When researching whether to trade a market, the most important factor for commodity trading advisors (CTAs) is liquidity. Volume and open interest are perhaps the best tangible measures of liquidity but they aren’t the same thing as liquidity. This is best measured by the ease with which a trader can execute high volumes at one price without causing the market to move against them, or slippage.
When commodity markets made the transition a couple years ago to electronic platforms from open outcry, it led to increased volume and open interest. But despite added volume, some CTAs have noticed that it has not been as easy to execute large orders. And if those CTAs had models that called for them to enter on stops, there was added danger. When stops are initiated and there are no standing orders in queue, the market can move against you rapidly.
This is less of a problem in the ultra liquid financial markets, but all other markets are affected. “The less liquid a market is, the more apt you are to fish out a stop and run something,” says Jon Thompson, VP of trading at Fall River Capital. “It is kind of tough in the bonds or the S&Ps to fish out a stop. But certainly ags, energies and some of the markets that are less liquid, if you fish stops out then they run.”
Most managers we speak to either use stop limits or have eliminated the use of stops altogether. If their entries are triggered by price ala a stop, managers will execute orders with discretion rather then face a possible cascading stop environment. “I don’t use stops. I would rather take the risk of having to rework the order than I would of having a stop that is significantly away from my risk parameters,” says CTA Gordon Linn.
CTA Richard Crow says, “I find the electronic system has created more volatility to the markets. The executed orders that we have to live with are not as good as what we would have experienced three years ago.”
Linn adds, “These are not necessarily high volatility markets, but they are high velocity markets. The point is when you can’t control your risk, you reduce size because you have to control the number of dollars you are going to use.”
WHY less liquid?
Since most markets have seen an uptick in volume, the question is why hasn’t that helped liquidity. A look at an electronic market gives you a clue (see “Is that all there is?”). At any give time, there is not a lot of size shown. Some bids and offers could represent traders willing to do more but unwilling to show it, but you don’t know. They could also represent stops with more size that could cause a big move.
“Take [Nymex unleaded gas], it is doing more volume than it has ever done, but right now I am looking at the book and you go between $1.8928 and $1.8900,” Thompson says. “If you sold 10 lots based on the depth that you see in the market, you would bring down the market 30 ticks. I see a one lot, a seven lot, a one lot, a one lot, a one lot and a one lot.”
Linn says, “The little trader is deceived by that. They look at these ladders and they think they have some sort of feeling of what is there. [That’s] baloney. You don’t.”
Crow has found it harder to execute size. “If you wanted to do size in the pit, you had more tools at your disposal.” He says locals knew they could take the opposite side and spread it off in another month. “You could lay it off simultaneously [with people spreading] in the pits. [Now], if you want to do size, hit the button and say go get it, it could run 30¢. Before, the spreaders in the pits were there to do some form of differential. You don’t have the mechanisms readily available to you to execute size.”
CTA Stanley Haar says, “It is tough to measure. In theory, in the electronic pits there shouldn’t be slippage. The market is what it is and the orders are all out there and you are not subject to the whims or mercy of the
execution broker.”
But the problem is that traders don’t like to show their hand. “It makes a situation where you have to be more cautious because if you don’t have the volume on the electronic trade, the market will rush into these vacuums and move more substantially than they seemed to back in the old days of the pit,” Haar says.
ICEBERGS
Managers have gone to some defensive measures like placing iceberg orders. Icebergs show a certain amount of size at a time, but not the whole order. If a manager has 100 to buy, the algorithm will show 10 at a time until the whole 100 are filled. This can be entered as a limit or stop.
It is debatable whether icebergs are a solution or part of the problem. “We use icebergs, but at the end of the day it is hard to tell how much they help or don’t,” says Thompson.
Fall River executes some of its orders themselves and uses brokers for others. “We do have an electronic platform in house and we do execute through FCMs. The people working those trading desks are convinced [that icebergs work]. They are all afraid to show size. Every time I give them size they say ‘I’ll iceberg it, I’ll iceberg it.’ Part of me thinks it is their way to make you think that they are really working for you. At the end of the day I am not sure how much it really helps.”
And Thompson is not the only one. “I would almost prefer not having icebergs,” Linn says. “You should have to show your size. Show it. If you want to move it, move it. The floor to some degree showed its size all of the time. It made for a more fluid market.”
Haar agrees. “The locals, or so it seemed, acted a little more as a buffer. They knew who else had size in the pits. They would work the orders, meaning they would take a little discretion. That seemed to make for a smoother
trading environment.”
While icebergs prevent the rest of the world from knowing your intentions, sometimes that is not a good thing. “I think you mislead a big part of the market that does not understand the price ladders and the depth of market,” Linn says. “You don’t have a clue if you are looking down on 10 numbers — one lots or five lots — you don’t know if there are 50 there or 5,000.”
He says someone could be looking to do similar size a couple ticks away and would be willing to move towards your price, but they don’t see it. They won’t move towards you if they aren’t confident there is sufficient size to get filled. They are afraid of chasing
the market.
Managers also worry that short-term algorithmic trading programs can spot icebergs and take advantage of them. “We know that there are so many other programs and algorithms that people are trying to pick up and identify when there are orders out there and that is why all these programs have icebergs,” Haar says.
He is skeptical that such order types can prevent algorithmic traders from spotting orders.
“There are people out there that are using more sophisticated systems than we are who might be able to identify something like [icebergs], so in general it would be a disadvantage,” he says.
It is a sort of algorithmic arms race, with different types of traders looking for ways to hide orders and others trying to detect them. It turns the price discovery purpose of markets around.
Thompson has explored using TWOP (time weighted average price) and VWOP (volume weighted average price) trades to get away from using stops and protecting against pockets of illiquidity. In the end he is not convinced they are the way to go.
Haar says, “Part of the problem is electronic trading systems operate at a higher speed than the human brain operates, so you have no time to react to anything.”
Linn says, “I found it interesting that one of the big guys told me that they had 40 quant guys working on various programs and implementing them within their trading scheme; 40 mathematicians writing their
programs, many of which were 15-minute programs. The point is, things are changing and you have to adapt to them.”
It is not that managers are pining for the old days. Most wouldn’t go back, even if they could. “I am not under any illusion that the old days were totally better in terms of costs. The pit brokers took their tick or two out of the market to get an order filled so it wasn’t necessarily a lower cost environment,” Haar says. “But it is trickier if you want to do size and if you want to do it quickly you can run into problems in the pure electronic trading. And therefore if you try and push it too much when the volume is not there you can get screwed.”
The increased volatility and velocity of markets cannot simply be attributed to electronic matching and short-term traders. At roughly the same time that commodity markets were making the transition to electronic trading, the phenomenon of index funds was occurring.
While the Goldman Sachs Commodity Index had been available as an investable index for some time, it along with other index funds experienced huge growth throughout the decade. Commodity imbalances and a rapidly weakening dollar led to concerns over an uptick in inflation and long exposure to a basket of commodities was promoted as a hedge against the onset of inflation.
These index funds represented a new type of trader in commodity markets. The funds would enter at a predetermined time and roll their long positions month to month based on specifications of the index. These positions were not subject to the same price pressures as your typical hedgers and speculators as they represented a small allocation of a much larger portfolio. They have changed the nature of some fundamental spread relationships and offered headaches and opportunities to the traditional market participant. The amount of money dedicated to long only commodity indexes was estimated to be $15 billion in 2003, by 2008 estimates of the size of that space grew to between $200 and 300 billion.
The political pressures placed on the market based on those who would place the blame on speculators have led to some pretty significant and outright wacky recommendations.
“They are interviewing people in the government every day. It creates this nature where people reduce their size and their liquidity goes down and everybody loses,” Linn says.
There also is the problem of fat fingered mistakes and trading on
money flow.
“Sometimes they are errors and sometimes they are more tactical errors in terms of the person placing too big of an order without a limit and if you hit a vacuum or the wrong part of the day, it could be brutal,” Haar says.
It got brutal in March corn on Dec. 30. Linn noticed what appeared to be a fat fingered error — supposedly a clerk placing 5,000 lot instead of 500 — shortly after the open (see “Oops”). “I had orders in to buy and was executed,” Linn says. “If I was long the market and went through my risk point, what would I do? Most of the time I wouldn’t exit out. I would look at the trade and say ‘that is stupid.’”
However, that is a tough call to make when it is your money flying away. There undoubtedly were traders who were stopped out and took significant losses only because perhaps an inexperienced clerk was working a trading desk over the holidays.
Linn says, “The environment created is one of a very spastic nature where we move in a direction very quickly and then don’t follow through the next day. You tend to blow through your risk parameters very easily.”
WHAT NOW
There are a number of factors that have made life more difficult for systematic traders, including extreme volatility, political and regulatory pressure and index fund activity. Electronic matching has made the industry more efficient and has cut costs. These efficiencies have led to new types of trading strategies that has also changed the nature of the game. The anonymity provided by electronic venues has led to less certainty. While some of the changes have benefited managers, others have made for a more risky environment.
There were always traders looking to run stops, but they also were dedicated to providing deep two-sided markets. Managers and hedgers may have had to give up an edge, but they knew there was someone willing to stand up and make a market.
The purpose of futures markets is risk transference and price discovery. To discover prices, traders need to show them and to transfer risk one must see a price.
“All markets evolve. This will straighten out when people understand what is going on and have a good feel, or they will simply lose their money and go away because markets that are spastic like this are almost meant to take the money away from the uninformed who think they can be smart enough to trade this type of market,” Linn says.
Locals provided an important service and while there is no going back, progress always comes with a cost.
“Sometimes you have to be careful,” Linn says. “The markets screamed to kill the goose of the middlemen, thinking that he was making a fortune and provided no function. In fact, now they are seeing that he indeed did provide a stability function and execution function that was extremely important.”
