Kitabı oku: «Locked-in Range Analysis: Why most traders must lose money in the futures market (Forex)»

Foreword

It is common for reasonable people to learn from their mistakes or from the mistakes of others, realizing the causes and effects of actions that lead to undesirable results. Knowing the statistics of those who “earn” on market speculation, each is certain that he is not like the others and that everything will turn out for him. And they are not even considering to leave this “way of making money”. While losing more and more money and time to find out “why trading is not for them”, people are being devoured by their failures because to accept a failure for them is equivalent to recognizing themselves an asshole.

Taking the reason for “why most traders must lose money in the futures market”, as a consequence, you truly realize your lack of advantages over the other market participants in the endless “exchange wars”, when one does not mind to yield this “battle” to others.

Chapter 1. Preparing to Analyze

1.1

Why Do We Analyze Futures Instead of Forex?

Starting with the Bretton Woods currency system (1944), the US dollar has been the main international reserve currency, so the quotes of other countries’ currencies are expressed through the US dollar.

Types of currency quotes:

– Direct quote (fixed amounts of the foreign currency are expressed as variable amounts of the domestic currency)

Example (US dollar is not the domestic currency): USD/CAD 1.3090 means 1 USD = 1.3090 CAD

– Indirect quote (fixed amounts of the domestic currency are expressed as variable amounts of the foreign currency)

Example (US dollar is not the domestic currency): EUR/USD 1.0680 means 1 EUR = 1.0680 USD

– Cross quote (the ratio between the two currencies, which is determined based on the rates of these currencies relative to a third currency)

Example: EUR/USD 1.0680, GBP/USD 1.2470 means EUR/GBP 0.8565 (1.0680/1.2470)

Based on the location of performing currency transactions, there is an exchange market and over-the-counter market.

Table 1. Comparison of exchange and over-the-counter market

Unlike exchange market, in the over-the-counter market there is no central marketplace (the exchange clearing house), where all information about the transactions, on the prices reached by the parties, is received. In addition, there is nobody that would control and regulate the activities of all participants in the trading process. Therefore, different exchange dealers may have different quotes of the same traded instrument (such as a currency). Nevertheless, the prices from exchange trades, on the relevant basic commodities for the nearest most liquid futures contracts, are used for the formation of over-the-counter quotes (WM/Reuters benchmark rates are used as standard rates for determining the OTC exchange rate).

Since Forex market is an over-the-counter market, and the transactions made in it (demand and supply) cannot influence the change in quotes, futures on the relevant currencies should be used for analysis and forecasting.

Table 2. The most liquid CME currency futures contracts as of 01.02.2017 and the corresponding Forex currency pairs. Types of Quotes – US dollar is not the domestic currency. Volume data source: cmegroup.com

Charts of Forex direct quotes are a mirror image of the relevant CME futures charts. Charts of Forex cross quotes (Examples: AUD/CAD; AUD/JPY; CAD/JPY; EUR/AUD; EUR/CAD; EUR/GBP; EUR/JPY; GBP/AUD; GBP/CAD; GBP/JPY) are the mathematical relationships of direct and indirect quotes, therefore, those who trade cross quotes are Lucky-traders.

1.2 An Introductory Guide to Futures

What Are Futures?

Standardized (according to quality, quantity, delivery time and place) contracts, for the purchase and sale of financial instruments or physical commodities, for future delivery on a regulated commodity futures exchange.

Who Trades Futures?

Conventionally, traders are divided into two main categories, hedgers and speculators. Hedgers use the futures market to manage (to reduce or limit) price risk associated with an adverse price change. (Examples: airlines hedging fuel costs; jewelry manufacturers hedging the cost of gold and silver; farmers sell futures on the raised crops to hedge against a drop in commodity prices;). Speculators, on the other hand, accept that risk in an attempt to profit from favorable price movement. While futures help hedgers manage their exposure to price risk, the market would not be possible without the participation of speculators. They provide the bulk of market liquidity, which allows the hedger to enter and exit the market in an efficient manner.

Why Trade Futures?

In addition to hedging, futures trading provides the trader (risk-taking investor) with greater flexibility because of liquidity and capital efficiency because of leverage.

Leverage is an amount of money deposited by both the buyer and seller of a futures contract to ensure their performance of the contract terms. The performance bond may represent only a fraction of the total value of the contract, often 2 to 12 %, making futures a highly leveraged trading instrument. Therefore, futures contracts represent a large contract value that can be controlled with a relatively small amount of capital.

What does it mean?

The Euro FX futures contract could have a value of 125,000 EURO, but you would be able to buy or sell this contract by posting a performance bond of about 2,750 USD, which is only 2% of the contract value (EUR/USD 1.1000).

Liquidity

A condition that describes the ability to execute orders of any size quickly and efficiently without a substantial affect on the price.

Liquidity can be described in terms of volume and open interest (abbr. OI). Each unit of volume represents a complete transaction. When one trader buys a contract and another trader sells the same contract, that transaction is recorded as one contract traded. Open interest represents the total number of contracts, either long or short, that have been entered into and not yet offset or fulfilled by delivery. Each open transaction has a buyer and seller, but for calculation of open interest only one side of the contract is counted. Volume and open interest are reported daily and are used by traders to determine the level of activity in a market for a given day or a price movement.

To quickly gauge the liquidity of a market, traders may look at 1) the distance between the best bid and ask prices (bid-ask Spread), 2) the number of limit orders pending in the market at each bid and ask level (Level II) and 3) the frequency with which trades take place (Time & Sales).

Trading in liquid markets, where there is enough volume for you to enter and exit your orders without substantially affecting price, will help to ensure that you can exit a position just as easily as you enter it.

Type of Order

Market Order

The simplest and most common type is the market order. When you place a market order, you agree to either buy or sell at the best available price.

Stop Order

An order that becomes a market order when a particular price level is reached. A sell stop is placed below the market; a buy stop is placed above the market. Sometimes referred to as stop loss order.

Limit Order

An order that allows the buyer to define the maximum price to pay and the seller the minimum price to accept (the limit price). A limit order remains on the book (Level II) until the order is either executed, canceled or expires.

Market Regulation

Futures markets are regulated (Example: CFTC, NFA) to foster open, competitive and efficient futures markets, and to protect market users and the public from any fraud, manipulation or abusive practices.

Contract Specification

Futures contract specification includes, but is no limited to:

Contract Size

Each futures contract has a standardized size that does not change.

Contract Value

Contract value is calculated by multiplying the size of the contract by the current price.

Product Code

The first two letters of a CME Globex (CME Group’s electronic trading platform, providing users across the globe with virtually 24-hour access to global markets) ticker symbol represent the underlying futures contract. The next letter in the ticker represents the month that the contract expires. The final number is representative of the the year the contract expires. Example: 6EH7 is a Euro FX (6E), March (X) 2017 (7) contract.

Contract Month

The month in which a futures contract expires. Delivery month is indicated by a letter: F – January; G – February; H – March; J – April; K – May; M – June; N – July; Q – August; U – September; V – October; X – November; Z – December.

Contract month contains the last trading day (settlement date) on which a futures contract may trade or be closed before delivery.

Tick Size

The minimum price change in a futures contract is measured in ticks. A tick is the smallest amount that the price of a particular contract can fluctuate.

Table 3. Contract specifications of most liquid currency, equity, energy, metals futures. Commodities contract months are the most active months for delivery according to volume and open interests. Specifications for all products traded through CME Group can be found at cmegroup.com

Settlement

Cash Settlement

At the end of the contract the holder of the position is simply debited or credited the difference between their entry price and the final settlement. (Example: the purchaser of an E-mini S&P 500 future is unable to take ownership of the index at expiration).

Physical Delivery

At the end of the contract the holder of the position will either have to deliver the physical commodity (if short) or take delivery (if long). The delivery payment is based on the contract's final settlement price.

The holder of the open long (buy) / short (sell) positions must inform their clearing firm that he intends to make delivery. Clearing firm is required to report to CME Clearing (the exchange clearing house) all open positions that will be delivered. CME Clearing then matches long clearing firm (or firms) to the short clearing firm, begins with long positions entered on the oldest vintage date.

1.3 Role and Capabilities of a Market Maker

Who Are Market Makers? (Definition by CME Group)

A market maker (one type of speculator) is an authorized customer permissioned to quote both the buy and sell side in a given market (while all other market participants may open positions only in one direction – unidirectional). The main function of the market maker is to provide liquidity to the marketplace (contractual agreement with CME), usually in exchange for a reduction in trading fees. Market makers often profit from capturing the spread, the small difference between the bid and offer prices over a large number of transactions.

Modern futures market cannot function without such a professional participant as a market maker, since 24-hour trades include illiquid periods when there are sharp imbalances in supply and demand, and if the market is allowed to determine prices independently in such periods, then we can observe increased volatility and price manipulation, which can be very significant and would be regarded by market participants as an increased trade risk, equivalent to an illiquid instrument; therefore, the stock exchange, in our case its CME Group, is interested in the presence of market makers, providing them with privileges in exchange for compliance with the established obligations to provide and maintain liquidity.

Responsibilities of Market Makers

During the specified period of the trading session (American, Asian-Pacific, European), the market makers must continuously maintain two-way futures quotes, observing the minimum volume of own orders agreed with the exchange and the spread between bid-ask quotes (widening of spread for periods of increased volatility is possible).

As counterparties to each transaction in terms of pricing, market makers must take the opposite side of your trade. In other words, whenever you sell, they must buy from you, and vice versa.

IMPORTANT. Why do market makers act as counterparties for most orders, but not for all? The rest of the transactions may temporarily be accumulated by other market participants, both with speculators and hedgers; however, over time, all open positions will pass on to market makers, when one of the parties of a transaction, in which the market maker does not participate, decides to close the position.

Capabilities of Market Makers

To understand the capabilities of market makers, one should know the limited market depth available to any participant: 1) Data featuring the nearest (best) placed 10 bid and 10 ask limit orders shows the price and number of contracts (Level 2). 2) Data featuring each transaction made shows the price, time, and number of contracts (Time & Sales).

CME Group market makers use the full market depth available to the exchange, namely:

1) Data featuring all existing placed limited orders

2) Data featuring all existing placed stop orders

3) Data featuring all open positions: price, volume, and side of order (buy/sell)

Figure 1. Net Positions (buy+sell) Market maker Order Book (Open orders, Open positions)

Market makers collectively create a market for each futures contract, centrally managing its common pool of positions to prevent conflicts of interest that would arise when working separately, when instead of earning the spread and self-quoting, market makers would get a large volume of positions that would not have a counterparty to close before the expiration of the futures. (Example: Speculator buys 1 cash settlement contract on the market, and his counterparty is Market Maker #1; then, the same speculator decides to exit the position and sell his contract; this time, his counterparty is Market Maker #2. As a result, the speculator does not have a position, and the market makers have 2 open positions that they can close only with each other; in this case, one of them will suffer losses).