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Today's edition of the Saxo Morning Call features the SaxoStrats team discussing the continuing weakness of the US dollar as commodity prices recover ground and in the wake of key US equity indices hitting all-time highs Thursday.
Article / 16 November 2016 at 14:30 GMT

Quality and equality

Hypothesis Testing
United Kingdom
  • Supply/demand curves do not show the whole picture
  • Elasticity/inelasticity also a crucial metric
  • Another important measure, or metric, is 'equality'

By fxtime*

Often in everyday life, we consider and evaluate a plethora of things just as we would when trading.

Here's a simple example: parents often mark the ever-increasing height of their children on the wall, as we are measuring growth in real time as the child ages. We also compare our childrens' heights to our own, using our own height as a measure of normality. 

It is this last point – the comparison with normalcy – that is regularly ignored in the general marketplace by new traders.

Prior articles have described normal moves for markets before a change in trend can be evidenced. Likewise in prior articles, we have described the application/understanding of the classic bell curve and standard deviation theory. 

These theories have their applications, along of course with the crux point about zero sum trades and how to skew them to your advantage to ensure your trading account consistently grows over time just as you would budget your expenditure every month to ensure you have some savings by month end.

We can, however, consider an alternative measure for trading purposes – namely, "equality".

Are Goldman Sachs and JPMorgan equal as finance powerhouses?

Are power supply generating firms elastic or inelastic?

Are the Dow Jones and S&P 500 indices equal despite their high confidence and correlation values?

Inelastic curves are near-vertical, meaning the quantity of stock vols needs change little to effect large price moves, but elastic stocks and indices have flatter demand curves so quantities have to be large to substantially shift prices.
 
All supply/demand curves, however, have to reflect a consensus view but they don't show the whole picture. Recent market events in the wake of Trump's win has shown inelastic market events, whereas with Brexit we saw inelasticity, but also elasticity. 

Economics offers us some great insights as to the market's prowess for pricing of anything to the supply and marginal utility of market places and their products. 

Let's simply look at the theory of elasticity...

Inelastic markets display steeper supply/demand curves where very small adjustments in supply or demand can cause severe distortion in price, but equilibrium rapidly returns. These scenarios are common in what I call "sticky markets" where it is hard to move your custom or the supplier is a monopoly powergroup. 

Telecom firms used to have ''sticky customers'' who were under contract with them regardless of the quality of service provided by the firm.

Now look at copper and the reaction we saw after Trump won the US election. Copper is a commoditised future contract that is deliverable, which means those holding the deliverable stock options etc. were happy to keep hold of their positions and the supply side of the stock became slightly constrained (but prices distorted rapidly in response to such small restrictions in supply). 

These situations rarely last before supply/demand reasserts an equilibrium.

With Brexit we saw the same thing for the FTSE 100 index as shareholders were wrong-footed by the vote but despite the drop, shareholders predominantly kept hold of their stocks. Again, real stock sellers didn't appear in sufficient volume so supply/demand elasticity rebalanced and the market recovered.

However with Brexit we also saw the other side of elasticity in GBPUSD. This isn't a sticky market; liquidity is huge and when the Brexit vote appeared, the market reacted instantly. As the supply side is always there, we saw cable fall hard.

Cable
And things have hardly brightened since. Photo: iStock

So elasticity gives us a "heads-up" for when to enter a market. We have all heard of the saying ''catching a falling knife'' and if we want to attempt this high-risk trade then we had best make sure it can be described as a ''sticky'' knife!

All the above merely tells us where to look for the safest mean-reversion trade, which is straightforward enough. But can we seek a better real time intraday or a daily equality trade that generates income?

Let's return to the  original question... are Goldman Sachs and JPMorgan equal in pricing and volatility? The answer is obviously no.. However most on this site watch other equities for trading purposes and perhaps a more relevant equality would be, say, that between Apple and NASDAQ (QQQ)... consider a 1:1 price value that seeks a balanced trade purchasing value. 

Remember we are trading for income (as would any business), so we seek measurable returns, thus:

  • Apple daily range averages 2.1% or, if you prefer, approximately $240
  • QQQ daily range is 1.6% or, if you prefer, approximately $163

There is then a disparity of $77 that you can trade for. Usually it is best to seek 50% of the expected move as the fastest rate of return with minimal time risk.

Also, when Apple is at its maximum range you would look at QQQ to be following and trade accordingly.

Equities
Source: fxtime* 

The normal range for the market place is one standard deviation. In other words, 68% of the time the equity remains in these percentile ranges and you can trade one against the other. You will be amazed at how often there is an imbalance between correlated stocks and also indices. 

The idea of efficient market pricing is great over a long time period, but intraday or even in a three-day period it is flawed. This is why inelastic market events occur: because we haven't reached an efficient market price nor is there a supply/demand balance. 

As usual, I will post real time updates. In the UK it is commonly recommended that you should eat a total of five fruit and veg per day. I view Apple equities as one of my five a day... just as the doctor ordered!

— Edited by Michael McKenna

*fxtime is an alias
2y
fxtime fxtime
I forgot to have the attached chart included to show price movement as described above ! Entirely my fault...hopefully this helps explains the commentary above
2y
Michael O'Neill Michael O'Neill
Great stuff: Your articles should be packaged on one site and berequired reading for every trader. .A lot of what you write brings clarity to old fashioned fundamental/technical analysis.
2y
fxtime fxtime
LOL...thanks Mike. The posts to Tradingfloor are only finite as there are projects running for me behind the scenes that will ultimately pull me away from the site ! But that is in the future.

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