FUTURESMAG.

COM | JANUARY 2011

Interest rates
OppOrtunities alOng
the yield curve
error trades
Bust Or adjust?

top 10 mIstakes
hOW tO avOid them
dodd-Frank
FrOm theOry
tO practice

spottIng
reversals
With vOlume spikes

BONDS AWAY!
Pimcos El-Erian outlinEs Global trEasury ViEw

US $6.95 CAN $8.95

Cover_Jan11.indd 1

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Best Price Execution Lowest Margin Rates Low Cost

1

Minimize Your Trading Costs

US Margin Loan Rates Comparison

US Commission Rates Comparison

100
Shares

1 E-mini
S&P 500
Future

1 Stock
Option

$25K

$200K

$1.5M

7.64%
7.575%

6.14%
6.575%

3.89%
3.750%

$7.99
$7.95

Interactive Brokers
optionsXpress
Schwab

1.70%
6.25%
8.00%

1.45%
5.00%
6.875%

1.07%
4.00%
6.25%

$1.00
$9.95
$8.95

TD Ameritrade

8.50%

7.25%

6.25%

$9.99

$10.74

N/A

thinkorswim

7.70%

7.70%*

7.70%*

$5.00

$2.95

$3.50

E-Trade
Fidelity
4 **

Margin Rate Comparison as of November 4, 2010. Services vary by firm. *Negotiable

$8.74
$8.70

$1.00
$12.95
$9.70

8
11

5
6
7
9

Plus
regulatory
fees

$2.99
N/A

Plus
fees

$0.85
$6.99
N/A

7
10

Commission Comparison as of November 4, 2010. Services vary by firm.

Data is for U.S. equities, stock options and futures.

**Lower commission rates for larger volumes and comparable rates worldwide.
**Lower commission rates for larger volumes and comparable rates worldwide.

Execution Price Comparison

US Stocks
(per 100 shares)

US Options

Interactive
Brokers

Industry

IB
Advantage

$0.25

$-0.03

$0.28

(per contract)

$0.97

$0.44

$0.53

European
Stocks

1.64

-1.20

2.84

(per 100 shares

Interactive Brokers
The Professionals Gateway to the Worlds Markets

Net Dollar Price Improvement [1]

vs. National Best Bid/Offer
Significantly better than the industry
as a whole[1B] for first half 2010.
Source: Transaction Auditing Group,
Inc. (TAG), a third-party provider of
transaction analysis.

www.interactivebrokers.com

Interactive Brokers LLC is a member of NYSE, FINRA, SIPC. Supporting documentation for any claims and statistical information will be provided upon request. [1]
Best Price Execution according to Transaction Auditing Group, Inc., (TAG) - Net $ Improvement per Share Definition: ((# of Price Improved Shares * Price Improvement
Amount) - (# of Price Dis-improved Shares*Price Dis-improvement Amount)) / Total Number of Executed Shares. [1B] According to TAG for US stocks (28 cents per
100 shares better), the analysis included all market orders of 100 shares or more, up to 10,000 shares from January - June 2010. The analysis for US options (53 cents
per contract better) included all market orders with order sizes of 1 to 50 contracts from January - June 2010. The TAG statistics for price improvement on IB orders
routed to exchanges in Europe include all orders routed for execution during regular trading hours including all market and marketable limit orders and orders near
the market (orders having a limit price within one-tenth of a Euro from the quote price at time of order receipt) on stocks listed on the included exchanges during the
first half of 2010, weighted by the volume executed on each exchange. The exchanges are XETRA, EURONEXT, CHI-X, WIENER BORSE, TURQUOISE, LONDON and
NASDAQ OMX. [2] Lowest Margin Rates - Barrons Margin Expands Regardless of Rate - October 19, 2009. Criteria included margin interest rate data as of February
13, 2009 and October 6, 2009, on balances of $10,000 and $50,000. Barrons is a registered trademark of Dow Jones & Company, Inc. [3] Low Cost Rated by Barrons
6 Years Straight - Low cost broker 2005 through 2010 according to Barrons online broker review. 2005 - 5 Stars, 2006 - 5 Stars, 2007 - 4.8 Stars, 2008 - 4.5 Stars,
2009 - 4.5 Stars, 2010 - 4.2 stars, according to Barrons How Barrons Ranks 22 Leading Online Brokers - March 15, 2010, ranked Interactive Brokers with a 4.2 star
rating for cost. Barrons is a registered trademark of Dow Jones & Company, Inc. Criteria included Trade Experience, Trading Technology, Usability, Range of Offerings,
Research Amenities, Portfolio Analysis & Report, Customer Service & Education, and Costs. [4] IB calculates the interest charged on margin loans using the applicable
rates for each interest rate tier in the interest and financing table on its website. For margin loan rates on other amounts, see www.interactivebrokers.com/interest.
[5] E-Trade - 150+ trades per quarter. [6] Fidelitys $7.95 flat commission applies to online trades in all U.S. equity securities for Fidelity Brokerage Services LLC retail
clients. It does not apply to foreign stock transactions or restricted securities transactions. Additional fees may be charged on orders that require special handling.
A minimum deposit of $2,500 is required to open most Fidelity brokerage accounts. [7] Plus exchange and regulatory fees (futures and options only). IB - Accounts
generating commissions less than $10 per month (with account equity of $2,000 or more) will be assessed the difference as a monthly activity fee. For new accounts,
the activity fee of $10 will be waived for the first 3 full calendar months. [8] optionsXpress - 1-1,000 shares. [9] optionsXpress - 1-10 contracts - Active Trader Rate.
[10] optionsXpress - between 1 - 40 contracts per month. [11] Schwab - For online trades in stocks and third-party exchange-traded funds.
11-IB10-341

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NG

TR AD

ER

years

RE

S M AG

Features

ED

38

FO

JANUARY 2011 VOLUME XL NUMBER 1

I
AT

Contents

AZ

MARKETS
26 Bonds reflect world of
default and deflation
By Michael McFarlin
While 2010 was marked by financial fears,
programs are in place to help launch 2011.
TRADING TECHNIQUES
32 Opportunities along the yield curve
By Paul Cretien
How to find profitable opportunities from
two-year T-notes to ultra 30-year bonds.
36 Market internals beat the herd
By Chris Vermeulen
How to use market internals
to capture quick profits.
40 A more modest approach
to naked straddles
By Robb Ross
Straddles can provide good premiums.
Sometimes extra protection is needed.

22

Cover story
El-Erian managing the new normal
investment landscape

44 When volatility distorts probability

By Sergey Izraylevich and Vadim Tsudikman
Keeping expectations in check when profit
probability is inflated by high volatility.

By Daniel P. Collins
In this age of corporate and sovereign solvency risk, we
correspond with Mohamed El-Erian, CEO and co-chief
investment officer at PIMCO, the worlds largest bond trader.

EQUITY TRADING TECHNIQUES

48 Trend reversal spotting
with volume spikes
By Billy Williams
Observing the relationship between price
and volume provides trend reversal clues.

Departments

FUTURES 101
50 Top 10 trading mistakes
and how to avoid them
By Jim Wyckoff
All traders lose money. Dont compound
that reality by making these mistakes.

8 Editors Note
More of the same?
10 Trendlines
Europe shores up the rulebook
NYPC takes another step
Japan seeks market integration
Industry asks for more time
Anatomy of a market corner
13 Trading Places
Bass brings big plans
to MF Global
14 Managed Money Review
For additional information,
visit futuresmag.com

16 Options Strategy
Using a bear-biased
put ratio condor
18 Forex Trader
Unsustainable patterns for 2011
20 Hot Commodities
21 Market Watch
Is the Fed playing with fire?
30 Market Strategy
Cuckoo for cocoa futures
61 Ad Index
62 Trader Profile
Cheung teaching his
winning ways

For reprints of 500 copies or more and e-prints of FUTURES articles,

please contact PARS International at [email protected] or (212) 221-9595.

MANAGED MONEY
52 Bust or adjust:
Inside the error can of worms
By Steve Zwick
Trade errors can leave any
trader hanging.
TRADE TRENDS
56 Dodd-Frank: Moving from
theory to practice
By Michael McFarlin
Reform was signed six months
ago. Heres a look at the challenges
facing market participants.

FUTURES January 2011

TOC_Jan11.indd 4

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combined with any other offers. Additional restrictions apply. Terms and conditions are subject to change at any time. No offer or solicitation to buy or sell securities, securities derivatives
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its affiliates. Past performance, whether actual or indicated by historical tests of strategies, is no guarantee of future performance or success. Active trading is generally not appropriate
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Want to knoW more?

Go online and check out our web-exclusive articles, resources,
charts and e-newsletters at futuresmag.com today.

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TRENDLINES
The Securities and Exchange Commission reviews the single-stock
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Editor's NotE

More of the same?

ith the November

Republican landslide,
which saw the GOP
take control of the House, the
Dodd-Frank Wall Street Reform
and Consumer Protection Act
of 2010 may lose its teeth. Many
pols, especially the new head of the House Finance Committee,
Spencer Bachus (R-Ala.), want to rescind many, if not all, of
the hard-fought rules the previous Congress had worked out.
Apparently these people had their heads in the sand during the
financial crisis and seem to believe everything was fine the way
it was prior to the fall of Lehman Brothers and the buckling
of Merrill Lynch, Citicorp and Bear Sterns. These are the same
people who are angry about the growing deficit, but voted to
extend the Bush tax cuts. Theyve also ignored how TARP-like
programs aided many of the biggest banks on Wall Street.
Before this mid-term election, I wasnt disgusted with the political scene. I thought the Dodd-Frank bill was a good compromise
to rein in some bad behavior and make more transparent the
trading world that caused many of the disruptions to the markets
two years ago. Apparently self preservation wasnt doing enough
to prevent unbridled greed. And by the United States bailing out
some of our largest banks and making a profit at it as well it
helped stabilize a system that had gone off the rails. The fact these
same bankers saw to it that big bonuses still were distributed
despite poor performance pretty much crystallized their cynical
viewpoint of government, taxpayers and the market in general.
The market works with a delicate balance of free market
principles and government and quasi-government rules and
regulations. Does anyone truly believe except Ron Paul and
Ayn Rand that the free market polices itself? And if it does,
isnt it more an after-the-fact policing, i.e., after the barn burns
well make sure we dont light matches around straw.
The Dodd-Frank Act, with all its flaws, still addresses key
weaknesses in our financial system. Did the banks like the rules?

Hell no, but they had already shown a reckless disregard for due
diligence and policing their own, even when it meant destroying
the firm. Just ask Richard Fuld, formerly of Lehman Brothers.
Hes furious the government didnt save his firm, but did save
others. But the only complaint should be, why did the government save anyone? The answer of course is that it was a necessary evil, and as loud as those are who pooh-pooh saving the
banks, the fact is, it was needed.
And the truth is, Dodd-Frank is needed. The New York Times
ran a front page story this past Sunday called A Secretive
Banking Elite Rules Trading in Derivatives. Nothing shocking
there, and though some points in the story might be questioned,
the key was, and no doubt will cause controversy for time to
come, the bad boy bankers are still in charge, still directing the
rules and still making it so they control the markets.
So is Dodd-Frank a sham? Have OTC derivatives players already
called their own shots so exchange clearing organizations will bow
to their requests, leaving behind other firms that want to join the
party? But wait, isnt price discovery all about transparency?
Electronic trading has changed the trading world, and largely
for the better. Its lowered the bar to entry, expanded product
choice, tightened bid/offer spreads and reduced, for the most
part, the cost of doing business. Moving OTC products onto
exchange clearing platforms can only strengthen that market,
and our financial system as a whole. Yet it appears many banks
dont want that; I fear they could learn the lesson of Mr. Fuld
too late, but well be the ones punched in the face.

E-mail me at [email protected]

Note: Last months Editors Note mistakenly identified Michael

Lewis as working for the wrong firm; he was at Salomon Brothers.

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Canada L5S1E9. Printed in the USA. COPYRIGHT 2011 by The National Underwriter Company, DBA Summit Business Media. All rights reserved. No part of this magazine may be reproduced in any form without
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analysis and strategies for futures, options and stock traders also is available in the electronic versions of the Business Periodicals Index.

FUTURES January 2011

EditorsNote_Jan11.indd 8

12/14/10 1:02:58 PM

The Risk Management Conference, hosted by the Chicago Board Options

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With topics ranging from basic derivatives applications to advanced trading
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Trendlines

End of principlEs?

Europe shores
up rulebook
A couple of years ago the more principle
based regulatory structure of Europe was
all the rage, but the credit crisis of 2008
has changed the playing field. Now, fast
on the heels of U.S. financial reform (see
Dodd-Frank: Moving from theory to
practice, page 56), the European Union
(EU) completed a review of the Markets
in Financial Instruments Directive
(MiFID). While the review left MiFID
with considerably more oversight power,
it has left some analysts wondering if
the cost may be too great.
In the most recent move, the very
shape of European regulation has begun
to change. The European approach
had always been principles based. They

would say you should do this or that,

and it was up to you to implement a
way of meeting the expectation of the
principles, says Jay Gould, head of the
investment funds practice at Pillsbury.
Now, we see a move toward much more
detailed guidance.
One area that has received considerable attention is high-frequency trading. Under the new
rule proposals, highfrequency traders
will have to fully
explain their
trading

onE-poT clEaring

NYPC takes another step

When New York Portfolio Clearing (NYPC) filed its application with the Commodity
Futures Trading Commission (CFTC) for derivatives clearing organization (DCO)
status in November, ELX Futures CEO Neal Wolkoff, a potential competitor of
the new NYSE Euronext Treasury complex set to launch in the first quarter,
noted that it was premature because there was no Securities and Exchange
Commission (SEC) rule filing.
Since then, the Fixed Income Clearing Corporation (FICC), a division of the
Depository Trust and Clearing Corporation (DTCC), has filed rule changes with
the SEC regarding cross margining agreements between the FICC and NYPC.
The NYSE Euronext plan to launch a full suite of Treasury contracts in the first
quarter is contingent on the dual launch of NYPC, which will clear both cash
and futures Treasury products in a one-pot clearing structure based on a unique
agreement between NYSE Euronext and DTCC.
According to the filing, the FICC will offer cross-margining of certain positions cleared at its Government Securities Division (GSD) and certain positions
cleared at NYPC." In essence, NYPC clearing members will be able to clear cash
and futures in one pot.
Wolkoff has argued that the agreement between the DTCC and NYPC is anticompetitive because the DTCC has a monopoly on cash Treasuries. In a comment letter ELX states that the NYPC DCO application fails to meet core principles regarding antitrust considerations.
Walt Lukken, CEO of NYPC, says, "Once the clearinghouse is up and running it
would allow other exchanges to access the efficiencies that it will offer once it is
operationally feasible." Lukken estimates the one-pot clearing method will add
an additional 15-30% in margin efficiencies to clearing members.
By daniel p. collins

algorithms design and functionality

to regulators before they can be used
in markets.
Miranda Mizen, head of European
research at TABB group, explains the
potential challenge. If you have to
explain your algorithm to the regulators, then that assumes the people you
are talking to can react very quickly and
understand what you are trying to do.
There is a lot of burden of responsibility being put into one place, she says.
Unlike in the United States, the
EU seems to be working to consolidate regulatory authority among both member
nations and asset classes.
What we are looking at
is an objective of creating a single rulebook at
a European level. That
has big ramifications
because were still talking about sovereign states, Mizen says.
While the attempt at creating panEuropean supervision has already
brought advancements, any move
is going to face difficulties. [PanEuropean regulation] is going to
create friction among the different
countries as they each have different
economic, social and political outlooks, Mizen says.
As in the United States, numerous
unknowns continue to haunt market
participants. Chief among these concerns is what new market structures
will look like. Will trading costs go
up or down? Will it be harder or easier
to find liquidity? Will the obligations
surrounding quoting requirements and
registration create the framework to
contain risk or will it remove liquidity
from the market because the requirement is too onerous? Mizen says.
What the market structure will look
like needs to be clearly understood.
While these questions still exist, a
disposition to work with other nations
is evident. There is a real willingness
among regulators across borders to
work together. There seems to be more
unanimity of though with respect to
macro issues than there has been in the
past, Gould says.
By Michael Mcfarlin

10

fUTUrEs January 2011

Trendlines_Jan11.indd 10

12/14/10 1:50:04 PM

coME TogEThEr

Japan
seeks
market
integration

Whats happening is
that even though China is closed
to foreign traders, they are climbing quickly in terms of volume along
with India, says Paul Rowady, senior
analyst at TABB Group.
The growth of numerous geographically close exchanges while interest in
Japanese markets stagnates has prompted some in the Japanese government to
discuss combining securities, currencies
and commodities bourses by 2013 to
boost trade and remain competitive.
A number of proponents, including Futures Industry Association (FIA)
Japan Vice President Yasuo Mogi,
have pointed to the silo structure
of Japanese market regulation as the
biggest detriment to growth. In a
Nov. 19 public hearing on the issue he
explained that existing laws, regulations and rules currently are separated
into regulatory silos. Further, separate regulatory agencies and self-regulating organizations each issue their

Although the Asia-Pacific region has

become one of the fastest growing areas
of financial interest, very little has been
said about recent Japanese propositions
to overhaul the countrys exchanges and
attract foreign investment.
Government officials have signaled a
desire to restore Japans position as an
important regional financial center.
While the Tokyo Commodity Exchange
(Tocom) was once the second-largest
commodities exchange after the New
York Mercantile Exchange, it ranked 11
last year and was surpassed by Chinas
Shanghai and Dalian exchanges.
For the first half of 2010, the [Osaka
Securities Exchange] (OSE) was ranked
15 in terms of contract volume in the
world; Tokyo Financial Exchange was 18.

ChartvIEw: is fear on The rise?

Just because equity indexes have experienced a strong two-year bull move and perhaps
a 2010 santa claus rally doesnt mean people arent worried. Well at least they are
doing something more constructive with that worry as volume and open interest (chart)
in futures on the cBoE futures Exchange's (cfE) benchmark Volatility index (ViX) the
fear gauge have risen dramatically in the last two years (though the index is near a
an eight-month low).

Jay caauwe, cBoE director of business development, says hedging by providers of

exchange-traded notes (ETn) based on the ViX has boosted volume but adds the popularity of ViX futures is based on years of work coming together.

and volatility as an asset class has been gaining steam as cfE will soon have competition. The Volatility Exchange (VolX) recently announced a licensing agreement with cME
group to launch realized volatility contracts on currencies.
600

180
160
140

400

120
100

300

80

200

Thousand

Thousand

ViX futures

Volume
open interest

500

60
40

100

20
0
Oct-10

Nov-10

Sep-10

Jul-10

Aug-10

Jun-10

Apr-10

May-10

Mar-10

Jan-10

Feb-10

Dec-09

Oct-09

Nov-09

Sep-09

Jul-09

Aug-09

Jun-09

Apr-09

May-09

Mar-09

Jan-09

Feb-09

Source: CBOE Futures Exchange

own reporting requirements based on

which regulatory silo they represent.
The result is a regulatory quagmire.
In FIA Japans November newsletter, Chairman Mitch Fulscher wrote,
The critical issue to be first addressed
is the need to break down the silos
created by separate laws, separate
regulatory agencies and regulations
issued by the separate regulators
and self-regulatory agenciesIt is
now apparent that government
and the regulators are ready for
this bold action.
A move to a single regulator
would solve many of these problems and greatly decrease confusion.
[A single regulator] makes sense. There
is some precedent when you look at the
European situation where there is a
more consolidated regulatory framework in the Eurozone. It would make
sense given what is happening in other
parts of the world, Rowady says.
While it historically has been difficult
for Japanese markets to attract a lot of
international business because of high
costs and inefficiencies in market structures, a renewed desire to develop Japan
as an international financial derivatives
center is causing officials to re-examine
their markets and regulations.
The bottom line is access. Japan is
somewhat unique in that it has been the
most mature of the Asia-Pacific markets
for some time, but has fallen on hard
times because of its own economic and
fiscal quagmire, Rowady says.
By Michael Mcfarlin

noT so fasT

Industry asks
for more time
Representatives of the private sector
seldom complain that a government
agency is getting things done too
quickly but, in a Dec. 7 letter, a group
of 11 trade associations representing
derivatives market participants urged
the CFTC and SEC to slow down and
use more discretion in the promulgating and implementing of rules required
by Dodd-Frank. While some issues
included registration requirements and
futuresmag.com

Trendlines_Jan11.indd 11

11

12/14/10 1:50:05 PM

Trendlines

clearinghouses, time constrictions on

firms were the biggest concern.
The group effectively asked the regulators to slow down so that firms have
time to first comment on rules and to
later implement them.
They say it is important for those
writing the rules to develop those rules
through a process that is deliberative,
gives all affected parties a reasonable
opportunity to comment (and have their
comments be given thoughtful consideration) and implements those rules in
a manner that gives market participants
sufficient time to do the work necessary
to comply with new requirements.
John Damgard, president of the
Futures Industry Association, says, "It
is better to get it done right than to get
it done fast. I just want more time for
people to reflect on the proposed regulations so we can comment with some
sense of confidence."
He noted that many of his members
and members of the other agencies who
signed the letter are banks, and banking
regulations require key people to take
at least two months' vacation. Many
people were out during the holidays,
making it more difficult for banks to
work through the rule proposals.
The group cites definitions as another example of their concerns. On Nov.
10, the CFTC approved issuance of proposed rules on topics including registration of swap dealers and major swap
participants. However, definitions for
swap dealers and major swap participants were not finalized until Dec. 1.
Additionally, they expressed concerns
over the implementation time-frame
for the new rules, saying that if regulators require too much change in too
short of a time, it increases the likelihood that market participants will be
unable to comply. Their only alternative would be to stop entering into the
transactions for which compliance is
not immediately possible, thus leaving
segments of the market with diminished or possibly no liquidity.
By Michael Mcfarlin & daniel p. collins

go to futuresmag.com for
additional news stories.

12

sqUEEzE play

anatomy of a
market corner
In the second possible case in
2010 of a corner in a commodity market, an unknown buyer,
reportedly a JP Morgan Chase
customer, has stockpiled up
to 80% of the copper on the
London Metal Exchange
(LME). While many traders
have tried to corner the market in a commodity, rarely
has it worked. Here are a
few past attempts:
1869 James Fisk and Jay Gould headed a group of speculators that sought to
corner the U.S. gold market on the New York Gold
Exchange. When President Ulysses S. Grant learned of
the attempt, the federal government sold $4 million in gold, sending
prices plummeting.
1950s Onion farmers were convinced traders on the Chicago Mercantile
Exchange were responsible for wild price swings in onions. In 1955, the price
fell from $2.75 a bag to just 15 cents, barely more than the cost of the bag.
Congress passed the Onion Futures Act banning trading in onions.
19791980 Brothers Nelson Bunker Hunt and Herbert Hunt tried to corner
the worlds silver supply. At one point, the brothers held more than 50% of
the worlds deliverable silver. During the accumulation, silver went from $11
an ounce in Sept. 1979 to more than $40 an ounce in Jan. 1980. Prices collapsed two months later to back below $11 an ounce.
1981 The Malaysian government began buying tin futures contracts and
spot physical tin in an attempt to protect its major export tin. While the
attempt initially worked, sending tin prices from less than 7,000 per ton to
nearly 9,000 per ton just eight months later, when the LME changed its rules
to allow sellers an alternative to physical delivery, tin prices fell drastically.
1990s Yasuo Hamanaka, Sumitomo Corporations chief copper trader,
attempted to corner the international copper market by accumulating the metal
over a 10-year period. At one point, he is believed to have controlled up to 5%
of the worlds copper supply. He ultimately lost $2.6 billion and was later sentenced to prison for market manipulation.
2010 Anthony Ward, aka Choc Fingers, took delivery of 240,100 tons of
cocoa valued at 658 million from NYSE Liffe this past July. That was equal to
7% of the worlds cocoa supply. The delivery left only 6,710 tons of cocoa available for delivery and pushed prices to a high of 2,732 ($4,388) a metric ton.
2010 A trader, reportedly a JP Morgan customer, has accumulated a position in copper equal to 80% of the LME supply. The move comes as there are
fears of a shortfall in supply next year and three companies have announced
their intentions to launch exchange-traded funds linked to copper.
By Michael Mcfarlin

fUTUrEs January 2011

Trendlines_Jan11.indd 12

12/14/10 1:50:06 PM

Trading Places

Bass brings big plans to MF Global

b y Mi c hae l Mc Fa r l i n

on Bass joined MF Global

Jason Dobson was
Send news of personnel moves to:
in the newly created role of
appointed by ICAP to join a
Futures, 222 S. Riverside Plaza, Suite 620
Chicago, Ill. 60606, Fax: (312) 846-4638
global head of institutional
newly created LME desk in
Attn: Michael McFarlin
sales. Im excited about the
Hong Kong.
e-mail: [email protected]
opportunity to work with the
Jennifer B. McHugh was
talented team at MF Global
named acting director of
John Dempsey has formed the
Jon Bass
and help build out and broadthe Securities and Exchange
J. Dempsey Group Ltd and is its CEO.
en the firms already impressive global
Commissions (SEC) Division of
Bryan Harkins was promoted to
platform, he says. Bass was previously
Investment Management.
chief operating officer at Direct Edge.
global head of fixed income at BTIG
Troy Yeazel was appointed VP of
John Catizone joined BNP Paribas
where he established the firms first
operations, and Jeff Connell was
commodity derivatives group as manglobal fixed income platform. He is
appointed VP of markets oversight
aging director for institutional and
based in New York.
at BATS Global Markets.
investor sales in New York.
Former CBOT and MF Global CEO
Bernard Dan joined Sun Holding
LLC as president
Roger Rutherford was named managing director, global head of FX products at
CME Group. Edemir Pinto was appointed to the companys board of directors.
THE
Mark Whitehead was named global
head of equity finance at MF Global.
Marie A. Chandoha was appointed
president and CEO of Charles Schwab
Investment Management.
Jan. 30-Feb. 1, 2011
Mark Davison has joined Alpari
as global head of institutional sales.
The Breakers Hotel
Mushegh Tovmasyan was appointed
Palm Beach, FL
global head of sales at the company.
Stephen A. Brodsky was appointed
chief financial officer at Spot Trading.
MFAS INDUSTRY DEVELOPMENT AND NETWORKING CONFERENCE
Christopher Calhoun and Crevan
OGrady were appointed to GAIN
Capitals board of directors.
June 21-22, 2011
Joseph Giordano was appointed a
The Fairmont
TheMillenium
Fairmont Park
director in RBC Capital Markets U.S.
Chicago, ILMillennium Park
financial products sales group.
June 21 - 22, 2011
Chicago, IL
Lon Gorman was named to the
board of directors at Lightspeed
MFAs Managed Futures
MFAS MANAGED FUTURES & GLOBAL MACRO
& Global Macro Investment
Financial.
INVESTMENT STRATEGIES CONFERENCE
Strategies Conference
Audrey Faveeuw was appointed
business development manager at LSE.
Richard Schell was named head
Oct. 20-21, 2011
of compliance, Americas at Newedge.
John A. Short joined the company as
The Pierre Hotel
director of steel products.
New York, NY
Robert Gagnon joined BTIG as head
of futures sales and trading on its newly
MFAS HEDGE FUND LEADERSHIP CONFERENCE FOR MFA MEMBERS ONLY
launched global futures trading desk.
Suraj Raythatha and Allison Carley
www.managedfunds.org
also joined the company as part of the
new futures trading desk.
futuresmag.com

TrdPlaces_Jan11.indd 13

13

12/14/10 1:59:58 PM

Managed Money Review

Watch your tail

b y Dan ie l P. Co l l i n s

e are hearing a lot these days

about tail risk hedging. An
internet hedge fund wire
service earlier this year noted, Tailrisk hedging is the summer buzzword
among institutional investors.
The story highlighted a new tail-risk
fund that could lose a minimum of
between 1% and 1.5% per month (1218% per year) just from the cost of the
options strategy, but would offer protection in case of a fat-tail event. While
that is pretty expensive insurance, the
story notes the fund already has more
than $100 million under management
from institutional investors.
In our cover Q&A with PIMCOs
Mohamed El-Erian, the co-chief investment officer said that we have entered
a new normal environment, which

we aRe #1
$300

Managed Futures assets Under Management (in billions)

$250
$200
$150
$100
$50
$0
2000

2003

2004

will be highlighted by flatter distributions with fatter tails. He recommends that investors expand risk management to ensure that diversification
is supplemented with cost-affective
tail hedging.
Most of the strategies concentrate

October

YTD

+3.81%
-2.90%
+3.55%
-2.27%

+7.84%
+15.17%
+2.25%
-0.99%

October

YTD

october's top CTas

Barclay CTA Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . +2.28% . . . . .+4.91%
Barclay Sub-Indexes:
Agricultural Traders. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . +4.37% . . . .+11.67%
Currency Traders. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . +0.41% . . . . .+3.53%
Diversified Traders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . +3.36% . . . . .+5.99%
Financials and Metals Traders. . . . . . . . . . . . . . . . . . . . . . . . +0.66% . . . . .+3.68%
Discretionary Traders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . +1.68% . . . . .+3.75%
Systematic Traders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . +2.57% . . . . .+5.41%

More than $10 million under management

1. Global Ag.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26.39% . . . . .87.89%
2. Mulvaney Capital Mgmt. (GI. Markets). . . . . . . . . . . . . . . . 22.29% . . . . .13.75%
3. Tactical Invest. Mgmt. (Instl). . . . . . . . . . . . . . . . . . . . . . . 18.20% . . . . .39.80%
4. AIS Futures Mgmt. (3x-6x). . . . . . . . . . . . . . . . . . . . . . . . . 17.97% . . . . .19.58%
5. M6 Capital Mgmt. (Standard) . . . . . . . . . . . . . . . . . . . . . . 17.45% . . . . .26.79%

Less than $10 million under management

1. Purple Valley (Diversified) . . . . . . . . . . . . . . . . . . . . . . . . . 25.77% . . . . .19.11%
2. D2W Capital Mgmt. (Radical Wealth). . . . . . . . . . . . . . . . . 20.80% . . . . .95.49%
3. District Capital Mgmt. (Divers.) . . . . . . . . . . . . . . . . . . . . . 20.45% . . . . .14.68%
4.Red Rock Capital (Fund) . . . . . . . . . . . . . . . . . . . . . . . . . . 20.07% . . . . . .8.48%
5. Level III Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18.50% . . . . .71.44%
Based on estimates of the composite of all accounts under management;
does not reflect the performance of any single account.
Source: Barclay Trading Group Ltd., Fairfield, Iowa; (641) 472-3456

14

2002

2005

2006

2007

2008

2009

2010
yTD

Source: barclayHedge

Comparing index returns

S&P 500 Total Return Index
Barclays Capital L.T. Treasury Index
Morgan Stanley EAFE Index
Futures Public Funds (November)

2001

on specific option hedges that will be a

drag on returns in those periods without fat-tail events and seem to forget
about what has been one of the most
affective tail risk strategies; managed
futures. Managed futures tend to be
non-correlated to equities in benign

Futures public funds summary

reporting: 42
november 2010 Number
Average performance for the month: -2.27%
Funds up: 12

Down: 30

Unchanged: 0

Top performers in november

Fund
Trading advisor(s)
Nov Return
YTD
Marathon Plus Portfolio . . . . . . . . . . . . . . . . . . .Multiple Advisors . . . . . . . . . . . 2.70% . . . .-1.26%
Marathon Currency & Financials Portfolio . . . . . .Multiple Advisors . . . . . . . . . . . 2.59% . . . .-3.87%
Marathon System Diversified Portfolio. . . . . . . . .Multiple Advisors . . . . . . . . . . . 2.39% . . . +0.37%
Marathon System Financial Portfolio. . . . . . . . . .Multiple Advisors . . . . . . . . . . . 2.01% . . . .-8.19%
Warrington Fund. . . . . . . . . . . . . . . . . . . . . . . . .Warrington Asset Mgmt. . . . . . . 1.76% . . . .-9.74%

worst performers in november

Tidewater Futures Fund LP . . . . . . . . . . . . . . . . .Chesapeake Capital Corp . . . -11.59% . . .-23.22%
FTC Futures Fund Dynamic . . . . . . . . . . . . . . . . .FTC Asset Mgmt.. . . . . . . . . . . -7.77% . . . .-6.95%
FTC Futures Fund Classic EUR . . . . . . . . . . . . . . .FTC Asset Mgmt.; Pomeranz . . -6.41% . . . .-6.11%
Morgan Stanley SB Spectrum Strategic LP. . . . . .Multiple Advisors . . . . . . . . . . -6.04% . . . +0.10%
Morgan Stanley SB Charter Aspect . . . . . . . . . . .Multiple Advisors . . . . . . . . . . -5.13% . . . +4.70%

2010 results
(through november 30)

Number reporting: 42
Average performance for the year: -0.99%
Funds up: 17
Down: 25
Unchanged: 0

Top performers in 2010

Fund
Superfund Gold Series A-1 . . . . . . . . . . . . . . . . . .
Superfund Gold Series B-1 . . . . . . . . . . . . . . . . . .
Westport JWH Futures Fund LP . . . . . . . . . . . . . . .
Morgan Stanley SB Spectrum Global Balanced LP .
Superfund Green LP Series B. . . . . . . . . . . . . . . . .

Trading advisor(s)
Nov Return YTD
Superfund Capital Mgmt. . . . .0.41% . . 35.70%
Superfund Capital Mgmt. . . . .0.09% . . 34.80%
J.W. Henry . . . . . . . . . . . . . . -4.16% . . 13.09%
Multiple Advisors . . . . . . . . . -1.24% . . . 9.98%
Superfund Capital Mgmt. . . . -3.34% . . . 5.22%

worst performers in 2010

Tidewater Futures Fund LP . . . . . . . . . . . . .
Bristol Energy Fund LP . . . . . . . . . . . . . . . .
FTC Commodity Fund Alpha. . . . . . . . . . . . .
Diversified Multi-Advisor Futures Fund LP II .
Warrington Fund. . . . . . . . . . . . . . . . . . . . .

Chesapeake Capital Corp . . . . . . . -11.59% . .-23.22%

SandRidge Capital Mgmt . . . . . . . . . 0.59% . .-20.62%
FTC Asset Mgmt. . . . . . . . . . . . . . . . -4.12% . .-19.90%
Multiple Managers . . . . . . . . . . . . . -2.70% . .-11.89%
Warrington Asset Mgmt . . . . . . . . . . . 1.76% . . .-9.74%

Note: Listed return may not be fully attributable to listed advisor(s).

FUTURes January 2011

MMR_Jan11.indd 14

12/14/10 1:59:26 PM

market environments and negatively

correlated in bear markets.
Investors may not be forgetting this
as allocations to managed futures are
at an all-time high and, according to
BarclayHedge, have grown beyond any
individual hedge fund strategy (see
We are #1, left).
Much of the justification for the
use of tail risk hedging is 2008, a year
when not only traditional long equity strategies struggled, but also most
hedge fund strategies. It is the year
when the BarclayHedge CTA Index
returned 14.09%, its best performance
since 1990 and perhaps best ever given
the different interest rate environment.
In 2008, 318 CTA programs returned
more than 20%. That is a pretty good
tail risk hedge.

hedge Funds
Hedge Fund Returns
Barclay Hedge Fund Index
Barclay hedge fund sub indexes
Barclay Technology Index
Barclay Fixed Income Arb. Index
Barclay Convertible Arb. Index
Barclay Emerging Mkts. Index
Barclay Multi Strategy Index
Barclay Event Driven Index
Barclay Equity Long Bias Index
Barclay Merger Arbitrage Index
Barclay Global Macro Index
Barclay Equity Long/Short Index
Barclay European Equities Index
Barclay Fund of Funds Index
Barclay Equity Mkt. Neutral Index
Barclay Pacific Rim Equities Index
Barclay Equity Short Bias Index

October return
1.95%

12-month return
10.57%

YTD return
7.14%

2.68%
0.95%
2.13%
2.22%
1.82%
1.73%
3.09%
0.23%
1.20%
1.68%
1.86%
1.47%
0.86%
0.82%
-0.95%

17.20%
14.01%
14.36%
14.29%
10.72%
10.96%
12.21%
6.87%
6.49%
5.66%
4.26%
4.45%
1.79%
3.16%
-13.70%

10.86%
10.67%
10.57%
9.75%
7.98%
7.07%
7.04%
5.32%
5.04%
3.37%
3.09%
2.81%
2.17%
1.83%
-7.28%

Source: Barclay Hedge

Buy The Rumor,

Sell The Fact
is a basic tenet in trading the futures and
options markets. Old timers have used the slogan
for years, and now FuTureS magazine has made it
a blog where you can go to get inside the industry.
Get the inside scoop, commentary and
sometimes irreverent view on events of the day
at BuyTheRumorsellTheFact.com, the blog of the
FuTureS editorial team. Check daily for updates,
as with the markets, you never know when
the rumor or fact will happen.

BuyTheRumorsellTheFact.com

The 24/7 ResoURCe FoR Todays TRadeRs

futuresmag.com

MMR_Jan11.indd 15

15

12/14/10 1:59:34 PM

OPTIONS STraTegy

Question: How can you avoid losing your shorts

when dramatic upward spikes occur amid bear markets?
Answer: A bear-biased put ratio condor
By E dWa R d L a P o R T E

ast month we wrote about ratio condors (unbalanced

condor) and how they can allow you to maintain a bullish position while protecting yourself against a dramatic
downward spike. It can work in the reverse, which may be more
valuable as bear markets often include dramatic upward spikes.
The ferociousness of a bear market rally is legendary. Many
investors believe we are currently in the claws of a grizzly market;
however, because of the often sharp and swift reversals associated with bear markets, even the best bear tracking trend traders
will find it grueling to maintain a short stock position.
The crash during the Great Depression still holds the title for
the most notorious bear market of all time, but surprisingly,
it had just as many advances as declines (see Being right is
not enough). And the recent 2008 bear market perhaps was
scarier for bears. On four separate occasions during the fourth
quarter of 2008 the Dow Jones Industrial Average had a 1,000plus point upward reversal within two days. The temporary
rebounds often were more swift and severe than the declines.
Many traders floundered as they watched their profits temporarily evaporate, particularly in the pre-listed options era.
Prior to listed option trading, there would have been many terrifying moments in a bears life, even though the Dow eventually
lost 89.2% of its value (381.17 High 41.22 Low). Fortunately,
we now are sophisticated enough to play chess (options) instead
of checkers (stocks). We now can set up a bearish position without the worry of loss should the markets move unexpectedly.
Many analysts believe the second shoe is still to drop in the
financial crisis of 2008 and that equity markets are due a more

BeINg rIghT IS NOT eNOugh

With todays leverage who could have maintained a short position?
Dow Jones Industrial average (October 1928 October 1932)
400
350

7 drops & 7 Bounces

+52%

300
+19%

250
+28%

-49%

-30%

200

+31%
-38%
-39%

+39%
+29%
-45%

150
+94% 100
50

-41%
-55%

29 Apr Jul

Oct 30 Apr Jul

Oct 31 Apr Jul

Oct 32 Apr Jul

Oct

Source: yahoo finance

16

serious downward leg. If you are not one of them, you can certainly remember the two market crashes of the last decade and
put yourself in the shoes of a confident bear.
Instead of putting a lot of capital at risk with a long straddle,
we will elect to sell an in-the-money (ITM) put spread to subsidize
the purchase of twice as many at-the-money (ATM) put spreads.
We notice that the DJX 114112 put spread (roughly 11,400
11,200) is trading at $1.20 ($3.02 - $1.82). By selling this spread,
we can purchase twice as many of the 111109 put spreads, which
are trading for $0.57 ($1.43 - $0.86) per share. The math looks as
follows and yields a net $60 credit if we do 10 contracts:
Pieces
Buy /
Strike Put Option
Dollars
Total
of Trade
Sell Quant. Price Option Mark per Option
Dollars
Short
Sell
-10 114
Put $3.02
$302.00 $3,020.00
Spread
Buy
10 112
Put $1.82
-$182.00 -$1,820.00
Long
Buy
20 111
Put $1.43
-$143.00 -$2,860.00
Spread X 2 Sell
-20 109
Put $0.86
$86.00 $1,720.00
Net Spread Credit =
$60.00

Depending on your broker, this even may be enough to cover

your commissions on this unbalanced condor sale.
Now, with 21 days remaining until expiration, we sit and wait,
and we even can sleep soundly. We no longer have nightmares
because we are safe no matter which way the market moves.
If the market moves lower by 200 Dow points (roughly $2 in
the DJX), we make our maximum amount of $2,000.
What if we are chasing a bear into the woods and run into
an injured bull? We still are safe. If the market runs higher by
roughly 300 Dow points (like the day we wrote this), then both
put spreads will expire worthless and we will keep our $60 credit
(minus commissions).
If you have a fair amount of time until expiration and a bearish opinion, you still can place a trade without having to worry
about stepping on a bear trap. With a statistically calculated
estimated range based on 23% implied volatility of $6.43 (or
643 Dow points), you can feel comfortable that your position
will not hurt you unless the market fails to move between now
and expiration. If you had purchased a straddle for a debit (by
buying the ATM call and the ATM put), you would have been
hurt more because it was trading for $3.19 (or $3,190 for 10 contracts). Obviously the unbalanced condor sale is a far superior
strategy for those wanting to sleep soundly at night without
worrying about time decay and volatility collapse.
Edward LaPorte is an advisor to Random Walk, which designs
options education material at RandomWalkTrading.com.

FUTURES January 2011

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FTS_FP_Ads.indd 18

10/13/10 4:40:18 PM

FOREX TRADER

Unsustainable patterns for 2011

b y A b e Co fn A s

s we start 2011, the question arises for many traders as

to which currency pairs offer the best opportunities?
By stepping outside of the usual day-to-day, and even
monthly scanning of the markets, we can detect patterns that
are not that obvious. Consequently, we can shape some interesting strategies for the coming year. Currency pairs certainly
react daily and weekly to changes in sentiment caused by new
economic related information and new fears, but when looking
at multiple quarters and multi-year periods, price action starts
reflecting major global forces that dont change too quickly.
From a multi-year perspective, classic resistance, support
and trend lines become robust landmarks. When price breaks
through them, it should get serious attention because they
are at the vanguard of a possible new direction. It is useful
to look at cross pairs because they leave the dollar out of the
picture, and often provide more stable price geometry. When
cross pair patterns break, the break is a more reliable predictor
of future direction.
The EUR./AUD merits attention for this reason. A 10-year
sideways range was broken in 2008, leading to a more than
35-handle move to historic highs. This was followed by a
return back into the range, and then a breakdown in 2010
leading to a drop of about 77 handles from peak to trough,
making an all-time low (see What now?). The fundamentals
of economic growth in Australia and turmoil in the Eurozone
certainly helped shape the pattern of the last two years, leading to the extreme lows of today. These conditions are not
likely to be sustained if a slowdown in the Aussie economy,
combined with some stability in Europe, occurs. The result is
the potential for a significant recovery for the EUR/AUD.
The CHF/JPY crosspair offers a classic example of the value
of looking at patterns. Looking back 10 years shows a remarkable sustained monthly downtrend from Q4 2003 until Q4
2008. Once the trend line was broken, a five-quarter uptrend
occurred that was followed by nearly two years of indecision.
At this point we have an equilateral triangle forming. When
a triangle forms, it reflects a compression of sentiment where
both bulls and bears are struggling to dominate, with neither
side winning. The ranges between the highs and lows become
narrower and narrower, leading to a breakout. Both the Swiss
franc and the yen have experienced excessive appreciation. The
Swiss franc has had general strength against the euro, and the
yen has had strength against the dollar. This has resulted in
the current stand-off with each other. It wont last. Therefore,
in 2011 there is a high probability of a CHF/JPY breakout in
either direction (see Something has gotta give).
Two major trading strategies can be considered. The first
is anticipating a break in the
for more cross pairs and
current patterns. Anticipating
significant moves, go to
the EUR/AUD bottoming
futuresmag.com/forex
and reversing would require a
18

WhAT nOW?
After two extreme moves, look for the eUR/AUD to move
back to a range.
2.15
2.10
2.05
2.00
1.95
1.90
1.85
1.80
1.75
1.70
1.65
1.60
1.55
1.50
1.45
1.40
1.35

EUR/AUD spot (monthly)

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Source: eSignal

SOmEThing hAS gOTTA givE

since breaking the long-term uptrend and then making a
multi-year low in 2008, the trading range in the swiss/yen
has continually narrowed.
106.00
104.00
102.00
100.00
98.00
96.00
94.00
92.00
90.00
88.00
86.00
84.00
82.00
80.00
78.00
76.00
74.00

ChF/JPY spot (monthly)

2006

2007

2008

2009

2010
Source: eSignal

small position that you add to as price confirms a reversal. Your

target is a return to the long-term range from most of the decade.
Trading a potential breakout of the CHF/JPY triangle is
more difficult because the trader would have to pick a direction. This leads to the second strategy of trading on the
confirmation of the break. Better to enter on a stop above
or below the breakout range. As the triangle narrows, this
becomes a nice lower risk trade as your stop is at the other
breakout line. In the CHF/JPY the trade would occur when
the monthly price closes outside of the pattern. Both trades
can require multiple months to set up, so patience is a must.
Abe Cofnas is the author of Sentiment Indicators (Bloomberg Press). He can be
reached at [email protected].

fUTURes January 2011

FrxTrd_Jan11.indd 18

12/13/10 4:56:09 PM

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FTS_FP_Ads.indd 1

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hot CoMModities

b y Dan iE l P. Co l l i n S

Cold hard gas

Is it a bull?

For an old energy source, natural Nat. Gas (Feb. '11) daily
$ per mmbtu
5.90
gas is the new darling of the green
5.80
5.70
energy movement, but that hasnt
5.60
5.50
helped its price much.
5.40
5.30
While gas has gotten up off of
5.20
5.10
5.00
last years f loor just over $2, that
4.90
4.80
is more a seasonal reality as inven4.70
4.60
tories remain at record highs. The
4.50
4.40
Februar y 2011 contract is only
4.30
4.20
4.10
about 50 above its contract lows
4.00
3.90
and that is thanks to an early
3.80
Jul
Aug
Sep
Oct
Nov
Dec
December cold snap. Experts say
Source: eSignal
it will take a lot more cold weather
to garner much more of a move. Dominick Chirichella, founder of the Energy
Management Institute, says, Unless the weather stays below normal for an
extended period of time, [natural gas] will be range bound.
He pegs the range for the February contract between $4-$4.70. The fact
remains we have a lot of gas in inventory, he says.
PFGBest Senior Energy Analyst Phil Flynn says the recent massive shale gas discoveries are causing a revision of how natural gas acts in winter. Now we have enough
supply, just look at the rig counts, Flynn says, referring to the amount of active drilling rigs. He expects greater demand for natural gas as it takes its place as an alternative transportation fuel, but doesnt expect that to have an effect anytime soon.
For now, Flynn says gas is a weather play and if it doesnt get and stay cold this
winter, gas can dip back below $4.

Jeff Greenblatt, director of Lucas

Wave International, says he is a little weary of looking for bearish time
windows in the S&P 500. Greenblatt
saw many come and go in the fourth
quarter and the index weathered
them all, making a multi-year high
in December. His conclusion is there
is more strength than many technicians thought.
A l a n Bu s h , A rc her Fi n a nc i a l
Ser vices senior f inancial futures
analyst, is not so conf licted. Bush
is bullish on the S&P now and into
2011. He attributes the strength to
the numerous stimuli by the Federal
e-MiNi s&P 500 (CoNtiNuous) daily
122500
120000
117500
115000
112500
110000
107500
105000
102500

Standing in high cotton

If you noticed more polyester prod- CottoN (MarCh '11) daily
$ per lb.
1.550
ucts in your stocking this year dont
1.500
1.450
blame Santa Claus. It is just that
1.400
1.350
the synthetics are about a quarter
1.300
of the cost of cotton after this falls
1.250
1.200
historic upward spike. But dont
1.150
1.100
fret because, as they say, the cure
1.050
1.000
for high prices is high prices.
0.950
0.900
And there could be a massive
0.850
0.800
cure already under way in cot0.750
0.700
ton. Commodities analyst Shawn
Hackett says we could be near or Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Source: eSignal
in the midst of an historic shorting opportunity. Hackett says that in past generational moves in the fiber, which
this falls rally certainly was, cotton typically corrects sharply as it did in midNovember and then attempts to test the high before a precipitous fall. We
spoke with Hackett on Dec. 10 after cotton settled well off its high. Hackett could
not say for sure that a high had been reached, but wasnt taking any chances as it
already had retraced about 65% of its correction.
Cotton made its historic highs after two tough years that included crop
failures in India and Pakistan, and fear of shortages leading to restrictions on
exports from those nations.
Hackett expects cotton to drop 50% from its high, potentially taking it below
80 by the end of the first quarter. He says if the sell-off is already under way, the
November low of $1.11 should provide a speed bump for shorts late to the party.
20

100000
Mar Apr

May Jun

Jul

Aug Sep Oct Nov Dec

Source: eSignal

Reserve and says it is paying off in

some areas, though not enough to
push the Fed to begin tightening in
2011. I dont think we needed QE2,
but it is going to make the recovery stronger, Bush says. He expects
the S&Ps to reach 1260 in January.
He sees support at 1216 but doesnt
expect it to be tested, adding even
if that were taken out, it would not
alter his bullish perspective.
Greenblatt is expecting choppy markets for the next several months and
any major move to be to the upside.
We escaped the gr im reaper in
September and October, Greenblatt
says, referring to the seasonally bearish months that coincided with significant turning points. This market
tried to go down and it wouldnt, he
says. Greenblatt adds, however, that
it may only be a temporary reprieve as
he sees a large move, probably down,
in July or August 2011.

FUTURES January
December
2011
2010

HotCom_Jan11.indd 20

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Market WatcH

Is the Fed playing with fire?

b y S t e v en K. B e c Kn e r

ow that the Federal Reserve has embarked on a new

round of quantitative easing (QE2), what can we
expect? The Fed plans to buy $600 billion of longerterm Treasury securities or $75 billion per month by the end
of the second quarter ($110 billion monthly including reinvestment of maturing mortgage backed securities) with an
average maturity of five to six years.
But all this is subject to change. The policymaking Federal
Open Market Committee (FOMC) said Nov. 3 it will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming
information and will adjust the program as needed to best
foster maximum employment and price stability.
St. Louis Fed President James Bullard told me the FOMC
has the flexibility to adjust how much bond buying it does,
in either direction.
Hopefully, the economy will do well enough that we dont
have to do any more, one policymaker confided.
But Chicago Fed President Charles Evans, one of this
years FOMC voters, suggests more may be needed. Fed
Vice Chairman Janet Yellen sees inflation lingering around
current levels for a long time and projects unemployment
remaining near 8% at the end of 2012.
For now QE2 is limited to Treasuries, but New York Fed
President William Dudley has suggested the Fed could resume
mortgage backed securities (MBS) purchases something others would balk at. Although buying is focused on the five- to
six-year maturity range, the Fed could decide to move further
out the curve. The Fed will probably carry through with the
full $600 billion, unless there is an upside surprise. The more
likely dilemma will be whether to go beyond QE2.
Going for a QE3 would involve the same weighing of costs and
benefits the FOMC went through last Fall. It judged the benefits
of creating more reserves to cut long-term interest rates and, incidentally, affect the dollar exchange rate, which outweighed the risk
of accelerating inflation, dollar depreciation and asset bubbles.
There would be opposition to more QE, but Chairman Ben
Bernanke wouldnt have much trouble rallying support if
unemployment were to remain high and/or inflation undesirably low as the end of QE2 approaches.
It wont be as easy for the FOMC to expand QE if joblessness stays high, but inflation and inflation expectations
move up. If inflation returns to the Feds implicit target
range of 1.6-2.0% or even exceeds it, some FOMC members
may feel no need to go beyond the scheduled $600 billion. If
inflation really picks up, the FOMC even could curtail QE2.
If GDP growth unexpectedly accelerates, that could limit
asset purchases. If it falls short, the FOMC could decide more
is needed. Unemployment may be the biggest determinant.
Bernanke stresses the incredible importance of reducing it.
Another factor will be the extent to which bank lending

picks up and converts vast excess reserves

into faster money supply growth. The worst case
scenario would be if inflation and inflation expectations
flare, but unemployment stays high. The Fed might be willing
to tolerate above-target inflation for a while, but not indefinitely, especially if it gets built into bond yields.
Eventually, the Fed must exit its ultra-easy policy. By
resuming QE it has made that task more difficult. Officials
have assured us that they have the tools to execute an effective exit strategy. They could:
drain reserves through reverse repurchase agreements and
could roll over those reverse repos indefinitely.
convert
reserves into term deposits at the Fed, which could not

be used as clearing balances or to meet reserve requirements.

hike interest on excess reserves (IOER) to encourage banks
to hold them rather than boost lending. That would entail
commensurate rises in the Federal Funds Rate. By raising
the IOER the Fed can theoretically exit from a zero funds
rate without first shrinking its balance sheet.
let maturing securities run off and not replace them.
actively shrink the balance sheet through asset sales.
As with conventional rate cuts, QE2s impact will be subject to
six- to nine-month lags. And there will be other forces impinging
on the economy, making it hard for the Fed to know whether it
has done enough and when it should start tightening.
Given the forecasting challenges, the Fed could find itself on
a slippery slope. What if the end of the $600 billion nears and
GDP, jobs and inflation are still at odds with dual mandate
goals? Will the FOMC up the ante and announce QE3? Then
QE4, making the balance sheet and the exit task ever larger? The
FOMC always has faced such judgment calls, but QE is different.
Fed Governor Kevin Warsh warns, As the Feds balance
sheet expands, it becomes more of a price maker than a price
taker in the Treasury market. And if market participants
come to doubt these prices or their reliance on these prices
proves fleeting risk premiums across asset classes and
geographies could move unexpectedly...
Even when it was running policy conventionally, the Fed
didnt have a great record for shifting to a tighter policy in a
timely way. The tendency has been to overstay accommodation.
The exit is far off. Because it cant cut the funds rate further,
it cant have a traditional easing bias. But it does have a quantitative easing bias thats likely to be in place quite awhile.
If the Fed gets what it wants, more inflation, it may need to
raise rates quickly, even while maintaining a bloated balance
sheet. The Fed just would have to hope it could use the IOER
to set a floor under the funds rate and move rates up.
The ultimate questions are ones of will and judgment.
Steve Beckner is senior correspondent for Market News International, a regular on
National Public Radio and author of Back From The Brink: The Greenspan Years (Wiley).
futuresmag.com

MrktWtch_Jan11.indd 21

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Bond market

Q&a

El-Erian, managing
the new normal
investment landscape
I n t er v I e w ed By da n I e l P. C o l l I n S

ohamed El-Erian, CEO and co-chief investment officer of PIMCO, is

one of the most knowledgeable people you can find on global financial
issues. Prior to joining Bill Gross as co-CIO at PIMCO, El-Erian managed the Harvard University endowment fund, was a managing director at Salomon
Smith Barney/Citigroup and spent 15 years at the International Monetary Fund.
He is in his second stint at PIMCO, formerly serving as a senior member of
PIMCOs portfolio management and investment strategy group before taking the
reins of the Harvard endowment. His 2008 book, When Markets Collide, addresses global capital shifts before the dramatic events of that year confirmed them.
We spoke with El-Erian regarding PIMCOs outlook for bonds and attempts to
navigate the new normal global financial landscape.

FM: What are the implications for industrial economies of this migration and
what do you think should happen?
Me: Industrial economies must adjust
22

to this migration, and do so in a manner

that is consistent with high global growth
and an appropriate domestic retooling. In
most cases, this involves a mix of structural measures aimed at strengthening international competitiveness, compensating
for past resource misallocations (such as
underinvestment in infrastructure and
education), strengthening social safety
nets and placing budgets and deficits back
on more sustainable paths.

FM: In analyzing the U.S. and other

Western nations response to the financial
crisis, you talk about winning the war and
losing the peace. explain, and tell us what
needs to be done to win the peace.
Me: A bold and coordinated global
response succeeded in avoiding a worldwide depression in 2009 that would have
devastated output, demand, investments
and employment around the world.
Policymakers thus won the war. However,

PhotoS by Jonah Light

Futures MAGAZINe: Sprinkled throughout various speeches and commentaries

by you and PImCo founder Bill Gross is the
term the new normal. explain what that
means and the implications of it on the
investing landscape.
MohAMed el-erIAN: The new normal is a world in which industrial countries face sluggish growth, persistently
high unemployment, private sector deleveraging and sovereign debt issues. It
is also a multispeed world that sees an
acceleration of the migration of wealth
and growth dynamics from industrial to
emerging economies. And remember, the
new normal speaks to what is likely to
happen given current conditions, rather
than what should happen.

FUtUreS January 2011

CoverStory_Jan11.indd 22

12/14/10 11:18:29 AM

In this age of corporate and

sovereign solvency risk, we
correspond with Mohamed
el-erian, co-chief investment
officer of PIMCo, the worlds
largest bond trader, with more
than $1 trillion in assets
under management.

futuresmag.com

CoverStory_Jan11.indd 23

23

12/14/10 11:18:35 AM

Q & a continued

the peace is yet to be secured. As a result, the global growth outlook still is fragile; unemployment remains stubbornly high,
investors are waiting on the sidelines, the risk of protectionism
is increasing, sovereign debt crises are periodically erupting
and global policy coordination has given way to fragmentation, frictions and even talk of currency wars.
FM: one thing PImCo noted after its 2009 forum and reiterated
in its 2010 forum was that the United States will de-lever. How
much of this has occurred and how much is yet to come?
Me: The best way to think about this is in terms of both stocks
and flows. Certain sectors, such as large companies, have completed the de-leveraging and are building robust balance sheets
as they are also cash flow positive. Others, including consumers, are cash flow positive, but still need to de-lever. And then
you have the government, which is cash flow negative and adding to a debt stock that has already risen significantly because
of the 2008-09 global financial crisis.
FM: So businesses and individuals are de-leveraging and government is taking on more leverage. Is this sustainable?
Me: Governments had no choice in 2008 and 2009 but to step
in with their balance sheets to compensate for what was a disorderly private sector unwind. The alternative would have been
a global depression. It is critical that this exceptional use of the
sovereign balance sheet, including that of the central bank, be
a bridge to the resumption of high sustained growth led by
the private sector. Otherwise, what was a private sector balance
sheet problem will become a sovereign balance sheet problem.

FM: You said Qe2 is likely to backfire. Why?

Me: There are both domestic and global dimensions. By buying
securities, QE2 seeks to push investors and consumers out the
risk curve. History suggests that when people are being pushed to
do something they would not do on their own, they either resist
or end up making unsustainable decisions.
Globally, QE2 is flooding emerging economies with liquidity
at a time when many of these economies are already very close to
overheating. And then there are the unintended consequences.
The involvement of the Fed as a non-commercial player in markets that are functioning normally can cause distortions.

FM: the Fed has become significantly involved in markets

since the end of 2007, from creating special auction facilities
and opening up the discount window to investment banks and
brokerages to Qe 1 and 2. do they need to be less involved?
Me: Yes, definitely. Like fiscal stimulus, this aggressive use of
the Feds balance sheet is a bridge and not a destination. And
the longer the Fed stays in this unusual mode of unconventional policy activism and experimentation, the greater the
risks to its institutional integrity, to the proper functioning
of markets and to efficient price signaling that is so key for
proper resource allocation.

FM: most critics of Qe2 feared a larger devaluation of the

U.S. dollar. the dollar is much higher since the november
Qe2 announcement. Why? What is going on?
Me: A couple of things. First, starting with Chairman
Bernankes Jackson Hole speech at the end of August, the
markets positioned for QE2 over many weeks and ended up
overdoing it. Second, we should never forget that the dollars
exchange rate is a relative price. As such, it is impacted by the
crisis in Europes periphery which has weakened the euro.
FM: Has the nearly 20-year bull market in U.S. treasuries
ended? What is your outlook for treasuries?
Me: Given how far yields have come down during the last 20
years, there is no longer the same room for U.S. Treasuries to
rally. Where we go from here is mainly an economic call. On the
one hand, a rebound in growth would translate into a backup
in yields. On the other hand, a weak growth outlook would
see yields go lower.

FM: What is your outlook for the yield curve for 2011?
Me: Range bound with a tendency to flatten. The front end
will be anchored by the Fed pinning policy rates essentially at
zero. The long end will be a tug of war between the impact of
sluggish growth, concerns about medium-term inflation and
the erosion of the global standing of the United States.
FM: Fixed income investing in general, and U.S. treasuries in
particular, have been seen as a safe haven. Is that still true?
Me: U.S. Treasuries play an important role in any portfolio,
and especially so given the fluidity of the global and national
outlooks. Their overall effectiveness over time is a function of
the U.S. credit standing and the robustness of its role as the
24

FUtUreS January 2011

CoverStory_Jan11.indd 24

12/14/10 11:18:36 AM

Go to futuresmag.com/El-Erian for the

unabridged version of this interview.

largest provider of global public goods, including the dollar

as a reserve currency.
In most instances, nominal Treasury bonds will continue to
provide investors with some offset against the harmful impact
of deflation on equities and other risk assets. TIPS (Treasury
Inflation-Protected Securities) will continue to assist in positioning for the possibility of unanticipated future inflation.
And, ladders of shorter term Treasuries will continue to form
the basis of many [investors] liquidity management.

FM: one of the implications of the new normal cited by you

and mr. Gross is that the assumption of 8% growth in pension
plans is unrealistic. many pension plans are underfunded as
is, let alone in a world of significantly lower growth. How big
of a problem is this? What is the solution?
Me: This is part of a general phenomenon that we expect will
attract greater attention in the years ahead. There are several
sectors such as pensions and insurance companies that will
be challenged because of historic promises that are no longer
consistent with the realities of lower return expectations and
historically low interest rates.

FM: Is it likely that many of them will not be able to meet

their obligations? What will be the fallout of this?
Me: Those that are both underfunded and experiencing negative cash flow will require timely capital injections if they are to
meet their promises. If they fail to secure these injections, the
situation would constitute yet another headwind to consumer confidence, demand and the ability to sustainably reduce
unemployment.
FM: one of the guiding principles of PImCo is taking a longterm approach to investing. How much of the financial crisis
can be attributed to a lack of long-term perspective, be it in
business, politics or investing?
Me: The run-up to the crisis and its aftermath are best seen
in terms of balance sheets. They are part of a secular process
characterized, first, by a great age of leverage, debt and creditentitlements and, now, by a multi-year adjustment process.
Unfortunately, both the political and financial systems are
not sufficiently hard wired to take longer-term views, and they
find it difficult to sustain focus on balance sheet and structural issues.
FM: Can a sustainable recovery be achieved without government and industry gaining this focus?
Me: No. Especially in this evolving global economy, it is
critical that tactical thinking be urgently supplemented by
strategic positioning and a greater ability to undertake timely
midcourse corrections.

FM: on the eve of the Irish bailout you stated that if the eU
didnt act promptly there was risk of contagion. Where does
that risk stand now? What is the chance that the eU will let
some sovereign debt fail? How do you see the situation with
the peripheral european nations (PIIGS) playing out?

Me: European officials have repeatedly failed to get ahead of the

crisis. They are viewed as being too reactive and not sufficiently
proactive. And they are too focused on liquidity solutions for
solvency challenges. As such, further contagion is a risk.
At some stage, Europe will have to deal more directly with
two issues: The debt overhang in peripheral economies and
their inability to grow robustly. Unfortunately, there are no
easy and risk-free approaches to dealing with these two difficult challenges.

FM: Is it possible that the eU will allow a failure on the sovereign debt of one of its members?
Me: That is indeed a key question. And by kicking the can
down the road through a series of liquidity rescue operations,
Europe is telling us that they are not ready to do so at this stage.
Yet, if the problems of the peripherals persist and expand, debt
restructurings for some countries will go from being an option
that can be undertaken in a relatively orderly fashion to one
that is imposed on them in a potentially disorderly fashion.

FM: What is the most prudent investment approach given

your outlook for flatter distributions with fatter tails?
Me: First, be aware of both what you know and what you do
not know. Second, ensure that the major investment theses
are robust in view of a bigger range of potential outcomes.
Third, scale investment positioning consistent with a bumpy
journey to a new normal. Fourth, expand risk management to
ensure that diversification is supplemented with cost-effective
tail hedging.
futuresmag.com

CoverStory_Jan11.indd 25

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12/14/10 11:18:38 AM

TreAsuries

MarKeTS

Bonds reflect world

of default and deflation
By M i c h a e l M c Fa r l i n

Last year, world economies faced fears of national default and slower
than hoped for growth. As 2011 begins, programs are in place on either
side of the Atlantic to try and combat both of these problems.

year ago we wrote, The global credit crisis kept interest rates near zero
in 2009, and the Federal Reserve is
determined to keep rates extremely low for
the foreseeable future, (see Interest rate
policy: Under pressure, January 2010).
That lead worked to describe the financial
situation of the country then, and it largely
still works today.
While the early months of 2010 were
painted with a rosy picture of an economy that was beginning to recover, that
picture was suddenly marred as the Feds
initial round of quantitative easing came
to an end and sovereign debt problems
arose in Europe. The world was reminded
that there was much work to be done to
unwind the mess that led to the credit
Quantitative easing
Sovereign debt
employment

crisis of 2008. Further, around the same

time the recession officially was declared
over since summer 2009, rumors began
that the Fed was leaning toward another
round of quantitative easing (QE2).
Jim Barrett, senior market strategist at
Lind Waldock, summarized 2010 nicely.
Bonds were in a little bit of a pickle in
the beginning of the year and around
26

April bottomed out around 114. [By] midApril, [Treasury] notes and bonds started
turning up, he says. The European
problems we are seeing now popped up
and the flash crash really started making
bonds look good. All summer we cruised
up as the [talk of a] double-dip [recession]
started becoming a banner event. The
double-dip fears were enough to influence
Bernanke and crew, he says.
Many of these stories that shook, and
in some places bolstered, global economies will continue to send reverberations
in 2011. Of those factors that will continue to move markets, fears of default
and deflation top the list.
Questions about the solvency of some
European nations still remain and will
likely continue to play a role in 2011. In
2010 we saw two of the five PIIGS countries (Portugal, Ireland, Italy, Greece and
Spain) face major problems with riots
resulting in Greece, and Ireland accepting
an 85 billion bailout package.
Even with bailouts, Greece and Ireland
still are being closely watched. Ireland
really didnt want to take the IMF
[International Monetary Fund ] money
and it really is just a Band-Aid on a bigger
wound, says Rob Kurzatkowski, senior
commodity analyst at optionsXpress.
They are paying upwards of 6% on their

current debt and it is unlikely their economy will grow at that pace. So, they will
have to keep issuing more debt to finance
the debt they already have.
This has left many speculating about
what we can see next year from the PIIGS.
I can see a few more countries like
Portugal and Spain having trouble, and
I can see the European Union (EU) propping them up. U.S. bonds would be the
safe haven bid as that happens, says Jack
Broz, founder of TradeBondFutures.com.
Germany and Britain are too strong for
the whole thing to crumble.
European turmoil was positive for U.S.
bond prices (see Quick turnaround,
right). The five-year Treasury note had
dipped below the years opening price
of 114 when news of problems in Greece
started to surface. As those problems escalated, U.S. Treasuries soaked up the risk
and started a sharp rally until the Feds
official QE2 announcement.
Overseas economies turned to U.S.
bonds in 2010, and some analysts expect
the trend to continue into 2011, noting
the fourth quarter pullback could have
been worse if not for the European problems. There are concerns that Portugal
and Spain will be the next to reach out
for aid. Also, Italy is racking up considerable debt. That is making the U.S. bonds

FUTUreS January 2011

Markets_Jan11.indd 26

12/14/10 11:09:39 AM

stronger by default, Kurzatkowski says.

We probably would see more of a pullback, especially in the 30-year bond, if it
wasnt for concerns that Europe may have
stretched itself a little too thin.
Even questions of whether the EU
will let sovereign debts fail are being
discussed. Perhaps it may not be so bad
for the EU to allow a member to go into
bankruptcy. We saw this in the United
States with GMs bankruptcy, and that
actually gave the company a fresh start.
Should that happen, though, serious
risk to the system could occur. If things
were to rapidly deteriorate over there,
there could be a lot of risk bid. In the
past, when there were the major overseas
events, we werent sitting at 2% [yields in
the]10-year note, says Kurt Kinker, chief
market analyst at Mirus Futures.
Even at current yields (see Riding the
curve, right), we could see further tightening because of European default fears.
Were going to see yields shrink. If the
European crisis spills over into the equities and we see a large correction in equity
prices, we may see long bonds rise a smaller degree than the five- and 10-year notes.
They may put some pressure on yields as
they shrink, Kurzatkowski says.
He also says Eurodollars will gauge
many of the shorter-term notes.
Although the recent strength of the dollar has been very supportive of Eurodollar
futures, Kurzatkowski cautions, Watch
currencies. The corporate bond market
could have an impact. If there is some
general panic or concern about the economy, then we may see Eurodollars fall back
in relation to notes. If things stabilize,
Eurodollars will probably hold up fairly
well because they are dollar based.
For Eurodollar levels, he pegs resistance
at 9975, saying the Fed would basically
have to go negative on interest rates to
cross that level. Support is found around
9950, and if that is broken then at 9925.
Home front
Fear of persistent low growth, even deflation, in the United States contributed to
the Fed launching another round of quantitative easing (QE2) in November, which
will be executed through the purchase of
$600 billion in Treasuries throughout 2011.
Low growth and high unemployment will

Quick TurnAround
While U.S. five-year Treasuries began the year in a pullback, european fears reversed
the trend after prices dropped below the years opening price.
122-21

5-year note Futures continuous (daily)

121-28
121-03
120-10
119-17
118-24
117-31
117-06
116-13
115-20
114-27
114-02
Dec

2010 Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec
Source: eSignal

riding The curve

The yield curve on Dec. 6. Yields continue to be historically low and the Fed is trying
to keep them there.
5.0

4.31

4.5
4.0
3.5

3.01

3.0
2.5

1.61

2.0
1.5
1.0

0.47
0.13

0.19

0.5
0

3 month

6 month

2 year

5 year

10 year

30 year
Source: yieldCurve.com

likely persist in 2011, and if not improved

on could lead to further Fed actions (see Is
the Fed playing with fire?, page 20).
Fed Chairman Ben Bernanke has made
it clear that unemployment and low
growth drove the decision.
Unemployment has been a major concern throughout the recession. The latest
official numbers, released on Dec. 3, put
unemployment at 9.8%. Other figures,
like those compiled at ShadowStats.com,
which includes discouraged workers and
part-time workers looking for full-time
positions, peg that figure even higher (see
Not adding up, page 28).
Bernanke said in a 60 Minutes

interview that it will take four to five

years before unemployment goes back
to pre-recession levels. He says we have
regained about 1 million of the 8.5 million jobs lost.
Bernanke has told lawmakers QE2
could create more than 700,000 new
jobs over the next two years. By buying
Treasuries, the Fed is hoping to make
loans cheaper and thus get Americans to
spend more, leading to job growth.
Another reason for QE2 was inflation.
In August 2010, when rumors of a second
round of easing were beginning, debate
arose as to whether inflation or deflation
would be worse for the economy.
futuresmag.com

Markets_Jan11.indd 27

27

12/14/10 11:09:40 AM

MarKeTS continued

noT Adding up
Stubborn unemployment figures pushed the Fed to Qe2. and the rolls of discouraged
and part time workers have grown faster than the core number.
unemployment rate official (u3 & u6) vs sgs Alternate
Monthly SA. through Nov. 2010 (SGS, BLS)
25%

official (U3)

Broadest (U6)

SGS alternate
20%

15%

10%

5%

0%
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Source: ShadowStats.com

Inflation comes into play because the

Fed is saying they want inflation. They
are so concerned about deflation that
they are willing to take on inflation,
Kurzatkowski says.
This is ironic in that part of the Feds
dual mandate is to fight inflation.
Bernanke said in the 60 Minutes piece
that the fear of inflation is overstated.
He added that while the Fed wants to
encourage inflation, it will not allow it

to rise over 2%, saying it can raise interest

rates in 15 minutes if it has to.
Critics say that it is not so easy to stop
that inflation train once it gets rolling,
and there have been a lot of inflationinducing policies easy money, devalued
dollar and deficit spending, to name a
few enacted over the last few years.
Analysts advise watching economic data
for indicators that the Feds program is
working. You want to be looking at this

economically. Is the economy picking up

steam? Are there jobs being created? As
those things happen, the yields will move
quickly higher, Kinker says.
Some analysts are skeptical. While the
bond buying may spur inflation, we have
to wonder if that will get employers to
hire. At this point, a lot of companies have
learned to operate at very high efficiencies
with fewer employees doing more work
than ever before. Now that banks and
companies are stable, the dilemma has
become, will they keep running efficiently
and continue pushing their employees, or
will they add jobs to ease their loads?
As to the actual bonds, the Fed is
targeting its buying at the mid-range
Treasuries. As such, the five- and 10-year
notes will be most sensitive to the economy. For now, though, Kurzatkowski sees
the five-year finding support at 120 with
secondary support at 119. Resistance,
he pegs around 121, but says we may
see 122 if prices push through the first
level. Barrett sees much the same with an
expected range of 119 to 121.
In the 10-year Treasur y note,
Kurzatkowski sees support at 123-16
with resistance around the contract highs
of 127-16. Barrett sees a slightly smaller
range from 123 to 126.
The 30-year Treasury note probably will

Tech Talk: Every trend must end

B y J ac K B r oz A N D Da n i e l P . co l l i nS

is chAnge in The wind?

143-24
n November, the front month U.S. 30 -year
140-20
30-year u.s. Treasury bond
Treasury bond futures broke below 126-24. That
137-16
continuous (monthly)
134-12
level was not mere support, but the midway point
131-08
128-04
between the all-time high made in December 2008
126-24
125-00
and the June 2009 low.
121-28
118-24
Retracements of 50% serve as strong support/
115-20
112-16
resistance and pivot levels, particularly when they
109-12
involve such volatile moves as we saw with the
106-08
103-04
30-year in 2008-09. The long bond has continued
100-00
96-27
to fall and will likely test the 2010 low of 114-11 in
93-24
January before testing the lower end of the 25-year
90-20
87-16
long-term trend channel, roughly at 112-21, refer2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
enced in the main story. If the long-term trend chanSource eSignal
nel is taken out, a larger and more dramatic downthere is plenty of room before it gets there.
turn could ensue, though the 2009 low, 111-25, could
provide a speed bump.
Jack Broz trades from the floor of the cBoT and provides analysis on
In the meantime, the fourth quarter weakness makes
the bond market at TradeBondFutures.com.
testing the lower end of that trend channel likely and

28

FUTUreS January 2011

Markets_Jan11.indd 28

12/14/10 11:09:42 AM

not be as affected by the Feds buying, but

watch inflation for an indication as to
where the long bond will go.
Broz points out that the 30-year has
been enjoying a nearly 25-year uptrend in
about a 20-point channel (see How long
can this last?, right) and current prices
are in about the middle of that channel.
He warns, If there is a breakout of this
channel, it could be very significant (see
Tech talk: every trend must end, left).
Most analysts forecast a little narrower
band for expected support and resistance
in the 30-year. Kurzatkowski said 130 is
a stout level of resistance but only gave
the low-120s for support (an area being
tested as we go to press). Barrett pegged
the 30-year in a range of 124 to 129.
Last year was marked by fears of default
and deflation. The EU is taking steps to
prevent defaults and the Fed is trying to
create inflation. The long-term impact of
these programs is still unclear.
Yields have been low for their own

how Long cAn This LAsT?

The U.S. 30-year Treasury bond has enjoyed an upward trending channel for the last
25 years. Prices are now in the middle of that channel.
143-24

30-year u.s. Treasury bond continuous (monthly)

137-16
131-08
125-00
118-24
112-16
106-08
100-00
93-24
87-16

cBoT changes coupon on

30-year to 6% from 8%

81-08

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Source: eSignal

extended period and, as long as high

levels of uncertainty remain, it is likely
U.S. Treasuries will remain the safe
haven. Kinker adds, There is very little

reason to hold most of these for very long

unless you think the economy is going to
do poorly over the next couple years.
Lets see how long the Fed holds them.

futuresmag.com

Markets_Jan11.indd 29

29

12/14/10 11:09:45 AM

Market Strategy

Cuckoo for cocoa futures

b y S h aw n h ac k e t t

ocoa is building bullish technical energy highlighted

by an ascending wedge formation that reflects a coiled
spring preparing to release an explosive move. The
MACD recently has triggered a buy signal, increasing the odds of
a breakout over the next several months (see Hot chocolate).
The breakout, should it occur, will be explosive, but the technicals are not the only reason to be bullish cocoa. The longterm structural supply/demand imbalances that have created
a series of recent deficits are not going away anytime soon. In
2010, Mother Nature was unusually kind but, because of the
aging tree population in the Ivory Coast and the depleted soil
content in Ghana, such favorable weather will not produce
record crops and likely will produce a global deficit in 2011.
Recently, many high profile cocoa analysts have downgraded global cocoa production as good weather was overplayed
and the deleterious effects of decades of lack of investment in
the cocoa industry were underemphasized in their analyses,
leading to overly optimistic global production expectations.

Hot cHocolate
MacD buy signal has been triggered, which improves the odds of
a near-term technical breakout over the next several months.

cocoa continuous (weekly)

$3,400 target

3400
3200
3000
2800
2600
2400
2200
2000

MacD turns bullish

Jul

Oct

09

Apr

Jul

Oct

10

Apr

Jul

1800
200
100
0
-100

Oct
Source: eSignal

The International Cocoa Organization (ICCO) recently has

increased deficit expectations for the 2009-2010 marketing
season. The likely probability for 2011 is that weather becomes
normal to adverse and sets global cocoa production back into a
major tailspin, leading to shortages of high quality cocoa. With
demand for this kind of cocoa strong and demand growth
expected apace, record highs are a matter of when, not if.
We have seen the cocoa market move well above $3,000 per
ton over the last several years without generating the kinds of
investments that are desperately needed to rejuvenate longterm global production. Additionally, there has been very
little demand degradation during these spikes. It will take
much higher prices to accomplish a more balanced cocoa
30

trade, especially against the

For more on cocoa, go
increasingly economically
to futuresmag.com
competitive alternative markets for growers, such as rubber, palm oil and coffee.
Is it any wonder that processors and merchants have loaded
up on cocoa futures to hedge against a likely price spike in
future years? The people that know more about the cocoa
trade than anyone else see much higher prices on the horizon.
Commercial operators tend to hold near-record long positions
at major bottoms as they rush in to protect upside price risk. If
you look at the times that commercial net longs have risen to
the levels we have today, they have been followed by bull moves.
It has been profitable for investors to follow the commercial net
positions and buy when they have become historically long.
With Intercontinental Exchange US (ICE) certified warehouse cocoa stocks being drawn down over the last six months
to some of the lowest levels seen since 2009, and with near
record cash premium differentials against futures, the fundamentals remain very bullish. Add that to the bullish technical
and commercial signals, and cocoa can make an historic move.
Another piece to consider when analyzing potentially major
turning points is relative value. For cocoa, two of the most
important relative value measures the cocoa/CCI (Continuous
Commodity Index) price ratio and the cocoa/sugar price ratio
are flashing major long-term buy signals. Both measures are
at some of the lowest levels seen over the last 40 years, and low
levels typically have preceded major bull market moves.
Cocoa has a history of being a rogue commodity with, at
times, very little correlation to the rest of the commodity
complex. This is important as we may be facing an extended
commodity correction, but the cocoa market could still see a
major bull run.
The initial margin requirement for cocoa futures is $1,610
per contract, making it one of the more affordable commodities to trade. Front-month cocoa closed at $2,758 on Dec. 1. A
trader could get long in that area with a protective stop placed
at the Sept. 13 low around $2,600, proving a better than 3:1
risk/reward ratio. A tighter stop can be utilized following the
bottom trendline which, as long as it holds, supports a long
position. Look for opportunities to buy March 2011 cocoa on
any correction that takes prices under $2,800 for an eventual
move up to the $3,400/ton area in 2011.
With the technicals, fundamentals, commercials and relative value measures all aligning with historical bullish signals, investors should take notice. And given cocoas history
of independence, it could be the one commodity to buy in
the first part of 2011.
Shawn Hackett, commodities broker and author of the Hackett Money Flow Report
newsletter (www.hackettadvisors.com), is a nationally recognized agricultural
commodities expert with more than 18 years of money management experience.

FUtUReS January 2011

MrktStrgy_Jan11.indd 30

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FTS_FP_Ads.indd 6

10/13/10 4:37:41 PM

TReasuRy FuTuRes

traDing teChniques

Opportunities along
the yield curve
By Pau l D. C r e t i e n

With the Federal Reserve maintaining a zero interest rate policy for an extended
period of time, Treasuries may seem boring. Not true, and heres why.

hese are exciting times for

Treasury futures. Futures on
several maturities of Treasuries
should help hedge changes that will
occur in a yield curve that is unusually low at present but should rise and
change shape with an improving U.S.
economy. Now is the time to prepare for
that eventuality.
The long end of the yield curve is
of particular interest at the moment
because the Federal Reserve having
approached the limit of reductions in
short-term interest rates is resorting to
purchases of longer-maturity bonds to
treasury notes
Classic bond
ultra bond

push more funds into the U.S. economy.

Flattening the yield curve will reduce
the cost of long-term debt, encouraging
investment in fixed-assets, while taking
some of the downward pressure off of
the dollar by allowing short-term rates
to increase. It also may reduce the positive carry currently enjoyed by banks and
other institutions with historically low
borrowing rates.
Five Treasury futures contracts are
included in the following analysis. The
32

short-term portion of the yield curve is represented by two-year, five-year and 10-year
T-note futures, while the longer maturities
are covered by the 30-year classic and ultra
30-year Treasury bond futures.
Understanding treasuries
The original 30-year bond futures contract has price and yield cash flows that
correspond to a 20-year fixed-income
security. The ultra 30-year T-bond
futures contract is so called because it
has a longer maturity, at least 25 years.
CME Group created the ultra to better
reflect a 30-year maturity. The original
bond contract specifications called for
30-year bonds with more than 15 years
left to maturity. When the Treasury
Department discontinued offering
long bonds in 2001, the supply shrank.
Because there were none offered for a
seven-year period, the remaining supply ref lected a shorter maturity. The
ultra has cash flow characteristics that
match a 30-year bond. Thus, the yield
curve is covered by two-, five-, 10-, 20and 30-year maturities.
Note that Trea sur y futures, a s
notional instruments, do not return
cash payments in terms of interest and
principal. Futures are held and traded
primarily to take advantage of price

For more from Cretien, go to

futuresmag.com/cretien

changes before their delivery dates.

Long and short Treasury futures contracts require a cash transaction on or
around the delivery date because these
derivatives are settled by the exchange
of Treasury securities that closely
match the maturity of the underlying
T-note or T-bond.
Three of the Treasury futures maturities are shown on Yields & rates (right).
The chart shows the eurodollar futures
quarterly rates and yield curve, U.S.
Treasury yields and T-note futures yields
at two-, five- and 10-year maturities.
Eurodollar yields form a smooth curve
that is slightly higher and parallel to
U.S. Treasury yields that are shown at
eight maturities from three months to
10 years. Eurodollar yields are based on
the geometric means of quarterly rates
that extend over a 10-year span.
The three Treasury futures maturities
shown on Yields & rates are two-, fiveand 10-year T-notes. The T-note yields
shown are slightly higher than corresponding eurodollar yields. Eurodollar
futures although representing dollar deposits that have more risk than
Treasury securities have the advantage

Futures January 2011

TT_Cretien_Jan11.indd 32

12/14/10 8:34:53 AM

Future changes
Option price curve equations are useful
for predicting changes in prices several
days forward, based on new underlying
futures prices with the same set of strike
prices. Three days predicted (page 34)

yields & RaTes

eurodollar rates and yields, treasury yields and treasury futures yields are compared
here. eurodollar rates are close to implied u.s. treasury forward rates.
0.050
0.045
0.040
0.035
0.030
0.025
0.020
0.015
0.010
0.005
0.000

Future expiration Dates

Sources: Barchart.com, Bloomberg, CME Group

Five-yeaR T-NoTe calls

the pricing model gives us upper and lower breakeven prices 109 days into the future.
it shows the markets assessment of yield and price volatility for the five-year t-bond
futures through March 2011.
5-year T-note calls Calls on March 2011 Futures (Oct. 28, 2010)
Futures
Price
120,711
120,711
120,711
120,711
120,711

strike
Price
122,500
122,000
121,500
121,000
120,500

Call
Option
Price
242.19
367.19
546.88
773.44
1,039.06

Predicted
Option
Price
233.00
351.90
522.67
763.28
1,095.73

Delta
0.201
0.290
0.412
0.573
0.781

upper
Breakeven
123,253
123,045
122,982
123,198
124,494

lower
Breakeven
119,505
119,446
119,383
119,361
119,381

Sources: Barchart.com, CME Group

shows options on 20-year T-bond futures

where the option price-to-strike price
is related to the futures price-to-strike
price. The curve shows close relationships between the predicted prices over
three days and initial prices on Oct. 28.
On Nov. 3 there is some indication of
the market prices falling slightly lower
than predicted by the fixed equation.
This will be an increasing tendency as
time to expiration decreases. Variations
between current market prices and predicted prices may be used to find temporarily over-valued and under-valued
options as prices tend to move back
toward the regression curve.
Trial & error
T-note futures yield & duration
(page 33) shows one section of an Excel

spreadsheet that calculates the yield on

a T-note or T-bond given the listed price.
The duration for the futures contract is
computed automatically on the spreadsheet at the same time it is calculating
the yield from a given price.
The two-year T-note has a price listed
as 109% of $200,000 par, plus 27.25 times
1/32nd of 1% of par. In decimal form, the
price is $218,852. Interest of $6,000 is
paid semiannually, with $200,000 par
value received at maturity. The yield that
corresponds to a $218,852 price must be
computed by trial and error, trying out
different yields until the computed total
present value is approximately equal to
the listed price. The trial-and-error process may be done manually, which is how
this table was created, or accomplished
by a computer program that gradually
futuresmag.com

TT_Cretien_Jan11.indd 33

Dec 20

Dec 19

Jun 19

Jun 18

Dec 18

Dec 17

Jun 17

Jun 16

Dec 16

Dec 15

Jun 15

Jun 14

Dec 14

Dec 13

Jun 13

Jun 12

Dec 12

Dec 11

Jun 11

eurodollar Yields
treasury Yields
eurodollar rates
t-note Yields

Dec 10

Yields and rates

of cash settlement at the delivery date.

Options on T-note and T-bond futures
may be analyzed by using the LLP option
pricing model available on Excel spreadsheets that can be downloaded from
futuresmag.com. For example, an option
price curve based on 12 strike prices was
computed for the March 2011 five-year
T-note futures on Oct. 28, 2010. A portion of the spreadsheet is shown on
Five-year T-note calls (right).
The analysis results in call option
prices predicted by a regression equation, the slope (delta value) of the option
price curve at each strike price and upper
and lower breakeven prices at expiration,
109 days in the future. Breakeven prices
are those that would result in zero gain
or loss on a delta-neutral trade between
calls and underlying futures.
For the five-year T-note option with
121.00 strike price, the breakeven prices
are 123,198 and 119,361. These prices
imply a yield spread for the five-year
T-note of 1.205% to 1.920%, while the
yield on Oct. 28 was 1.665%. The price
and yield spread on the measurement
date shows the options markets assessment of yield and price volatility for fiveyear T-bond futures through the expiration date in March 2011.
Calls on Treasury futures (page 34)
shows the option price curves for the five
Treasury futures on Oct. 28, 2010. Heights
of the curves correspond to the maturities of the underlying note or bond. For
example, calls for the 30-year ultra T-bond
futures are on the highest curve because
longer maturities produce the largest
change in price for fixed-income securities
with equal risk. As shown on Breakeven
prices & yields (page 34), breakeven yield
spreads for the five Treasury-based futures
increase with larger underlying maturities. Because the five Treasuries have
identical risk and equal times to expiration, maturities are the primary reason for
different curve heights, breakeven prices
and yield spreads.

33

12/14/10 8:34:54 AM

traDing teChniques continued

calls oN TReasuRy FuTuRes

here we can see the option price curves for the five treasury maturities. the highest
curve is for the longest-dated treasury.
March 2011 calls on Treasury Futures (Oct. 28, 2010)

Option Price / strike Price

30-Yr Bond

20-Yr Bond

10-Yr note

5-Yr note

2-Yr note

0.043
0.038
0.033
0.028
0.023
0.018
0.013
0.008
0.003
-0.002
0.953

0.963

0.973

0.983

0.993

1.003

Futures Price / strike Price

Source: Barchart.com

BReakeveN pRices & yields

these price ranges are for the March 2011 delivery date. they were computed on Oct. 28.
upper Price

lower Price

two-year t-note*

110.726

0.597%

109.512

1.740%

Five-year t-note

123.198

1.205%

119.361

1.921%

10-year t-note

129.199

2.636%

121.931

3.395%

20-year t-bond**

136.338

3.466%

122.368

4.319%

30-year t-bond

145.197

3.542%

123.236

4.570%

The principal of the two-year note is shown here as $100,000

Classic 30-year T-bond

**

Source: Barchart.com, CME Group

ThRee days pRedicTed

Option pricing equations can help us predict price changes several days forward.
0.050

Based on Oct 28 equation

0.045

Option Price / strike Price

0.040
0.035
0.030
0.025
0.020
0.015
0.010
0.005

Oct 28

nov 1

nov 2

nov 3

0.000
0.92

0.94

0.96

0.98

1.00

1.02

1.04

Futures Price / strike Price

Source: Barchart.com

34

centers in on the required discount yield.

Yields and prices also may be looked up
on tables of price-to-yield and yield-toprice available online at CME Group.
CME Group publishes a Treasury price
index online the Dow Jones Chicago
Board of Trade (CBOT) Treasury Price
Index based on five-year, 10-year and
20-year maturities. The T-note futures
yield & duration spreadsheet includes
a section that produces data similar to
the Dow Jones CBOT index, and shows
how the index is computed.

Bond duration
Because duration is an important element in the index calculation, it may be
well to describe duration in more detail.
Duration is the weighted average of time
to maturity of any asset. The weights are
equal to the present value of cash flows
in each time period divided by the assets
total present value.
Duration is shown computed on
T-note futures yield & duration (right),
where the fourth column shows the calculation of weights for each time period
and column five multiplies the weight
and the time period number. The weighted average time to maturity, or duration, of the two-year note is computed
as 3.8372 six-month periods or 1.9186
years. Duration changes constantly with
new data for market yields and periodic
cash flows; however, it is always equal to
or less than calendar time to maturity.
Duration is a critical factor in hedging individual financial instruments
and entire portfolios. In theory, a portfolio that has a given weighted duration
that includes its total holdings may be
hedged by a long or short position in a
single Treasury futures contract with the
same computed duration.
It is important to realize that prices
on fixed-income securities change in
relation to their durations rather than
simply time to maturity. Treasury price
index (right), calculated on Oct. 28,
2010, includes modified durations (where
duration is divided by (1+ i), with i equal
to the computed yield). For example, the
weighted average maturity of the 30-year
ultra T-bond is 15.6497 years. The time
pattern of cash flows determines duration, resulting in the $100,000 par value

Futures January 2011

TT_Cretien_Jan11.indd 34

12/14/10 8:34:55 AM

Subscribe to
Futures today!

T-NoTe FuTuRes yield & duRaTioN

this spreadsheet uses price to calculate duration and yield.

FUTURESMAG.COM

Price of the contract quoted by CMe group

109% of par
plus 27.25 times 1/32 of par value
equals the quoted price

Par value = 200,000

trial yield
total PV

109 - 272
218,000
852
218,852

Grain outlook:
U-tUrn
Marke ts coMplete

Period

Present Value
at trial rate

Weight =
PV / total PV

Weight x
Period

6,000.00

5,963.76

0.02725

0.0273

6,000.00

5,927.75

0.02709

0.0542

6,000.00

5,891.95

0.02692

0.0808

206,000.00

201,068.51

0.91874

3.6750

218,851.97

1.0000

3.8372

Duration is 3.8372 six-month periods, or 1.9186 years

Modified Duration = 1.9186 / (1.0000 + 0.012152), or 1.8955 years

aSian outlook:
hong kong and
singapore on
the rise

SyStem buildinG:
ion
FroM idea to execUt
breakout or
head fake:
separating
the wheat
FroM chaFF

1.2152%
218,852

interest &
Principal

| NOVEMBER 2010

to

From Planting,
to Delivery,
s
ithmMAG.COM
| DECEMBER 2010
algorFUTURES

Neal Kottke
talks grains
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&

Top 50 Brokers:
Survival of the fitteSt
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HoT MarkeTs:
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MarkeT risks
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Sources: Barchart.com, CME Group

TReasuRy pRice iNdex

these prices are weighted by modified durations. the price index, over time, shows the
combined movement for a weighted average of treasury futures.

Price

Yield

index
Weights

Weighted
Price

2-year

218,852

1.2152%

1.8955

8.2560

1,806,849

5-year

120,711

1.6655%

4.3845

3.5694

430,861

10-year

125,063

3.0702%

7.7100

2.0298

253,850

20- year

133,625

3.6223%

12.5995

1.2421

165,975

30-year

133,625

4.0529%

15.6497

1.0000

133,625

Maturities:

5, 10, 20 yrs.

6.8412

850,686

Sum of Weighted Prices

Weighted average Price = = 124,347
Sum of Index Weights
Sources: Barchart.com, CME Group

received on the 30-year bond shrinking

in its impact on price because of the longer time to maturity.
If we were to begin a Treasury price
index similar to the Dow Jones CBOT
Treasury Index, using just the five-,
10- and 20-year maturities as shown on
Treasury price index, the three prices
would be weighted. The index weights
are calculated by dividing the modified duration of the 30-year T-bond by
the modified duration of each of the
other maturities. In this way, the pricing effects of different maturities are

premier publication in
circulation today serving

calculation of a Treasury price index (Oct. 28, 2010)

Modified
Duration

Futures magazine is the

equalized and the index is made comparable over time.

The importance of the Treasuries in
hedging, speculating and forecasting
interest rates and yields of all maturities
hardly can be overstated. Their futures
and options will be of increasing usefulness as the Federal Reserve uses financial markets in its efforts to accelerate
economic recovery.

futures, options, stock and

forex traders. Your most
complete source for obtaining
critical strategic guidance
in global markets, trading
strategies and tactics,
market news, successful
trader proles and more!
Call 800.458.1734
or SubSCribe online at
FutureSMag.CoM/SubSCribe

Paul Cretien is an investment analyst

and financial case writer. his e-mail is
[email protected].
futuresmag.com

TT_Cretien_Jan11.indd 35

35

12/14/10 8:34:57 AM

E-mini S&P 500

Trading TeChniques

Market internals beat the herd

By C h r i s V e r m e u l e n

Using market internals can put you ahead of the herd to capture quick
profits while the masses are still wondering what happened.

f you are dedicated and disciplined,

you can read the market internals
to day- and swing-trade, making
consistent profits trading futures and
exchange-traded funds (ETF).
Most of us remember when we first
learned and experimented with technical
analysis and chart patterns. Likely, you
were blown away by discovering what you
may have imagined to be the Holy Grail of
trading strategies. However, after the first
six months of real trading, your trading
account was the same size and your trades
were winning around 50% of the time.
The culprit usually is that many of the
breakouts you buy into quickly reverse,
and you watch as price action goes
against the original position. Thats when
the obvious reveals itself: Reading chart
patterns and volume is not enough to
give you a significant trading edge.
nYse advance/decline
Put/call ratio
nYse buying strength

We hear professional traders articulate that to consistently pull money out

of the market, you need to trade against
the masses and avoid herd mentality.
This sounds quite simple, but just how
do traders go about doing it?
Market internals are the answer. The
concept is relatively simple. In theory, if
everyone is buying a commodity or stock,
36

then it is only a matter of time before

everyone runs out of trading capital and
the buying will evaporate. When the last
buyers buy, it leaves only the sellers in
control of the broad market.
A simple, clean pattern that large numbers of traders see unfolding means only
one thing: Everyone is taking a position
before the breakout in anticipation of the
coming move. With the general public
moving into this chart pattern, it would
make sense that the underlying investment vehicle would move higher and lead
to a breakout with the last traders (breakout traders) jumping on the train.
Just as these last traders enter the position, the smart money (large traders)
would start selling into the buying surge,
getting top dollar. Once the breakout fails,
everyone who was long hopes for another
rally, which inevitably never comes. As
time drags on, this leads to traders getting impatient, exiting their positions and
causing price to erode and create more
fear in the market. As this process comes
full circle, significant numbers of traders
get out of their losing positions, causing
a waterfall sell-off with an unlucky few
holding the proverbial bag.
The key is to look at the market backwards from the straightforward analysis. Focus on buying into heavy volume
sell-offs and selling into heavy volume
breakouts. This is a tough transition for
most breakout traders to make, and it

For a more in-depth look at

these indicators, go to
futuresmag.com/McCurtain

is best to paper trade until you are comfortable with buying into fear and selling into greed. It feels completely wrong
at the beginning, but the profits speak
for themselves.

E-mini trading strategy

Four main tools are required to trade against
the herd. This will be described for the S&P
500 E-mini futures contract, although it
also works with other markets.
The futures market structure makes
it easy to capitalize on both rising and
falling markets. Additionally, there is no
requirement to have a $25,000 minimum
in your trading account to meet the pattern-day-trading rule, which is required
to day trade stocks or ETFs.
The internal market indicators to focus
on are the New York Stock Exchange
(NYSE) down/up volume ratio, the put/
call ratio and the NYSE advance/decline
line. While these may seem elementary
at first glance, when you combine their
information you end up with a simple,
highly effective trading strategy.
Over the last two years, the S&P 500
has provided a 1.25% profit, on average,
each time one of these extreme sentiment
readings occurred (see Extreme reactions, right). These trades were in late

FuTures January 2011

TT_Verm_Jan11.indd 36

12/13/10 5:05:59 PM

August and averaged a 1.75% return, and

each trade lasted only 24 hours. Another
benefit is that money is not at risk for
long periods of time.
Now, lets look more deeply at how to
find these low-risk trades using market
internals.

ExtrEmE rEactionS
When our three market internal indicators are extremely high, short-term downward swings in
the s&P 500 are signaled.
110500

NysE advance/decline
The advance/decline line is a favorite
indicator that measures market breadth.
It is a simple measure of how many stocks
are taking part in a rally or a sell-off. This
is the meaning of market breadth, which
answers the question, how broad is the
rally? The formula for the advance/
decline line is as follows:

average s&P 500 sentiment moves

over the past two years is 1.25%

110000
109500
109000
108500

108000

107500
107000
106500

106000
105500
105000

= Sell signals

104500

A/D line = number of advancing stocks

- number of declining stocks

104000
08/17/10 08/18/10 08/19/10 08/20/10 08/23/10 08/24/10 08/25/10 08/26/10 08/27/10 08/30/10 08/31/10 09/01/10

This is the most easy to follow and

understand of the three indicators. This
tool is most effective when there are
1,000 or more individual stocks trading
up on the day. In that scenario, the market is nearing an overbought condition,
meaning too many stocks have moved
up too quickly, and traders should start
to take profits or exit their positions (see
Market advancement, right). Its also
helpful to look at the intraday and daily
chart for topping patterns or resistance
levels. Then, wait patiently for the other
two indicators to confirm this sentiment
before going short the market.
Put/Call ratio
The put/call ratio is based on Chicago
Board Options Exchange (CBOE) statistics. The ratio equals the total number
of puts divided by the total number of
calls traded. When more puts are traded
than calls, the ratio will exceed 1.00. As
an indicator, the put/call ratio is used
to measure market sentiment. When the
ratio gets too low, it indicates that call
volume is high relative to put volume
and the market may be overly bullish
(see Selling down, page 38). When the
ratio gets too high, it indicates that put
volume is high relative to call volume and
the market may be overly bearish.
Put/call ratio = number of put options
/ number of call options

Source: eSignal

markEt advancEmEnt
The advance/decline line is useful for identifying overbought areas. it measures how broad a
market rally really is. here it meets our sell targets in extreme reactions.

Sell Zone

2113
2000

4
1500

2
1000
500
0
-500
-1000
-1500

Buy Zone

-2000
08/18/10

08/19/10

08/20/10

08/23/10

08/24/10

08/25/10

08/26/10

08/27/10
Source: eSignal

This indicator can be a little tougher to

use because when the market is trending
down, the ratio tends to fluctuate in the
upper end of the scale between 0.75 and
1.20. In an uptrending market, the indicator will trade between 0.35 and 0.75.
As long as you monitor the upper and
lower range for the current market trend,
your analysis should be right on track. In
addition, if you zoom out slightly on the

chart, you will see the average range it has

been trading in, and then you can set the
upper and low bands accordingly.
Back in late August, the S&P 500 was
trending down, and a good strategy was
to sell bounces in the market. When the
broad market bounces and we see the
put/call ratio drop into the lower band,
it says that the majority of traders have
gotten bullish. This tends to happen
futuresmag.com

TT_Verm_Jan11.indd 37

37

12/13/10 5:06:00 PM

Trading TeChniques continued

SElling down
The put/call ratio is effective at indicating where trader interest is with respect to the current
trend, and can provide good timing direction for selling into an existing downtrend. here it adds
a second confirmation for our august shorts.

1.15

Buy Zone

1.1
1.05
1
0.95
0.90
0.85
0.80

Sell Zone

2
1

0.75
0.746

4
5

08/18/10

08/19/10

08/20/10

08/23/10

08/24/10

08/25/10

08/26/10

08/27/10
Source: eSignal

tracking thE hErd

nYse buying/selling volume provides a good indication of when the majority of market participants are
expecting a strong uptrend. here it completes our three sell confirmations for extreme reactions.

12

nYSE Buying volume ratio

10

Buy Zone

4
6

4
2
0

08/18/10

08/19/10

08/20/10

08/23/10

08/24/10

08/25/10

08/26/10

08/27/10

08/30/10
Source: eSignal

once a previous high is broken, as it triggers short covering and breakout traders
start buying.
While there are other times on this
chart where the indicator traded into
the lower range, there was not a signal to
short the market because the other two
indicators did not confirm the extreme
sentiment level. For this strategy to be
the most effective, they all must have an
extreme reading for the trade to have the
best odds and greatest profit potential.
38

NysE buying/selling volume

The NYSE buying/selling volume indicator is a simple volume-based indicator
that measures fear and greed in the market. It routinely is a powerful tool for timing market tops and bottoms. Calculated
by taking the NYSE buying volume and
dividing that by the selling volume, it measures panic buying and acts as a contrarian
indicator. It is not an indicator that many
other traders follow, but is critical for getting a feel for the rhythm of the market.

NYSE buying strength =

Up volume / Down volume

When you see this indicator rise to about

3.00, it means there are three buy orders
for every one sell order on the NYSE. The
majority of traders (the herd) are buying.
Obviously, the higher this indicator moves,
or the longer it stays above 3.00, the more
potential there is for a sharp sell-off (see
Tracking the herd, left). Obviously this
is only a confirming indicator; both the
indicator and the market can continue to
rise after touching 3.00.
Putting it all together
With these indicators, you can stay ahead
of the herd and capture quick sharp moves
while the masses are still wondering what
happened. As always, logistics are important. Focus on 15-minute charts. Trade
only with the trend. For instance, even
though the market bottomed in July the
downtrend exploited in Extreme reactions was still in place until the trendline
was broken in September.
Do not get greedy. This strategy is
designed to capture short-term market
swings; take profits at defined levels 1%,
2%, etc. If you wish to hold on for larger
gains, its critical to take partial profits at
a 1% gain and move your protective stop
to a level that locks in a profit for the balance of the position.
Wait for all three indicators to reach
extreme levels concurrently before you
initiate a trade. The market trend can
keep individual measures at extremes
for one to two weeks. Trading on the
anticipation of an overbought/oversold
condition before all three indicators confirm your suspicions is a great way to lose
money. Be patient, and wait for the indicators to confirm. There will be plenty of
time to acquire a quality entry.
The strategy as presented works best
in a downward trending market. While
it also works well in a bull market, there
are some minor changes required on each
of the indicators that affect their userfriendliness.
Chris Ver meulen can be reached at
[email protected] or from his
website www.ThegoldandOilguy.com.

FuTures January 2011

TT_Verm_Jan11.indd 38

12/13/10 5:06:01 PM

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OptiOnS

TRaDiNg TechNiques

A more modest approach to

naked straddles
By Ro b b Ro s s

Straddles can provide good premiums in certain markets. However, when markets
start to move, sometimes extra protection is necessary.

or those who have been active in

the markets for a quarter-century or more, its difficult to find
anything unique. But when it comes to
options, the list of strategies is enormous.
These include such methods as bull put
spreads, butterflies, iron condors, bear
call spreads, straddles, strangles, etc.
Then, there are variations. Here, well
look at one variation of the classic straddle called the scantily clad straddle.
Naked straddles
Dressed up straddles

The scantily clad straddle is a premium-capturing program that involves selling the straddle and then placing orders
in the underlying commodity to provide
a level of coverage should the underlying
move significantly in one direction.
The scantily clad straddle can be used
in any market that has options, including
futures, forex, stocks and bonds.
For those new to options, a straddle is a
trade that engages both at-the-money put
and call options. If the S&P 500 futures
are trading at 1,000, then selling the
straddle would involve selling the 1,000
put and the 1,000 call. A long straddle
would purchase both options. A straddle
is usually a volatility play rather than a
directional trade, with a long straddle
betting on an increase in volatility and
a short straddle, a decrease in volatility.
40

Many trading platforms let you sell the

straddle instead of executing each leg of
the trade separately. By selling the straddle, you collect the option premium. You
are thereby naked the straddle.
Its nice to collect the premium, but the
danger is that the underlying market will
move enough that the option buyer can
execute against you. When selling options,
the exposure is technically unlimited.
Taking the above example, if you collected 50 points for the straddle, but the
S&P 500 dropped to 800, the put would
then be worth at least 200 points and you
would be down at least 150 points. At $50
per point, thats $7,500. The loss could be
more, depending on how much time value
is remaining on the options.
Dressing up
The scantily clad straddle offers a level
of protection for the options positions
thus, the position is no longer naked.
Applying this to the previous example, if
we got 25 points for the call and 25 points
for the put, a pair of good until canceled
stop orders in the S&P 500 would be
appropriate (see Protective orders,
right). The orders would be:
Buy one S&P 500 E-mini
at 1025 stop GTC
Sell one S&P 500 E-mini
at 975 stop GTC
Once the straddle has been sold and

the orders have been placed, there are

three basic scenarios in which the trade
makes a profit. In the perfect scenario,
the market stays below 1025 and above
975. The trade collects the entire option
premium on one side and part of or the
entire option premium on the other side,
depending on the close at expiration. If,
in this case, the market closed at expiration at 1002, then the entire put premium was retained and 23 of the 25 points
of the call premium were captured.
However, it is unusual that neither of
the stops were hit. What normally happens is a trend develops in at least one
direction during the trades life. In Hit
the stop (right), it is assumed that the
buy stop was hit and executed at 1025.
On the day of expiration, the market is
at 1054. The call expires being worth 54
points. It was sold for 25 points, resulting
in a loss on the call option of 29 points.
However, you went long the S&P 500 at
1025, and it closed at 1054. The resulting
gain on the S&P was 29 points. The long
trade covered the call position. The other
thing to remember is you collected all of
the 25 points on the put. As long as the
market remains above the puts 975 strike
price, the position will make money (see
On expiration, page 42).
Anything above 975 is profitable. Every
price above 1000 achieves the maximum
profit of 25 points ($1,250). If the market
trends strongly in the direction of the ini-

FuTuRes January 2011

TT_Ross_Jan11.indd 40

12/13/10 5:06:44 PM

tial stop, the trade will be profitable. Unlike

other option writing programs that get
hammered during a trend, the scantily clad
straddle loves trending markets. It locks in
the profit and covers the losing side.
Finally, instead of the market hitting
your 1025 buy stop, lets say it went down
and engaged your sell stop at 975 and then
continued down and closed at 900 on the
day of expiration. Youd lose 75 points on
the put (100 points value at expiration
minus the 25 points collected in premium). But youd also make 75 points on the
short sale and wash out the put loss. Then
youd gain all 25 points on the call option
because it expired worthless.

prOtective OrderS
by placing stop orders above and below the market equal to the premium we gained from the
sales of the put and call options, we can build an element of insurance into the trade.
1030

buy stop at 1025

1020
1010
1000
990
980

sell stop at 975

970
expiration

Day-9 Day-8 Day-7 Day-6 Day-5 Day-4 Day-3 Day-2 Day-1 Day 0

Market drift
When the market ambles sideways, its best for our straddle position. in this case, we keep the
full premium of the put we sold and all but a couple points on the call side.
1030

buy stop at 1025

1020
1010
1000
990
980

sell stop at 975

Day 9

Hit tHe StOp

sometimes, the market doesnt stay within the stop levels. here, it powered higher through the
buy stop.
1060
1050
1040
1030
1020
1010
1000
990
980
970

buy stop at 1025

Long at 1025

used, there will be times that youll get

slippage (the order is filled at worse than
your stop price). If, on expiration day the
futures price closes near the strike, it may
not be clear whether the option will get

Day 9

expiration

Day 8

Day 7

Day 6

Day 5

Day 4

Day 3

Day 2

Day 1

Day 0

Day-1

Day-3

Day-2

Day-4

Day-5

Day-6

Day-7

Day-8

sell stop at 975

exercised. You dont want to come in on

Monday thinking you had a profitable
trade only to find out youre long the S&P
500 and it dropped Sunday night by 50
points. Sometimes, its better to buy back
futuresmag.com

TT_Ross_Jan11.indd 41

expiration

Day 8

Day 7

Day 6

Day 5

Day 4

Day 3

Day 2

Day 1

Day-1

Day 0

Day-3

Day-2

Day-4

Day-5

Day-6

Day-7

Day-8

Day-9

970

Day-9

The downside
To my knowledge, there is no perfect system.
Every trading method has losing scenarios,
and this includes the scantily clad straddle.
There are two basic situations where the
trade loses money: Gaps and whips.
With a price gap, the market jumps past
your stop and executes you at a worse price
than you were expecting (see Leaping to
losses, page 42). In the chart, the market
gaps past the 1025 buy stop and gets filled
at 1041. This additional 16 points from
the original stop costs you $800 more
on the trade. In this situation, the trade
still made money ($450) because the put
expired worthless and you kept the entire
$1,250 premium. But if it had opened at,
say, 1060, the entire trade would have been
at a loss. Because of this risk, its advisable
not to use this strategy with commodities
known to have locked limit days, such as
lumber, hogs, corn, etc. It works best with
liquid markets like the E-mini S&P 500.
Another scenario that ends in a loss is a
whip trade. This occurs when both buy and
sell stops are hit. When the second one is hit,
then the entire trade is exited. This involves
buying back the straddle. The resulting loss
is dependent on how much time premium
is left in the options. The earlier the whip
occurs in the trades life, the bigger the loss,
as opposed to a whip occurring with only 10
days remaining in the options life.
The most catastrophic situation is a whip
with double gap fills beyond each stop. This
would be an extremely rare occurrence, but
it still must be considered a possibility as
you evaluate this strategy.
Finally, because stop orders are being

41

12/13/10 5:06:45 PM

TRaDiNg TechNiques continued

On expiratiOn
if the sell stop is not hit, then this is what the profit potential of the scantily clad straddle is on
the day of expiration.
30.00
25.00
20.00
15.00
10.00
5.00

975

980

985

990

995

1000

1005

1010

1015

1020

1025

1030

1035

1040

1045

1050

1055

1060

1065

1070

1075

1080

1085

1090

1095

1100

0.00

Leaping tO LOSSeS
if a price gap takes the market past your stop, then the futures position can get filled at a lessthan-favorable level, limiting its protective features
1060

Buy one December T-bond futures

at 132-09/32 stop GTC
Sell
one December T-bond futures

at 127-20/32 stop GTC

The placement of the stop was equal to
the distance of the strike price and the premium collected: Call premium of 2-17/64
plus 130 strike for a buy stop of 132 9/32;
then 130 strike minus put premium of
2-32/64 for a sell stop of 127-20/32.
A few days later, the bonds moved
higher and hit the buy stop at 132-09. The
bonds continued their climb to 135-12.
During this phase, were pretty happy with
the trade. The call has been covered by the
long position. If the bonds stay above the
strike price of 130, now five points away,
the trade will be profitable. Then the price
started dropping and returned to the high
130 area. On November options expiration, December T-bond futures closed at
131-20. The results were as follows:

1050
1040
buy stop at 1025

1030

Long at 1041

1020
1010

Call option
Sold:
Expired:
P/L:

2 17/64
1 40/64
+41/64 (+$640.63)

Put option
Sold:
Expired:
P/L:

2 23/64
0
+2 23/64 (+$2359.38)

1000
990
980

sell stop at 975

at least one leg of the option right before

expiration just to avoid this scenario.
Be sure to cancel the related standing
stop orders when the trade is completed.
Also, if the futures month is not expiring,
then the option is not a cash settlement,
but the option is exercised and youll be
long or short the underlying commodity.
There are situations in which the price
might close just in the money for the
option, but is not exercised. This happens because the option owner has several hours to make up his or her mind on
whether to exercise the option. In afterhours trading, the commodity might
move against the option owner to where
its not profitable to exercise. When the
price is close to the strike, it is best to exit
the position. It will cost you a little, but
will provide some peace of mind.
42

expiration

Day 9

Day 8

Day 7

Day 6

Day 5

Day 4

Day 3

Day 2

Day 1

Day 0

Day-1

Day-3

Day-2

Day-4

Day-5

Day-6

Day-7

Day-8

Day-9

970

Bond trade
In Treasury bonds, the strikes are in full
handles (129, 130, 131, etc.). The options
trade in 64ths. T-bond futures trade on a
quarterly cycle: March, June, September
and December, but include serial options
that trade every month. The November
options are based on the December futures.
Options expire the month before, meaning
the November options expire in October.
In mid-September, the November
T-bond option straddle with a strike price
of 130 was sold. The December T-bond
futures contract, the underlying for the
November options, was trading around
129-28/32. The premium collected was
2-17/64 for the call and 2-23/64 for the
put. This resulted in a total collected premium of 4-40/64, or $4,625. Once filled,
two stop orders were placed:

Futures trade
Long:
Exit:
P/L:
Result
Call option:
Put option:
Futures trade:
Total P/L:

132 9/32
131 20/32
-21/32 (-$656.25)

+ $640.63
+ $2,359.38
- $656.25
+$2,343.76

Other elements can be calibrated to fine

tune the strategy, such as time frame and
volatility. However, this basic concept is
straightforward and successful.
Robb Ross runs White indian Trading co.,
and developed its stairs trading program (see
Ross: White indian and rubber chickens,
august 2010). he is an experienced programmer and system developer, having worked at
both Microsoft and Nasa.

FuTuRes January 2011

TT_Ross_Jan11.indd 42

12/13/10 5:06:46 PM

Put Time and Money on Your Side and

Take Your Trading to the Next Level

Subscribe to MarketPulse FREE eNewsletter and get
invaluable information on where commercials and trades stand
so you can position yourself for upcoming market moves!

SigN up TodaY!
FuTureSMag.coM/eNewSLeTTerS

FUT eNews FP.indd 1

10/27/10 1:46:13 PM

Vo l ati l it y

TradIng TechnIqueS

When volatility distorts probability

By S e rg e y I z r ay l e v I c h a n d va d I m T S u d I k m a n

Profit probability can become inflated during periods of high volatility.

Heres how to keep your expectations in check.

odern option pricing theories from the basic BlackScholes model to advanced
mathematical algorithms are based
on probability concepts. One of the
most popular indicators used to evaluate the investment attractiveness of both
single options and their combinations
is the probability to earn profit. This
gauge expresses the probability that at
the time of options expiration (or any
other time point prior to expiration) a
given option will make money. Whether
the payoff function is positive or negative is determined by the future price of
the underlying asset.
Profit probability
Payoff function

Applying classic probability theory,

the profit probability of an option, or
combination of different options, can
be calculated by integrating the product of the combination payoff function
by the probability density function over
the price range (or ranges) for which the
payoff function is positive:

where x is the underlying asset price;

44

PF(B,S,x) is the payoff function of combination S with the underlying asset B;

LogN(Mean,,x) is the probability density function of lognormal distribution
with parameters Mean (mathematical
expectation of the price); and variance
; ( y) is the theta-function with argument y = PF(B,S,x), which has the following values: ( y) = 1, if y > 0, and ( y) = 0
in other cases.
The above formula applies if the price
is considered as a continuous variable.
In the discrete case, a finite price series
{xt ,t = t1, t2 , , t n} replaces the continuous variable. These prices constitute a
set of all possible future outcomes. The
set of probabilities {p(xt ,t),i = 1, 2, , n},
i
assigned to the corresponding prices,
replaces the probability density function. Price index i forms two subsets:
I+ = {i : PF(B, S, Xt ) > 0}, where the payoff
1
function is positive, and I- = {i : PF(B, S,
Xt ) 0}, where the payoff is negative or
1
equal to zero. Profit probability can be
estimated as a sum of probabilities of all
elements forming the first subset:

Estimating profit
Profit probability (PP) is widely used by
traders and is included in almost all software products developed for analyzing

For more from Sergey and vadim:

futuresmag.com/sergey-vadim

options. It represents one of the main

criteria used in different market scanners and rankers designed for identifying
potential trading opportunities appearing on options exchanges. The popularity
of this indicator is accounted for by the
relative simplicity of the PP calculation
and by sufficiently high effectiveness of
its practical application. Combined with
another important indicator, expected
profit, PP enables accurate estimation
of option profitability.
At the same time, according to longstanding observations, PP of short
option combinations may be overvalued significantly during highly volatile
periods. It is common knowledge that
shorting options is one of the riskiest
option strategies. In periods of high
market volatility, and especially during
financial crises, risks inherent in shorting options increase manifold. Because
overstated estimates of PP inevitably
lead to risk underestimation, it is absolutely essential to determine the extent
to which the volatility of the underlying
asset affects the probability values.
To accomplish this task, statistical
studies were conducted using a five-year
database containing prices of options

FuTureS January 2011

TT_Izray_Jan11.indd 44

12/14/10 2:14:27 PM

Profit Probability vs. volatility

Vertical and horizontal analyses of relationships between profit probability and
implied volatility are helpful to examine. At higher volatility levels, the profit probability becomes overestimated.
vertical analyses
100
90

Profit Probability

80
70
60
50
40
30
20
10
0

20

40

60

80

100

120

140

160

Implied Volatility

Horizontal analyses
100
90
80
Profit Probability

and their underlying assets (from 2005

to 2010). This period includes data pertaining to both calm and extreme market conditions (the last financial crisis).
Using these data, horizontal and vertical
analyses were performed involving relationships between profit probability and
underlying asset volatility.
In the vertical analysis, 1,000 of the
most liquid U.S. stocks were used as
underlying assets. For each of them, we
created three short straddle combinations
(using strike prices that are closest to the
current underlying price) for the first, second and third weeks before the expiration
date. All combinations were constructed
for September 2010 expiration. In total,
we estimated 3,000 short straddles.
For the horizontal analysis, f ive
stocks were selected with actively traded options: Apple, Boeing, Ford Motor,
General Electric and IBM. For each of
these stocks, one short straddle was created on each trading day during a fiveyear period. By analogy with the vertical
analysis, all combinations were created
using the most liquid option contracts
(the nearest expiration date and strike
prices that are closest to the current
underlying asset price). For all combinations, profit probability was calculated
and recorded for implied and historical
volatility values. Altogether, about 6,000
combinations were evaluated.
Profit probability vs. volatility (right)
illustrates the relationships between
profit probability and implied volatility.
In both vertical and horizontal analyses
the probability to earn profit increases
as volatility increases. Although these
relationships are not strong (correlation
coefficients range from 0.36 to 0.66),
they are statistically significant in all
cases. At extremely high volatility levels, corresponding to crisis periods, PP
rises to 80%-90%, and in some cases to
nearly 100%. Obviously, such estimates
are biased. Intuition suggests and the
experience of the latest financial crises
proves this that in periods of extreme
market fluctuations, the probability to
gain profit from short option positions
decreases rather than increases. If this
is the case, how can the existence of the
direct relationship between probability
and volatility be explained?

70
60
50
40
30
20
10

50

100

150

200

Implied Volatility

Solving the puzzle

To find the solution, we compare the time
dynamics of implied and historical volatilities. It is commonly believed that during crises, option premiums (and, therefore, implied volatility) increase sharply
because of rising uncertainty of market
participants. Although historical volatility
increases as well, this happens slower and
with an evident time lag. Trends in volatilities (page 47) illustrates this phenomenon using Boeing stock as an example.
The divergence in cycles of two volatilities is because during crises, option premiums increase sharply, while historical

volatility rises more slowly. This is because

it is calculated with historical data that
include prices from less volatile periods.
Increased premiums imply higher values
of the payoff function; relatively low historical volatility implies lower variance
used in the lognormal probability density
function. As it follows from the previous
formulas, both factors cause PP to increase
at higher levels of implied volatility.
Unjustifiably inf lated values of PP,
obtained in periods of high volatility, are
inappropriate for estimating the profitability of option portfolios containing short
positions. It is essential to develop methfuturesmag.com

TT_Izray_Jan11.indd 45

45

12/14/10 2:21:25 PM

Wave59 is easily one of the most sophisticated technical analysis tools youll nd on the market. It does many things, does
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TradIng TechnIqueS continued

trends in Volatilities
historical volatility rises slower than implied volatility and has an evident time lag.

80
Implied volatility
historical volatility

70
Profit Probability

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ods that enable us to adjust PP according

to the current volatility level. There are several approaches to solve this problem:
Calculation of historical volatility
used as variance to build the probability
density function is based on an historical price series of a given length. The
longer the price series, the greater the
influence of old data data belonging
to the calm period preceding an extreme
market and the greater the divergence
in historical and implied volatility cycles.
This leads to overvaluation of PP. The
distortions in probability estimates may
be reduced significantly by regulating
the length of the price series parameter,
according to the current level of implied
volatility. The parameter should relate
inversely to the volatility.

The standard method used for calculating historical volatility is based

on historical prices, each of which has
equal weight relative to all other prices.
Alternatively, we can consider differential application of weight coefficients
similar to what you would do in calculating an exponential moving average
as opposed to a simple moving average.
Higher weights would be assigned to
recent prices, while older prices receive
lower weight coefficients. As a result,
recent price f luctuations would exert
greater inf luence on the variance as
compared to older price changes. The

May 10

Jan 10

Sep 09

May 09

Jan 09

Sep 08

May 08

Jan 08

Sep 07

May 07

Jan 07

Sep 06

May 06

Jan 06

Sep 05

May 05

Jan 05

function setting the weights can be

of any form linear, exponential, etc.
One of the main factors determining
the payoff function of an option combination is the premium obtained by the
trader as proceeds from opening the
short position. During crises, the premium grows faster than historical volatility,
leading to the divergence of volatilities
and distortion of probability. Thus, to
obtain unbiased PP it is possible to reduce
the divergence between two volatilities by
artificially decreasing the payoff function
profile. This can be achieved by introducing the adjusting coefficient that lowers
premium values by some fixed amount or
by a certain coefficient.
High volatility is a fact in todays
market. Whats more, it often manifests
without warning. It is critical that traders recognize this and adjust their analysis techniques accordingly. The methods
discussed here are viable solutions to the
problem of high volatility distorting profit expectations in options positions.

Join Wave59 founder Earik Beann

and other featured speakers for
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Learn all-new trading methods
designed to maximize your ability
to nd future turning points.

See conference details at:

Wave59.com/LasVegas2011

March 26-27 2011

Mandalay Bay Resort,
Las Vegas

Sergey Izraylevich, Ph.d., and vadim

Tsudikman are authors of Systematic Options
Trading (Financial Times Press, 2010), where
you can find an extended discussion of practical application of the option profit probability
indicator and the methods used to determine
the optimal values of its parameters. contact
the authors at [email protected].
futuresmag.com

TT_Izray_Jan11.indd 47

47

12/13/10 5:08:29 PM

EquitiEs

EquiTy Trading TEChniquEs

Trend reversal spotting

with volume spikes
By B i l ly W i l l i a m s

Price and volume are key market indicators as is the relationship between the two.
Observing this relationship can provide clues for trend reversals.

ll traders experience it. You have

selected the right stock, entered
the position perfectly, watched
the stock take off and sat back as profits rapidly mounted. Waves of traders
latch onto the trend in place, attracting
more to take part. Volume surges, creating additional interest from other likeminded speculators.
Then prices reverse. Traders on the
sidelines jump on board en masse at
the prospect of getting in at a better
price, spiking the stocks price to ever
greater heights, with volume soaring two or more times normal levels.
Climactic volume
Trend reversals

After this final push, the buyers are

exhausted. There simply are no more.
Those traders and investors who got in
at the end of the move realize they got
in at the wrong time and panic sets in.
Upon this icy realization, the trend falls
apart while all the profits you watched
pile up evaporate like dew on a midJuly morning. If you knew the warning signs, you could have gotten out
with most of your profits intact. The
key is understanding the relationship
between price and volume.
48

Volume basics
Volume is to the markets what rocket
fuel is to the space shuttle. Its the stuff
that can cause stock prices to advance
or decline and, for many traders, is the
single biggest determinant on whether to
participate in a stocks trend.
The amount of trading volume in a
particular stock reveals the interest that
other investors or traders have in it. It
also reflects a stocks liquidity, which
indicates how easily you can enter or exit
a position at your price.
Volume also can be the catalyst that
attracts multitudes of buyers or sellers that will cause a stock to rise or fall
in value according to the laws of supply and demand. This activity yields
profits or, to those who fail to consider
what volume is communicating, losses.
Volume is a compass to the direction of
stock price trend.
While volume is a key factor in timing the trading of a trend, it also can
reveal where price is likely to reverse.
Knowing these key price points is a
function of being aware of the significant high or low points of price
and combining that awareness with a
knowledge of how price and volume
interact, which can give you a huge
edge in the markets.

go to futuresmag.com to see
more from Billy Williams.

P/V relationship
The relationship between price and volume is a familiar one. If the relationship
remains symmetrical, they will move
forward and progress together. But, if
one of the two displays a much different
pattern than in the recent past, then it
signifies a change.
This is often demonstrated with individual stocks. If trading volume begins to
surge at price highs or lows to levels that
are two or more times the 20-day average volume, something is up. This type of
price/volume activity at these key levels
can reveal that traders are over-committing to their positions, trying to push or
will the stock in the desired direction.
This last-ditch surge in volume is
referred to as climactic volume, which
occurs after a strong move in a given
direction and signifies the end of one
trend while signaling the beginning
of a countertrend move (see Spike &
stall, right). Different from breakout
volume, when a surge pushes a stock
upward or downward through a significant support or resistance level,
climactic trading volume is the result

FuTurEs January 2011

ETT_Jan11.indd 48

12/13/10 5:09:26 PM

of a final push of traders committing

to one final wave of buying or selling to
continue a stocks trend. This type of
trading activity is the result of fear or
greed manifesting itself while revealing
the last gasp of a stock that has run its
course. These moments are where price
and volume have reached their maximum divergence and indicate a price
reversal is likely.
At this point, the smart trader knows
its a sign to lighten his position or cash
out, while at the same time looking for a
new trend to emerge. Climactic volume
serves as both a warning signal and an
alert for new trading opportunities.
Points of reversal
When a stock is setting up to break out
of a tight trading range, normal volume
moves in tandem with price, typically
moving with price closing in the upper
quarter of its trading range, and then
expanding daily trading ranges in the
direction of the dominant trend. When
price and volume move this way, it reveals
their inherent harmony.
Warning signs include trading days
that have high trading volume but a price
range that doesnt reflect this harmony.
For example, if a stock is in a bullish
trend and there is a huge spike in trading volume but the price bar doesnt have
a large range or closes below the open,
something is wrong.
Conversely, if the stock is in a down
trend and experiences large flows of selling with spikes in trading volume but
closes near or above its opening price, it
indicates a possible reversal. This is especially true if the stock has been experiencing a strong downward trend and is forming a bottoming pattern (see Patterns &
volume, right).

sPikE & stall

agrium (agu) caps a nice bull move shortly after a climactic volume spike on
march 21, 2010. This is your clue to take profits and perhaps get short as a significant
downtrend follows.
agrium (aGu)

agu gaps higher

on climactic volume

Volume

7.5M

Climactic volume

5M
2.85M
2.5M
Feb

Mar

Apr

May

Jun

Jul
Source: eSignal

PattErns & vOlumE

mercadolibre inc. (mEli) trades downward while forming an inverse head-and-shoulders
pattern. Climactic volume occurs on Feb. 23, signaling the end of the downward trend
and on march 1, price breaks the patterns neckline. notice how an earlier climactic
volume event confirmed the pattern.

mercadolibre inc. (mEli)

56.00
54.00
52.00
50.00
48.00
46.00
44.00
42.00
40.00

left shoulder

38.00

head
Climactic vol. is in step
with large downward
move confirming trend

Volume

Tight relationship
A close study of the relationship between
price and volume can reveal trend reversals. It shows both the strength and
weakness of the trend. Trend trading is
a safe and bankable method of making
steady profits, but nearly always incurs
significant losses when the trend reverses.
Having the ability to get out at or near
the reversal point through analyzing climactic volume gives you a big edge.

74.00
72.00
70.00
68.00
66.00
64.00
62.00
60.00
58.00
56.00
54.00
52.00
50.00
48.00

The stock peaks three days later and

begins a long downtrend

right shoulder

36.00

here, climactic volume

indicates reversal

3M
2M
1M
616.69K
0

Dec

2010

Feb

Mar

Apr
Source: eSignal

And, just as important, a study of climactic volume can also help you catch
new trends earlier in their formation, giving you the opportunity to exploit them
for huge potential gains.

Billy Williams is a 20-year veteran trader specializing in momentum trading of both stocks
and options. read his market commentary at
www.stockOptionsystem.com or his newsletter on ETF Trading at www.FinanceBanter.com.
futuresmag.com

ETT_Jan11.indd 49

49

12/13/10 5:09:27 PM

To p 1 0 m i s TA k e s

futures 101

Top 10 trading mistakes

and how to avoid them
By J i m W yc ko f f

The best traders often joke that the way to make money is not to lose it
in the first place. All traders and systems lose money at times, but you dont
want to compound that reality by making these mistakes.

chieving success in futures trading requires avoiding numerous

pitfalls as much, or more, than it
does seeking out and executing winning
trades. In fact, most professional traders will tell you that its not any specific
trading methodologies that make traders successful, but instead its the overall rules to which those traders strictly
adhere that keep them in the game
long enough to achieve success.
Following are 10 of the more prevalent
mistakes traders make in futures trading,
in no particular order of importance.
Have a plan
Discipline
overtrading

Failure to have a trading plan in

place before a trade is executed:
A trader with no specific plan of action in
place upon entry into a futures trade does
not know, among other things, when or
where he or she will exit the trade, or
about how much money may be made
or lost. Traders with no pre-determined
trading plan are flying by the seat of their
pants, and thats usually a recipe for a
crash and burn. A mentor once gave me
50

the following bit of wisdom: Any fool

can get into a trade, but its the real pros
who know when to get out.

Inadequate trading assets or

improper money management:
It does not take a fortune to trade futures
markets with success. However, the higher volatility in futures markets in recent
months has prompted the major futures
exchanges to increase trading margin
requirements. Traders with less than
$5,000 in their trading accounts can and
do trade futures successfully. The electronic E-mini futures contracts have
become a favorite among traders with
small and large accounts, as the margin
requirements are much less than the
full-sized futures contracts. Importantly,
traders with $50,000 or more in their
trading accounts can and do lose it all in
a heartbeat. Part of trading success boils
down to proper money management and
not gunning for high-risk home-run
trades that risk too much trading capital at one time.

Expectations that are too high,

too soon:
Beginning futures traders that expect to
quit their day job and make a good liv-

for more trading advice, go to

futuresmag.com

ing trading futures in their first few years

of trading are usually disappointed. You
dont become a successful doctor or lawyer or business owner in the first couple
years of the practice. It takes hard work
and perseverance to achieve success in
any field of endeavor, and trading futures
is no different. Futures trading is not the
easy, get-rich-quick scheme that a few
unsavory characters make it out to be (in
fact, you can add to this list listening to
folks who try and convince you that you
can make a fortune overnight trading
futures). Before dreaming of becoming
a successful full-time trader, you should
first work on becoming a successful parttime trader.

Failure to use protective stops:

Using protective stops upon entering
a trade provide a trader with a good idea
of about how much money he or she is
risking on that particular trade, should it
turn out to be a loser. Protective stops are
a good money-management tool, but are
not perfect. Limit price moves in futures
markets can blow right past protective
stop orders. The recent higher price

futures January 2011

F101_Jan11.indd 50

12/13/10 5:18:53 PM

volatility in the commodity markets has

made stop placement a trickier endeavor,
but protective stops are a prudent moneymanagement tool. Added volatility highlights the importance of using stops and
should not be used as an excuse to avoid
them. Slippage is a fact of life in trading
and should be worked into the equation.
Understand that you will not always get
filled at your stop price on losing trades
and plan accordingly. Remember that
there are no perfect money-management
tools in futures trading.

Lack of patience and discipline:

While highlighting these virtues has
become clich, when determining what
unsuccessful traders lack, not many will
argue with their merits. One classic example of trader discipline in trading markets
lies with the rally of the U.S. stock index
futures that occurred early last autumn.
Veteran traders know that the months of
September and October are historically
bearish for the stock indexes. However,
the stock indexes last fall powered right
through those historically bearish months
and set fresh for-the-move highs on a
regular basis during that period. A trend
trader exhibiting the discipline to continue trading with the trend and the patience
to let the market tell him or her when that
up-trend had ended, would have booked
sizable profits during a period of several
weeks. Other, less disciplined traders may
have just bet on the hunch that markets
were headed lower in September and
October, without making the market
show them technical evidence of such.
Also, dont trade just for the sake of trading or just because you havent traded for
a while. Let those very good trading setups come to you, and then act upon them
in a prudent way. The market will do what
the market wants to do and nobody can
force the markets hand.

Trading against the trend or

trying to pick tops and bottoms:
Its human nature to want to buy low
and sell high (or sell high and buy low for
short-side traders). Unfortunately, thats
not at all a proven means of making profits in futures trading. Top and bottompickers usually are trading against the
trend, which is a major mistake. The

2010 rally in the precious metals markets, in which gold futures hit an all-time
high and silver futures notched a 30-year
high are prime example of markets that
continued to show solid up-trending
price moves despite moving into the
stratosphere. Would-be top pickers
in the precious metals markets were
brutalized in 2010.

Riding losing positions

too long:
Most successful traders will
not sit on a losing position
very long. Theyll set a tight
protective stop, and if its
hit theyll take their losses
(usually minimal) and
then move on to the next
potential set-up. Traders
who sit on a losing
trade, hoping that the
market will soon turn
around in their favor,
are usually doomed. You
can make adding to a loser 7B. There
is a tendency to want to price average
down on losing long positions (or up on
losing shorts) because if you like, say, corn
at $3.50, youll love it at $3.25. This is
often a bad idea and always dangerous.

Over-trading:
Trading too many markets at one
time is a mistake, especially if you are
racking up losses. If trading losses are
piling up, its time to cut back, even
though there is the temptation to make
more trades to recover the recently lost
trading assets. It takes keen focus and
concentration to be a successful futures
trader. Having too many irons in the fire
at one time is a mistake.

Failure to accept complete responsibility for your own actions:

When you have a losing trade or are in
a losing streak, dont blame your broker
or someone else. You are the one who
is responsible for your own success or
failure in trading. You make the trading
decisions. If you feel you are not in firm
control of your own trading, then why
do you feel that way? You should make
immediate changes that put you in firm
control of your own trading destiny.

10

Not getting a bigger-picture

perspective on a market
both technically and fundamentally:
You can look at a daily bar chart and get
a shorter-term perspective on a market
trend. But a look at the longer-term weekly or monthly chart for that same market
can reveal a completely different perspective. It is prudent to examine longer-term
charts, for that bigger-picture perspective, when contemplating a trade. From a
fundamental perspective, also make sure
you have a bigger-picture view of whats
occurring in the market you are following. The recent sovereign debt uncertainty
surrounding the smaller countries in the
European Union (EU) roiled the currency and other markets for much of 2010.
Currency and financial market traders
needed to keep a closer eye on the news
events and upcoming events revolving
around the EU debt crisis. Not knowing
or following key fundamental events in a
market can blindside a trader.
Jim Wyckoff is the proprietor of the analytical, educational and trading advisory service, Jim Wyckoff on the markets. He has
a website at www.jimwyckoff.com and his
email address is [email protected].
futuresmag.com

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Market Structure

Managed Money

Bust or Adjust:
Inside the error can of worms
By Ste ve Zwick

the May flash crash sent a chill down the markets collective spine,
but theres still no consensus on how to deal with collateral damage from
such unforeseen events. Heres a peek inside this complex debate.

little over a month ago, an

unnamed trader placed a market order to buy 1,000 shares of
an unnamed stock, even though just a
few hundred shares were on offer. The
order was executed simultaneously on
all American exchanges, and the price
jumped precipitously.
It wasnt, technically speaking, an
obvious error in the sense that he
didnt accidentally sell one million shares
instead of 100,000; he didnt push buy
instead of sell; and he didnt buy 1,000
shares at the price of $1 instead of one
share at the price of $1,000. Furthermore,
his 1,000-lot order didnt cause a major
market move like the May 6 flash crash,
which sent the Dow down more than 900
points in a matter of minutes, only to see
it bounce right back.
circuit breakers
Stop logic functionality

Even though it didnt fit the definition

of an obvious error, the incident was
clearly a mistake, and at least one exchange
we spoke to made it go away.
Speaking generically on handling similar types of problems, Ed Boyle, who just
left NYSE Euronext to handle business
strategy development at Getco, says, We
52

would call all the traders who made the

other side of those trades and say, look, a
customer put this order in improperly. He
shouldnt have done that, and he knows
he shouldnt have done that. We would
like to adjust the price appropriately. Can
we give him a break?
Market makers usually will adjust the
trade, even though they dont have to.
They will do it as an accommodation,
Boyle says. It shows how the industry
and traders work very closely with the
trading desks at each exchange and internally to make sure certain customers get
fair trade within the industry.
Such procedures echo the out-trades
of old, when floor clerks would gather
at long tables to rectify, negotiate and
settle discrepancies and errors from the
previous day. The main difference is that
errors today, though less frequent, have
greater consequences.
Indeed, as markets become more interlinked and trades more instantaneous,
the damage that an error can inflict is
increasing. Nothing illustrates this better
than the flash crash, which contrary to
initial reports wasnt a classic fat finger trade where someone pushes a wrong
button. Rather, it was a case of someone
hitting the market with an unusually
large trade at the exact wrong moment,

according to Findings Regarding the

Market Events of May 6, 2010. Issued
jointly by the Securities and Exchange
Commission (SEC) and the Commodity
Futures Trading Commission (CFTC) in
late September, the report concluded that
the market was already on the ropes when
a massive sale of S&P E-Mini futures contracts triggered a flurry of additional sales
by high-frequency algorithmic traders.
Since then, the SEC beefed up its
circuit breaker system, which already
imposed trading halts across all markets
when prices move too far too fast.
The flash crash, however, only moved
a small part of the market a far distance,
and fast. It didnt move enough of the
market to trigger circuit breakers, so the
SEC piloted circuit breakers that halt
trading in shares that move more than
10% in five minutes. It also added provisions for busting trades that happen
outside the circuit-breaker range.
All of these provisions are designed to
prevent wild moves that are sparked by
something other than real-world events,
while also letting the market go where it
should if real-world events so dictate.
The new circuit breakers have been triggered several times since June, and as we go
to press, the SEC is working with exchanges to develop a plan that its calling limit

FUtUReS January 2011

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up/limit down, which could either be

more complex and sophisticated than the
current system, or simpler, depending on
which arguments win out.
Critics have attacked the SEC for taking so long to come up with a solution,
but anyone who attended the November
Futures Industry Associations (FIA)
Expo in Chicago can tell you the issue
isnt as easy as it seems. Four separate
panel discussions focused on the new
risks ushered in by electronic trading, and
they offer a glimpse into the challenge of
keeping a market running right and preventing it from driving into a ditch.
Pre-Trade prevention
The FIA has issued two reports on market risk. The first, FIA Market Access
Risk Management Recommendations,
was published in April by the Principal
Traders Group (PTG) just before the
flash crash. Then, in November, the PTG
followed up with Recommendations for
Risk Controls for Trading Firms (see
Nipping it in the bud, right).
Both reports are available online and
suggest requiring exchanges and brokers
to impose pre-trade filtering on customers. The recommendations apply mostly
to traders entering trades manually, and
include such things as position limits, price
collars and volatility filters, but also call
for the development of more algorithms
that can protect markets from machines
engaged in high-frequency trading.
The CFTC technology advisory group
also commissioned a survey to see which
brokers already implement such measures, and got responses from 20 exchanges globally. The report has not yet been
released, but preliminary figures made
public show that 16 of the 20 exchanges
have some sort of controls, and 12 have
filters for fat-finger errors. Beyond these,
however, there is wide variance in what
exchanges do and dont do.
About seven of the exchanges have
some sort of maximum long-short position limits in place, said Leslie Sutphen,
formerly head of eSolutions at Newedge,
who helped put the survey together.
Some of the exchanges require a margin
utilization figure to be in place, and three
of the exchanges have some requirement
for some kind of intraday profit and loss

NippiNg it iN tHe bud

the Fias Ptg wants to see all firms implement these pre-trade filters PdQ.
pre-trade risk Limits: Limits on size and position size based on a customers
trading style, experience and risk tolerance.
price collars: Trading systems should have upper and lower limits on the price of
the orders they can send, depending on the product. Any order for a price outside
of the price collar doesnt leave the system.
Volatility awareness: Specified action, such as alerts, pauses or automatic freezes
if an unusual price move or volume spike occurs during a specified timeframe.
Fat-Finger Quantity Limits: Upper limits on the size of the orders they can send,
configurable by product.
repeated automated execution throttle: Automated trading systems should
be able to monitor the number of times a strategy is filled and then re-enters
the market without human intervention. After a configurable number of repeated
executions, the system should be disabled until a human re-enables it.
Outbound Message rate: Trading firms should limit the number of order messages
their trading systems can send to the exchange in a short period of time. These
limits should be in line with exchange rules and the trading firms risk tolerance.
Market data reasonability: Trading systems should have reasonability checks
on incoming market data as well as on generated values.
kill button: Trading systems should have a manual kill button that, when
activated, disables the systems ability to trade and cancels all resting orders.
Market Maker protections: Firms acting as designated market makers should be
aware of and, when appropriate, utilize exchange-provided market maker protections.
Source: FIAs Principal Traders Group

restrictions as well.
Such mechanisms are not new, but traders have pushed back against their use in
the past because they can slow down transaction time even if for a nanosecond.
Sutphen, however, says shes never experienced that sort of resistance.
The trading firms we deal with always
had no problem if we required them to
have risk controls in place, she says. The
challenge we face is that theyre not standardized across firms, so if youre going to
implement mandatory risk controls, not
necessarily mandated by the exchange,
youre going to end up with 600 different
risk management tools that youre supposed to be maintaining. Its very difficult
for an FCM to perform that task.
Indeed, several people have called for
the implementation of standardized
best practices including CME Group
Executive Chairman Terry Duffy.
Hed like to see the whole industry
adopt the CMEs stop logic functionality, which under certain stressful market
conditions temporarily pauses the markets for five to 20 seconds. When testifying before lawmakers investigating the

flash crash, he said stop logic paused the

market long enough to let more liquidity
in, and that trading on the CME led the
bounce back.
In 2008, we were averaging close to 50
errors in a month and now were down
[to] around 19 or fewer, and we really do
believe that its very much so attributable
to the automated processes that we put in
place: Price banding, no-bust ranges, credit
controls, says CME COO Bryan Durkin.
Each year we come up with some additional innovation, which allows us to minmize the occurrence of these situations.
Ed Dasso, manager of market regulation for Intercontinental Exchange (ICE),
says ICE is looking into the adoption of
stop logic, and also believes in more uniformity across platforms.
There should be standardization,
says Robert Brown, global head of eBusiness integration at BGC, but its going a
little bit too far to say they need to be in
place for every single trader.
Steffen Kohler, head of product development at Eurex, says procedures are
already standardized in the EU.
In the U.S., you have these case-to-case
futuresmag.com

ManagedMoney_Jan11.indd 53

53

12/13/10 5:20:28 PM

Managed Money continued

tHe MOre tHiNgS cHaNge...

a 2006 market study titled error trades in Futures Markets showed that markets
usually bounce back quickly from error trades thanks to traders willingness to take
the opposite side of wild moves. these dow futures chart from that report demonstrates that. Busting trades could make traders less willing to take that risk.
time Series of trades and in cbOt error events

trades

error trades

Price

yM07 03 03

9.20
9.10
9.00
8.90
8.80
8.70
8.60
8.50
8.40
7:38:01 8:33:32 8:41:42 8:51:08 9:00:40 9:04:35 9:12:28 9:22:07 9:30:27 9:38:05 9:43:15 10:04:01 10:35:43 11:13:49 11:40:26
Time
yM02 14 03

8.10
8.05

Price

8.00
7.95
7.90
7.85
7.80
7.75
12:20:38

12:36:52

12:58:28

13:22:38

13:44:02

14:01:40
Time

14:20:19

14:30:34

14:55:34

15:34:03

Source: Error Trades in Futures Markets

laws, he says. But in the EU, the principle is one rule has to fit everything, which
is a challenge because different market
participants have different interests.
The debate becomes intense when they
start talking about what happens if the
filters fail and an error takes place especially if that error triggers other trades
in other accounts, and those trades lose
money. On particularly wild days, like
May 6, trades executed outside a certain
range may be busted (canceled), and its
not always clear what guidelines indicate
if that happens or not.
They dont tell you right away,
either, says Shelly Brown, a director with Chicago trading firm PEAK6
Investments. We spent some long hours
on May 6 not knowing what our position was or what our risk exposure was,
and were not alone.
The problem, he says, is not the busted
trades, but the trades that remain after a
bust. If youre a market-maker or options
trader, youre always hedged. Thats rule
number one, he says. But lets say you
have a position, and then you hedge it, and
then the first trade gets busted. Now what
you thought was a hedge is really a liability. Thats what we were afraid was going
to happen to us on May 6.
Fortunately, that didnt happen at least
54

not to him. But trades were busted, and

traders say that makes them reluctant to
take positions on wild days for fear of either
hedging or exiting those trades and then
finding themselves back in the market.
The CFTC exchange survey cited above
shows that six of the 20 exchanges require
those who make an error to compensate
those who lose money if that error triggers
contingent orders, such as stops.
Boyle says the exchanges prefer to
adjust rather than bust, but that thats
not always possible. Lets just say this
is a stock that opens at $4, but then you
get this outlier price, and suddenly its at
$1, he says. You cant always adjust a customers buy limits back up to, say, that $4
level because the customer says, No I have
a limit in buying it at $1, and Im not buying them at $4.
Kohler agrees. On the one hand you
have market makers that need certainty
and immediate certainty would be best,
he says. On the other hand, we have a
number of end customers that do not
have this highly sophisticated trading
validation methodology and infrastructure and we have to give them the chance
to get out of a trade if the price is bad.
We adjust wherever we possibly can
in the U.S., says Lynn Martin, COO of
NYSE.Liffe. Europe is a slightly different

set of considerations because the U.S. has

more algorithmic traders spread across
more market structures.
When busts do occur, she adds, its
important to keep the lines of communication open and clear.
On May 6, in the equities market,
quite a few trades were busted as a result
of their impact on the market, she says.
In a situation like that, the most important thing is to communicate effectively
with the market about when a decision is
made, how it is being made and why.
Don Wilson, CEO of hedge fund DRW,
agrees and says firms must communicate errors as soon as they discover them
as well. In some cases, thats incentivized.
At Eurex, if you apply for a mistrade
within the first 30 minutes, the trade
would be busted, he says. Then, from
minute 31 to minute 180, the beneficiary of the trade has the right to make the
decision to either [bust it] or adjust it.
That works in futures, but less so in
equities and options where trades are executed at the best price on several exchanges simultaneously and more interlinking
positions are created as a result. In those
markets, the chance remains for a marketmaker to be stuck with unhedged positions in the event of a busted trade. Boyle,
however, says that concern shows how far
the markets have actually progressed.
Its like the automobile, Boyle says.
When it went 10 miles per hour there
was little risk of a serious injury in an
accident, but that changed once you got
it going 50 or 60, and safety standards
needed to follow.
He says that markets have gotten faster
and more efficient, so both operators and
users have to become more diligent.
Your broker better be very professional in how hes handling himself and
how hes working, he says. And the
exchanges all need to become very good
at monitoring and controlling the process. Were like the car manufacturer and
the brokers are the users.
And using the speed analogy, if the old
floor with runners bringing orders into
the pit was the 10 mph stage, current
markets where trade latency is measured
in micro-seconds has broken the sound
barrier. Pilots know what happens when
.
you make a mistake at that speed.

FUtUReS January 2011

ManagedMoney_Jan11.indd 54

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COMMOdities
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FTS_Web_Commodities_FP.indd 1

5/6/10 3:52:44 PM

FiNaNcial reForm

TraDe TrenDS

Dodd-Frank:
Moving from theory to practice
By M i c h a e l M c Fa r l i n

Financial reform was signed into law six months ago and regulators have been
busy moving it from theory to a rules-based structure. Now, hopes and reality are
starting to clash as challenges arise for all participants.

oth the Commodity Futures

Trading Commission (CFTC)
and the Securities and Exchange
Commission (SEC) were given monumental tasks by Congress in promulgating
rules that will shape the Dodd-Frank Wall
Street Reform and Consumer Protection
Act, the largest overhaul of the financial markets since the Great Depression.
Along with the list of rules to write (see
Financial reform from A to Z, right),
they were both given very tight timetables
for actually completing the job. Some
rules, such as those pertaining to retail
forex, had deadlines as little as 90 days
after the passage of the Act. Most have a
one-year deadline from enactment.
Financial reform
Swap execution facility
Systemic risk

While some of the recent rules are areas

the CFTC already has been studying,
Dodd-Frank gave the Commission direction to bring an entire class of previously
unregulated products under their rule.
They have an enormous job. They have
been asked to create a regulatory system
for a whole series of market participants
and regulatory categories that didnt exist
56

before, says Daniel Waldman, partner

at Arnold & Porter LLP. They have to
figure out what to require to be cleared,
what to be exchange-traded, what new
forms of exchange trading really mean
and how trades will actually be executed
in this new market paradigm.
In addition to this task, both agencies
have been working hard to increase transparency in the rulemaking process, just as
Dodd-Frank aims to increase transparency
in the marketplace. In addition to almost
weekly meetings to release rule proposals,
the CFTC and SEC also hosted a number
of public roundtables to gather public
insight into issues. Also, the CFTC has
issued advance notices of rulemaking in
which they have asked for industry comment on subjects such as disruptive trade
practices and anti-manipulation rules.
Considering the task and timetable the
regulators have been given, most in the
industry are pleased with the progress so
far. Ive been impressed with the amount
of openness shown by both the CFTC and
SEC. The fact that they have given some of
these time and study makes me applaud
them, says Dr. Sharon Brown-Hruska,
economist at NERA Economic Consulting
and former CFTC commissioner. I would
ask that they slow down a little bit so we

For more on new rules, go to

futuresmag.com

have time to digest and comment on what

they have put out so far.
Others have been more impressed with
the regulators commitment to accomplishing the task given to them. In terms
of the timeline, the CFTC and SEC have
been pretty impressive. The CFTC grabbed
the bull by the horns at the get-go and
came out with the list of areas for which
it needed to make rules and it has been
rolling out proposed rules, says Willa
Bruckner, partner at Alston & Bird LLP.

Challenges
Even since clearing the final legislative hurdles on its way to becoming law, the DoddFrank Act has faced challenges and passed
those onto the regulators who now must
shoulder them, end-users who must wait
patiently and a new Congress with many
fresh members who oppose the Act.
Regulators are being asked to write
rules for a major overhaul of the markets
by three standards that normally do not
all go together good, fast and cheap. An
old production management axiom says
that in any endeavor, you can pick two of
those qualifications, but never all three.

FUTUreS January 2011

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Congress gave the regulators a task that

requires all three qualifications to be met
for success. As such, each is an individual
challenge and doing the job while meeting
all three is an even greater one.
By the nature of the rules being written,
they have to be good. Regulators have to
provide a fairly robust justification for the
decisions they make, Brown-Hruska says.
It behooves them to do a very well reasoned and careful analysis; otherwise they
may be subject to challenge. Weve seen
this at the SEC and even have seen some
of their rules thrown out by judges.
Couple stringent dealines with the need
for comprehensive, detailed rules, and you
have a daunting task. A prime element of
this is definitions.
Being new regulations, definitions to
incorporate the new swaps market had to
be adjusted and whole new ones created.
Just to get rules out for comment, the
CFTC had to promulgate many of them
without formal definitions in place. In
an ideal world, there would have been a
better way, but it has an incredible task
in a very short amount of time. Congress
put this legislation in place, but Im not
sure Congress sat down and realized what
an enormous task they were giving the
CFTC, Bruckner says. If the CFTC had
sat down to hash out the definitions first
before writing all the rules, it may never
have met the deadlines imposed on it.
Finally, regulators are being asked to
create new market structures and rules
on the cheap. Besides the initial task of
writing all the new rules, they also have to
be able to monitor, regulate and enforce
them once they actually are enacted.
The CFTC has been acting swiftly and
Chairman Gary Gensler says he has appropriate resources to complete the rule writing but will need considerable additional
funding to implement the rules once they
are in place (see Gensler: Correcting the
record, September 2010).
Resources are a big issue for the regulators. While they have hired some additional staff, it is a task that is much bigger
than anything they have had to deal with
in the past, Bruckner says. Once the rules
are in place, they then have to implement
and enforce them, so the resource issue will
continue to be a challenge for them unless
they get a lot more funding from Congress

FiNaNcial reForm From a to Z

With the speed and volume of rulemaking, it can be hard to keep up. heres a quick
recap of some of the rules already proposed.
Sept. 10

Final: Regulation of off-exchange retail foreign

exchange transactions and intermediaries

Sept. 10

Final: Performance of registration functions by National Futures Association

with respect to retail foreign exchange dealers and associated persons

oct. 14

Interim nal rule on reporting of pre-enactment swaps transactions

oct. 14

Financial resources requirements for DCOs

oct. 18

Requirements for DCOs, DCMs, and SEFs regarding

mitigation of conicts of interest

oct. 26

Agricultural commodity denitions

oct. 27

Privacy of consumer nancial information

oct. 27

Business afliate marketing and disposal of consumer information rules

Nov. 2

Provisions common to registered entities

Nov. 2

Anti-disruptive practices authority contained in the Dodd-Frank Act

Nov. 2

Process for review of swaps for mandatory clearing

Nov. 2

Position reports for physical commodity swaps

Nov. 2

Removing any reference to or reliance on credit ratings in Commission

regulations; proposing alternatives to the use of credit ratings

Nov. 3

Prohibition of market manipulation

Nov. 3

Investment of customer funds and funds held in an account

for foreign futures and foreign options transactions

Nov. 17

Implementation of conicts of interest policies

and procedures by FCMs and IBs

Nov. 19

Registration of foreign boards of trade

Nov. 19

Designation of a chief compliance ofcer; required compliance policies;

and annual report of a FCM, swap dealer, or major swap participant

Nov. 23

Registration of swap dealers and major swap participants

Nov. 23

Implementation of conicts of interest policies and procedures

by swap dealers and major swap participants

Nov. 23

Regulations establishing and governing the duties of

swap dealers and major swap participants

Nov. 26

Public input for study regarding oversight of

existing and prospective carbon markets

in order to meet those resource needs.

Those additional funds are going to
be a difficult sell. Were in a major crisis in terms of the federal deficit and we
need to see cuts and fiscal responsibility
in general, and that is going to affect the
CFTC and SEC as well, Brown-Hruska
says. Theres probably going to be some
cutback in resources. That just makes it
more and more difficult for the CFTC to
get its work done.
The cost dilemma is mostly outside the
CFTCs hands as a new Congress consisting of many who opposed Dodd-Frank
prepares to take power (see Major turnover, page 58). [Republicans] may not be

able to reverse the legislation, but they will

be looking at other ways of modifying or
impacting the outcome of that legislation.
Not providing additional funding may be
one way of doing that, Bruckner says.
That could be as effective as overturning it. If the House wont approve an
expanded budget for the CFTC and SEC,
it is almost impossible for them to implement the provision. It is a very indirect
way of influencing, says Gary DeWaal,
general counsel at Newedge. It would be
inappropriate, though, because the CFTC
is an independent government agency.
These are challenges Congress will
be facing in the upcoming session and
futuresmag.com

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TraDe TrenDS continued

major turNover
The incoming congress has a lot on its mind, least of which is reform its members
dont agree with. here are a few key likely changes in house committees.

committee

outgoing
Democratic chair

Potential
republican chair

Agriculture

Collin Peterson (MN)

Frank Lucas (OK)

Appropriations

David Obey (WI)

Jerry Lewis (CA)

Budget

John Spratt (SC)

Paul Ryan (WI)

Energy & Commerce

Henry Waxman (CA)

Joe Barton (TX)

Financial Services

Barney Frank (MA)

Spencer Bachus (AL)

Oversight & Government Reform

Edolphus Towns (Ny)

Darrell Issa (CA)

ones whose impact may not be evident

for some time. One thing working in the
regulators favor that multiple experts
mentioned is that many of the new
Congressional representatives have little
or no political experience, which may
dampen the effects they are able to have
on the budget and thus reform.
Finally, end-users, dealers and traders
all are anxiously awaiting the finish of rule
writing to see the new costs and capital
requirements that now will be required.
The problem is going to be the cost.
This is going to be an incredibly costly
proposition for firms to implement,
DeWaal says. The proposals out there
are all about increasing cost and decreasing revenues. The economics of this business are really going to be challenged. If
at the end of the day you have great theoretical rules but no participants, then you
have defeated the purpose.
Those added costs to market participants are shaping up to take a variety of
forms, including increased compliance
costs, additional technology requirements
and connectivity requirements. Finally,
there are added requirements for business
conduct as well as back office standards.
However, many have argued that by
opening OTC markets to a broader group
of participants, end user costs could go
down. While compliance costs will go up,
much of the complaining is coming from
dealer participants who will face greater
competition and reduced margins.
Included in the legislation are a number of provisions that drastically will
change the marketplaces, including
areas such as swaps and position lim58

its. New requirements for swaps trading and clearing probably have the most
far-reaching potential.
This area is among the more controversial. On the one hand, they want to
be careful not to discourage the use of
exchanges to transact business that is a bit
more customized, Waldman says. On
the other, they want to make changes to
market structure to encourage more preand post-trade transparency. It is a delicate balance they are trying to strike.
What the new swap execution facilities (SEFs) will even look like has drawn
considerable attention. The nature of
an SEF is going to be very important.
There is a lot of sentiment out there that
it should be more than just an exchange,
DeWaal says.

Dodd-Frank will bring to the markets.

It will certainly be a great help to have
a lot of the bilateral products traded
through a clearinghouse and executed
on an exchange. Transparency is a good
thing, DeWaal says. The CFTC and
SEC have to keep in mind the requirement of open access. If at the end of the
day, the only people engaged in swap
clearing are the current dealers, then this
will be a failure.
This is a major issue for non-bank
FCMs who feel the initial structure for
CME Groups interest rate swap clearing
solution favored the major investment
banks that have dominated the space
and were major contributors to the financial crisis for years.
Brown-Hruska is less optimistic on
changes. [Reform] will be detrimental to
the quality of the derivatives market. I am
a proponent of exchange trading and the
SEF is a great idea. On balance, though,
they overshot the mark and are doing too
much in terms of trying to decrease systemic risk and raise transparency.
At this point, most rules have been proposed and are in their comment period.
As such, experts and regulators are urging
dealers and traders to share their views
with the regulators through comment
letters so that rules can be adjusted and
made to better fit the markets.
Moving forward, answers and basic
structures are beginning to take shape,

If at the end of the day, the only people

engaged in swap clearing are the current
dealers, then this will be a failure.
Gary DeWaal

Not only is the structure of the SEFs

in question, but exactly what must be
openly traded and cleared has left dealers
wondering. They have to be very sensible
about what is eligible for clearing. They
have to realize a significant number of
these swaps are customized and not eligible for clearing, Brown-Hruska says.
The Dodd-Frank Act is a sweeping and
far-reaching overhaul of the financial
markets that calls for many changes in
the coming months and years. Yet, there
are nearly as many opinions as there are
experts as to the actual benefits that

but there are still a lot of questions and

definitions that needs to be added to
reform. Brown-Hruska remembers her
time as a commissioner and recalls burning the midnight oil just to stay up on
her own reading at the time, and says
she does not envy the job the current
commissioners have of creating rules to
reshape an entire market.
Considering the speed at which new
rules are being written, it is apparent the
current commissioners are burning their
share of oil. It also might help explain the
climb in coffee prices.

FUTUreS January 2011

TradeTrends_Jan11.indd 58

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Classifieds_Jan11.indd 61

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12/15/10 8:39:34 AM

TRADER PROFILE

Cheung teaching his winning ways

ickey Cheung has built some of the most successful

trading systems that are in great demand by hedge
funds and institutions, but his first love is trading; he
views himself more as a trader than a system developer.
I am a trader. The reason I develop systems is to prove or
verify that my trading has a definitive edge. Through developing
many systems, I became a better trader. [With] each new system
I develop, I have new [ideas] about how to trade better, Cheung
says. Developing a system can bring discipline and confidence
to a trader. This learning skill cannot [be obtained in any other
way] besides developing your own system.
Cheung grew up in Hong Kong and went to the University of
Houston to study biochemistry. There a professor introduced
him to futures trading and he was hooked. He taught me how
to trade soybeans and it got me excited, but I had no money to
trade, Cheung says.

RiCkey CheUng

He went on to earn an MBA from Houston before moving

back home to Hong Kong in the early 1980s. There he immediately began trading, mainly in the foreign exchange market.
I could work my full-time job in Hong Kong while it is the
night time in USA, and after I finished work I could trade the
U.S. market, he says.
Utilizing all of the standard indicators in his early trading, he
was not successful. Each futures market has its own characteristics, so using popular indicators like MACD, RSI , etc., to trade
all the markets will end up with a mediocre result.
And he needed to keep his day job because he was not making money trading. The onset of electronic markets was a huge
boon for Cheung. I used common indicators and lost almost
every year until I discovered that the Nasdaq 100 moved faster
than the S&P and started doing a lot of research and testing
on it.
That discovery allowed him to post his first positive trad62

ing year in 2000 and led to the creation of his first system, RC
Success, which uses the Nasdaq 100 to forecast entries in the
E-mini S&P. The program was rated the number one S&P program by Futures Truth for several years.
When building a system, I start with an observation, then
test it and find out the reason or logic behind it. I observed NQ
[moves] faster then ES, so I tested it and it worked, he says.
Cheung then created RC Beginner in 2008 (currently the
number one rated S&P program by Futures Truth with an average annual return of 147.1% since launch), a simplified version
of RC Success to teach to his students.
Most of them did not know what ES was all about, so I
simplified my system. After I simplified it, it became even better, Cheung says. In trading, at the beginning, many people
go through the same stage, using more and more sophisticated indicators thinking that is the way to go, but that is not
the way to go. Nowadays, I make it very simple and trade one
or two times a day.
He became registered as a commodity trading advisor in 2004 after
developing his first system and remains so. However, he chose to sell
his systems to hedge funds and teach his methodology while trading
and developing systems for himself instead of managing money.
Cheung has created more than 100 systems, many of which he
has sold, but he is currently trading off of a proprietary indicator he created that measures overbought and oversold conditions. Not only does Cheung reject standard indicators, but he
doesnt even look at charts. All his trades utilize intermarket
analysis and are based on numbers.
He trades the ES, euro, Heng Seng Index and crude oil.
Mostly it is a trend following system, but my edge is finding
overbought and oversold conditions, Cheung says.
He is teaching students how to trade with the overbought/
oversold indicator, which he applies to the ES and euro but will
not reveal its mechanics.
My course usually just runs for two hours, but the backtest
exercise will take them many days to do and redo. I provide them
with data and model answers to practice; after backtest, they
become skillful and have confidence. Then they will do forward
testing, before they do real trades, he says.
Cheung says his overbought/oversold indicator correctly predicts market moves 80% of the time as opposed to the RSI, which
he says is only 35% accurate. I did a lot of research on it. Trend
following many people can do, but when does the trend stop?
When it goes to overbought and oversold; this is my edge.
Cheung says his current methodology is more successful than
the RC Beginner system, which he has published for all to see.
Why? I do not need this system any more, Cheung says. Using
NQ to trade ES is what I did from 2000 until now, and it's for
beginners. I have a more unique indicator that can win consistently, so it's good to share [with] others, and to show traders
another way of trading futures, no charting required.

Photo by Garry Studio

b y Dan ie l P. Co l l i n s

FUTURes January 2011

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FTS_FP_Ads.indd 4

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