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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 / 11 May 2016 at 13:00 GMT

Skewed thinking

Hypothesis Testing
United Kingdom
  • Ebay may look like an example of perfect, efficient pricing at first glance
  • But the popular auction site is really an example of a skewed buyers' market
  • Currently we have a positive skew to the markets implying drops can be exacerbated
  • Traders should consider the impact of a liquidity spiral/crisis
By fxtime

Carry out the following exercise:

  • Firstly think of a whole number between 2 and 9 (inclusive),
  • Multiply that number by 9,
  • Add the two digits together,
  • Subtract 5,
  • Convert the answer to a letter of the alphabet eg A=1 B=2 etc,
  • Think of a European country starting with that letter,
  • Now take the second letter of that country and think of a mammal (but not a sea creature or a bird) beginning with that letter.
All things being equal, were you thinking of an elephant with a Danish flag?

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Don't get trampled in the rush to conclude that choices
are always random, and markets perfectly efficient. Photo: iStoc
k

 The above exercise relies on a type of probability for association of animal and the selective choices for the country and subsequent letter choices from your supposedly random selections are in truth a form of skewed thinking.

We've all seen Ebay online auctions and witnessed tricks of buyers to capture the best price for any product. They do not await a true balancing auction price where all bidders have reached their maximum given values. Instead, a cheeky bid arrives in the last few seconds of the online auction, that is fast enough to ''win'' the product sale and timed to prevent a counter bid. So Ebay is not really a perfect efficient pricing model then. It's more like a skewed buyers' market.

Option traders would know this Ebay effect as negative skew. When events change prices it is to the upside only.


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Ebay may look like a perfect efficient pricing model at first glance, but time of trading anomalies reveal that it's really a skewed buyers' market. Photo: iStock

How many times have you heard that someone must win the lottery? When in truth they don't. The lottery will have had days when no-one won and a rollover occurs. Yet we are always led to believe that someone must win. Obviously eventually someone will win but it doesn't occur every week. Advertising skews our expectations and expected probabilities...markets are no different.

Currently we have positive skew to the markets, so surprise elements to the market where time is limited, for example the end of the week or public holidays where markets are shut... will be to the downside. But we can benefit from this skew and mispricing.

So if the Implied Volatility/Implied Volatlilty Ratio (IV/IVR) skew and pricing models show the current bias for market surprises is to the downside, then we should consider trades with that defensive bias. The trend may be your friend, but you might need to consider where does that leave you when things suddenly fall into a liquidity spiral....there isn't space for this particular subject here but I will come back to it in a few weeks.

Now look for inequalities in the market place where the so called efficient pricing model is flawed. Where can we benefit from the inequalities described.

A strategy that may be of interest?

Day traders bread and butter trade(s) are gap days. Using the prior day close price and compare to todays opening price on say the SP500 or FTSE100 we see events such as ex dividend dates or world macro events or even catastrophes cause gap down days. It doesn't matter what caused the gap. The fact remains a gap occurred.

15yrs of rolling data suggests that 83.9% of ALL down gaps fill within five trading days !
77% will rally to the 50% of the down gap in one wave. So we know that a long at the point of open ;-
A) The fastest return is to seek the 50% of expected gap fill.
B) Odds are that the gap will fill over the five day duration.

Can the trade be enhanced as I haven't defined any money management / stops?
It can... but consider one other factor for this trade. Should the down gap occur AND the open price is entirely below the prior day trading range. These usually occur after bank holiday periods or world catastrophe events or weekends. The gap down is the efficient pricing algos trying to reflect new values pre-market the world event etc has already happened when the markets are shut so indices are heavilly marked down. A long at the open is contrarian to the panic drop but is usually ultra profitable in the same time frames with the 50% of gap still being the fastest rate of return.

What if the market just drops from the opening bell? You still have the same strategy as the probabilities refer to a five day trading window. Make your opening trade smaller than normal and if we get a lower close scale a small trade onto the original trade. Make the opening trades at say 10% Stake size and the second at another 10 or 20% stake size.

These trades are probability and rely on no indicators so trade small as your money management technique. The profits do build and compound over the year so keep risks lower than normal trade position sizing. I don't add any more trade positions after the second opening trade.

This is a long-only trade structure and does not work with gap-up days. I will comment on those later. Also weekly dated options can be superb for these trades.
g



Looking at gaps is something for another day. Photo: iStock

– Edited by Robert Ryan


*fxtime is a pseudonym


4y
fxtime fxtime
screengrab of the daily SP500...
4y
zefy zefy
Use of weekly dated options is very interesting point.
4y
Michael O'Neill Michael O'Neill
Another great and entertaining article. I did the exercise but my answer was "elk"- Just kidding, of course, I googled the names of animals starting with "e".
I used to trade the gap between the Toronto close and New York open in interbank USDCAD, long before charts on computers were available, using graph paper and plotting High low open and close. Very rudimentary but it works, and still does.
4y
fxtime fxtime
LOL...I never thought of Elk LOL....interesting what you say about the Toronto close and New York open as Victor Niederhoffer in his book Education of a speculator (I think ??) had to back test his theories on a quant model. He was trying to prove active scalping did earn consistently but amazingly he found that from 1993 to 2003 if you bought at the close and covered at the opening bell the average return per trade was 0.05% Where as buying at the open and covering at the close would on average incur a loss of 0.01% on SP....he then done exactly what you have said and the data changed to 0.07% average return so trading in globex was far more profitable !
4y
fxtime fxtime
SP500 and FTSE100 down gaps met the minimu 50% down gap fill today. Infact they exceed the minimum moves so i got my scalps as I seek the fastest /easier returns however I still expect the gaps to fill within the time frames. The cheapest route is obviously a weekly option but most here utilise CFDs so if we drop lower I will view this as an opportunity to re-open a gap fill trade :-)
4y
Michael O'Neill Michael O'Neill
I know its none of my business but I am curious-Are your trades all algo's and autoexecuted?
4y
fxtime fxtime
The vast majority are manual....a lot of long term trades run in the background. End of Day are built via preset orders and a lot of those have algo stops. Intraday I have a day planner that looks for certain trade set ups at pre-determined timings. So usually on the hour I will know exactly what are high confidence trades for certain markets and then either preset orders or link to ensign software for it to auto execute as a algo. the std deviation trades and probability intraday trades have to be algo however. The control factor on the algo is obviosly the trade strategy probability with an overlay of the most recemnt rolling 100 trades dataset. If the 3yr or in some cases 5yr rolling data or the very short term rolling data show a probability below 84% the trade is cancelled.
4y
fxtime fxtime
Range breakout strategies are preprogrammed into ensign/iddata but I can easilly make the same trades manually without any material difference to my normal daily tradeplan(s). In addition I use Genesis technologies as a back up system which links well with my excel/jags/stan and R data models.
4y
fxtime fxtime
If you want I can post the time sequence for each day where trade scenarios would be highlighted/actioned. In an earlier post I commented that each day has a variation especially with FX. Also I will trade markets as per usual....today I waited for Amazon to exceed 2% on the day before shorting manually for a meagre $2.00 profit. All my systems will show distributive data and historic data along with probability etc. I keep my charts very basic however just the OHLC as I am simple LOL. The trade set ups I post all work together or individually for trade entries or can be reversed as trailing stops. My beta stuff for trades that exceed three days seem to be the poorest received here hence my postings for scalps mainly.
4y
fxtime fxtime
Spread trading rely on spreadsheets only. I have no need for charting there just as you wouldn't on Theta trades...the time periods are generally longer than the average of most postings here. Consequently I don't really post them. Presumably Mike you too trade the monthly OTM trades with 84% probability of profit and know the quirks for rollovers to maximise premium returns but that is all manually entered and there are option specialists here that could explain that subject far better than me.
4y
fxtime fxtime
Sorry for the long winded response and hope it makes sense...presume you too trade commercially and trade manual and preset orders as your trades are often for trends to be caught and can be fine tuned by manual adjustments responding faster/easier to market sentiment shifts ?
:-)
Have a good evening Mike....if you are up for it I would be intrigued on your own set up/management?
4y
fxtime fxtime
Incidently looking at market depth on Amazon I suspect the new norm for that equity is a move of 2% then retrace...whilst I only earned $2.00 = 200pts... it is a fast revenue stream which tracked the std dev nicely !!
4y
zefy zefy
Down gap means price is beyond 2nd std dev and trade is about price to return to between 1st and 2nd std dev?
4y
zefy zefy
Is there going to be new article later about gap-up days?
4y
fxtime fxtime
Oh yes but next week is a bit off the wall....just remember that all the tarde articles link together in various ways and before the gap up strategy is shown we need to consider a childs' see-saw analogy !
4y
zefy zefy
Sounds good!
4y
fxtime fxtime
You would think in this line of business I could type the word ''trade'' successfully !
The down gap is not necessarilly due to a std dev violation although it often is and the 84% rule subsequently applies but more often due to inefficient market economic pricing models. ISLM curves etc !!
4y
zefy zefy
Yeah, cant't wait to read next week article :)
Thanks for clarification.
4y
inukshuk inukshuk
Superb article. Will try out. Have been having lots of fun with the DAX looking for spurts during closing. And you are right, it is a weird beast. I just use time to trade, looking a pure price action
4y
Rodrigues Rodrigues
We should be very aware of exposure management in this trades cause it only takes one trade to loose it all. Saying that If you have 80% probability of success and you think thats equal to 100% you might get those 20% ruin your account. Do you use stop orders or just wait for the tide to turn in your favour cause you are confident of the past probability? Excelent article as always. Cheers.
4y
fxtime fxtime
Stake sizes are smaller and I can ramp the stake size up rapidly. Normally i use near dated options as risk is defined.

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