From the December 01, 2010 issue of Futures Magazine • Subscribe!

Navigating the new electronic financial landscape

Over the past 16 years, this magazine has covered topics such as neural networks, data mining, adaptive systems, genetic algorithms, equity curve analysis, portfolio-based strategies and more. Still, most traders gravitate toward simple systems. This hasn’t necessarily been a bad thing; however, in recent years the markets have capitulated toward electronic trade matching, and what once worked no longer does.

Electronic markets are different from traditional pit-based markets, and the simple systems are not so effective anymore. Markets that used to open when traders filed in every morning now "open" in the middle of the night, such as the Intercontinental Exchange’s 1 a.m. start. In addition, the information and price flow between the United States and Europe is now fluid and instantaneous. Today’s markets never sleep.

Systems traders have been most impacted by this evolution. The long-term backtest is almost invalid. Electronic data and older pit-traded data no longer are comparable with today’s prices in significant details. Some data vendors attempt a solution that combines old pit data with the after-hours electronic markets, but this only produces noisy and thinly traded highs and lows.

It’s necessary to take a closer look at how these changes in markets, data and technology affect today’s traders. First, we’ll look at popular strategies that no longer work. Then, we’ll overview some areas of analysis that may be ripe for further study. We also will discuss the need for smarter systems as the markets evolve, and will revisit some tools that now have gained new importance.


Goodbye, old friend

The opens in today’s markets are arbitrary. Currently, the only markets that have tradable pit markets are the S&P 500 and Nasdaq. For them, we can use pit data to trade our classic open-range breakout in the electronic markets. These markets are the exception, however.

One solution to this issue is to create an artificial day session from electronic 24-hour data. The old pit times will have some significance for a while, but that will fade over time. The stock indexes are different because the pits are still active enough to be relevant, and the pit and electronic markets can’t get too far out of sync because of arbitrage.

An alternative is to trade a breakout of the previous session’s close. This works in some markets, but not all, and is not as reliable as the opening-range breakout. Another solution is to create a balance point, or an artificial open using recent data and then trade a breakout of that. The problem with this is because all markets are at a different level of maturity in terms of 24-hour volume, it’s necessary to use an adaptive model based on some type of statistical analysis for each market. Also, these 24-hour markets only have been liquid for a few years, limiting our history.

Of course, electronic markets have their benefits. Slippage is far less than it was in pit-traded markets. Commissions are much cheaper. Limit orders get filled more often if we touch the price. In the old days, a system with $100-$125 in per-trade profit before slippage and commission was un-tradable. Today, it is a potentially viable approach.

We also can record market orders as close limits. In electronic markets, you can change market orders that enter at the next day’s open to limit orders based on the most recent close. This solves the problem of junk open prices, and only rarely will a trade get missed when you don’t trade back to that previous close. Numerous bias patterns that we filter to create systems now can be traded with more cases and fewer parameters. Many of these types of patterns will perform well, as they have not been over-exploited because most traders found them unusable until recently.

The range in electronic markets is wider and noisier because markets are open for more hours, and many of these hours have low volume. The result is highs and lows that would not have happened if markets were not open 24 hours. The trading ladder also exacerbates this issue. If you see at 2 a.m. that you have one order at an expected price and nothing else, you could be an order away from the market and hope someone else uses a market order. This is what makes 24-hour markets different.

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