Futures trading - a survival game
Numerous studies have shown that for more than 90% of all private traders the commodities and futures markets are a losing game. Being a classic zero sum game overall, there must be someone who wins, and that someone is a minority of professionals. Let's have a look at the advantages of the three main winning groups.
Contrarian trading is only for producers
Price movements of futures markets are noisy. There are random fluctuations and self-induced or manipulated starts and breakouts, which later prove to be not substantial. This is the base for an anticyclical trading strategy, buy low and sell high or the other way round. As studies have shown, hedgers, companies or entities that sell what they produce or buy what they need for producing, are the big winners of the commodities markets.
Producers have the advantage that they are hedging and so they only need to conduct one side of the trade in the market. This gives them the ability to calculate their trade in the light of their main business, which essentially caps their risk. Also, being better capitalized, they can afford to be longer-term oriented. Finally, they often have a better insider knowledge about what is going on in their market than anyone else.
The contrarian system could prove disastrous for the private trader or investor. What if the price move turns out to be substantial and results in a trend or at least doesn't swing back? Combining the counter-cyclical market entry with a stop-loss would be a self-contradicting system. Such a trading strategy is incoherent and will likely produce bad results.
Having no stop-loss is of course even worse. That's how amateurs go broke even in the stock market. In the futures markets leverage creates practically an infinite risk. Without a stop-loss even the best directional player will be put out of business sooner or later.
Sometimes producers choose to go with what they see as an emerging trend or what they anticipate to become an enduring new supply and demand situation. They are not bound to the counter-trend method, but the long-term contrarian trading strategy is only appropriate for them. To emphasize it again, studies have shown that they are the big winners.
The constant money drain by brokers, dealers and floor traders
Fees and spreads are common to all financial markets, but open outcry markets have a tendency to make prices run away in the wrong direction for orders from outsiders that seek to be filled. This elastic pricing behavior particularly found in the futures markets is rightfully called slippage. It remains an unanswered question whether the pure specialist system of listed stocks like the old NYSE, the competing market maker system of NASDAQ, either one combined with a competing electronic order book or the open outcry market is the fairest market.
Pit traders like to accuse specialists of having too much power to manipulate their prices. They conceal that specialists have the obligation to make an orderly market with guarantees for reasonable fills. Taking into account that open outcry traders tend to behave coherently, there is no big difference to the specialist's power. Both, but even more the pit traders, resist to compete against a computerized market like an ECN or outright refuse to trade off-floor through a computer system, which would put them on par with other market participants. Nowadays exchanges try to have their own ECN's and bring existing ones under their control so that their members at least make the rules.
Following the trend - well known secret of trading futures?
The third group of winners in the futures markets are commodity trade advisors (CTAs), hedge fund managers and well capitalized and experienced trading houses or individual traders. They act primarily, as long as they make money, cyclically by buying high and trying to sell higher or vice versa. Is it this easy? No, even the most successful traders of this group suffer severe setbacks, they just won't tell it you. However, they have some advantages over the ordinary speculator. They are bigger in size, they use sophisticated statistical methods to create mechanical trading systems that actually do make money and they know about the importance of good money management.
Creating breakouts of ranges or starts and turns of a trend
The naive way to start trading trends might go like this: Take a chart, spot some trends and get the impression, that one just had to enter the market here and leave it there to become rich. Well, that's hindsight! To get early on a trend and to let it run as long as possible is easy in hindsight, but hard in reality.
First, you have to enter a trend. You are looking for a starting point. That's where the malaise begins. There are strong market players, who produce breakouts of ranges, restarts and turns of trends, because they know many will stumble after them in expectation of a new or ongoing trend. If the "trend" turns out to be short lived, they can still get out with a profit, because they entered the market at the best levels. Guess what, who pays the bill? Mostly the small private trader, but often enough also the professional trend followers. That's why the rate of failure among them is much higher than these professionals are ready to admit.
Who plays this pattern of entering at early stages, pushing the price through a resistance or support, clamping a breakout and reversing it or turning a trend around in order to initiate the next small trend? Probably both, producers and trend followers, they just have to have enough capital. The futures markets are exceptionally prone to false breakouts and trends have wilder swings, tempting traders to leave early or enter late, possibly with a loss. Just have a look at charts and compare them with the stock market. But be cautious, this is easier said than done. The human mind is a pattern recognizing machine, it will always find the patterns it is looking for.
Using statistics to develop a mechanical trading system
One way to circumvent this problem of an optimistic mind finding occasions not only occasionally is to compile a trading system into an algorithm, which is then followed by a computer without being distorted by sentiments and psychological effects and without making mistakes by lacking discipline. But first one has to identify an edge that is statistically sound. This means that you can use statistics to crystallize a system, which meanders around all pitfalls - all the edges winning players have. Of course there is not much space for winners left, and that's why even professional system traders often lose.
The typical private trader has really a disadvantage in this area, as he is just not sophisticated enough. He might buy complete systems or programs, which can evaluate trading systems, test them and optimize them, but mostly he is not aware of the mathematics that are behind all this.
Over-optimization or curve fitting is the cardinal sin here. It means that with backtesting and optimizing, a trading system just learns in a fuzzy way the specific price history of a market. An over-optimized trading system works in testing mode essentially like a database that directly looks up prices after the market entry to declare that entry a buy or sell signal. This "hindsight-trading-system" has of course no problem with the past, but for the future it fails miserably.
Trading systems that actually work
However, properly designed mechanical systems are able to extract regularities that really exist, mostly with cyclical behavior. There are even anticyclical statistical trading systems that try to identify two levels of price, one for entering against the direction of a movement and a protective stop-loss in case the price doesn't reverse its direction. Nonetheless, this is a difficult endeavour. Markets change their characteristics and the statistical intelligence finds out about that only much later than the farmer who just knows that there is a new pest threatening the next harvest.
Moreover, especially the anticyclical trading system is highly sensitive to other traders using a similar system. Too many traders trying to profit from one inefficiency of the market will extinguish it. As soon as in a market such an inefficiency has emerged it is already gone, ironed out by the same system traders that are now being left behind confused, because their statistical analysis tool suddenly suggests something completely different.
Second guessing of mechanical trading signals is another problem. The typical trader tends to mix up signals of his system with discretionary decisions or tries to change the system every next time. Emotions have discipline in headlock and chaotic behavior is the result, which is the opposite of a trading system.
Bad money management makes things worse
An additional reason why so many novices are losing in this game is the lack of proper money management. Newcomers intuitively often misinterpret the margin they have to pay as their bet size, and that's why they are overtrading grossly. Usually they are out of the game very soon. But even making trade sizes only slightly too big will let your capital decline over time. Bad money management destroys your advantage if you have one at all.
To make a simple example, assume that you have no edge and put on trades with a very big trade size. A typical gain of 50% of your capital has statistically the same probability as a typical loss of 50%. But to recoup one loss you must offset it with a gain of 100%, because the first rule of money management is, to adjust the trade size to the actual capital. If you choose to neglect this rule and make trade sizes relative to the starting capital, you will go broke even sooner. In this example two bad trades may be enough.
Of course, this is an example of extreme overtrading, but the advantage a trading system may have can always be neutralized by trade sizes that are too big for it. The trade size that breaks even is astonishingly small for realistic trading system efficiencies and the optimal trade size is of course even smaller.
Summary of a zero sum game
Brokers charge a fee and have a riskless income. Floor traders and other dealers who make the market slip away and cut out small but constant gains. Producers skim the markets big with contrarian trading. Deep pockets initiate false movements and let others stumble into their losses. The only chance are trends, but they are rare, because of the small number of things to trade.
Compared with the stock market with its thousands of stocks and its worldwide diversification, there are only a handful of goods and financial indices. Also, the rare opportunities are better caught and exploited by statistically sophisticated system traders or producers with better fundamental foresight. The private trader has to make the sum of the zero sum game become zero. He is there to feed the sharks.