You
make or lose real money, and that can
be stressful. The indicators involved
in making a decision can be confus-
ing. Applying them correctly can
require an enormous amount of
willpower. This adds stress. You might
sometimes find yourself coming up
with reasons to avoid trading, simply
to bypass the stress and exhaustion
that can result from a trade, good or
bad. You trade smaller positions. You
sideline yourself more often. Its OK
to take a break when you do it con-
sciously to regain focus and get back
in the game. Its not OK when you do
it subconsciously.
Exhaustion, boredom, relief, excite-
ment and happiness are all warning
signs that you are trading emotionally.
SOLVING THE PROBLEMS
When we talk about trading mistakes
and emotional trading, it is usually
code for failing to have discipline.
Staying disciplined is tougher for dis-
cretionary traders who are not locked
into a system with definitive rules.
But even discretionary traders can
create rules for how they execute
trades and the parameters they use in
determining an entry. It is important
to remember that the best systems and
traders experience losses. Every trade,
win or lose, needs to be evaluated. We
can be fooled into believing the prob-
lem is with our losing trades when it
may be with failing to properly exploit
our winners.
To avoid these pitfalls, your goal
should be to eliminate emotions from
your trading. You must learn to appre-
ciate the value of feeling nothing
while you trade.
Trading impulsively is one of the
most common pitfalls. You know
intellectually that you should wait for
a sharp run, a clear turning point or a
clear trend, but for whatever reason,
you dont wait. For example, you try
to pick the bottom and by doing so,
you put the odds against you. The
result is you suffer an immediate loss,
a choppy pattern of losses and gains or
at best a minimal gain.
When you feel pressure to trade for
the sake of trading, learn to be patient.
Accept that opportunities always come
along. Remind yourself to wait for a
clear opportunity. This conserves ener-
gy. Decision-making will not be
exhausting. Your interest level will
remain high as you scan for the next
opportunity. You will not look for
relief, excitement or happiness.
If you have a tendency to miss a
good entry point, work on identifying
entries earlier, do not enter a trade
hoping your last parameter will be
met. Decide or stand aside.
If you do not train yourself to recog-
nize a good entry point and act fast,
then you can end up holding the bag.
Yes, you can also enter too soon and
be just as wrong, but there is a line
between an instinctive trader (or at
least a well-trained trader) and a trad-
er frozen by his own indecisiveness. A
frozen trader keeps catching the tail
www.futuresmag.com | January 2008 43
READ AND REAP
When you feel anxious, embarrass yourself into being patient.
When you see a sharp run, a clear turning point or a clear trend, then long the strongest contract, stock,
exchange-traded fund or whatever in a bull move (short the weakest in a bear move). If you delay, wait for a
pullback. If there is no pullback, stand aside. Train harder and work on your speed.
When you make a bad trade or a mistake, exit immediately or before the close. Each moment you wait makes
you weaker and makes your denial stronger. Do not hold a bad trade overnight.
When you experience a particularly good period of trading, slow down. Reflect on your success. Train harder.
Then continue trading.
end of good trades.
The inability to act is one reason
why many traders do not follow their
own trading system. They do not trust
themselves or their system. The solu-
tion here is know your systems entry
logic not just what gets you into a
trade but how the market tends to act
around an entry point. Study old trades
and learn to enter good trades sooner.
If you deny losing positions, train
yourself to believe that denial is bad
for traders. Do not rationalize losses.
Shock is different than denial. Shock
sets in immediately after a bad trade
or a mistake and is temporarily
beyond your control. But when the
shock wears off, you have an opportu-
nity to regain positive control. You
must admit the trade and exit or you
will lapse into denial, which can be
much longer lasting. Understand how
denial and shock work. Admit that
shock can and will happen and learn
to bounce back quickly.
If you have a tendency to enter a
drawdown immediately following prof-
itable periods, look at trading as work.
Trading is a unique collision zone
between people who know it is work
and people who assume it is impossible
or easy. Occasionally, academics will
insist it is impossible to select and time
winning trades or that buy-and-hold
strategies and random darts are as good
as human analysis. These commenta-
tors ignore successful traders the
money managers, pit traders, investors
and day-traders who have made a
career out of taking other peoples
money using the markets.
But in some ways, they are correct.
Bad can frequently follow good, giving
the impression of randomness to an
otherwise solid strategy. Often,
though, this return to the mean can
be attributable to emotional trading
rather than randomness. Just like a
worker in any other profession, traders
are at risk of wanting to work less, to
be less disciplined. In a word: lazy. We
are typically at a greater risk of falling
into this trap just after weve per-
formed our strongest.
If you are doing well, do not reck-
lessly speed up or get lazy. Keep your
mind clear and centered during the
good times. A tick, or several tick, loss
on a winning trade is just as costly as
that tick loss on a losing trade.
Too many traders blow out because
they spiral downward to the point
where they are mentally and finan-
cially hollow. They have no reserves
to help them rally. Dont fall that far.
Think how many successful, even leg-
endary, traders failed mightily before
they sprang or clawed their way back.
These traders had a last ditch
defense. Think of it as the safety in
football or the backstop in baseball.
You need something watching your
back. Consider these techniques.
First, scale back your size. If you can
financially handle x contracts or
shares then restrict yourself to x
minus y contracts. That way, even if
you take repeated hits, you wont sink.
If you are determined to make one of
the common trading mistakes, then,
in this case, delay. Delay, trade small,
and go to cash as soon as you can
summon the willpower.
Trading can be an expensive process.
A lot of failed species lie in the wake of
Darwins process of natural selection.
Thats also true for traders who were
unable to keep their emotions in
check. Learn to control your emotions
before they lead you down the wrong
evolutionary path. If more would
approach the mental side of trading
with the same methodical approach
that they tackle their strategy rules,
they would more quickly evolve into
better, less emotional, traders.
Ri chard L. Muehl berg uses l i near
regression channels and intermarket analysis
to day trade his own account. He publishes
a day tradi ng di ary on hi s si te:
www.DayTradingWithLinesInTheSky.com.
E-mail: richardmue@yahoo.com.
44 FUTURES | January 2008
Trading Techniques continued
FM
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T
he first time Gregory T. Weldon saw the Comex trading
floor in 1983, he found himself in awe of the excite-
ment and the physicality of the pit and of how much it
reminded him of playing basketball for Colgate. Thats the
lane, he remarked, pointing to the floor. I want to get in
there and throw elbows, he said to Stanley B. Bell, founder
of Stanley B. Bell and Company. Bell loved the analogy and
after conferring with Craig Bell, offered Weldon his shot to
become a trader. I got a top position because Im 610; so I
could hand paper over people, sling it to the back of the
booth and throw elbows. It was trial by fire, he says.
He went on to trade for ber trader Louis Moore Bacon at
Moore Capital Management, and there learned to watch for
and trade macro-economic trends, which was not a typical
approach at the time, and to think
through multiple scenarios and
plan responses for multiple out-
comes, And perhaps more impor-
tantly, to be extremely disciplined
about managing risk. In 1992, he
was up more than 25% for the year.
He later traded for the
Commodity Corp., which he
describes as a think tank environ-
ment, where people discussed the
art and philosophy of trading and
dissected good and bad trades. Its
there that he developed the confi-
dence in his methodology, and in
1996, his best year there, he was up
more than 27%.
My methodology is multi-
pronged, Weldon explains. First,
he looks for secular trends based on
macro-level geopolitics or economic
themes. Then he looks for micro-
technical confirmations against
market data; and all while he actively manages his risk with a
statistical approach, stressing diversification within his preferred
markets, which include fixed income, stocks, foreign currencies,
petroleum products, agricultural commodities and gold.
To produce a theme, Weldon relies on his own research,
which he publishes in multiple newsletters that he writes for
hedge funds and risk managers and uses in his recently
launched commodity trading advisor. Weldon tears into the
data. You go right to the source, wherever these statistics are,
he says, rifling off a long list of agencies that includes the
Bureau of Labor Statistics and the Peoples Bank of China.
From there, he tests and retests his ideas against the market.
Next, he hones the strategy based on discretion and the syn-
chronization of the market with his macro-economic thesis.
That crystallization is what drives my decision making on the
implementation side, he says. And through that process he
anticipated recent moves in the Japanese yen, 10-year note
and the huge correction in equities. Its a simple methodology,
and it requires a lot of work, he says.
Because of the increase in available information and the
speed with which it is disseminated through the market,
Weldon says that everything, even the minutia, matters,
and that it is critical to plan for several potential outcomes
to any scenario.
Nowhere is that more important than in his money manage-
ment process. It is the third prong, Weldon says, and
explains that he uses a statistical overlay for each trade, portfo-
lio and sector. I go at it from a statistical basis where I am
looking at risk to stop, variations of volatility, VAR, and stan-
dard deviation to monitor the risk as it applies to individual
positions, sector risk and the overall
portfolio risk. While he warns that
risk can always be greater than you
think, by following his statistically
derived process, he can calculate
risk based on where his stops are
and where potential volatility is,
with a degree of confidence.
If you get the idea that Weldon is
an unemotional trader, youre right.
Weldon funnels that energy into his
research and analysis. I come from
the old school; when you are up big,
if you allow yourself to be euphoric,
you are not going to be able to deal
with this. You have to maintain an
even keel. Theres always some
emotion involved and youre going
to feel it. I channel it into digging
and digging and digging.
Thats not to say that he cant
make mistakes. But Weldon under-
stands his potential weaknesses.
One potential data mistake is to look for things that reflect
your opinion, he says. You have to look at everything and
when it doesnt reflect what you want it to, you have to change
your thinking, he says.
Another, because trends start at the micro level, would be
entering a trade early, which he did in April 1997. The Asian
currency markets were pegging, de-pegging and the volatility
was crazy, resulting in his worst drawdown, 11.18%. I tend to
be early, so the recovery time tends to be quick, he says. We
made that money back in two months, adding that when
emerging trends are buried in the micro data, it can take some
time to manifest in the market, and the experience didnt
cause him to question his methodology.
I pour my heart and soul into doing what I do, Weldon
says. And with his pedigree, research and confidence, his
customers should benefit.
GREGORY T. WELDON
BY CHRI S McMAHON
66 FUTURES | January 2008
Trader Profile
Weldon: Old school trading
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