0108 Futures Mag

www.futuresmag.
com January 2008

Avoiding trading pitfalls 38 Using market breadth 46
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www.futuresmag.com January 2008
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WILL WICKED
HOUSING
MARKET
WRECK THE
ECONOMY?
WHAT TRADERS NEED TO KNOW
page 22
WILL WICKED
HOUSING
MARKET
WRECK THE
ECONOMY?
WHAT TRADERS NEED TO KNOW
page 22
Reproduction or use of the text or pictorial content in any manner without written permission is prohibited.
Copyright 2008 by Futures Magazine Group, 111 W. Jackson Blvd., Suite 2210, Chicago, IL 60604
TRADING TECHNIQUES
32 Failed flags can lead to
E-mini success
By Al Brooks
Flag formations on five-minute
charts in the E-mini S&P 500
can be valuable, yet it is when
those signals fail that gold can
be mined. We show you how.
38 Smoother way to trade interest
rate swaps
By Paul D. Cretien
Trading opportunities in inter-
est rate swap futures are grow-
ing, but to benefit you must first
understand the relationship
between swaps, T-notes and
Eurodollars.
Contents
J ANUARY 2008 VOLUME XXXVI I NUMBER 1
2008 Economic outlook:
Wicked housing market
spins economy
By Chris McMahon
The Federal Reserve Bank moved into easing
mode in the latter part of 2007, thanks to the
subprime crisis, resulting credit crunch and
ongoing housing weakness. Treasuries have
soared as a result, yet many analysts think easy
money and high energy prices will lead to
greater inflation. There also is talk
of a looming recession, which would force the
Fed to pick its poison: fight inflation or
support the economy. We look at the outlook
for Treasuries as we enter 2008.
22
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F E A T U R E S
Contents Continued, page 8
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6 FUTURES | January 2008
PICTURED: JIM ROGERS
EQUITY TRADING TECHNIQUES
30 Using equity DNA to improve your portfolio
By Mike Barna
Advances in genetic programming are allowing systems to be tailored to the
individual components in a portfolio rather than applying one static strategy to
all. We explain how.
42 Avoiding common trading pitfalls
By Richard L. Muelhberg
It is customary to make resolutions at this
time of year and here are some of the most
common mistakes all traders should
resolve to avoid.
46 Using market breadth in trading systems
By Lawrence Chan
Price may be the most important input in
a trading system but it shouldnt be the
only input. Many other easily available
market statistics can help you to build a
robust system. We show a few here.
D E PA R T M E N T S
10 Editors Note Dont get fooled again
12 Trendlines Forex min cap increases
BM&F IPOs SEC/CFTC tie up a
no go Subprime bailout
International News Chartview
15 Trading Places Thain named CEO at
Merrill Lynch
16 Managed Money Review
18 Hot Commodities E-mini S&P 500,
Euro, Natural gas
20 Options Strategy Butterfly spread
28 Forex Trader FX outlook for 2008
49 New for Traders New products and
services for traders
57 Book Review Millionaire Traders:
How Everyday People Are Beating
Wall Street at Its Own Game and
Naked Option
58 Dateline January and February
61 Ad Index
66 Trader Profile Gregory T. Weldon:
Old school trading
Contents continued
page 38
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please contact PARS International at reprints@parsintl.com or (212) 221-9595.
FUTURES 101
50 To be or not to be
By James T. Holter
Binary options used to be a gimmick
instrument first made popular by
the Iowa Electronic Market to
gauge political candidates
popularity, and later as a proxy for
sports gambling. But now they are
becoming a useful instrument to
trade tradition futures products.
Here is a look at how they work.
TRADE TRENDS
54 Forbidden fruits
By Steve Zwick
We show you Europes hot new
products, and explain why,
at least at this point, they are off-
limits to American traders.
F E AT U R E S
group publisher / editorial director
Ginger Szala
managing editor Daniel P. Collins
associate editor Chris McMahon
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editor at large Steve Zwick
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Murray A. Ruggiero Jr.,
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A UNIT OF
Let me begin by making as direct a

statement I can before beginning this
conversation, which is that this home-
owner bailout is simply a horrible idea.
Mike Gasior, AFS Seminars
F
or some reason, awhile ago I
began receiving Mike Gasiors
e-newsletter and admit to
reading it with some glee, enjoying his writing style and for the
most part, although not always, agreeing with his commentary. His
most recent newsletter, which is a combination of marketing,
economic analysis, righteous indignation and good humor, began
with the above quote, with which I totally agree. When the Bush
administration released this latest bone-headed plan to rescue the
U.S. economy by freezing subprime rates over a five-year period, I
thought it was a joke. Now I think its just downright scary. And
led by the likes of Hank Paulson, you wonder if Ben Steins column
a week ago taking Goldman Sachs to task was even more on target
than originally thought (although Wall Streeters ravaged him like
hyenas). It makes you wonder: What skin does Goldman Sachs
have in this game?
It seems all lenders have skin in this game, and apparently the
Bush plan would help them more than the borrowers it at least on
a public relations level is said to aid. Furthermore, those borrowers
it does help seem to be the least responsible, those who pretty much
borrowed an entire amount of what a house was worth without hav-
ing the proper credit worthiness. Scandalous for sure, but the bigger
question is: how exactly did that happen? Werent lenders supposed
to assess the creditworthiness of their borrowers? Isnt this the main
reason they exist? So if they werent doing their job, were they
expecting the government to step in when it all hit the fan?
Now Im one for helping out my fellow Americans, but Ive got to
tell you, freezing rates on already bad loans is, as Mr. Gasior says, a
horrible idea, despite being voluntary for lenders. Freezing rates
or prices in any way is bad. Seeing this move, the cynic inside
me wonders if the Bush administration would freeze gasoline prices if
it would help the energy companies. What this move does is delay the
inevitable until Bush is out of office, but I fear it wont help. This
economy has a lot of issues, and despite what my financial planner
may tell me, recession could be in the cards for 2008.
In our 2008 Economic Outlook: Wicked housing market spins
economy, by Associate Editor Chris McMahon, (page 22) we find
that the illness in the housing market is spreading and moving across
the entire economy. Right now, in early December, the Street is
poised on a will it or wont it crevice on whether the Federal
Reserve Bank will cut rates. Last week, it looked pretty good it would.
This week, after reviewing the jobs report, a cut of more than 25-basis
points is looking less certain. Our analysts provide a long-term view.
In our article, one analyst notes, at some point the Fed is going to
have to disappoint Wall Street and not cut rates when Wall Street is
screaming for another cut, just to show that Wall Street doesnt get to
call the tune. Thats well put, but is it realistic? Gasior notes in his
commentary: Please remind yourself that right in the middle of so
many banks and brokers announcing multi-billion write-downs on
their subprime holdings, Wall Street was announcing record bonuses
for investment bankers and brokers who underwote this garbage. So
basically, the employees are out shopping for new homes in the
Hamptons and Aspen while the shareholders of their employers are
left holding the bag. Nice work when you can get it. Like I said, I
dont agree with all he says... Not all employees are shopping, the
little guys got laid off awhile ago. Whatever the Fed does, one thing is
certain: 2008 is sure to be a wicked ride.
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Dont get fooled again
EDI TOR S NOTE
E-mail me at gszala@futuresmag.com
THE DEAD POOL
Forex min cap increases
Having a hard time getting your forex
dealer on the phone? Dealers who can-
not meet the new $5 million minimum
capitalization requirements by Dec. 21
are scrambling to merge, repositioning
themselves as software providers or
preparing to go out of business. Firms
that offer 100-to-one leverage or greater
will need $10 million in capitalization.
In his Sept. 26 congressional testi-
mony, Daniel J. Roth, president and
chief executive officer of National
Futures Association (NFA), said that
members acting as counterparties to
retail forex transactions account for less
than 1% of NFAs membership, but
that they also account for more than
20% of customer complaints and more
than 50% of NFAs enforcement dock-
et and emergency enforcement actions
taken this year. The one characteristic
the troubled firms share, according to
Roth, is that they are under capitalized.
I have very mixed feelings about it,
says Michael Stumm, president of
Oanda Corporation. He says that NFA
is right to be concerned about retail
clients and safeguarding their capital.
However, with the higher capitalization
requirements, the barriers to entry have
become higher. Had this been a rule
five years ago, then we wouldnt be in
business today, he says. You wont get
a bunch of guys in a garage coming up
with an idea that will revolutionize the
space. They cant just go out and
become market makers like Oanda did.
Glenn Stevens, CEO of Gain
Capital Group, supports the increase, as
well as Roths proposed $20 million
capital requirement. At the rate retail
investors are coming into the markets,
and with the volatility weve seen late-
ly, its critical that [Forex Dealer
Members] are on solid financial foot-
ing, he says, adding that Gain is in
active discussions with several other
FDMs who will not be able to meet the
new capital requirement. In late sum-
mer, Gain assumed all customer
accounts from Direct Forex when it
could no longer meet minimum capi-
talization requirements.
But a senior manager at an ade-
quately capitalized forex dealer said
that within the industry, the fear is that
NFA could wreck havoc on retail cus-
tomers by shutting down undercapital-
ized firms while not providing adequate
support for transferring customer funds
to more-solvent firms, as the first result
of such an action would be massive
employee defections.
Already, firms including Forex
Liquidity LLC (FXLQ) and Hamilton
Williams LLC have been effectively shut
down for failing to maintain minimum
capitalization, among other violations.
And according to reports filed with NFA
by Oct. 31, many other firms do not cur-
rently meet the capitalization requirement.
We worked with the NFA directly
on some of these regulations, and over-
all they strengthen the industry. The
number of customers moving into the
market is impressive and having some
of these smaller players adhere to more
stringent requirements is a good thing,
says a spokesperson for GFT Forex Ltd.
By Chris McMahon
REGULATORY SCRUM
SEC/CFTC tie up a no go
Rarely do business leaders who must
deal with regulators criticize those regu-
lators so openly, but there is no getting
around the lack of respect heaped on
the Securities and Exchange
Commission (SEC) recently by those
in the futures industry. Craig Donohue
was dripping with disdain for the SEC
when he compared the possibility of
the SEC merging with the Commodity
Futures Trading Commission (CFTC),
during a panel at the Futures Industry
Associations (FIA) annual expo in
Chicago, to a fictitious merger of
Toyota and Ford with the Ford family
running the business.
His point was clear. The SECs pre-
scriptive rule model and massive
bureaucracy does not work in the mod-
ern financial world, and until they can
straighten up their act, any potential
tie up of regulators where the mere
size of the SEC would dictate that its
model would survive would risk all
the gains of principles-based regulation
that were achieved in the last CFTC
Source: CME Grroup, Inc.
Trendlines
News, trends and insights for traders
CHARTVIEW: MOVING DAY
From a traders perspective, the merger of the Chicago Board of Trade and the Chicago
Mercantile Exchange becomes real in the second week of January when CBOT products
launch on Globex.
Launch weekend 1 (Jan. 11-13) Pre-Open State
Friday, Jan. 11 Agriculture and Hosted Exchanges Futures 1:30 PM - 6:00 PM
Dow complex and KCBT Equity Futures 4:00 PM - 6:00 PM
Sunday, Jan. 13 Agriculture and Hosted Exchange Futures 3:00 PM - market opening
Dow complex and KCBT Equity Futures 3:00 PM - market opening
Launch weekend 2 (Jan. 25-27)
Friday, Jan. 25 Interest Rate Futures 4:00 PM - 6:00 PM
Sunday, Jan. 27 Interest Rate Futures 3:00 PM - market opening
CBOT product trading hours are expanded on CME Globex
Earlier Start Times Current (Chicago) New-Chicago New-London New Singapore
Pre-Open Futures 5:30 PM 5:00 PM 11:00 PM 7:00 AM
Open: Financial 6:00 PM 5:30 PM 11:30 PM 7:30 AM
Open: Equities 6:15 PM 3:30 PM 9:30 PM 5:30 AM
Open: Agricultural 6:30 PM 6:00 PM 12:00 PM 8:00 AM
Open: Hosted Exchs' 6:30 PM 6:00 PM 12:00 PM 8:00 AM
reauthorization in 2000.
The current reauthorization process
of the CFTC is frozen. A possible link
in the reauthorization chain, the U.S.
Farm Bill, deadlocked since early
November, was stranded in the Senate
on Dec. 3. Even if the bill is passed in
December, lawmakers say the final bill
will likely not be sent to the White
House until early March.
CFTC Commissioner Michael
Dunn, chairman of the CFTCs
Agricultural Advisory Committee, says
the biggest roadblocks to reauthoriza-
tion are provisions addressing energy
and retail futures fraud, and that the
Congress is still working on the Farm
Bill to be passed. Dunn says theres still
no agreement on how to best enhance
the transparency of the energy markets
or ensure that the commission has
jurisdiction over retail futures fraud.
MERGER?
The reason there has been more sub-
stantive talk of late regarding a possible
merger of regulators is that there are
more and more areas where the two
cross paths. Issues of products falling
under both the futures and securities
label as well as the ongoing issue of
portfolio margining of both futures and
securities in a single account has led to
controversy. Jurisdictional battles have
led to delays in getting new products to
market, which is an issue in a world-
wide competitive marketplace.
Speaking at a panel at the FIAs
annual expo on Nov. 29, CFTC
Commissioner Bart Chilton made the
case for greater cooperation between
the two agencies while maintaining
that a merger would be the wrong thing
at this time. Chilton said periodic and
public accountability sessions with the
SEC and CFTC were needed, and said
that a Memorandum of Understanding
(MOU) should be set up as a perma-
nent regulatory structure. I cant
believe that theres no MOU on new
product approvalno wonder the
industry is frustrated, Chilton said.
William Brodsky, chairman and
CEO of Chicago Board Options
Exchange (CBOE), called Chiltons
comments refreshing, but remained
skeptical about the CFTCs ability to
accomplish those goals. He raised con-
cerns about international competition,
and said London had the best overarch-
ing regulatory structure. FIA President
John Damgard, moderator of the panel,
concurred, saying, Modernization is
necessary for the U.S. to remain in the
forefront of the industry.
It was CBOE that waited months to
get their credit-derivative-based option
product approved as Eurex got the
jump on them and it is partly anecdotes
like that that led the Treasury
Department to review the U.S. finan-
cial regulatory structure in its larger
review of the competitiveness of U.S.
capital markets.
In a comment letter to the
Treasury, Penson GHCO CEO Chris
Hehmeyer recommends a Twin
Peaks approach where a single regula-
tor would be split into two divisions:
one in charge of capital formation and
the regulation of public companies
and the other focused on market par-
ticipation, conduct and ensuring mar-
ket integrity. The division focused on
capital formation would be primarily
rules based while the division focused
on financial markets participation,
marketplace conduct and market
integrity would be principles-based,
writes Hehmeyer.
Eventually, under this plan, the two
regulators would be combined. That
could be a problem for the futures side,
which is happy with its regulator. It is
companies like Penson, that operate
both on the futures side and securities
side, that would benefit from better reg-
ulatory cooperation.
By Christine Birkner and Daniel P. Collins
FOR PROFIT
BM&F IPOs
The Brazilian Mercantile & Futures
Exchange S.A. (BM&F) completed its
initial public offering in November, and
its shares leaped more than 20%, clos-
EXCLUSIVE NO MORE
MTS Star continues to fade
Just a few months after Borsa Italiana executed an option to buy cash bond
platform MTS away from NYSE-Euronext, the platform is struggling to keep
its lucrative franchise.
MTS changed the way European governments manage their debt, by
restructuring debt for countries one nation at a time, and then centralizing all
of the liquidity on its central order book. The platforms value comes from the
fact that many countries require their secondary bonds be traded on the MTS
platform a move designed to concentrate liquidity, which was a major goal
of the restructuring.
In July, Borse boss Massimo Capuano canned the man who had built up
MTS, Gianluca Garbi, and announced he would let hedge funds onto the
MTS platform as part of his plan to build Italy into a center of hedge fund
activity. It was a decision many say he had to take, as several European gov-
ernments have spoken of easing MTSs exclusive hold on their secondary
bond markets, but market makers have been in revolt. Both the Belgian and
Dutch governments say they will let rival platforms such as BrokerTec list
their bonds in the future, while smaller countries like Portugal say they need
the concentration of liquidity in one place.
Now Credit Suisse says it will stop making markets on MTS in protest of the
hedge fund decision, which it says will open the market making system to abuse.
MTS answers that hedge funds will have to follow strict rules of conduct.
By Steve Zwick
www.futuresmag.com | January 2008 13 Reproduction or use of the text or pictorial content in any manner without written permission is prohibited.
ing on the first day of trading at 24.40
reais; the offering was reportedly the
seventh largest IPO globally this year.
The BM&F entered an equity
swap agreement with the CME
Group in late October, in which the
CME offered a 2% stake for a 10%
interest in BM&F, a deal valued at
$700 million.
The deal is proceeding as expect-
ed, and should close in 2007, says a
CME Group spokesperson. The deal
also includes an order-routing
arrangement, allowing a connection
between the CMEs Globex electronic
distribution network to BM&Fs dis-
tribution network for the electronic
routing of orders between the
exchanges. In addition, CME Group
would provide collateral management
to BM&F clearinghouses; and BM&F
would become a super-clearing mem-
ber of the CME.
The Urbana Corporation, which
concentrates on investments in private
and public securities exchanges around
the world, was one of the larger buyers,
snagging 300,000 shares for $3.4 mil-
lion U.S. dollars.
By Chris McMahon
SUBPRIME BAILOUT OR WASHOUT
Reprieve for borrowers?
Media coverage of the subprime crisis often
centers on confusing new securitized-debt
obligations and how mechanisms to price
them were so wrong that it led to massive
losses for dealers. But behind those bundles
of bad debt, and lost in the discussion, are
the individuals having trouble paying off
those loans, many of which will reset to
much higher rates in 2008.
Treasury Secretary Henry Paulson
worked out a plan with a group of market
participants to avoid preventable foreclo-
sures and to minimize the impact of the
housing downturn on the U.S. economy.
I dont think hes doing a bailout,
says Kimberly Amadeo, publisher of
WorldMoneyWatch.com. The biggest
benefit of the plan is that it could
restore confidence to the market and to
the economy. Subprime mortgages and
other collateralized debt obligations are
so complex that no one knows what the
impact is going to be.
In a presentation to the Office of
Thrift Supervision National Housing
Forum, Paulson said that half of foreclo-
sures occur without borrowers talking
with lenders or a mortgage counselor. In
response, a coalition of mortgage
servicers, counselors and investors,
called the HOPE NOW Alliance, will
begin reaching out to mortgage holders
120 days prior to their interest rate
adjustments and begin working with
them to avoid preventable foreclosures.
The Treasury plan will focus on help-
ing homeowners with steady incomes
and clean payment histories who could
afford the introductory mortgage rate
but not the higher adjusted rate.
But what will this mean to the fixed
income market? This is not going to keep
bond rates down, says Peter Kefalas, head
of research at Denali Asset Management.
We saw a nice bounce [in early
December], he says, and coupled with the
rebounding equities in the first week of
December, he takes that as a sign of
increasing stability.
By Chris McMahon
Trendlines continued
ICE STORMS CHICAGO
I nterconti nental Exchange ( I CE)
announced that their primary trade
matchi ng engi ne for al l OTC and
futures products will migrate per-
manently from Atlanta to the com-
panys Chicago data center location
upon the close of business on Jan.
18, 2008. ICEs customer connections
will automatically be routed to the
Chicago data center and customers
will not be required to make any
network or connection configura-
tion changes. Mark Wassersug, ICEs
vice president of operations, says
the transition will be seamless,
and will meet customer demands
for speed. By moving to Chicago
weve eliminated 80% of the time it
takes to transact on the exchange.
FREE AT LAST
The Refco estate has sold its 35%
stake in Forex Capital Markets LLC
( FXCM) to Lehman Brothers and
Long Ridge Equity Partners and its
affiliates for an undisclosed sum.
We are delighted, says Marc
Prosser, chi ef marketi ng offi cer,
adding that this completely termi-
nates all relationships with Refco,
and that there will be no changes to
the FXCM management.
NSE RETAINS TOP SSF SPOT
I ndi a s Nati onal Stock Exchange
(NSE) regained its spot as the world
leader in single-stock futures (SSFs)
in October, when it traded 24 mil-
lion contracts, compared to 8.4 mil-
l i on on the Johannesburg Stock
Exchange. Its not clear that posi-
tion is sustainable, however. NSEs
volume surged from 1.7 million in
September, while JSEs September
was 5.7 million.
IB BUYS FUTURETRADE
I nteracti ve Brokers Group I nc.
bought FutureTrade Technologies
and subsi di ary FutureTrade
Securities in late November.
We were specifically attracted
to FutureTrade by its customer base
of over 200 i nsti tuti ons, thei r 40
software developers and the tech-
nology they have developed over
the past five years, says Thomas
Peterffy, chairman and CEO of IB.
He says that integration between
the IB and FutureTrade platforms
should take four to six months.
EUREX AND ISE CLOSE TO FINAL
Si x months after the deal was
announced, Eurex looks poised to
merge wi th the I nternati onal
Securi ti es Exchange ( I SE) . We
expected [final approval] to take
quite some time because of the reg-
ulatory process, a spokesperson for
Eurex says. The deal, could close by
the end of December 2007, accord-
ing to an ISE spokesperson.
International News
J
ohn A. Thain was named
chairman and chief execu-
tive of Merrill Lynch. He
was previously chief executive
of NYSE Euronext. Prior to
that, he was president and
COO at Goldman Sachs. I am
excited and honored to have
the opportunity to lead such an
outstanding organization, Thain said in
a statement.
Duncan Niederauer replaces Thain.
He had been NYSE Euronexts presi-
dent since April 2007.
Gary Katz is now president and
CEO of the International Securities
Exchange (ISE). He was ISEs COO.
David Krell is now chairman.
J. William Twenty is now CFO of
Alaron. Previously he was COO and
CFO of First Continental Trading Group.
John Leonard was promoted to co-
head of equities at UBS Asset
Management.
Yassine Brahim was named CEO of
GL Trade. He also manages global sales
and client support.
Jeff Singer is now senior vice presi-
dent and head of Nasdaq International.
Ian Fay was named managing direc-
tor to oversee energy and natural
resources for the Americas at BNP
Paribas.
David Ryan is now head of
Southeast Asian operations for
Goldman Sachs. He was previously a
partner and head of the banks financ-
ing group for Asia excluding Japan.
Walid Chammah and James
Gorman have been named co-presi-
dents of Morgan Stanley.
Martin Doyle is the general counsel
of Quadriserv Inc. and president of
Quadriserv Brokerage Services.
Previously he was president and general
counsel of OneChicago.
Jorge Bermudez was named chief
risk officer at Citigroup. He succeeds
David Bushnell, who retires Dec. 31.
Sumeet Nihalani is now Dow Jones
senior director of sales for
Asia Pacific.
The Chicago Board Options
Exchange (CBOE) elected 10
individuals to its board of direc-
tors: Robert Birnbaum, Janet
Froetscher, R. Eden Martin,
Roderick Palmore, David
Fisher, Anthony McCormick, Kevin
Murphy, Bradley Griffith, John
Smollen and Paul Kepes.
Send news of personnel moves to:
Futures, 111 W. Jackson Blvd., Suite 2210
Chicago, Ill. 60604, Fax: (312) 846-4602
Attn: Christine Birkner
E-mail: cbirkner@futuresmag.com
Trading Places
www.futuresmag.com | January 2008 15
JOHN THAIN
Thain named CEO at Merrill Lynch
BY CHRI STI NE BI RKNER
N
ever has a financial disaster
unfolded in such an excruciat-
ingly slow-motion fashion as
the subprime debacle and resulting
credit liquidity crisis. It was mid-July
when several hedge funds either felt
the pain of re-pricings in the mort-
gaged backed securities and collateral-
ized debt obligation (CDO) market or
were affected by the resultant credit
crunch, but it wasnt until several
months later when investment banks
started reporting huge write downs in
third quarter performance when the
scope of the disaster began to take
form. And most analysts we talk to
say there is still a lot to unfold before
we see the true picture.
While the specific problem was sub-
prime, particularly for the Bear
Stearns hedge funds that went bust,
the resultant credit crunch affected
more markets and managers. If we
are looking at August in terms of the
extreme events, it wasnt so much
everyone had this subprime exposure,
it was that everybody was having to
deliver and get liquid and that started
to affect commodity markets, equity
markets, etc., says Rian Akey, head
of research for Cole Partners Asset
Management.
Akey, who started seeing the popu-
larity of these structured products rise
in 2004, believes the market will take
a close look at risk. There is going to
continue to be an appetite for that
kind of risk, whether it is subprime or
equity market exposure, or whether it
is exposure to China or emerging
markets in general, [but] the next
time around when people are looking
at CDOs or looking at these kinds of
structured products they are going to
be a little bit more aware of what the
true return profile potential is.
Anything that is non-exchange trad-
ed, you are going to see a little more
focus on valuation, Akey adds.
A spokesperson for Horizon Cash
Management points out there has
been a disturbing tendency by certain
high-yield bond funds to use the word
cash in their description.
Horizon had no exposure to any of
the questionable securities involved
in subprime but noticed the tendency
Whatever happened to diversification?
BY DANI EL P. COLLI NS
Comparing index returns
Octobers top CTAs
October YTD
S&P 500 Total Return Index +1.59% +10.87%
Lehman Brothers Treasury Index +1.52% +5.47%
Morgan Stanley EAFE Index +3.84% +15.15%
Futures Public Funds (October) +4.42% +3.21%
October YTD
Barclay CTA Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .+1.93% . . .+5.50%
Barclay Sub-Indexes:
Agricultural Traders . . . . . . . . . . . . . . . . . . . . . . . . . . . .+2.60% . . .+0.38%
Currency Traders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .+0.97% . . .+2.51%
Diversified Traders . . . . . . . . . . . . . . . . . . . . . . . . . . . . .+2.66% . . .+8.45%
Financials and Metals Traders . . . . . . . . . . . . . . . . . . . .+1.72% . . .+5.52%
Discretionary Traders . . . . . . . . . . . . . . . . . . . . . . . . . . .+0.08% . . .+3.81%
Systematic Traders . . . . . . . . . . . . . . . . . . . . . . . . . . . . .+2.40% . . .+6.60%
More than $10 million under management
1. Tulip Trend Fund Ltd. (USD C) . . . . . . . . . . . . . . . . .+17.00% . .+48.61%
2. Parrot Trading Partners . . . . . . . . . . . . . . . . . . . . . .+14.75% . .+26.69%
3. Willowbridge Associates (Agro) . . . . . . . . . . . . . . . .+14.39% . .+16.41%
4. Mulvaney Capital Mgmt. (GI. Markets) . . . . . . . . . .+13.72% . . .-22.49%
5. Tucson Asset Mgmt. (TAMI Macro) . . . . . . . . . . . . .+12.99% . .+33.02%
Less than $10 million under management
1. Edge Inv. Mgmt. (GI Diversified) . . . . . . . . . . . . . . .+36.93% .+180.15%
2. DEC Futures Fund Ltd. . . . . . . . . . . . . . . . . . . . . . . .+28.50% . . .-10.30%
3. Dorset Futures Corp. (E-Mini) . . . . . . . . . . . . . . . . . +23.65% . . .+7.80%
4. Superfund Trading Mgmt. (Cayman) . . . . . . . . . . . .+19.98% . . .+0.23%
5. Jalex Trading (Futures) . . . . . . . . . . . . . . . . . . . . . . .+17.89% . .+39.54%
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
Managed Money Review
Top performers in 2007
Fund Trading advisor(s) Nov. Return YTD
Northfield International* . . . . . . . . . . . . . . .Northfield Trading . . . . . . . . . . . . . . . . . . . . . . .2.53% . . . . . .28.55%
SB Warrington Fund . . . . . . . . . . . . . . . . . . .Multiple managers . . . . . . . . . . . . . . . . . . . . . . .5.40% . . . . . .23.04%
Hutton Investors Futures Fund II . . . . . . . . .J.W. Henry; Trendlogic . . . . . . . . . . . . . . . . . . .11.10% . . . . . .17.55%
MSDW Charter Graham LP . . . . . . . . . . . . .Graham Cap. Mgmt. . . . . . . . . . . . . . . . . . . . . .-1.17% . . . . . .16.80%
Salomon Smith Barney Orion Futures Fund Multiple managers . . . . . . . . . . . . . . . . . . . . . . .2.61% . . . . . .15.82%
Worst performers in 2007
Smith Barney Tidewater Futures Fund . . . .Chesapeake Capital Corp. . . . . . . . . . . . . . . . .-10.05% . . . . . .-36.75%
Dean Witter Portfolio Strategy Fund . . . . . .Hyman Beck & Co. . . . . . . . . . . . . . . . . . . . . . .-6.36% . . . . . .-22.01%
Dean Witter Diversified Futures Fund III LP .Morgan Stanley . . . . . . . . . . . . . . . . . . . . . . . . .-5.91% . . . . . .-14.46%
MSDW Spectrum Technical Fund . . . . . . . .Multiple Advisors . . . . . . . . . . . . . . . . . . . . . . . .-3.93% . . . . . .-14.00%
Shearson Select Advisors Futures Fund . . .J.W. Henry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2.28% . . . . . .-13.58%
public funds summary
Number reporting: 48
Average performance for the month: -0.99%
Funds up: 20 Down: 28 Unchanged: 0
November 2007
Number reporting: 48
Average performance for the year: +0.77%
Funds up: 29 Down: 19 Unchanged: 0
2007 results
(through November 30)
Note: Listed return may not be fully attributable to listed advisor(s). * Offshore fund.
Top performers in November
Fund Trading advisor(s) Nov. Return YTD
Hutton Investors Futures Fund II . . . . . . . . .J.W. Henry; Trendlogic . . . . . . . . . . . . . . . . . . .11.10% . . . . . .17.55%
SB Warrington Fund . . . . . . . . . . . . . . . . . . .Multiple managers . . . . . . . . . . . . . . . . . . . . . . .5.40% . . . . . .23.04%
Marathon System Financial Portfolio . . . . .Multiple Advisors . . . . . . . . . . . . . . . . . . . . . . . .4.48% . . . . . . .6.78%
Marathon Currency & Financials Portfolio .Multiple Advisors . . . . . . . . . . . . . . . . . . . . . . . .3.60% . . . . . . .9.76%
Marathon Diversified Portfolio . . . . . . . . . . .Multiple Advisors . . . . . . . . . . . . . . . . . . . . . . . .3.58% . . . . . . .5.86%
Worst performers in November
Smith Barney Tidewater Futures Fund . . . .Chesapeake Capital Corp. . . . . . . . . . . . . . . . .-10.05% . . . . . .-36.75%
Quadriga Superfund, L.P. Series B . . . . . . . .Superfund Capital Mgmt. . . . . . . . . . . . . . . . . .-7.55% . . . . . . .-7.50%
MS Charter Campbell . . . . . . . . . . . . . . . . . .Campbell & Co. . . . . . . . . . . . . . . . . . . . . . . . . .-6.72% . . . . . .-12.99%
Dean Witter Portfolio Strategy Fund . . . . . .Hyman Beck & Co. . . . . . . . . . . . . . . . . . . . . . . .-6.36% . . . . . .-22.01%
Campbell Strategic Allocation Fund LP . . . .Campbell & Co. . . . . . . . . . . . . . . . . . . . . . . . . .-6.34% . . . . . .-12.51%
Futures
of such products to be used as a form
of cash. The cash that we are
entrusted with we view as the most
essential, fundamental, protectable
part of ones portfolio. This is not to
be put as a wild investment. This is to
provide the bedrock against which
those eventual investments could be
made by the fund manager in accor-
dance to his or her strategy. This is
meant to be cash, the most safe
and sound investment, says the
spokesperson.
Sowood Capital was a hedge fund
that lost more than 50% of its assets in
a couple of weeks in July and eventual-
ly sold its assets to hedge fund giant
Citadel. In a letter to investors,
Sowood said it wasnt necessarily direct
exposure to subprime that caused the
problem but a downgrade in their col-
lateral. While we cant assume they
were typical, it does illustrate how this
began to snowball because these prod-
ucts, which were mispriced, were used
as collateral for other investments.
Absolutely, people bought them
and then used them as collateral for
further loans, to do more business,
and the hair cuts on those have got-
ten to be substantial. Right now, I
dont think a lot of people accept that
stuff as collateral any longer, says
Bob von Halle, managing partner at
Horizon.
Von Halle says that that a fund of
funds with a 20% exposure to sub-
prime, if it used that as collateral
could face greater risk in the remain-
der of its portfolio. The pain caused
by the rapid decline of the value of
that 20% would cause them to liqui-
date other strategies to bailout the
problem that was created in the sub-
prime, and the losses would have a far
greater impact on the overall portfo-
lio, he says.
He adds, That goes in the category
that you sell what you can, not what
you want to [sell].
Modern portfolio theory holds that
by being diversified in multiple non-
correlated asset classes a portfolio
stands a better chance of avoiding
financial ruin. If the collateral that is
backing such investments is not stable
and extremely liquid, it would seem
that would negate some of the effects
of diversification.
Prav Sambamurti, senior manager at
Ssaris advisors, agrees. There were
other asset managers, even mutual
funds, that had exposure to this indi-
rectly because there were some
enhanced cash funds that were invest-
ed in these things, so mutual funds with
excess on hand may put it into these
cash funds that are supposed to be mak-
ing 25-50 basis points over Libor but
they are taking these excessive risks.
Ssaris had no exposure to this.
Collateral management is a critical
aspect of asset management, so we vet
any of the cash management vehicles
that these guys would be investing
in, Sambamurti says.
He does see the subprime crisis
being a boon for managed futures
though. When volatility comes into
the marketplace, that is usually good
for people like us, he says. A lot of
the guys on Wall Street have been
taught since school that markets are
efficient all of the time, that trends
shouldnt exist and breakouts happen
only by chance. They are skeptical
about what we do.That being said,
[Ssaris] has made a living at this for
30 plus years, Sambamurti says.
Managed futures have been around
for a long time but have taken a back
seat to more sexy strategies. However,
their ability to diversify a portfolio
and daily mark to market attributes
make them the best choice in alterna-
tive investments.
MF GLOBAL SETTLES
MF Global, formerly Man Financial,
has reached an agreement with the
receiver for bankrupt hedge fund
Philadelphia Alternative Asset
Management (PAAM) and related
entities to pay $69 million into a
restoration fund for the benefit of
PAAM investors plus an additional
$6 million in legal fees. The receiver
had sued Man Financial, who agreed
to the settlement without admitting
or denying wrongdoing.
Hedge Funds
Hedge Fund Returns October Return 12 Mo. Return 2007 YTD return
Barclay Hedge Fund Index 2.91% 15.85% 12.04%
Barclay hedge fund sub indexes
Barclay Emerging Mkts. Index 5.14% 33.52% 24.71%
Barclay Merger Arbitrage Index 2.33% 18.43% 15.54%
Barclay Equity Long Bias Index 3.42% 19.05% 14.18%
Barclay Global Macro Index 3.43% 15.87% 11.49%
Barclay Event Driven Index 2.52% 15.32% 11.23%
Barclay Distressed Sec. Index 2.13% 15.09% 11.19%
Barclay Fund of Funds Index 2.95% 14.04% 10.27%
Barclay European Equities Index 2.22% 14.23% 10.1%
Barclay Equity Long/Short Index 2.01% 11.97% 9.58%
Barclay Convertible Arb. Index 1.61% 7.78% 5.69%
Barclay Pacific Rim Equities Index 1.25% 6.83% 5.33%
Barclay Equity Mkt. Neutral Index 1.31% 6.03% 4.43%
Barclay Fixed Income Arb. Index 1.28% 2.87% 1.94%
Barclay Equity Short Bias Index -0.1% -3.21% -1.48%
Is S&P bull back?
In the first week of December, the E-mini S&P had retraced 50% of its fall losses,
almost 100 S&P points, putting traders in a holiday mood. Growth is the key
word, says Hector Galvan, senior market strategist for R.J. OBrien & Associates.
Technicals are loopy. We have been drawing on so much negative, that any news
helps bounce things up. In the New Year, he expects the dollar to firm and add
support. Depending on what the dollar does, we could test 1575, he says, and
support is at 1475.
At this point its the apprehen-
sion before the [Dec. 12] Fed meet-
ing, says Larry Levin, president of
Secrets of Traders. A quarter point
was the talk for a long time; now its
a half point almost assuredly. And,
because the market is now condi-
tioned to expect more bad news
related to subprime losses, those are
now priced into the market. This
market has a better chance to go up
than to go down at this point, he says.
In January, Levin expects consolidation in the 1550 to 1560 area, where the
market was when the subprime news broke, and picks 1600, the October high, for
a top. Thats a good psychological level, he says. Levin has support at 1520.
Hot Commodities
BY CHRI S MCMAHON
Euro peaks?
While the euro lost ground
against the dollar in early
December, few analysts think it
is the start of a greater trend.
The news from the Gulf
Cooperation Council in early
December could have been
worse for the U.S. dollar, says
Jerry Furst, director of Investors
Education Network. While
Kuwait decided to remove its
dollar peg, other Arab countries,
including Iran, decided to stick with the greenback. So in the short run, the dollar
is going to stabilize. Its not going to regain much, but its not going to completely
crater. Its not in anybodys interest, he says. During January, he expects greater
volatility and for the USD/EUR to trade between 145 and 150. Relatively speak-
ing, prices are going to stabilize at these levels, Furst says.
We have had a significant overshoot in terms of dollar weakness, says Brian
Dolan, senior research director for Gain Capital. He says that the dollar has slowed
its fall, and that dollar weakness is now cycling into other economies, specifically
those in the United Kingdom and Canada. Those countries cut rates in early
December; and the euro zone, where European Central Bank Chairman Jean
Claude Trichet held the market off for another meeting, could follow suit, as the
euro zone economy is also slowing and a strong euro is killing exporters, such as
Airbus. In January, Dolan expects the dollar to strengthen against the euro and to
trade between 1.38 and 1.43.
Bargain bin gas
Warmer weather, near-record storage
levels and a lack of trading volume
have dragged the natural gas market
down, observes Dean Hazelcorn, trad-
er for Coquest Inc. After the
Amaranth thing, you see a lot less big
funds. All you need is that money
flow and you get that number back
up, he says. Without it, he expects
February gas to trade sideways to
downward. If support fails at $6.96,
we could trade down to $5.50.
Conversely, it wouldnt take much to
blow through the previous high of
$7.44. It doesnt need much of an
excuse to rally, he says.
There has been a continual lower-
ing and degradation of industrial
demand, says Kyle M. Cooper, ener-
gy analyst for IAF Advisors, and con-
tinual growth in the residential and
commercial sector, resulting in a mar-
ket almost entirely driven by weather.
It sounds like a cop out, but you have
to put in a $3 to $4 range, it all comes
down to Mother Nature, he says; and
La Nina has created unsettled weath-
er with no locking pattern, and pre-
dictions have been inaccurate. How
long and how deep that cold pene-
trates for the balance of the month
will determine that, he says. We are
at $7; if it stays warm, then $5 is pos-
sible, and if the cold heads south of
Chicago, then even $11 is not out of
the question. Cold air in Canada or
Minnesota is not going to do it,
he says.
Source: eSignal
Euro (spot cash) daily
Source: eSignal
1.5000
1.4800
1.4600
1.4400
1.4200
1.4000
1.3800
1.3600
1.3400
E-mini S&P 500 (continuous) daily
13 20 27 3 10 17 24 1 8 15 22 29 5 12 19 26 3 10
157500
155000
152500
150000
147500
145000
142500
140000
137500
Aug Sep Oct Nov Dec
Source: eSignal
9.20
9.00
8.80
8.60
8.40
8.20
8.00
7.80
7.60
7.40
7.20
23 30 6 13 20 27 3 10 17 24 1 8 15 22 29 5 12 19 26 3
Aug Sep Oct Nov Dec
23 30 6 13 20 27 4 10 17 24 1 8 15 22 29 5 12 19 26 3 10
Sep Oct Nov Dec
Nat. Gas (Feb. '08) daily
$per mmBtu
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BY HOWARD TYLLAS
T
he high cost of buying an outright call or put option on
many markets makes ownership quite expensive and
in most cases a bad bet unless held for a short period
of time. The vertical spread is my first choice in placing a
bet on which direction the market will go. That is a great
strategy to use when you feel the market can move signifi-
cantly in one direction; but to capture a larger profit on a
bigger move, the vertical spread becomes expensive as well.
The next strategy to look at is the butterfly spread (the
Fly). The Fly spread lowers the cost of buying an outright
option when you need more than three months until expira-
tion. The ultimate goal of this spread is to forecast where the
market will be at expiration. If correct, the reward is great; if
partly right, the reward is very good; and if barely right, you
still get even money. If wrong, you know exactly what your
risk is and the exact amount you will lose.
The other benefit of this spread is that in any major move
against your position, you still have time for the market to do
what you thought. No need to become emotional or be
forced to exit your trade before you decide whether your mar-
ket projections are still valid.
The simplest way to look at this spread is to understand
that it is two vertical spreads. One spread you buy and one
spread you sell. Here is one example:
March 08 crude oil settled at $96.05 on Nov. 23, 2007, its
options expire on Feb. 14. The March 95 call settled at 586
($5,860 at $10 per tick), the 100 call settled at 373 and the
105 call settled at 229.
Buy 1 CLH8 95 call @586
Sell 1 CLH8 100 call @373
On Nov. 23 you would have paid 213 ($2,130) for the
95/100 vertical call spread. Now:
Sell 1 CLH8 100 call @373
Buy 1 CLH8 105 call @229
You would have collected 144 ticks. Your total cost (not
including fees) for the 95/100/105 Fly on Nov. 23 is $690
(213-144= 69 or $690).
This strategy is reflective of the opinion that on expira-
tion, March crude oil will be trading at $100. If correct, you
paid $690 plus commissions and it is worth $5,000. Almost a
6 to 1 risk/reward, and if you use a $340 sell stop, a 12 to 1
risk/reward. If oil settles at $98.50, it would be worth 350
ticks ($3,500), about 4 to 1 after paying commissions.
An outright 95 call costs 586 ($5,860) and would be pur-
chased because you thought that it could go to $106 for
example. If it did indeed go to $106, your profit
would be $5,140. You paid $5,860 for an $11 move
($11,000-$5,860= $5140 profit). Not even 1 to 1
risk/reward and it had to go to $106 to get that!
Instead of buying the outright 95 call for 586, or
the 95/100 spread for 213, I can buy the Fly spread
for 69 ticks plus commissions. At $95.69 you get
your 69 ticks back, and if wrong and the market
goes down, you lose 69 ticks, instead of 213 or 586.
The 95 call has the high cost of time decay working
against it, with the vertical spread greatly reducing
that cost, and the Fly really taking most of it away.
If the market was at the same price of $96.05 on expiration
as it was on Nov. 23, the outright call would be worth
$1,050, creating a loss of $4,810; the 95/100 call spread
would be worth $1,050, creating a loss of $1,080; and the Fly
spread would be worth $1,050, a profit of $360.
With the 95/100/105 Fly, the most you can lose is what
you paid, and that would happen below $95 or above $105 at
expiration. The most you can make would be if the market
closed at $100.
If you think you can pinpoint the market, or believe you
can be close, you can greatly reduce your risk and greatly
improve your reward using the Fly. This strategy rewards you
nicely if only partially right.
Howard Tyllas is registered with the CFTC as a floor broker and CTA. Hes
a member of the NFA and a veteran trader of 31 years. He has traded
options on futures since their inception. www.howardtyllas.com.
Options Strategy
Question: How do you reduce the cost of high-priced options
when you think the market will make a large move?
Answer: The butterfly spread.
BETTER BANG FOR YOUR BUCK
You can create a solid risk/reward trade when you can pinpoint a certain move
by using the Fly.
Settlement Price (+1) 95 CALL (-2) 100 CALL(+1) 105 CALL Result
$94 0 0 0 0-$690=-$690
$97.50 2.5 0 0 $2,500- $690=$1,810
$99.25 4.25 0 0 $4,250-$690=$3,560
$102 7 -4 0 $3,000-$690=$2,310
$103.35 8.35 -6.7 0 $1,650-$690=$960
$107 12 -14 2 0-$690=-$690
T
he year ahead will provide a test
of the U.S. economys
resilience, about which Federal
Reserve officials have so often spoken.
The Feds own flexibility, guts and credi-
bility may also be tested.
So far, the Fed has done all that
reasonably could have been expected.
In the second half of 2007, as the hous-
ing slump deepened and the subprime
mortgage implosion sent shockwaves
through the financial system, the Fed
responded with alacrity to contain the
economic damage.
Not only did it slash the federal funds
and discount rates, it aggressively pro-
vided liquidity through open market
operations and liberalized the collateral
it would accept for loans.
Despite lingering concerns about
inflation and inflation expectations
prompted by dollar depreciation and
soaring oil prices, a risk-managing Fed
preemptively insured against reces-
sion. The jury remains out on just how
effective the Feds ministrations were.
How much more aggressive will the
Fed need to be or should it be in
2008? Will our resilient locomotive
again show its stuff and, perhaps with
the help of the U.S. Treasury-coordinat-
ed freeze on subprime teaser rates, pull
the economy out of its quagmire? Or
will housing and housing finance prob-
lems continue to fester and spill over,
dragging down demand?
The Feds best guess, as expressed in
its policymaking Federal Open Market
Committees (FOMC) first quarterly
three-year forecast released Nov. 20, is
that the economy will rebound this year
from what was expected to be pretty pal-
try fourth quarter growth.
The central tendency forecast of
Fed governors and Federal Reserve Bank
presidents is for real GDP growth of
1.8% to 2.5% on a fourth quarter over
fourth quarter basis this year; a sharp
downward revision from the July fore-
cast of 2.5% to 2.75%. Unemployment
is projected to average 4.8% to 4.9% in
the fourth quarter, up from 4.75%.
Growth is projected to pick up to 2.3%
to 2.7% in 2009 and 2.5% to 2.6% in
2010, with unemployment around 5%.
Core inflation, meanwhile, is expect-
ed to run between 1.7% and 1.9% this
year, a bit lower than the 1.75% to 2%
forecast released in July, and stay close
to that range in 2009 and 2010.
Those forecasts, compiled at the Oct.
31 FOMC meeting, carry an assumption
of appropriate monetary policy. That
means the future policy is most likely to
foster trajectories for output and infla-
tion consistent with the participants
interpretation of the dual mandate of
price stability and full employment.
Given some of the more dire private
predictions, the FOMC forecasts dont
sound too bad. But as the Fed said in an
accompanying statement, most partici-
pants viewed the risks to their GDP pro-
jections as weighted to the downside and
the associated risks to their projections of
unemployment as tilted to the upside.
Participants were concerned about
the possibility for adverse feedbacks in
which economic weakness could lead to
further tightening in credit conditions,
which could in turn slow the economy
further, it continued.
Moreover, after the forecasts were
released, some of those downside risks
were indeed realized.
In late November, Chairman Ben
Bernanke warned that higher gas
prices, the weak housing market, tighter
credit conditions and declines in stock
prices were likely to create some head-
winds for the consumer.
The FOMC would need to judge
whether the balance of risks to the eco-
nomic outlook had shifted materially and
would need to be exceptionally alert and
flexible in such uncertain times, he said.
The Fed has, arguably, played its
lender of last resort role responsibly and,
despite some internal dissent, judiciously
lowered the cost of money to insure
against economic weakness.
The philosophy was aptly expressed
by Vice Chairman Don Kohn: People
should bear the consequences of their
decisions about lending, borrowing,
and managing their portfolios, both
when those decisions turn out to be
wise and when they turn out to be ill
advised... however, when the decisions
do go poorly, innocent bystanders
should not have to bear the cost.
But the Fed cannot throw caution to
the wind. As recently as August, the
FOMC was leaning toward raising rates
to curb inflation. Numerous officials
have continued to warn that inflation
risks remain. They are also conscious
that it was the Feds draconian rate cuts
early in the decade, however justified
they seemed at the time, which set the
stage for the housing boom-bust that
continues to afflict the economy.
Having put substantial easing in
place, the full effects of which will only
be felt later, the FOMC is apt to proceed
cautiously this year, lest it set the stage
for more problems down the road.
Steve Beckner is senior correspondent for
Market News International, which sponsors
his Web site The Beckner Report. He is
regularly heard on National Public Radio and
is the author of Back From the Brink: The
Greenspan Years (Wiley).
Testing the limits of resilience
BY STEVEN K. BECKNER
Market Watch
MARKETS
2008
ECONOMIC
OUTLOOK:
WICKED
HOUSING
MARKET SPINS
ECONOMY
BY CHRI S MCMAHON
Forced by the
subprime meltdown
and the resulting credit
crisis, the Federal Reserve
Bank moved into easing
mode at the end of 2007.
However, the housing market
remains sick and it appears its
spread to the rest of the economy.
D
espite an increase of 4.9% in gross
domestic product (GDP) in the third
quarter, the negatives confronting the
U.S. economy are many. First, the
United States is facing a significant economic slow-
down based on the continuing recession in the hous-
ing market, the tightening of credit and the negative
wealth effects of declining home values. Combine
those bitter ingredients with record high oil prices, a
softening employment situation and the cheapest
U.S. dollar ever, and there are real concerns that the
U.S. consumer may cut spending, sending the U.S.
economy into a period of protracted weakness.
On Halloween, the Federal Open Market
Committee cut the Fed funds rate by 25-basis points
to 4.5% and the discount window rate by the same
amount to 5%, and said The Committee judges
that, after this action, the upside risks to inflation
roughly balance the downside risks to growth, in
their accompanying statement. In addition, the Fed
revised downward its 2008 projections for real GDP
growth to 1.8% from 2.5%, which was down from
the June projection of 2.5% to 2.75%; a month later,
the Bush administration cut its expectation to 2.7%
from 3.1%.
The aggressive posture that the Fed started tak-
ing in August basically delayed what was going to be
a recession in 2008, until 2009 or 2010, says Peter
Kefalas, head of research at Denali Asset
Management. We are on course for a serious slow-
down, if not a recession, in the New Year, he says,
adding that the strategy has been to delay the reces-
sion until after the 2008 elections. He notes that the
bond market has been anticipating an easier policy
for a while and that the current interest rate on the
10-year Treasury note, which is less than 4%, is not
realistic and that market rates should begin climbing
to the 4.25% to 4.5% range.
They just dont believe that the Fed is serious
about risks being balanced, says James OSullivan,
U.S. economist for UBS Investment Bank. We will
see if that persists, but the markets are fully pricing
in a cut in December, he says, adding that while
the economic situation had not deteriorated dramat-
ically relative to expectations in early December,
corporate earnings are down and the financial sector
is amongst the worst hit. Spreads are out; you look
at LIBOR and CP [commercial paper] spreads over
the funds rate, they are up pretty sharply since the
October meeting, he says, discounting the probabil-
ity that the Fed would add any restrictiveness to the
financial system, which would likely cause growth to
slow. At this point, OSullivan says that Treasuries
and Fed funds futures contracts are looking for
another 100-basis points of easing and
that fixed income markets have rallied
sharply. In addition to slower growth,
he expects the unemployment rate,
which recently rose to 4.7% from 4.5%,
will climb to 5.2% by the third quarter
of next year.
THE WAIT
Its the most anticipated recession in
U.S. history, says M. Cary Leahey,
senior economist for Decision
Economics Inc. You already had a big
slowdown. Growth over the last year
was only 2.25%. If next year it is 1.75%,
that is only a slowdown of a half per-
cent, versus a slowdown from the previ-
ous year of 1%, so the slowdown has
already come. He says there will be sig-
nificant rate cuts, taking us to 4% by
mid-2008, and then to 3.5% into 2009;
and the Feds primary motivation is pre-
venting the spillover from the housing
recession and the credit crisis.
OSullivan says that he is not expect-
ing a recession in early 2008, and that
the 1% to 1.5% GDP growth that he
projects wouldnt be recessionary in any
conventional sense. Even if unemploy-
ment rises to 5.2%, which he admits is
recession-like, he is not counting on
payroll growth turning outright nega-
tive, which he says would be required
for a recession. In the 2001 episode,
GDP growth was -0.1% year over year
at one point; you had a strong positive
quarter, a negative quarter, a positive
quarter, a negative quarter, but no con-
secutive negative quarters. But what
defined it as a recession was outright
contraction in payrolls, he says, and if
the U.S. economy does land in a full-
fledged recession, he would expect even
more aggressive interest rate cuts.
The Fed doesnt have to cut rates for
the economys sake, but it is all tied
together, says Kim Rupert, Action
Economics managing director of global
fixed income analysis. She is slightly
more optimistic, stressing that the
underpinnings of consumption are the
labor market and wage growth, and she
too does not expect employment to
contract. The smaller increases in
employment can be written off, to some
extent, to productivity. And thats why
we dont think the economy is headed
toward recession any time soon and why
we dont think the Fed needs to cut
interest rates, she says.
However, the Fed could cut for other
reasons; for example, to provide assur-
ance that it is the lender of last resort,
and that it is monitoring the credit and
growth situations, so that the financial
situation doesnt completely dry up and
to minimize systemic risks.
OPEN HOUSE
While new-home sales increased 1.7%
in October, the median home price fell
13% from a year ago, the largest
decline since 1970, according to the
U.S. Commerce Department, and
homebuilders cut new projects by more
than 19%. And Kefalas notes that in
each of the four housing recessions
(See Permits plunge, left) the num-
ber of housing permits dropped below 1
million units before the next advance,
which coincided with Fed easing. The
current 1261 level leaves us with room
to decline.
The progressive tightening of mort-
gage lending conditions during 2007 has
been the major factor behind the set-
back in home sales this year, says
David Seiders, chief economist at the
Markets continued
Source: Denali Asset Management
3000
2500
2000
1500
1000
500
0 S1
PERMITS PLUNGE
Housing permits dipped below 1 million units in each of the four housing recessions
since 1959, and recovery coincided with an easing of monetary policy.
Source: Decision Economics
5
4
3
2
1
0
-1
GDP (left axis)
Less housing
99 01 03 05 07
THE ANCHOR: HOUSING
Housing accounts for roughly 5% of the U.S. economy, and while housing is down 20%
this year, the other 95% is growing at 3%.
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GDP GROWTH AND HOUSING (PERCENT CHANGE YEAR-AGO)
National Association of Home Builders
(NAHB). NAHB expects home sales
to begin a gradual recovery in the early
part of 2008, but that is predicated on
avoiding recession and an improvement
in the mortgage finance system. He is
calling for at least two more cuts in
short-term interest rates to ensure that
those conditions are met.
Leahey explains that over the last two
years, construction and housing have
fallen by 20% to 25% and account for
5% of the economy, and that the rest of
the economy is growing at 3%, which is
below our historical average (see The
Anchor: housing, left). His primary
concern is that as credit tightens and
home values fall, it will adversely affect
consumer spending. That is the event
that the Fed wants to get in front of,
Leahey says. The Fed is taking out
some recession risk insurance by cutting
rates in advance of a major slowdown in
consumer spending, and because con-
sumer spending accounts for 70% of
GDP, that is not an idle concern.
We will be skating close to a reces-
sion, says Daniel Alan Seiver, San
Diego State University professor of
economics and finance, especially if
we begin to feel poorer because our
wealth, in terms of housing, has
decreased. You throw in $97 per bar-
rel oil and a slowly rising unemploy-
ment rate, thats going to put pressure
on consumption, weakening the econ-
Source: Decision Economics
7
6
5
4
3
2
1
0
OVERSEAS GROWTH BACKDROP
World
U.S.
Excluding U.S.
1989-98 2005 2006 2007 2008
US AGAINST THE WORLD
At 2% GDP growth, the United States lags far behind the G-7. Non-U.S. GDP growth
exceeds 5% annualized, compared to only 3% in the 1990s.
omy in the fourth quarter and into the
first half of 2008. Unlike the financial
markets, which can collapse in a short
period of time and clear out any excess,
housing markets dont work like that,
and given how illiquid housing is, and
the fact that owners can live in the
house, the recovery could stretch
into 2009.
In November, The Conference
Board Consumer Confidence Index
declined to 87.3 from 95.2 in
October. In a press statement, Lynn
Franco, director of The Conference
Board Consumer Research Center,
said the decline reflects consumers
apprehension about the short-term
outlook due to volatility in financial
markets, rising gas prices and likely
higher home heating bills this winter.
In addition, consumers inflation
expectations have surpassed the spike
experienced this spring.
It has been quite impressive how
the authorities have managed to engi-
neer such a rescue, Kefalas says. But
at some point in time in the not-to-
distant future, the housing collapse
will sink the economy in a full-fledged
recession. He will be looking to the
equity market to gauge the Feds suc-
cess and should the S&P 500 break
below 1325 that will be the cue that
authorities have failed to delay the
recession.
FOR SALE BY OWNER
The slowing of the U.S. economy is now
largely a given, and the very weak U.S.
dollar is being openly derided by the
likes of rap star Jay-Z and supermodel
Gisele Bndchen. Now the question is
how the rest of the world will react.
Already the deep discounting of finan-
cial services stocks has resulted in the
Markets continued
T
he U.S. Treasury bond market has been trading
inversely to equities, which are being dragged
lower by subprime lending issues and the related credit
crunch. When the bonds rally as equity markets drop it
is called a flight to quality, when it rallies along with
equities it is believed to be following them. So, how do
we identify market direction for the bond market?
A few useful technical tools are chart patterns,
trendlines (or speedlines), the 200-day moving average
and 50% retracements of important moves.
In Stacking bullish signals, you can see how in
June of 2007 (bottom left corner) bonds put in a low
and then rallied to a high of 114.07 in early September.
The 50% retracement of that rally was 110.15. The sub-
sequent pullback in late September and retest in early
October held above that price. Thats bullish. Now, note
that the pullback and retest also formed three points of a tri-
angle pattern. The sharp one-day rally in mid-October formed
point four of the triangle and pushed bonds away from its
200-day moving average (the green line) that was minimally
breached in the correction and retest of support.
What followed was an upside breakout of the triangle.
Note that the market is stacking bullish information on top of
bullish information:
Held initial 50% retracement
Pushed away sharply off the 200-day moving average
Broke out to the upside of the triangle
The key is to try to stay long in this market.
The market hit a high five days after the triangle breakout,
and then started to sag back. The 50% retracement of the
rally originating on point three of the triangle to that high
was 112.11; note the pullback (October 30) held above that
price. Bonds were still bullish.
The subsequent rally took bonds up through the existing
highs to near 119. The 50% retracement of that rally is
114.14; although that is useful to find direction, its too far
away to be of any order-entry use.
After the extreme volatility of Nov. 28-29, we drew in the
first speedline (off the October low) touching the spike low
made in mid-November and projected out to the current mar-
ket. We drew a second speedline connecting the mid-
November low to the Dec. 2 low. A break of those speedlines
will be our first inkling that the bull run is over.
Jack Broz trades bonds and mini-Dow from the trading floor of the CBOT
where he has been a member since 1996. Through his company, The
Marlin Letter Inc. (www.themarlinletter.com), Jack advises, educates, and
mentors traders. He can be reached at tttdow@themarlinletter.com.
STACKING BULLISH SIGNALS
Jul-07 Sep-07 Oct-07 Nov-07 Dec-07
Source: Trade Navigator
1 1 9 - 0 0
1 1 8 - 0 0
1 1 7 - 0 0
1 1 6 - 0 0
1 1 5 - 0 0
1 1 4 - 0 0
1 1 3 - 0 0
1 1 2 - 0 0
1 1 1 - 0 0
1 1 0 - 0 0
1 09- 00
1 08- 00
1 07- 00
1 06- 00
1 05- 00
0.5
Tech talk: T-bond analysis
BY J ACK BROZ
0.5
0.5
08/02/2007
109-16
114-07
114-14
112-11
111-26
110-02
104-25
OFF 6/04 LOW 3 PT. NOW
Abu Dhabi Investment Authority buy-
ing a 5% interest in recently distressed
Citigroup Inc. for $7.5 billion; and with
the substantially weakened U.S. dollar,
foreign investors are likely to start buy-
ing up U.S. companies and assets.
Foreign investment in the U.S.
ought to be phenomenal now; and it is
because we are offering a fire sale with
a 20% decline against the euro,
Leahey says. And given that an out-
right diversification of foreign currency
holdings would hurt entities with large
dollar holdings, he expects more direct
investment, but that capital flows will
weaken, as has been reflected in the
Treasury International Capital (TIC)
data. The more subtle part of the ques-
tion is what will happen to other major
economies, such as Japan, Korea and
China as the composition of the U.S.
slowdown targets consumers. (see US
against the World, page 29).
One of the reasons that interest
rates have been trending downward is
we have had the foreign buying of our
Treasury securities, says Ronald J.
Ryan, CEO of Ryan ALM Inc. Its
hard to believe that this trend can con-
tinue forever. Sooner or later they will
diversify; its not that they would dump
U.S. securities, but they could not
grow as much. That has to put pressure
on interest rates. Who is going to buy
our Treasury securities if they continue
to grow in terms of the amount we are
trying to finance?
BUYER BEWARE
While there is little dispute the Fed
will continue to be accommodating to
avoid more spillover from the housing
and subprime problems, the reality is
that cheap money is what got us here.
At some point the Fed is going to
have to disappoint Wall Street and
not cut rates when Wall Street is
screaming for another cut, just to
show that Wall Street doesnt get to
call the tune, Seiver says, and a
tightening of lending standards is
under way, as reported in last months
senior lending officer survey.
I am not sure that rates are going to
go sharply higher over the next couple
of months, as people are going to want
to keep their Treasury holdings close to
them, Rupert says. I am not sure how
much more upside the Treasury market
has. But I dont think that any of these
underlying fears are going away soon.
Its a waiting game: waiting for the other
shoe to drop. And the fear is that its
Imelda Marcos closet.
Visit Your DAILY Futures Resource:
FM
I
f 2007 provided any lessons, they were on the emergence
of intermarket relationships. No matter what kind of trad-
er you were, currency movements crossed your radar
screen. The synchronicity of the dollar/yen pair and the Dow
Jones Industrial Average became apparent many times and
the upward moves in crude oil pushed the Canadian dollar to
parity with the U.S. dollar and beyond.
Another force in 2007, one to monitor into 2008, is interest
rate policies of central banks. The U.S. Federal Reserve Bank
began a trend of cutting rates, while most of the rest of the
world stopped raising rates.
Lets explore some forex dimensions and scenarios for 2008
that could help shape forex traders trading plans.
1) Decline of global interest rates
As 2007 ends, the signs are already there for the topping out of
rates and the beginning of a decline in rates. The United
States has been the leader, but the projected slowdown of the
world economy by the Organization of Economic Cooperation
and Development (OECD) and others will lead to an environ-
ment of global rate cutting. The Bank of Canada and Bank of
England both recently cut rates by 25 basis points, and
Germany, Australia and New Zealand will likely cut rates
next. Traders can play these fundamental shifts in interest rate
policies by looking to sell these nations currencies. The unan-
ticipated beneficiary of this scenario is the U.S. dollar. When
currencies weaken due to their weakening economies, they
could very well weaken against the U.S. dollar.
2) China contraction
After the 2008 Olympics in China, forex traders should keep
an eye out for contraction in the Chinese economy. If U.S.
and global growth slows, demand for Chinese exports and ser-
vices will be lower. A slowdown in China, or even a rumor of
a slowdown, can be played by selling Aussie dollars.
3) The rise of the dollar
If global interest rates drop, the dollar will benefit. Lower
interest rates weaken a currency. If the central banks of the
European Union, Great Britain and Canada lower rates, the
U.S. dollar would strengthen in relative terms. And if the Fed
decides that inflation vigilance is still important, that would
help the dollar as well. Breaking the trend (left), shows the
possible beginning of a U.S. dollar recovery in its global Trade
Weighted Index (TWI). If the TWI breaks above its current
downtrend, it may signal a shift toward a stronger dollar.
4) Opportunities to trade non-correlated currencies
The tendency of currency movements to cascade across the
dollar pairs presents a risk because currencies are intercon-
nected. However, data shows that there are variations in
correlations. Superderivatives, a global leader in currency
analytics, generates real-time correlation data that shows
that there are variations in correlations.
For example, one of the most traded
currency pairs is the EUR/USD. The
EUR/USD is 90% negatively correlated
with the USD/CHF (Swiss franc) but only
6% correlated with the EUR/NOK
(Norwegian Kroner). The EUR/USD is
only 0.31% correlated with the
USD/MXN (Mexican Peso) pair. The
Norwegian Kroner, the least correlated currency, is a solid
commodity currency. Currency correlations (left), shows
the various one-month correlations among currency pairs,
which will allow them to trade the fundamentals of a curren-
cy. By using correlation data, the trader can find trades that
minimize exposure to the global emotional contagion in the
dollar pairs and may be a useful strategy in 2008.
Abe Cofnas is president of learn4x.com LLC and author of The Forex
Trading Course: A Self-Study Guide To Becoming a Successful Currency
Trader (Wiley Trading). E-mail: learn4x@earthlink.net.
FX outlook for 2008
BY ABE COFNAS
Forex Trader
BREAKING THE TREND
Source: iBoxx FX
0
2
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0
1
-
2
0
0
7
1
3
-
0
3
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2
0
0
7
2
2
-
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5
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2
0
0
7
3
1
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7
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2
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0
7
0
9
-
1
0
-
2
0
0
7
1
5
-
1
1
-
2
0
0
7
80.0
78.0
76.0
74.0
72.0
70.0
68.0
66.0
64.0
62.0
60.0
USD TRADE WEIGHTED INDEX
Source: Superderivatives.com
CURRENCY CORRELATIONS
EUR/ USD/ EUR/ GBP/ EUR/ USD/ EUR/ AUD/ EUR/ USD/ EUR/ USD/
USD JPY JPY USD GBP CHF CHF USD AUD CAD CAD SEK
EUR/USD 1 -0.31 0.42 0.68 0.31 -0.9 0.03 0.46 0.22 -0.55 0.14 -0.86
USD/NOK -0.73 0.11 -0.59 -0.54 0.1 0.64 -0.26 -0.36 -0.28 0.67 0.2 0.76
J
ust as computers forced the
evolution of technical analysis
tools, such as static simple,
moving averages to sophisti-
cated indicators that dynamically
adjust to market conditions, technolo-
gy is again fueling a leap in trading
system capabilities. We can now
develop trading systems that are indi-
vidually tailored to the issues in the
portfolio while maintaining the
robustness of the overall system.
The implication of having a trading
system proven in out-of-sample testing
for each stock is profound. No longer
will portfolio performance depend on
gains elsewhere to offset realized losses.
Rather, stocks can be placed with prej-
udice. We can elect to trade certain
stocks when their performance corre-
lates to the periods when an individual
trading system can be expected to pro-
duce positive returns.
COMPUTER AS ANALYST
This new horizon in system trading is
possible by enabling the computer to
write the system logic instead of just
optimizing a previously established set of
rules. In this process, the computer
begins by evolving a set of rules. Those
rules are then backtested on out-of-sam-
ple data to ensure robustness while
determining the best trading solution for
a given set of input parameters.
From here, the rule set is converted
to a standard trading platform lan-
guage, such as Tradestations
EasyLanguage, to exercise the trades on
real-time data. The complete trading
system development process including
input selection, design, testing and
translation is fully automated and
accomplished quickly.
In essence, we are employing soft-
ware to write software. The complete
process of creating these trading sys-
tems can be accomplished in a little
over one minute on a readily available
Core 2 Duo computer operating with
the Windows XP operating system.
Genetic programming is perhaps
thousands of times faster than other
artificial intelligence algorithms. The
central engine allowing this to happen
is known as Automatic Induction of
Machine Code with Genetic
Programming (AIMGP).
Although technically complex, this
power is available with a few clicks of
your mouse. If you can cut and paste,
you can design a trading system. You
do not need to define a trading system
before the evolution begins because
the engine will sort out the inputs to
form the trading rules. You do not need
to select or develop your inputs unless
you wish to do so. No trading system is
defined at the beginning of a run; in
fact, only raw inputs and operators are
available at the beginning of a run.
The Trading System Lab platform, for
example, uses an input data matrix visu-
alized as 62 columns and a row for each
bar to be used in the back- and forward-
testing. Using at least several years of
daily data is recommended. Although
many data preprocessors exist, the data
in each column can be virtually any-
thing you like. It can be numeric or
Boolean. It can be indicator values, pat-
tern descriptions, intermarket data, etc.
Although 62 columns of data are used
as inputs, the platform typically selects
only a small fraction of them for use in
writing the final evolved trading system.
However, unlike other artificial intelli-
gence approaches, the AIMGP com-
bines the selected inputs using dozens of
other functions, such as addition, sub-
With modern technology, no longer does portfolio performance depend
on the law of large numbers to mediate volatility. Rather, stocks can be
traded according to their individual tendencies, even if they are merely
one piece of a complex puzzle.
BY MI KE BARNA
Using equity DNA to
improve your portfolio
EQUITY TRADING TECHNIQUES
traction, trigonometry and exponential
functions.
NOT SO NOISY
Of course, it makes sense to select
inputs that have some logical relation-
ship to reality to avoid a garbage-
in/garbage-out scenario.
One important tangible characteris-
tic of market data that can be mea-
sured is its cyclic content. Well look at
two example trading systems evolved
for the S&P 500 futures contract, trad-
ing both long and short over the past
five years. Although this approach is
demonstrated on the index, as dis-
cussed earlier, one of its best uses is in a
portfolio of individual equities.
We start with a bandpass filter,
developed by John Ehlers of Mesa
Software. The bandpass filter allows
only the signal energy within its
band to get through, rejecting both
higher and lower frequency compo-
nents. Because the passband is rela-
tively narrow, the filter output can be
characterized as:
A*Sin(360*t/Period), where
A is the amplitude of the output
signal, and
Period is the cycle period of the
center frequency to which the filter is
tuned
The first 21 columns of data are the
filter outputs for filters tuned from
eight-bar periods to 48-bar periods in
even increments of two bars. In other
words, the filter channels are tuned to
8-, 10-, 12-, 46-, and 48-bar cycles.
The next 21 columns of data contain
the rate of change of each of the filter
outputs in the first 21 columns. You
may recall from calculus that the rate
of change of a sine wave is a cosine
wave, which leads the sine wave by 90
degrees (characterized as A*Cosine
(360*t/Period)).
As every trader recognizes, having a
leading indicator is crucial to creating
an effective trading system.
The final 20 columns of data com-
prise the sum of the squares of the cor-
responding channels to obtain the
instantaneous signal amplitude at the
output of each filter channel. This is
easily seen from the familiar trigono-
metric relationship.
Therefore we have the complete
phase and amplitude relationship of
each bandpass filter over the range of
periods that we think are applicable for
an effective trading system. Bandpass
code (above) shows the EasyLanguage
code for the bandpass filters to gener-
ate the data matrix used in the evolu-
tion of the example trading systems.
Human logic would lead us to select
the channel having the largest output
the majority of time and then seek the
phase relationship between the sine
and cosine outputs that give the best
trading signals. In fact, this author has
even written trading systems that
dynamically sense the dominant cycle
and change the filter outputs used as a
function of time.
GENETIC PROGRAMMING
PERFORMANCE
Genetic programming automatically
selects the most significant columns of
data and combines them in ingenious
ways that often defy logical description.
The result is an evolved trading system
whose performance best meets the fit-
ness criterion.
In our example, a single contract sys-
tem evolved in four minutes, 20 sec-
onds, evolving and evaluating trading
systems at the rate of 770 systems per
Source: Mesa Software. Download for code can be found at futuresmag.com.
BANDPASS CODE
This EasyLanguage code generates a channelized filter data matrix. It was written by John
Ehlers and includes in-phase and quadrature filter outputs for cycle period channels
between eight bars and 42 bars. The sum of the squares of the in-phase and quadrature
components provides the signal amplitude at the output of each channel.
Inputs:
Price(Close),
Delta(.20);
Vars:
Period(0),
gamma(0),
alpha(0),
beta(0),
count(0),
mmf(0);
Arrays:
V4[63](0),
OldV4[21](0),
OlderV4[21](0);
mmf = pricescale;
For count = 1 to 21 Begin
Period = 2*count + 6;
beta = Cosine(360 / Period);
gamma = 1 / Cosine(720*delta /
Period);
alpha = gamma -
SquareRoot(gamma*gamma - 1);
V4[count] = .5*(1 -
alpha)*(Price - Price[2]) + beta*(1 +
alpha)*OldV4[count] -
alpha*OlderV4[count]; //in phase
V4[count + 21] = (Period /
6.28318)*(V4[count] - OldV4[count]);
//quad
V4[count + 42] =
V4[count]*V4[count] + V4[count +
21]*V4[count + 21]; //amp
OlderV4[count] = OldV4[count];
OldV4[count] = V4[count];
End;
if currentbar=1 then
print(file(C:\Program
Files\TSL\Data\datainfo.txt),
numtostr(barinterval, 0), ,
numtostr(bigpointvalue,4), , min-
move:4:4, ,
pricescale:4:4,
,newdate(date):8:0, , newdate(lastcal-
cdate):8:0, ,
getsymbolname, ,descrip-
tion, );
Print(file(C:\Program Files\TSL\Data\allda-
ta62n.txt), {TSL-TC-NUMERIC ONLY}
v4[1]: 8:4, , {1}
v4[2]: 8:4, , {2}
.
.
.
//etcetera for all 62 channels
.
.
.
v4[61]:8:4, , {61}
v4[62]:8:4, , {62}
0.2:1:2 , , {63}
newdate(date[0]):8:0 , , {64}
mmf*open:6:0 , , {65}
mmf*high:6:0 , , {66}
mmf*low:6:0 , , {67}
mmf*close:6:0 ); {68}
second. This is not curve fitting. The
evolution is guided by parsimony pres-
sure, multiple runs, randomization of
parameters and an unbiased input set.
Parsimony pressure forces the genetic
program to use as few input parameters
as possible.
Further, out-of-sample performance
is evaluated and any given system is
discarded if it is not robust in this eval-
uation. Its important to realize, how-
ever, that out-of-sample performance is
not analyzed or used during the evolu-
tion or else it would not be out-of-
sample. In situations where the input
set is poor, the setup parameters are
inefficient or the market is extremely
random, out-of-sample performance
will suffer. This is an important test of
robustness.
For our runs, a total of five years of
data were used, four years as in-sample
development data and one year of data
for out-of-sample performance verifica-
tion. At the end of the evolution, sine
wave channel periods of 14, 16, 32, 34,
36 and 38 bars were used in the exam-
ple trading system. Cosine channel
periods of 22, 34 and 48 bars also were
used. No amplitude data were used,
demonstrating that the phase relation-
ships of the filtered outputs are
crucial for the generation of trade
timing signals.
Which waves? (above) shows the
channel filters that were used by the
platform in relationship to the price
data and the trading signals.
A second trading system was evolved
using the same data, but this time
allowing for a multiple contract trading
system to be developed, using money
management during the development
process. In this case, only the genetic
program determined when and how
many contracts to trade. If a trade were
deemed risky, only one contract was
traded. Multiple contracts, up to a
maximum of five, were traded on the
higher probability trades.
This time, the evolution took only
one minute, 13 seconds. Similar, but
different, channels were used in the
evolved trading system. More interest-
Equity Trading Techniques continued
OUT-OF-SAMPLE IMPROVEMENT
The first chart shows how out-of-sample profit increased while drawdown stabilized. The
final reward-to-risk ratio was more than 6:1, as measured by the ratio of net profit to
drawdown. Next, we can see how the profit grew steadily over the out-of-sample period.
Source:
4 8 12 16 20
210000
160000
110000
60000
10000
-40000
Min Error Pass out of Sample
P
r
o
f
i
t

a
n
d

D
r
a
w
d
o
w
n
OUT OF SAMPLE EQUITY GROWTH
Source: Tradestation
Aug Sep Oct Nov Dec 07 Feb Mar Apr May Jun Jul Aug
1560.00
1540.00
1520.00
1500.00
1480.00
1460.00
1440.00
1420.00
1400.00
1380.00
1360.00
1340.00
1320.00
1300.00
30.00
20.00
10.00
0.00
-10.00
-20.00
-30.00
Buy
WHICH WAVES?
This shows the channel filters that were used as the trading signals. Sine wave channels are
shown in red and cosine channels are shown in cyan. In retrospect, it is relatively easy to see
how the crossing of these indicators occurred at crucial times for the trading signals.
Short
Short
Short
Short
Short
Short
Short
Short
Short
Short
Short
Short
Buy
Buy
Buy
Buy
Buy
Buy
Buy
Buy
Buy
0 100 200
230000
184000
138000
92000
46000
0
P
r
o
f
i
t

a
n
d

D
r
a
w
d
o
w
n
Bars out of Sample
OUT OF SAMPLE RUN LOG
0
ing, three amplitude channels were
also used. Because a money manage-
ment algorithm needs to respond to
volatility of the underlying market, it
seems natural that the genetic program
chose the more extreme movements
inherent in the amplitude segment of
the input data matrix.
A total of 43,930 trading systems
were examined and only 17 of these
were retained as having better perfor-
mance over the course of the evolu-
tion, although far more systems were
stored in the trading system buffer.
Out-of-sample improvement
(page 34) shows how the out-of-sam-
ple performance improved as the trad-
ing system evolved. Initially the draw-
down (shown in red) increased as the
net profit (shown in blue) was
increased. However, as the trading
system evolved, the out-of-sample net
profit increased and the drawdown
decreased, stabilizing at about
$35,000, an indication of robustness
of an evolved trading system.
The second chart in Out-of-sample
improvement shows the out-of sample
equity growth of the final evolved sys-
tem. A more detailed examination of
the trading system showed it had a
total of 60.9% profitable trades and a
profit factor of 2.47 over the period
from August 2006 to August 2007.
BETTER TRADING WITH TECHNOLOGY
Using modern technology, including
both signal processing and genetic
programming, highly accurate and
robust trading systems can be evolved
in mere minutes. This means that
each stock, exchange-traded fund or
commodity futures contract in a port-
folio can have its own customized
trading system so that each element in
the portfolio is highly profitable in its
own right. Then, correlation between
all the elements in the portfolio can
be accomplished to enable further
reduction in variations of the portfolio
equity growth.
Other implementations of this algo-
rithm are possible in financial analysis
as well as options trading system
design. Here, we used indicators creat-
ed by human knowledge and an evo-
lutionary machine learning algorithm
to automatically write our trading sys-
tem for us, thus demonstrating one
successful cooperation between man
and machine.
Mike Barna is president of Trading System Lab. He
can be reached at mike@tradingsystemlab.com.
Code for Bandpass Code, (page 33), will be
available at futuresmag.com under downloads.
FM
A
five-minute E-mini S&P 500
chart provides an incredible
amount of information. But
despite this massive flow of
information, simple analysis of its
price action is all that is needed to
trade successfully. One such strategy is
based on flag formations, and it usual-
ly presents several profitable entries
every day.
A flag formation occurs when the
market forms an area of conges-
tion following a surge of activi-
ty. This indicates that both buy-
ers and sellers are equally active
at the current price. If the previ-
ous surge was upward, the break-
out will usually be to the upside.
However, if the flag extended
far enough to break an up trend-
line, then buyers will be wary
because this is a sign that the
momentum is waning. Many bulls
will scalp out with a small profit
on the breakout to the new swing
high. Also, bears will look for
another opportunity to sell at the
slightly better price that the new
high offers. This often leads to a
reversal that may be either a scalp-
ing opportunity or the start of a pro-
tracted downswing. In either case, it is
a low-risk, high-probability entry.
One of the most reliable entry methods
is on a stop at one tick beyond the prior
bar. If the market is in a bull flag and you
are looking to buy, place a buy stop order
one tick above the high of the prior bar. If
by the time the current bar is complete,
the bar does not extend beyond the high
of the prior bar,
lower the buy stop to
one tick above the current bar that just
completed itself. (Do the opposite when
trying to sell a breakout from a bear flag;
enter it on a sell stop at one tick below
the low of the prior bar).
On a five-minute E-mini S&P 500
chart, if you picked your entry cor-
rectly, an initial four-tick protective
stop works in more than 80% of the
breakouts. If the bars are large or the
flag looks like it has more to go, either
risk six ticks or, even better, wait for a
second entry.
Waiting for a second entry means
that you do not take the initial trade.
Instead of buying the breakout of the
high of the prior bar, wait to see if the
bar after the breakout has a lower high.
If it does, place an order to buy one tick
above its high. (This move represents
the second attempt at a bull breakout.)
In the first chart in When the bear
turns (right), TL1 is a steep down
trendline that is broken by Flag 1. In
general, fading a strong trend is a los-
ing proposition. However, in this par-
ticular case, there were three large bear
bars and the previous two had decent
tails; thus, the bears might be tem-
porarily exhausted. Also, because the
downward trend bars did not close
within a couple ticks of their lows, the
sellers are showing that they are not as
aggressive as they could be.
The next bar is a small bull reversal
bar, with its low below the prior bars
low, and a close above the open and
Some aspects of trading are painfully simple. A technical condition can
be either right or wrong. A reliable pattern in the E-mini S&P 500 futures
market is a flag formation on a five-minute chart. However, its when
they fail that you often have the best chance to profit.
BY AL BROOKS
Failed flags can lead
to E-mini success
TRADING TECHNIQUES
above the close of the prior bar. This is
a mark of buying. Also, four of the five
bars of the bear flag had closes above
their opens, again indicating that buy-
ers are active. Once the bear flag broke
to the downside, the breakout bar was
not large. The next bar was even small-
er and its close was near its high. All of
this increases the odds that there will
be at least a second leg up (the bear
flag being the first leg up).
This is a low-risk long entry and it
has a high probability of extending at
least six ticks. A six-tick breakout is a
magical number for E-mini day traders.
Many traders scalp for four ticks and to
do so, the move has to extend six ticks.
Why do you need a six-tick move to
make four ticks? You enter on a stop
that is one tick above the prior bar,
and you are trying to exit at four ticks
above that. Most of the time, a sell
limit order will not be filled unless the
market goes above it by at least one
tick, meaning that a six-tick move is
required to net four ticks on a scalp.
MARKET TURNS
When trading counter trend, it is natu-
ral to be hopeful that the trend has
reversed and that your trade will make a
fortune. The reality is that you just
bought a bear trend and the odds are
high that the bear trend will resume. As
such, it is wise to take profit on most of
your position after just a small up-move.
For example, if you bought three
contracts, you might take profit on two
at four ticks (that is, scalp when trad-
ing counter trend). Then, place a pro-
tective stop at breakeven on the
remaining contract. If a sell signal
develops in the meantime, take the sell
signal and exit your remaining long at
the same time. If it turns out that you
did just buy the low of the next 10
years and you are angry for taking a
scalpers profit instead of holding on
for a fortune, remember that every
strong trend will have plenty of great
entries that you can swing for more
profits. Also, it is important to main-
tain discipline. This is a strategy to
take advantage of short-term correc-
tions and it should be treated as such.
This second leg of the up-move in
the first chart in When the bear
turns formed a bull flag (Flag 2).
There was a small breakout bar (Bar 2)
that failed on the next bar, which had
a low below the low of the breakout
bar. You dont want to buy the break-
out because it follows several small bars
that closed near their open, which
indicates indecision. When bars are
small and closes are near the opens, a
better play is to watch for an entry,
dont take it and then wait for it to fail
and trap one side; enter as the trapped
traders are forced to reverse.
In this example, most bulls would not
have bought at Bar 2 because of the
small sideways bars that made up the
flag. Likewise, bears would be hesitant to
sell on the bar after Bar 2 when the bull
breakout failed, because there was not
enough up momentum to trap many
longs. However, when the market made
a second breakout to the upside at Bar 3,
this is a great long entry, again only for a
scalp because there is no evidence that
the market is in a bull swing.
Flag 3 had two bull breakouts and
both failed. Again, the bars in the flag
were tiny, indicating lack of convic-
tion. However, this second failure of
the bull flag breakout is a great short (a
second entry is almost always a good
trade), especially because the down
momentum of the first 90 minutes of
the day was so strong. Also, three legs
up in a bear often works like a wedge,
resulting in a new low.
Flag 4 broke a steep trendline and
WHEN THE BEAR TURNS
We can see several examples where failed flag formations provided short, but high-probability,
trades against the prevailing trends.
4/11 7:00 7:30 8:00 8:30 9:00 9:30 10:00 10:30 11:00 11:30 12:00 12:30 13:00
1,474.00
1,473.00
1,472.00
1,471.00
1,470.00
1,469.00
1,468.00
1,467.00
1,466.00
1,465.00
1,464.00
1,463.00
1,462.00
1,461.00
1,460.00
1,459.00
55,000
25,000
1
2
3
4
5 6
7
Flag 1
TL1
Flag 2
Flag 3
TL4
TL3
TL2
Flag 4
6/11 7:00 7:30 8:00 8:30 9:00 9:30 10:00 10:30 11:00 11:30 12:00 12:30 13:00
1,534.00
1,533.00
1,532.00
1,531.00
1,530.00
1,529.00
1,528.00
1,527.00
1,526.00
1,525.00
1,524.00
1,523.00
1,522.00
1,521.00
1,520.00
1,519.00
1,518.00
1,517.00
1,516.00
35,000
15,000
1
2
3
4
Flag 1
TL1
Flag 2
Flag 3
TL2
Double
Bottom
reversed the low of earlier in the day
(two of the bars in the flag were above
the highs of the prior bar). When the
market reversed upward again at Bar 7,
it was the second attempt to reverse
after a new low of the day and it also
followed a bear flag breakout. Also,
both the flag and the new low had lots
of tails and the closes were above the
opens, indicating that buyers were
coming into the market by the time
the bars closed. This makes a long at
Bar 7 a high probability long scalp.
The second chart in When the bear
turns shows a bear trendline (TL1)
followed by a small, two-bar bear flag
that broke the trendline. There was a
bear breakout that failed on the next
bar, which was a great long entry.
What made this particularly strong was
that the low of this leg was exactly at
the low price of the opening range, cre-
ating a double bottom. Also, the range
of the day at this point was only about
six points and the average range had
been more than 10 points, indicating
that there would likely be a breakout of
the range either up or down.
Because the market made an exact
test of the low followed by a bear flag
breakout, creating another attempt at a
breakout into a bear swing and a mea-
sured move down, and both attempts
failed, there was a great chance that
the market would attempt an upside
breakout. When an entry has a reason-
able chance of being the low (or high)
of the day, it is best to scalp out only
part and let most of your trade swing.
For example, if you traded three con-
tracts, you might scalp one at four ticks
and hold the other two with a
breakeven stop.
The market formed an extended bull
move to a new high, but Flag 2 broke
below the bull trendline (TL2). After
the bull flag breakout, Bar 3 traded
below the low of the prior bar, provid-
ing a short entry. This entry is against a
strong trend, so you should scalp all or
most of your trade. The market formed
a larger bull flag (Flag 3), which was a
well-shaped bull flag on higher time-
frame charts (such as the 15-minute
chart). Bar 3 was a short entry below
the low of the prior bar, creating a
failed bull flag breakout.
More examples of these formations
are shown in Reading the breakdown
(left). It shows a powerful failed flag at
Bar 1, which was a possible low of the
day (every new low is a possible low of
the day). Flag 2 was protracted and
broke below a bull trendline (TL2).
There was a large breakout bar that
failed on the following bar. The break-
out was so strong and the prior up
move so convincing that you should
not be looking to short here (wait for a
second sell signal). This failure became
just a test of the breakout (a failed
attempt at a failed breakout), and was a
great second-chance long entry.
Bar 2 was a wonderful short entry.
The bull poked above a bull trend chan-
nel line and reversed back down, indi-
cating exhaustion. The move had three
thrusts up, making it a wedge. The
move was basically a measured move up
that tested yesterdays close and imme-
diately reversed down. The entry bar
was a second entry (remember the first
Trading Techniques continued
READING THE BREAKDOWN
Flag 2 provided second chance at a long entry following the failed attempt at the breakout,
while Bar 2 was an excellent short entry trade.
EASY STREET
There are times when you wont want to play the counter-trend game. Here, conditions
supported a continuation of the larger bear move.
6/11 7:00 7:30 8:00 8:30 9:00 9:30 10:00 10:30 11:00 11:30 12:00 12:30 13:00
1,530.00
1,525.00
1,520.00
1,515.00
1,510.00
1,505.00
70,000
30,000
1
2
Flag 1
TL1
Flag 2
TL2
Trend Channel Line
(Wedge)
7:00 7:30 8:00 8:30 9:00 9:30 10:00 10:30 11:00 11:30 12:00 12:30 13:00 6/8
1,539.00
1,537.00
1,535.00
1,533.00
1,531.00
1,529.00
1,527.00
1,525.00
1,523.00
1,521.00
1,519.00
1,517.00
1,515.00
1,513.00
1,511.00
1,509.00
1,507.00
1,505.00
1,503.00
55,000
25,000
1
2
Flag 1
TL1
entry that occurred on the bar after the
breakout?). A climactic move usually
results in an extended move in the
opposite direction. This is a great short
and you should swing most of your
shorts, expecting at least an hour or so
down and usually at least two clear legs
(here, there was just one extended leg).
GOING WITH THE FLOW
Easy street (page 40) shows when you
should stick with the trend. Bear Flag 1
broke the down trendline (TL1), provid-
ing a great long scalp at Bar 1. Because it
is a counter trend, you should scalp
most or all of your contracts. If you hold
some, you would exit the balance at
breakeven. Following the long entry,
there was a bar that poked above the 20-
period exponential moving average
(EMA) but closed below its midpoint,
indicating that the bears won the bar.
Bar 2 was a second attempt at cross-
ing above the 20-period EMA, and this
time the bar closed near its low and the
range was larger than that of the prior
EMA test bar, showing that the bears
were now even more aggressive. Also,
this leg up had a lower high than the
high of Flag 1 (a bear trend has lower
lows and highs). Finally, this was the
first touch of the 20-period EMA in a
couple hours, indicating that the bears
have been aggressive all day.
When you see this much bear
strength, you need to start looking for
bull set-ups. The reason is each will be
seen as a possible low of the day,
month or even year by lots of generous
traders who will buy, lifting the market
for only a few ticks. When no strong
bull bar forms after their entry, they
will feel trapped with no profit and
likely a one- or two-tick loss that never
seems to go away. They will place their
sell stops to exit at one tick below the
low of the prior bar. They will exit at a
loss and not be eager to buy again until
the next small up-close bar forms.
The most reliable trading opportuni-
ties always occur when someone is
trapped. Each of these small long set-ups
saw weak bulls trapped with losses, with
their protective stops providing the per-
fect area to get short, at one tick below
the low of the prior bar. Because you are
trading with the trend, you should
swing most of your contracts because a
trend will always extend much further
than anyone thinks it should.
Al Brooks stopped practicing medicine 20 years
ago to stay home and raise his kids and has been
day trading for his personal account ever since.
FM
E
lectronic, or automated, trading
of interest rate swaps has cre-
ated an easily accessible
method for controlling inter-
est rate risk as well as for hedging and
speculating on interest rate move-
ments. With increasing volume and
improved trading platforms this mar-
ket is destined to become
more popular for individual
traders along with larger insti-
tutional users.
Over-the-counter (OTC)
plain vanilla swaps allow two
counterparties to exchange
cash flows based on a nominal
amount of principal, in which
one of the parties wishes to
swap fixed interest income for
cash flows generated by float-
ing rate. The fixed rate (the
swap rate) is initially set to
equalize the present values of
fixed and floating cash flows.
Depending on the movement
of the floating rate, cash in
each period may flow in either
direction and by netting the
fixed rate against the floating
rate, only the net amount
needs to be transferred.
The OTC interest rate swaps mar-
ket is known for its large volume of
trading and underlying principal
value. According to the Chicago
Board of Trade (CBOT) the notional
amount of OTC U.S. dollar interest
rate swaps equaled nearly $73 trillion
in 2006. The CBOT instituted swap
futures in 2001, starting with the 10-
year maturity and following with five-
year swap futures in 2002. In March
2007, the exchange added 30-year
swap futures.
MARKET BENEFITS
Advantages of exchange-traded
interest rate swap futures
include standardization and
elimination of most counter-
party credit risk. CBOT swap
futures have prices that are
similar to Treasury note
futures. Both the 10-year and
five-year contracts are based on
a notional $100,000 principal
value with a 6% coupon rate.
Interest is paid semi-annually.
Having the same price base
as CBOT T-note futures per-
mits the notional yield for
interest rate swap futures to be
calculated as the discount rate
that makes the present value
of semi-annual payments of
$3,000 and $100,000 at matu-
rity equal to the current price.
Reversi ng thi s cal cul ati on
As liquidity grows in interest rate swap futures, traders will benefit from
improved hedging and trading possibilities. However, to take advantage of
these markets, you need to understand the relationships among futures on
swaps, T-notes and Eurodollars.
BY PAUL D. CRETI EN
Smoother way to trade
interest rate swaps
TRADING TECHNIQUES
al l ows a swap yi el d to be used
i n determi ni ng the pri ce of a
futures contract.
For example, a price for the five-
year interest rate swap listed by the
CBOT as 105-295 (105 points, each
equal to $1,000, plus 29.5 32nds of a
poi nt, whi ch i n dol l ar terms i s
$105, 922) has a rel ated yi el d of
4.66%.
The yield computed for a five-year
interest rate swap is likely to be close
to the yield for Eurodollar futures at
the same maturity of five years. The
reason for this, as pointed out by
Robert W. Kolb in Futures, Options
& Swaps (Blackwell Publishers,
2000), is that a strip of Eurodollar
contracts may be regarded as a substi-
tute for an interest rate swap. Recall
that the Eurodollar yield curve is com-
posed of a series of geometric means,
in which quarterly rates are succes-
sively multiplied and then the nth
root of each product determines the
yield to a specific future quarter.
The yields for five-year interest rate
swaps over the August through October
period in 2007 are compared with the
Eurodollar yields each day on Yield
comparison (right). The chart shows
that the two yields are virtually the
same at the end of each day. During the
trading day, automated computer trad-
ing continuously adjusts the two yields
to stay approximately equal.
A similar chart for 10-year swap
yields vs. Eurodollar yields at the 40th
quarter would show less equality
between the yields. This difference is
probably related to the shortage of
trading volume at the longer maturity
for both the swap futures and the
Eurodollar futures.
Although the yield on a five-year
interest rate swap is essentially equal
to the five-year yield for Eurodollar
futures, the two yields are arrived at
by different routes. As shown above,
the swap yield is related to a 6%
coupon note having semi-annual
interest payments and a notional
maturity value of $100,000. The
Eurodollar yield at the five-year matu-
rity is calculated as the last of 20
yields in a chain of yields based on the
geometric mean through 20 quarterly
rates. When all 40 Eurodollar future
quarters are included, the entire
Eurodollar yield curve is complete.
PARTS OF THE WHOLE
The structure of the Eurodollar yield
at any maturity is composed of three
segments: the U.S. Treasury yield at
that maturity, a credit spread, and a
correction to make up for the lack of
convexity. Price changes for
Eurodollar futures are always $25 per
basis point regardless of movements in
the U.S. Treasury yield.
The yield structure of a five-year
interest rate swap also has three parts,
but it varies from the Eurodollar struc-
ture. The two are mutually dependent
on the U.S. Treasury yield curve as
the base yield. An interest rate swap
also has a credit spread, which may be
YIELD COMPARISON
Thanks to automated trading systems that continually arb these markets, swap yields and
their comparable Eurodollar yields move hand in hand.
Source: CBOT, CME
1 6 10 15 20 23 28 31 6 11 14 19 24 27 2 5 11 16 19 24 29
5.40
5.30
5.20
5.10
5.00
4.90
4.80
4.70
4.60
4.50
5-YEAR EURODOLLAR YIELD AND 5-YEAR INTEREST RATE SWAP YIELD
SWAP VS. EURODOLLAR PRICE SPREADS
By selling the swap against Eurodollars, Eurodollar futures can be used to mitigate the
negative effects of a price increase.
Source: CBOT, CME
2 8 13 16 21 24 29 4 7 12 17 20 25 28 3 9 12 17 22 25 30
3000
2500
2000
1500
1000
500
0
-500
C
u
m
u
l
a
t
i
v
e

P
r
i
c
e
s

a
n
d

S
p
r
e
a
d
s
SWAP VS. EURODOLLAR PRICE SPREADS (CUMULATIVE PRICE CHANGES)
Aug Sep Oct
5-year Eurodollar Yield
5-year Swap Yield
5-year Swap
5-year Eurodollar Futures
Spread
Aug Sep Oct
considered equal to the Eurodollar
credit spread because they both are
based on the London Interbank Offer
Rate (LIBOR), which introduces a
small amount of bank risk.
The third element of the swap
yi el d i s convexi ty. Li ke T-note
futures, interest rate swap futures
have periodic notional coupon cash
flows and principal value at maturity.
Price calculations for interest rate
swaps are also different from prices of
Eurodollar futures. As discussed, the
price of a CBOT interest rate swap
futures contract is the present value of
a 6% coupon notional five-year or 10-
year note. The Eurodollar price for
the same maturity of five years is the
quarterly rate for the 20th quarter sub-
tracted from 100. In effect, there is no
dollar price for the Eurodollar futures
for a specific quarter; there is only an
index equal to 100 minus the quarter-
ly rate. However, the change in the
index from one period to the next
permits a price change to be calculat-
ed at $25 per basis point of change in
the price index.
SPREAD DIFFERENCES
Because of the difference in pricing
there are changes in the spread
between the prices of interest rate
swap futures and Eurodollar futures.
The progression of spreads is shown
on Swap vs. Eurodollar price spreads
(page 43). The chart shows cumula-
tive price changes for the five-year
interest rate swap and the Eurodollar
contract with five-year maturity.
It is expected that the average price
change for an interest rate swap will
exceed the average change in the cor-
responding Eurodollar futures. The
proportional difference between the
two changes may be estimated by
comparing basis point values (BPV),
and by computing the ratio between
average absolute changes over an
extended period.
Selling the swap vs. Eurodollar price
spread implies that the trader believes
interest rates will rise. The chart
shows how the spread changes with
no adjustment for the difference in
comparative price movement. With
this trade, Eurodollar futures are used
to mitigate the negative effects of a
price increase with the swap futures
rising at a faster rate than Eurodollar
prices. The Eurodollar part of the
spread also reduces profitability when
interest rates increase.
While the Eurodollar yield curve is
approxi matel y paral l el to U. S.
Treasury yields, the quarterly rates
that create the yield curve have a
compl etel y separate curve. The
unusual shape is required for succes-
sive quarterly rates to result in the
desired yield curve. This means that
the swap vs. Eurodollar price spread
i s i nf l uenced by changes i n
Eurodollar quarterly rates (and corre-
sponding price changes) that vary at
some distance above the yield curve.
Yield curves (left) shows the
Treasury yields at two-, three-, five-
and 10-year maturities, the curves of
Eurodollar quarterly rates and yields,
and T-note futures yields at two-,
five- and 10-year maturities on Nov.
2, 2007. A si ngl e dot on the
Eurodollar yield curve shows the five-
year swap yield.
The Yield curves chart indicates
the problems that may be encoun-
tered in predicting price changes for
the five-year interest rate swap and
the swap vs. Eurodollar spread. As the
Eurodollar quarterly rate curve bends
to make the Eurodollar yield curve
conform to the Treasury yield curve,
resulting price changes may not follow
usual interest rate/price patterns. As
long as the swap yield follows changes
in the Eurodollar yield curve,
Eurodollar yields (and the underlying
Eurodollar quarterly rates) are impor-
tant price determinants of interest
rate swaps.
Over time, increased trading vol-
ume in all maturities of interest rate
swap futures should result in improved
hedging and trading possibilities. The
relationships among swap futures, T-
note futures, and Eurodollar futures
should continue along the trends
described here with smoother curves
and enhanced predictability as the
exchange-traded market for interest
rate swap futures progresses.
Paul Cretien, CFA, is an investment analyst and
financial case writer. He may be e-mailed at
PaulDCretien@aol.com.
FM
YIELD CURVES
When the Eurodollar quarterly rate curve changes so that the Eurodollar yield conforms to
the Treasury yield curve, unexpected price changes may follow.
Source: CBOT, CME, Bloomberg.com
D
e
c

7
J
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n

8
D
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c

8
J
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n

9

D
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c

9
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1
0
D
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c

1
0
J
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n

1
1
D
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c

1
1
J
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n

1
2
D
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c

1
2
J
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n

1
3
D
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c

1
3
J
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1
4
D
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1
4
J
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1
5
D
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1
5
J
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1
6
D
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1
6
J
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n

1
7
0.0600
0.0550
0.0500
0.0450
0.0400
0.0350
Eurodollar Yields
U.S. Treasury Yields
Eurodollar Quarterly Rates
T-note Futures Yield
5-year Swap Yield
T
rading is Darwinian. If you
evolve the qualities needed to
trade profitably consistently,
then you survive. If you do
not evolve these qualities, you
become extinct. The fittest thrive.
When I began my journey to trad-
ing full-time, an opportunity to speak
with an exceptionally successful
investor presented itself. We talked
about several aspects of trading,
including the differences between
long-term investing (his approach)
and short-term trading (my
approach), but it was one of his ques-
tions that was most enlightening.
How do you feel when you make a
good trade? he asked.
Id never thought of this before, and
although my answer was truthful, it
was surprising: When I make a good
trade, I feel nothing.
He said that was good. While we
talked for some time longer, the real-
ization that emotions have no place in
trading, win or lose, was the most
valuable lesson from our conversation.
No matter how well you know how
to trade you may have memorized
the greatest trading strategy ever
devised if you dont keep your
emotions in check, you will never
be successful. Of course, no one
can completely escape their
emotions, but we can
understand and practice
what it means to feel
nothing.
TRADING PITFALLS
Regardless of your trading style, tech-
nique, time frame or market, there are
a number of common traits that can
trip you up. Not all underperforming
trades can be traced to the following
reasons, but in the absence of simply a
bad trading technique, many can:
The tendency to trade impulsively.
The tendency to miss an entry
point, then enter too late.
The tendency to deny a losing posi-
tion.
The tendency to enter a bad period
of trading immediately after a good
period.
Frequently, these pitfalls result in a
condition known as the ugly trader
syndrome. It describes the ability of a
trader to trade just fine to a point.
At that point, seemingly inexplicable
f orces i ntervene to prevent hi s
account from growing further. This is
often defined by a specific dollar
amount.
No matter how much the trader
wins, he loses the gains in a frustrating
win/lose cycle. Or the trader loses a
chunk of money, makes a partial come-
back then finds a new, lower dollar
level blocking any advance.
It is customary to make resolutions for the New Year. In the spirit of
this custom, traders should resolve to avoid common pitfalls that lead
to losing trades. Thankfully, many of these pitfalls can be traced to
one underlying cause: emotional trading.
BY RI CHARD L . MUEHL BERG
Avoiding common
trading pitfalls
TRADING TECHNIQUES
$
However, theres no mysterious force
behind this cycle. The trader is at the
root of this, and its up to the trader to
admit that he is the source of it.
The first step in avoiding these
common trading pitfalls is to accept
that you are the cause. And the rea-
son why is at the heart of the human
condition: emotion.
LUCKY OR GOOD
You know the feeling. Youre happy
when you win. You feel excited,
relieved, maybe even bored or
exhausted. Consider these one by one.
If you feel happy and excited, the
psychological translation may be that
you are trading to be happy or excited.
The downside of this is more apparent
when you consider what happens
when you make a bad trade. You can
be tempted to ignore the bad trade
because you dont want to be denied
happiness and excitement. Ignore
enough bad trades and you go broke.
Game over.
You feel powerful when you are
happy and excited. While we general-
ly view happiness as a good thing,
whats wrong with it relative to trad-
ing is that we have no power over the
markets. Feeling powerful can lead
you to assume that any trading deci-
sion you make will be right, that you
do have power over the markets. A
bad trade does not fit with a sense of
power. You may try to use your sense
of power to wish a bad trade away.
Ignoring bad trades is expensive.
Whats wrong about feeling relieved
when you make a good trade is that by
doing so you equate the act of making
trading decisions to a mental pressure
that you want to release in other
words, avoid. You cant expect to
become good at trading if you try to
escape decisions.
Sometimes, you can become bored
after making a good trade. This is nor-
mal. Trading can be an emotional
roller coaster. You can swing between
enthusiasm and depression, and bore-
dom is a stop on the way. You escape
from the swings by seeking a disassoci-
ated mental state.
Exhaustion is another common
result from a good trade. A trading
decision has real consequences. You
make or lose real money, and that can
be stressful. The indicators involved
in making a decision can be confus-
ing. Applying them correctly can
require an enormous amount of
willpower. This adds stress. You might
sometimes find yourself coming up
with reasons to avoid trading, simply
to bypass the stress and exhaustion
that can result from a trade, good or
bad. You trade smaller positions. You
sideline yourself more often. Its OK
to take a break when you do it con-
sciously to regain focus and get back
in the game. Its not OK when you do
it subconsciously.
Exhaustion, boredom, relief, excite-
ment and happiness are all warning
signs that you are trading emotionally.
SOLVING THE PROBLEMS
When we talk about trading mistakes
and emotional trading, it is usually
code for failing to have discipline.
Staying disciplined is tougher for dis-
cretionary traders who are not locked
into a system with definitive rules.
But even discretionary traders can
create rules for how they execute
trades and the parameters they use in
determining an entry. It is important
to remember that the best systems and
traders experience losses. Every trade,
win or lose, needs to be evaluated. We
can be fooled into believing the prob-
lem is with our losing trades when it
may be with failing to properly exploit
our winners.
To avoid these pitfalls, your goal
should be to eliminate emotions from
your trading. You must learn to appre-
ciate the value of feeling nothing
while you trade.
Trading impulsively is one of the
most common pitfalls. You know
intellectually that you should wait for
a sharp run, a clear turning point or a
clear trend, but for whatever reason,
you dont wait. For example, you try
to pick the bottom and by doing so,
you put the odds against you. The
result is you suffer an immediate loss,
a choppy pattern of losses and gains or
at best a minimal gain.
When you feel pressure to trade for
the sake of trading, learn to be patient.
Accept that opportunities always come
along. Remind yourself to wait for a
clear opportunity. This conserves ener-
gy. Decision-making will not be
exhausting. Your interest level will
remain high as you scan for the next
opportunity. You will not look for
relief, excitement or happiness.
If you have a tendency to miss a
good entry point, work on identifying
entries earlier, do not enter a trade
hoping your last parameter will be
met. Decide or stand aside.
If you do not train yourself to recog-
nize a good entry point and act fast,
then you can end up holding the bag.
Yes, you can also enter too soon and
be just as wrong, but there is a line
between an instinctive trader (or at
least a well-trained trader) and a trad-
er frozen by his own indecisiveness. A
frozen trader keeps catching the tail
READ AND REAP
When you feel anxious, embarrass yourself into being patient.
When you see a sharp run, a clear turning point or a clear trend, then long the strongest contract, stock,
exchange-traded fund or whatever in a bull move (short the weakest in a bear move). If you delay, wait for a
pullback. If there is no pullback, stand aside. Train harder and work on your speed.
When you make a bad trade or a mistake, exit immediately or before the close. Each moment you wait makes
you weaker and makes your denial stronger. Do not hold a bad trade overnight.
When you experience a particularly good period of trading, slow down. Reflect on your success. Train harder.
Then continue trading.
end of good trades.
The inability to act is one reason
why many traders do not follow their
own trading system. They do not trust
themselves or their system. The solu-
tion here is know your systems entry
logic not just what gets you into a
trade but how the market tends to act
around an entry point. Study old trades
and learn to enter good trades sooner.
If you deny losing positions, train
yourself to believe that denial is bad
for traders. Do not rationalize losses.
Shock is different than denial. Shock
sets in immediately after a bad trade
or a mistake and is temporarily
beyond your control. But when the
shock wears off, you have an opportu-
nity to regain positive control. You
must admit the trade and exit or you
will lapse into denial, which can be
much longer lasting. Understand how
denial and shock work. Admit that
shock can and will happen and learn
to bounce back quickly.
If you have a tendency to enter a
drawdown immediately following prof-
itable periods, look at trading as work.
Trading is a unique collision zone
between people who know it is work
and people who assume it is impossible
or easy. Occasionally, academics will
insist it is impossible to select and time
winning trades or that buy-and-hold
strategies and random darts are as good
as human analysis. These commenta-
tors ignore successful traders the
money managers, pit traders, investors
and day-traders who have made a
career out of taking other peoples
money using the markets.
But in some ways, they are correct.
Bad can frequently follow good, giving
the impression of randomness to an
otherwise solid strategy. Often,
though, this return to the mean can
be attributable to emotional trading
rather than randomness. Just like a
worker in any other profession, traders
are at risk of wanting to work less, to
be less disciplined. In a word: lazy. We
are typically at a greater risk of falling
into this trap just after weve per-
formed our strongest.
If you are doing well, do not reck-
lessly speed up or get lazy. Keep your
mind clear and centered during the
good times. A tick, or several tick, loss
on a winning trade is just as costly as
that tick loss on a losing trade.
Too many traders blow out because
they spiral downward to the point
where they are mentally and finan-
cially hollow. They have no reserves
to help them rally. Dont fall that far.
Think how many successful, even leg-
endary, traders failed mightily before
they sprang or clawed their way back.
These traders had a last ditch
defense. Think of it as the safety in
football or the backstop in baseball.
You need something watching your
back. Consider these techniques.
First, scale back your size. If you can
financially handle x contracts or
shares then restrict yourself to x
minus y contracts. That way, even if
you take repeated hits, you wont sink.
If you are determined to make one of
the common trading mistakes, then,
in this case, delay. Delay, trade small,
and go to cash as soon as you can
summon the willpower.
Trading can be an expensive process.
A lot of failed species lie in the wake of
Darwins process of natural selection.
Thats also true for traders who were
unable to keep their emotions in
check. Learn to control your emotions
before they lead you down the wrong
evolutionary path. If more would
approach the mental side of trading
with the same methodical approach
that they tackle their strategy rules,
they would more quickly evolve into
better, less emotional, traders.
Ri chard L. Muehl berg uses l i near
regression channels and intermarket analysis
to day trade his own account. He publishes
a day tradi ng di ary on hi s si te:
www.DayTradingWithLinesInTheSky.com.
E-mail: richardmue@yahoo.com.
FM
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M
ost traditional trading
models use historical price
data series as the only data
inputs for the rules that
decide whether to buy or sell. However,
you can build better systems by looking
beyond this singular way of thinking. By
designing and collecting your own mea-
sures of market breadth, you can inte-
grate these data into a trading system
and get a much better picture of market
dynamics, particularly with markets
having many components.
Here, we will use an example trading
system to demonstrate the usefulness of
designed breadth data. Looking at the
E-mini S&P 500 and its related compo-
nent stocks, we can write rules that take
advantage of this new information.
First, though, we need to collect the
right data.
MEASURING MARKET BREADTH
Market breadth analysis in general refers
to technical indicators dedicated to the
study of the overall behavior of the stock
market based on statistics that are drawn
from all the traded stocks within the
stock market. We have all heard about
advance/decline issues, advance/decline
volume, 52-week new highs and new
lows. Those are market breadth data of
the stock market as a whole.
The good news is these breadth data
are available through the stock
exchanges in real-time. You can easily
access them so you can gauge the over-
all strength of the stock market.
However, if you are a trader whose pri-
mary interest is trading a specific stock
market index, then the broad based mar-
ket breadth data may not provide the
specific information you need for the best
analysis. A stock market index has only a
small set of symbols compared to the
thousands of symbols that are traded
within the stock market as a whole. The
breadth data for the entire equity market
may not accurately reflect what the
index components are doing.
The solution is to create your own
custom designed breadth data indicators.
ROLLING YOUR OWN
The idea is to design our own breadth
measurements as opposed to looking at
the classic ones that have been handed
to us decades ago. As long as we can
define the measurement and apply it
across all the components, we will get
our own designed breadth data. Because
our breadth data will measure very spe-
cific aspects of the components, we
should be able to uncover new informa-
tion about the market we are trading.
One measure of market breadth is the
count of three-day advance issues. The
three-day advance issues number is sim-
ply the number of stocks that have a
current price higher than their close
from three days ago.
By counting all 500 component
stocks of S&P 500 that meet this criteri-
on, we get a customized three-day
advance issues data series. This informa-
tion can be collected in real-time and
can be used alongside any other data
you received in real-time. Whos ris-
ing? (right) shows an example of the
three-day advance issues line for the
S&P 500.
Due to how the custom three-day
advance issues indicator is designed,
there is essentially no need of a three-
day decline issues counterpart. Thats
because unlike in the broader stock
market, there are exactly 500 symbols
that we care about. For example, ignor-
ing the minor if inconsequential effect
of stocks that are flat, if the value of the
Price is such an important input for trading models that in most cases, its the
only input. However, many more market statistics are at your fingertips and
can help build a robust system. You just need to know how to use them.
BY L AWRENCE CHAN
Using market breadth
in trading systems
TRADING TECHNIQUES
three-day advance issues is 300 today,
then the corresponding value of the
three-day decline issues must be 200.
SYSTEM UTILIZATION
Because the three-day advance issues
data series is range bound (from zero to
500), we can assume that it behaves like
an oscillator. One approach to investi-
gate the usefulness of this market
breadth data is to implement a simple
overbought/oversold system using the
data series to see if it has any signifi-
cance in terms of price prediction on
the E-mini S&P 500 index futures.
An overbought condition can be
defined as high values. In other words,
there are a large number of individual
stocks trading above their close from
three days ago. For an oversold condi-
tion, there are a large number of indi-
vidual stocks trading below their close
from three days ago. The assumption in
both cases is that the extreme nature of
either condition will not be sustained;
and when it breaks, the market will
tend to reverse direction. Of course,
defining whats extreme can be a mov-
ing target. This is an acknowledged
problem with simple overbought/over-
sold systems, but not one that should
subtract from its usefulness.
Here are the rules and specifications
of the system:
1. Always in the market
2. Regular trading hours only
3. 130-minute bars are used (this
removes the last 15 minutes of E-
mini S&P trading)
4. SPD3A = three-day advance issues
5. SMA = eight-period simple moving
average on SPD3A
6. Long when SPD3A > SMA and
SPD3A crosses above 220
7. Short when SPD3A < SMA and
SPD3A crosses below 360
In plain English, the system always
stays in the market with either a long or
short position. The system goes long
when the three-day advance issues line
is rising from an oversold condition
while sitting above its trend. The system
goes short when the three-day advance
issues line is dropping from an over-
bought condition while staying below
its trend.
The reason why the last 15 minutes
of regular trading hours in the E-mini
S&P 500 must be discarded is because
there are no breadth data for that
time period. Breadth data only can be
collected while all the components
(the individual stocks that make up
the S&P 500) are actively trading.
This is a limitation of breadth data
in general.
Rules for trading (above) shows the
rules for the system written as
NeoTicker formulas (these simple rules
could easily be ported into any reason-
ably flexible trading system software
that allows custom systems). Playing
with breadth (page 52) graphically
depicts how the system goes long and
short with relation to the three-day
advance issues line and its average.
PERFORMANCE
The performance of the system is inter-
esting in many ways (see Profits with-
out price, page 52).
First, the S&P 500 has moved up
about 400 points during the testing
period, and that translates to about
$20,000 profit for a buy-and-hold strat-
egy executed in the E-mini S&P 500.
The system presented here has made
more than twice that, demonstrating
WHOS RISING?
The three-day advance issues line tends to rise when the stock index itself also rises.
Sometimes, however, we will see the advance issues line level out before prices
themselves turn, particularly following a swift run-up.
Source: TickQuest NeoTicker
Sep.10 Sep.12 Sep.14 Sep.18 Sep.20 Sep.24 Sep.28 Oct.1
1,550.00
1,525.00
1,500.00
1,475.00
1,450.00
500
400
300
200
100
RULES FOR TRADING
Heres the trading system rules for NeoTicker, although these could easily be reproduced
for most trading system software programs
makeindicator (signal_trend, average, data2, param1);
$buy_signal := xaboveconst (data2, param2) > 0 and data2 > signal_trend;
$sell_signal := xbelowconst (data2, param3) > 0 and data2 < signal_trend;
longatmarket ($buy_signal, defaultordersize, LE);
shortatmarket ($sell_signal, defaultordersize, SE);
plot1 := currentequity;
2007
that the approach has some merit and
is worth further investigation.
Second, the short side of the system
is making about the same amount of
money as buy-and-hold strategy. In
such a strong bull market, this implies
that the system does not overly rely
on Beta (simple exposure to the mar-
ket) for its profits.
However, there are always issues
before a basic model can be deployed
in real life. For example, the system
does not employ any money manage-
ment rules to protect itself from mar-
ket shocks; thus, large drawdowns are
expected. If you are going to build a
trading system around this concept
or any concept, for that matteryou
must work out the money-manage-
ment and risk-control details first.
Finally, the decision making of the
system is independent from the price
series itself, making it possible to be
used as a timing tool for other instru-
ments that are highly correlated to
the S&P 500 index.
DATA COLLECTION
There are several ways to collect your
own market breadth data in real time.
Some real-time trading platforms
have the ability to construct synthetic
symbols based on a combination of mul-
tiple symbols and their indicator values.
If your platform has this feature, you can
define your custom breadth data direct-
ly. Some platforms even allow you to
reconstruct historical data for these syn-
thetic symbols, making it easy to con-
duct research on your own customized
breadth design.
For those platforms that do not sup-
port such functionality, you can accom-
plish something similar through writing
a custom indicator that works on multi-
ple data series within a chart. The disad-
vantage with this approach is that you
cannot save up the historical data when
there is a need to change components.
While collecting your designed
breadth data in real-time, you must
remember to maintain an updated
component lists. With only a few issues
switched in and out of an index within
a month, there is no big impact on the
usefulness of the data. Thus, there is no
need to update the component list
every day. In general, if you can keep
up with the component changes once a
month, the data you have collected
will remain accurate.
However you go about collecting your
data, this simple three-day advance
issues system is just an example of how
you can design your own breadth mea-
surements to improve how you trade a
stock index. It demonstrates the useful-
ness of simply having an improved ver-
sion of the classic breadth measure-
ments. By taking time to create more
sophisticated breadth data yourself, you
will be able to uncover more useful
information about the indexes
you trade.
Lawrence Chan is a trader and principal design-
er of NeoTicker. Lawrence@tickquest.com.
Code for Rules for trading, (page 51), will be
available at futuresmag.com, under downloads.
FM
PROFITS WITHOUT PRICE
These simple market breadth rules have impressive performance figures on their own.
With additional research, backed by out-of-sample testing, and an effective money-
management overlay, this could become a promising trading system.
PLAYING WITH BREADTH
Basically, we are going short when the three-day advance issues line (red line, middle
chart) moves out of overbought territory and has already crossed below its eight-day sim-
ple moving average (blue line, middle chart). We reverse and go long when the red line
moves out of oversold territory and is above the blue line.
Apr.9 Apr.23 May7 May21 Jun.4 Jun.18 Jul.2 Jul.16
Yearly Performance
Period Net % L Net L % S Net S %
Period Profit Profitable Profit Profitable Profit Profitable
2004 $16,405.00 79.31% $10,050.00 86.67% $6,355.00 71.43%
2005 $6,365.00 59.46% $4,172.50 66.67% $2,192.50 52.63%
2006 $16,187.50 68.57% $12,447.50 88.89% $3,740.00 47.06%
2007 $15,837.50 77.14% $10,690.00 88.24% $5,147.50 66.67%
Average $13,698.75 71.12% $9,340.00 82.62% $4,358.75 59.45%
Initial Capital $10,000.00
From Date 2/2/2004
To Date 9/28/2007
Total Trades 137
Total Commission $682.50
Profit Before Commission $55,192.50
Winners / Losers Ratio 2.4
Sharpe Ratio 6.4
Profit Factor 3.32
1,575.00
1,550.00
1,525.00
1,500.00
1,475.00
1,450.00
1,425.00
500
400
300
200
100
0
67,500
65,000
62,500
60,000
2007
EXCHANGES
Eurex launched Eurex SecLend, an
electronic marketplace for secured
securities lending and borrowing, based
on the Eurex Repo markets. The
product is designed to help banks and
financial service providers improve the performance
of thei r securi ti es hol di ngs wi th securi ti es
lending.www.eurexrepo.com
The New York Mercantile Exchange (NYMEX) intro-
duced the MACI futures and the Crude Oil Backwardation-
Contango index futures contracts. They will be launched in
February. www.nymex.com
The Chicago Board Options Exchange (CBOE) has regulato-
ry approval to launch a new electronic system for trading
index and equity Flexible Exchange (FLEX) options. The new
system, CFLEX, is the first Internet-based, fully automated
electronic trading system in the U.S. marketplace for the trad-
ing of FLEX options. www.cboe.com
Also CBOE will publish three new benchmark indexes,
the CBOE S&P 500 3-Month Volatility Index (VXV), the
CBOE VIX Premium Strategy Index (VPD) and the CBOE
Capped VIX Premium Strategy Index (VPN). CBOE also
will re-launch a new version of its CBOE S&P 500 VARB-
X Strategy Benchmark (VTY). www.cboe.com
U.S. Futures Exchange (USFE) will exclusively license the
Bombay Stock Exchanges (BSE) benchmark SENSEX Index
for U.S. dollar-dominated futures trading beginning Feb. 22.
The CFTC was appraised before the licensing agreement was
signed, and USFE does not expect any regulatory issues with
the contract, which will be officially self-certified closer to its
launch date. www.usfe.com
The Nasdaq Stock Market (Nasdaq) expanded its Select
Market Maker Program for issuers to New York Stock
Exchange (NYSE)-listed companies. The program will pro-
vide access to Nasdaqs Market Intelligence Desk and
Nasdaq Online at no cost. www.nasdaq.com
Also Nasdaq launched the Nasdaq Internet Index, a bench-
mark to track companies engaged in Internet access providers,
search engines, web hosting, site design and Internet retail
commerce. www.nasdaq.com
OMX and Singapore Exchange (SGX) agreed to imple-
ment a clearing system that will serve as the clearing plat-
form for SGX derivatives, securities and OTC clearing busi-
nesses. www.omxgroup.com
ICE Futures U.S. implemented Trade At Settlement
capability in the ICE electronic trading system for Cotton
No. 2 and FCOJ-A futures contract
months. Orders to trade a futures con-
tract at the settlement price can be
submitted at the start of the pre-open
period through the end of the futures
contract settlement window each day.
TAS orders will be matched on a first-in, first-out basis.
www.theice.com
FOREX
Citi and Saxo Bank will launch CitiFX Pro, an online for-
eign exchange trading platform. www.citi.com
TECHNOLOGY
Trading System Lab launched the Trading System Lab
platform, which automatically creates trading systems,
including single market systems, pairs systems, portfolio sys-
tems, daytrading systems and options systems.
www.tradingstystemlab.com
Trading Technologies International, Inc. (TT) connected its
X_TRADER7 order-entry platform to the Chicago Climate
Futures Exchange (CCFE). The gateway will offer customers
access to CCFE futures contracts, including sulfur financial
instrument futures, carbon financial instrument futures, certi-
fied emission reduction futures and ECO clean energy index
futures. www.tradingtechnologies.com.
The International Capital Market Association launched
BondMarketPrices.com, a free online portal providing data
on investment grade bonds with a large issue size. The portal
offers access to pricing and liquidity information on the glob-
al bond market. www.BondMarketPrices.com
OTHER
For t i s announced that its clearing facility, EMCF,
can now clear Swiss stocks in addition to Dutch,
German, UK and French stocks. www.merchantbank-
ing.fortis.com
The Op t i o n s I n d u s t r y Co u n c i l ( OI C)
announced the addition of a new Virtual Trading
System (VTS). VTS screens include strategies such
as spreads, straddles and covered calls, and the abili-
ty to investigate order types like triggers and one-
cancels-other. www.optionseducation.org
Dow Jones Indexes launched the Dow Jones 2008
Summer Games I ndex, whi ch meas ur es t he
performance of the companies that are official part-
ners and sponsors of the Bei j i ng 2008 Ol ympi cs.
www.djindexes.com
New For Traders
Send new product information to:
Futures, 111 W. Jackson Blvd. Suite 2210
Chicago, Ill. 60604, Fax: (312) 846-4602
Attn: Christine Birkner
E-mail: cbirkner@futuresmag.com
BY CHRI STI NE BI RKNER
I
ts win or lose, nothing in
between. That s how bi nary
options work. In other words, if
you buy a binary option and:
A happens by B, then you receive C.
A does not happen by B, then you
receive nothing.
A is the event defined by the
exchange l i sti ng the opti on.
Examples include gold achieving a
certain price per ounce, a corpora-
tion filing for bankruptcy, or the
Federal Reserve cutting its target for
the Federal Funds rate.
B is the date by which A must
happen.
C is the amount of money, or
asset, you stand to gain.
The seller of a binary option, by
contrast, must pay C if A happens by
B. The seller is compensated for
assuming this risk, according to the
current market price for the binary
option in question. Of course, the
seller pays nothing if A does not hap-
pen by B.
Binary options differ from plain
vanilla options in that a binary
options payoff does not increase the
more it is in-the-money at expiration.
A typical corn put option with a
$3 strike will be worth $0.50 if corn
settles at $2.50 per bushel. on option
expiration day. Alternatively, a bina-
ry put option with a $3 strike with a
payoff of 1 per bushel will pay only
that 1 no matter how far the price
of corn falls by expiration day. See
All or nothing (page 55) for a
graphical representation of the payoff
profile of binary options.
HISTORY OF DIGITS
Binary options have long been used
on the over-the-counter market, the
peer-to-peer or dealer network mar-
ketplace where large financial insti-
tutions establish custom positions in
non-standardized contracts without
the intermediation of an exchange.
As with many other OTC deriva-
tives, these binary options are sliced,
diced and accessorized to accomplish
any number of specific financial
goals.
Examples of these more exotic rep-
resentati ons of bi nary opti ons
include one-touch binaries, which
pay off if the price of the underlying
hits the strike anytime before expira-
tion; ladder binaries, which include a
series of payoffs at different levels;
and range binaries, which pay off if
the price of the underlying stays
within a set range.
Despite their popularity among
big-money players, most of us are
familiar with binary options due to
their prevalence in a financial arena
as far removed from the OTC market
as any other and we probably dont
even know it. Liquidity, logistical,
infrastructural and regulatory consid-
erations notwithstanding, many gam-
ing Web sites offer good examples of
simple binary options.
Such sites allow users to bet on
anything from the outcome of foot-
ball games to presidential elections
to, yes, the level of the S&P 500 on a
certain date. These bets pay a set
amount, usually quoted as $1 per
contract, to the buyer if the
event (the Bears beat the Packers,
the incumbent loses or the S&P clos-
es above 1410 on Dec. 8, 2007)
occurs.
Only recently, however, have these
basic, intuitive products found their
way to regulated financial exchanges
Binary options offer a pleasingly simple way to participate in market
moves, but only recently have these most basic of financial instruments
become accessible to retail traders. Heres what you need to know.
BY J AMES T. HOL TER
To be or not to be
FUTURES 101
in the United States.
RETAIL ALTERNATIVES
Individual traders have a few alterna-
ti ves i n exchange-traded bi nary
options. Heres whats available:
In July 2006, the Chicago Board
of Trade (CBOT) started offering
binary options based on the results of
Federal Reserve monetary policy
decisions.
In July 2007, the Chicago Board
Options Exchange (CBOE) started
offering binary options based on cor-
porate credit events, such as a com-
pany defaulting on previously issued
bonds, followed in August by broad-
er, sector-based credit events.
In October 2007, the U. S.
Futures Exchange (USFE) started
offering weekly binary options based
on the prices of crude oil, gasoline,
gold, silver and the euro.
The CBOT already owned the mar-
ket in standard Federal Funds futures
when it launched its binary option
contracts on the same. The Fed funds
futures trade with respectable volumes
and are widely quoted as reliable pre-
dictors of changes to the Feds target
Fed funds rate.
The CBOT binary options pay
$1,000 to the buyer at expiration if
the option expires in-the-money.
They are quoted in terms of 100
minus the target Fed funds rate. Calls
expire in-the-money if the target rate
is above the strike price at expira-
tion. Puts expire in-the-money if the
target rate is below the strike price
at expiration.
The CBOE offers two classes of
credit event binary options (CEBO).
There are single-name CEBOs and
basket CEBOs.
Single-name CEBOs are cash-set-
tled call options that pay $100,000
when a pre-defined credit event
occurs. Examples of possible credit
events that the CBOE might use as
the basis for the options include, but
are not limited to, a bankruptcy or a
default on a certain debt obligation.
Initially, the CBOE listed single-name
CEBOs based on General Motors
Corp. (GM), Ford Motor Co. (F),
Hovnanian Enterprises Inc. (HOV)
and Standard Pacific Corp. (SPF).
The basket CEBOs are similar, but
they are based on the credit perfor-
mance of all the companies included
in the basket and can pay out when
one or more of the companies in the
basket defaults, declares bankruptcy
or satisfies the conditions of the pre-
defined credit event.
Al though the CBOE s bi nary
options are unique and enormously
flexible in terms of how new contract
specifications can adjust to current
events, they are more useful to insti-
tutions that have large exposure to
corporate-issued debt or debt expo-
sure spread around a number of com-
panies in a certain sector.
The binary options at the USFE,
however, were designed with the
retail trader in mind. These contracts
are active for one week at a time, and
listings include at least nine strikes
for each referenced market. They
have a payout of $1,000 per contract.
The USFE offers two types of binary
options: single-asset binary options
and event binary options.
Single-asset binary options expire
in-the-money if the underlying set-
tles above the options strike price at
the end of the week. Single-asset
binary options open for trading on
Monday morni ng and expi re on
Friday afternoon.
Event binary options expire in-the-
money if a pre-defined event occurs;
so far, the USFE has listed event
binary options on whether the CME
ALL OR NOTHING
The payoff profile for a binary option is simple. If the price of the underlying is above a
specified amount, $100 as shown below, a call pays a fixed amount while the put at that
strike would be worth nothing. If the price of the underlying is below a specified amount,
a put pays a fixed amount while the call at that strike would be worth nothing.
80 85 90 95 100 105 110 115 120 125
12
11
10
9
8
7
6
5
4
3
2
1
0
P
a
y
o
f
f

o
f

o
p
t
i
o
n

a
t

e
x
p
i
r
a
t
i
o
n
BINARY CALL OPTION
BINARY PUT OPTION
Price of underlying at expiration
80 85 90 95 100 105 110 115 120 125
12
11
10
9
8
7
6
5
4
3
2
1
0
P
a
y
o
f
f

o
f

o
p
t
i
o
n

a
t

e
x
p
i
r
a
t
i
o
n
Price of underlying at expiration
or InterContinental Exchange would
merge with the CBOT.
Whats out there (below) lists the
major contract specifications of the
CBOT (now CME Group), CBOE and
USFE binary options.
THE WAY YOU MOVE
Binary options simple win-or-lose,
all-or-nothing payoff structure takes
a lot of uncertainty off the table.
That means that the going market
price for the option itself is an effec-
tive probability forecast of whether
the event will take place.
For example, USFE single-asset
binary options are quoted between 0
and 100. The value can be consid-
ered the implied probability that the
contract will expire in-the-money. In
other words, if the $800 strike gold
cal l opti on i s tradi ng at 97 on
Thursday, the market is implying
theres a 97% chance that gold will
settle at or above $800 when the
market closes the following day.
The clear probabilities make it easy
to verbalize your risk and reward in a
potential trade. In other words, a
$970 investment (97 x $10 point
value) has a 97% chance to make
$30 (3 x $10); alternatively, you
could sell the option for $970 for the
3% chance that youd get to keep the
premium. If either looks like a good
deal to you, given your personal anal-
ysis of the gold market, then theres a
trade to consider.
One interesting attribute in binary
option pricing is that they tend to
appear somewhat one-sided during
periods of price trends and more bal-
anced at perceived turning points or
during periods of uncertainty. A good
illustration of these periods is when
the Federal Reserve is considering
shifting its monetary policy bias from
contractionary or expansionary to
neutral, or vice versa.
Assume the Fed has been on a
tightening binge and the target rate
i s currentl y at 6. 50%. You ve
crunched the numbers and believe
that its about time rates should sta-
bilize or even drop. Based on current
unemployment, housing starts, the
dol l ar/ euro rate, etc. , you thi nk
theres a 70% chance the Fed will
stop raising rates, with a 40% chance
theyll hold steady and a 30% chance
they l l actual l y shi f t gears and
decrease the target rate by 25 basis
points, to 6.25%. That leaves a 30%
Futures 101 continued
WHATS OUT THERE
Below are the contract specifications for the binary options listed by U.S. exchanges.
Source: CBOT, CBOE, USFE
CONTRACT: FED FUNDS BINARY OPTION
EXCHANGE: CME Group
UNDERLYING: Federal Open Market Committee (FOMC)
target fed funds rate decisions.
PAYOUT: $1,000
MINIMUM PRICE FLUCTUATION: $10
DELIVERY MONTHS: Determined by the concluding day
of the regularly scheduled FOMC meeting that the
option references, as shown in the FOMC meeting cal-
endar at the time the option is listed for trading.
LAST TRADING DAY: The business day after the FOMC
meeting adjourns.
TRADING HOURS: 6 p.m. to 4 p.m., Chicago time, Sunday
through Friday. Trading in an expiring option shall end at
2 p.m. Chicago time on the last trading day.
STRIKE LEVELS: Option strikes shall bracket the pre-
vailing target fed funds rate. For newly listed delivery
months, strikes shall be listed in increments of 12.5
basis points, at the prevailing target plus 20 consecu-
tively higher and 20 consecutively lower strikes;
strikes can never be less than 0 or greater than 100.
CONTRACT: CREDIT EVENT BINARY OPTION
EXCHANGE: CBOE
UNDERLYING: Credit events as defined by the CBOE
when the contract itself is listed.
PAYOUT: $100,000
DELIVERY MONTHS: One to four series for each year up
to 10.25 years from the current expiration cycle.
LAST TRADING DAY: When the credit event occurs, or
the third Friday in the March, June, September or
December expiration month.
TRADING HOURS: 8:30 a.m. to 3 p.m., Chicago time
STRIKE LEVELS: N/A
CONTRACT: EURO/DOLLAR BINARY OPTION
EXCHANGE: USFE
UNDERLYING: Exchange rate between the euro and the
U.S. dollar.
PAYOUT: $1,000
DELIVERY MONTHS: N/A, contracts listed on a weekly basis
LAST TRADING DAY: Last business day of week
TRADING HOURS: 5:25 p.m. to 4 p.m., Chicago time.
Trading in an expiring option shall end at noon
Chicago time on the last trading day.
STRIKE LEVELS: A minimum of nine strikes based on
end-of-week, at-the-money value. Strikes added as
necessary. Strike increment of 50 pips.
CONTRACT: Gold Binary Option
EXCHANGE: USFE
UNDERLYING: Comex gold futures.
PAYOUT: $1,000
Trading in an expiring option shall end at 1 p.m.
necessary. Strike increment of $10.
CONTRACT: OIL BINARY OPTION
EXCHANGE: USFE
UNDERLYING: Nymex WTI oil futures
PAYOUT: $1,000
Trading in an expiring option shall end at 1:30 p.m.
necessary. Strike increment of $1.
CONTRACT: SILVER BINARY OPTION
EXCHANGE: USFE
UNDERLYING: Comex silver futures.
PAYOUT: $1,000
Trading in an expiring option shall end at 12.45 p.m.
necessary. Strike increment of $0.25.
chance the Fed will continue tight-
ening and raise rates by 25 basis
points, to 6.75%.
You can play this analysis any
number of ways.
You could sell both the at-the-
money put and the at-the-money
call, which have the strike of 93.50
(100 6.50). If the market agrees
with your analysis, you will collect
$300 per option. If the Fed does
nothing, the options expire worthless
and you will keep the total $600 you
collected. However, if the Fed raises
rates, you will pay $1,000 on the
binary put you sold, for a net loss of
$400. Likewise, if the Fed lowers
rates, you will pay $1,000 for the
binary call you sold, for a net loss
of $400.
Binary options also are useful when
it comes to so-called six-sigma events
those market shocks that seem to
take everyone by surprise and result
in incredible profits and losses.
Although its often pointed to as a
classic mistake of beginning plain
vanilla options traders, buying far
out-of-the-money binary options
with the hope of cashing in on these
events is a bit more defensible for
two reasons. One, because their pay-
out is capped, binary options are gen-
erally cheaper. Two, in the case of
binary options quoted from 0-100,
the i mpl i ed probabi l i ty that the
event will occur is laid out in front of
you; you may be betting on a highly
unlikely outcome, but at least you
wi l l know f i rst-hand j ust how
unlikely it is.
As a trader, its always better to
have additional choices in how you
risk your money. At some point you
may become overwhel med wi th
which route to take, but once you
understand the lay of the land, hav-
ing the opportunity to choose among
several ways to trade a forecast can
mean the difference between win-
ning a little and winning a lot.
Binary options are a relatively new
route on the retail trading landscape.
Binaries have gone from a gimmick first
popularized by the Iowa elections mar-
ket as a way to legitimize sports gam-
bling to a mechanism to hedge econom-
ic reports, but the binary structure is
now being applied to traditional futures
markets. Although a binary option
wont always be the right choice, and
could even leave a lot of money on
the table in the event of a big move,
being able to trade it when you want
it is a nice option to have. FM
GET CALCULATED
A free online binary option price calculator is available at
www.sitmo.com/live/OptionBinaryCash.html. That address will take you directly to the
calculator for a binary option with a cash payout of all or nothing shown below. For an alternative
online binary option calculator, see www.montegodata.co.uk/Consult/Binary/binary.htm.
Source: www.sitmo.com
T
his past July, nearly 2,000
retail traders converged on the
upscale Frankfurt suburb of
Aschaffenberg, Germany. The
draw was Trading Expo an event for-
merly known as Futures Expo. One rea-
son for the name change: Futures
arent really the big story anymore, says
Bruno Stenger, whos been running the
conferences for more than a decade.
In Germany, the big stories are
Zertifikate (certificates) and CFDs
(contracts for difference), he says,
referring to two varieties of product
sweeping the Continent. Germanys
Federal Financial Supervisory
Authority (the Bundesanstalt fr
Finanzdienstleistungsaufsicht, or
BaFin) believes the underlying
notional value of certificate volume in
that country alone will end up near
300 billion this year, and several
politicians have proposed tighter regu-
lation on the instruments (See:
Product explosion, right).
U.S. authorities have a simpler answer:
here, theyre just not allowed.
CFDs more closely resemble popular
British retail products called spread
betting, which are in fact patterned
after the spread bets made every Sunday
during football season in the United
States, while Certificates are something
akin to synthetic leveraged purchases or
sales: from the customers perspective,
its as if hes purchasing the spot product
on margin, often paying a monthly
financing fee, while from the brokers
perspective, the company is making a
market and then hedging with spot
futures. The advantage for customers is
that contract sizes are usually smaller
than they are in futures, and theres no
need to execute rollovers every month
or two.
CFDs tend to be more flexible and
smaller than certificates, but also tend
to have higher fees. Niche players such
as CMC-Markets Deutschland domi-
nate the CFD trade, while old guard
companies like Goldman Sachs and
Dresdner Kleinwort dominate the cer-
tificates markets.
In 2006, ABN Amro took the con-
cept of certificates to the next level by
launching Market Index platform
(www.abnamromarketindex.com/uk/Ho
me.aspx see: Market index: Danger!
Danger?, page 64), which lets you
define your contract size and leverage
and then trade pretty much any product
on which futures are offered.
Like many liquid OTC markets,
exchanges want in. The Australian
Securities Exchanges exchange-traded
CFDs, launched on Nov. 5, have shown
immediate success (see: Jumping out of
the gate, right).
BANNED BOILERS
The new products have several regula-
tory strikes against them, and for a
change its not the fault of the
Securities and Exchange Commission.
Rather, its because most of the products
arent exchange-traded instruments, but
over-the-counter (OTC) instruments
that are either hedged on-exchange, or
not hedged at all.
The U.S. ban on such instruments
flows from decisions made in the 1930s,
when the Commodity Exchange Act
(CEA) led to the creation of the
Commodity Exchange Authority, part-
ly to prevent traders from cornering the
grain markets and partly to prevent
boiler rooms from creating and selling
fake futures contracts. The Commodity
Futures Trading Commission (CFTC)
succeeded the CEA in 1974, but these
1930s regulations remain in effect on
most instruments.
Thats because boiler rooms made
European retail traders are enjoying a golden age of product development that
lets them access major commodity and financial products with small amounts of
risk and lots of flexibility. Heres a look at some of the nifty products
proliferating overseas and why theyre off-limits to American traders.
BY STEVE ZWI CK
Forbidden fruits
TRADE TRENDS
money by combining 1930s era
Certificates with good, old-fashioned
fraud: telling half their customers that
their research indicated a price rise, and
the other half a price drop. Half would
go long, and half would go short, with
the broker netting out the two positions
and keeping the spread plus commission
and impressing half of his customers,
who hed then hit up for referrals. Its in
response to these activities that
Congress passed the CEA, which
among other things codified the self-
regulatory mandate of exchanges and
said any futures contract not executed
on a regulated exchange was not only a
void contract but probably an act of
fraud as well.
PRUNING THE REGS
The treatment of off-exchange retail
products has softened. The first soften-
ing came in response to the introduc-
tion of swaps, which until recently were
neither standardized nor traded on an
exchange. In 1987, the CFTC began
investigating Chase Manhattans com-
modity swap business and warned that
swaps may be subject to the CEA. That
raised the specter of existing swaps
being declared legally void, and swap
trading in the United States slowed dra-
matically or moved offshore.
This led then-CFTC Chairman
Wendy Gramm to draw up the Swaps
Policy Statement in 1989, which stated
that at this time most swap transactions,
although possessing elements of futures
or options contracts, are not appropriate-
ly regulated as such under the Act. That
declaration carved out a safe harbor for
swaps, which Gramm defined as being
cash-settled, non-standardized transac-
tions that werent cleared or offset by an
exchange-style mechanism.
They also had to be transactions
executed among active professionals,
who could only make trades related to
their line of business, a description
that doesnt apply to most of us.
In 1990, the Federal District Court in
New York dribbled some new mud into
the already murky waters when it asked
the CFTC to determine whether paper
barrels of Brent crude oil a type of
forward contract should be regulated
as futures. Although the CFTC said the
paper barrels were not futures, they
werent exactly swaps, either.
What they were was a question a
growing number of participants in the
hybrid instruments market were asking.
After all, if the courts couldnt figure
out the legal standing of these instru-
ments, how could they?
For a while, the CFTC managed to
steer through the regulatory no-mans
zone by issuing no-action letters regard-
ing interest rate swaps and other prod-
ucts, but it took what Gramm termed a
rather painful reauthorization to clear
things up in 1992. During hearings leading
up to that reauthorization, exchanges
fought for laws that would force swaps onto
their platforms or ban them altogether,
while industry players like Enron fought to
keep the market unregulated.
In the end, Congress passed the
Futures Trading Practices Act, which
went into effect in October 1992 and
authorized the CFTC to exempt certain
products from the CEA. That freed the
commission to adopt the Swaps
Exemption in January 1993.
It wasnt a law, but it was a legally
sanctioned exemption, and one that
PRODUCT EXPLOSION
Germanys regulator, BaFin, doesnt track volumes of certificates, but requires so-called
base prospectuses to be filed when a broker issues a certificate. The number of filings
doesnt indicate volume, but it does tell you how many different certificates exist.
Source: BaFin
64,285 125,476
140,000
120,000
100,000
80,000
60,000
40,000
20,000
0
JUMPING OUT OF THE GATE
New contracts typically take time to develop but CFDs took off immediately at ASX. Notional
value of all CFD trades for November was A$153.8 million, and ASX reports that the bid/ask
spreads of many of the CFDs are near parity with underlying markets.
Source: Australian Securities Exchange
5 6 7 8 9 12 13 14 15 16 19 20 21 22 23 26 27 28 29 30
1,800,000
1,600,000
1,400,000
1,200,000
1,000,000
800,000
600,000
400,000
200,000
0
O
p
e
n

i
n
t
e
r
e
s
t

c
o
n
t
r
a
c
t
s
Open interest contracts (LHS)
Volume contracts (RHS)
2006 2007 through Nov.
C
o
n
t
r
a
c
t
s

t
r
a
d
e
d
600,000
500,000
400,000
300,000
200,000
100,000
0
November
Market index: Danger! Danger?
S
ometimes, you just want to play a hunch, or pick a bottom,
or otherwise break your rules. Or, if youre just getting
started and dont have much to lose, you want to trade small
smaller even than what the mini contracts offer.
Either way, you find yourself wanting to trade, but dont have
the stomach for the amount of risk offered even by mini-futures,
and you want something a bit less clunky than an exchange-traded
fund (ETF). Then, you stumble across ABN Amros marketindex
(www.abnamromarketindex.com/uk/Home.aspx for the English
version) and come to believe youve found the best of all worlds.
The Marketindex platform is a multi-asset-class certificates
platform that not only lets you trade crude oil, soybeans,
precious metals, bonds, FX, and stock indexes, but also lets
you define the contract size and the leverage.
And if you want to trade small, you can do a $5 position at
30:1 leverage, for example. Put up $5 in margin, and you con-
trol $150 or $300 worth of crude, currencies, or beans. You
dont pay commissions, but instead accept a bid-offer spread
that remains constant regardless of how big or small your
trades are. Unlike most certificates programs, there isnt even
a financing fee.
And the interface is as simple as it gets: a chart with a pop-
up order entry form, both generated using Java, which means
no proprietary programs to download. If you want to overlay
classic indicators like Bollinger bands or stochastics, just click
on the tools box. Want to draw trendlines or define price
channels? Piece of cake. If you want to trade on the run, even
from an Internet caf, just log on and hope they dont have a
restrictive firewall, as can happen in rare instances.
If you want to execute a basic option strategy like a strad-
dle or strangle, click on the box option link and draw a box
around the price and time parameters you want to be inside
or outside of, get the quotes, and make your decision.
Its the same system that powers the Oanda platform (see
Build Your Own Intraday Options, November 2002), so you
will get to see your position and risk in real time, marked to
market every few seconds. You can change your orders as
often as you like, and you can enter all sorts of order types (fill-
or-kill, stops, market-if-touched, one-cancels-the-other, etc.).
You wont get margin calls, but you will get warnings if
your net asset value falls close to 50% of the initial margin
required to keep all positions. If you dont heed those calls
and your balance drops below 50% of the initial margin, all
your positions will be liquidated.
Just dont try to open an account if you are a U.S. citizen,
even if youre living abroad. Thats because ABN Amro delivers
the service by making a market in all the products offered,
and then hedging the risk in futures. As such, its a classic boil-
er room under U.S. laws although some would argue, not
in reality.
explicitly exempted swaps from daily
reporting requirements and the
exchange-traded rule. But it also left
the door open for the CFTC to investi-
gate and prosecute cases of fraud and
manipulation in those markets and,
because it wasnt a law, could be
reversed if the CFTC later decided it
had made a mistake.
Gramm once likened exemptions to
a pruning process where broad,
sweeping rules are imposed and then
pruned away from specific industries
that request them. With the exemp-
tive authority in place and a clear set
of basic exemptions for swaps on the
whole, she seems to have expected a
flurry of requests for industry-specific
exemptions.
Unfortunately, she said in 1998,
this exemptive authority has not
been utilized much.
One group that did take advantage of
the exemption was Enron (see: Did
Enron write its own rules?, March
2002). Enrons business plan involved
making contracts to buy gas from a pro-
ducer at one price and offsetting them
against contracts to sell gas to a con-
sumer at another price while keeping a
chunk of the middle, a practice that
looked similar to the boiler rooms the
CEA act had been drafted to combat.
The Commodity Futures
Modernization Act of 2000 attempted
to clarify regulation of OTC currency
platforms but the 2005 Zelener court
decision created more confusion that is
yet to be worked out. Still, not a day
goes by, it seems, without some retail
forex dealer being sanctioned.
But does the structure of the product
create the sleaze? With broker-designed
products proliferating in Europe, it will
be interesting to see whether any corre-
lation will materialize between the exis-
tence of what U.S. regulators see as
boiler-rooms and the existence of full-
fledged high-pressure sales groups.
Youre never really exempt from
fraud, says Frank Partnoy, a law pro-
fessor at the University of San Diego
School of Law. Fraud is fraud, and
most OTC transactions that go bad
are handled not by regulators but by
anti-fraud laws. [The International
Swaps and Derivatives Association]
set the standard that these transac-
tions are handled by the laws of either
New York or London.
That, at least, is how things are
done in the institutional world.
Europes experience with these new
products will help answer the question
of how best to offer retail traders flexi-
bility and freedom of choice while
also protecting them from fraud.
Trade Trends continued
FM
Millionaire Traders: How Everyday
People Are Beating Wall Street at Its
Own Game
By Kathy Lien and Boris Schlossberg
John Wiley & Sons, Inc.
406 pages, $39.95
REVIEWED BY LESLIE N. MASONSON
Using a question and answer format,
this book offers insight into the lives of
a dozen traders, including background,
trials and tribulations, trading methods
and tools used, best and worst trades,
key lessons learned, and how they
achieved financial success.
It begins by identifying one significant
trading idea from each trader. While a
few of these princi-
ples are common
knowledge, others
were more insight-
ful. For example,
using probative
orders, knowing
that revenge is
never sweet, know-
ing yourself and
knowing your trade. An explanation of
each traders key lessons is summarized
at the end of each chapter.
I would have welcomed more trader
interviews and viewpoints. Perhaps in
the books revised edition, the authors
will consider eliminating the
background and family information,
which was not very useful, and instead
interview more traders. The most
useful questions pertained to the
traders approach, methodology and
lessons learned.
One excellent part provided guidance
about when to start to trade. In particu-
lar, they covered the importance of
being well capitalized, the reality of
expecting to lose money for the first six
months of trading, testing strategies
before trading, trading to your personali-
ty, using stops and including the right
tools for trading.
The authors broad focus on individu-
als with different trading preferences
provides the reader with a comprehen-
sive exposure to the nuances of trading
different markets. This provides useful
insights into how different markets
require adjustments in trading style,
trading rules and protecting profits.
Readers should not expect to find an in-
depth view into only one type of market
trader. This book reminded me of Jack
Schwagers Market Wizards, except that
Schwagers traders were all well-known
heavy hitters trading large sums of
money. This is contrasted to the every-
day traders interviewed in this book.
Overall, this book is best-suited for
new traders and those looking to make
improvements to their existing
approach. The traders profiled provide
many practical ideas that can hopefully
be adapted by readers to improve their
performance. Knowledge and a trading
plan with specific rules are both critical
elements to making consistent profits.
This book offers a realistic look at how
selected individuals made the transition
to a successful trading career.
Leslie N. Masonson is president of Cash
Management Resources. He is the author of All
About Market Timing and Day Trading on the
Edge. E-mail: lesmasonson@yahoo.com
Naked Option
By Joe Kolman
Harriman House
272 pages; $25.00
REVIEWED BY GINGER SZALA
If you are headed to the beach for a
break this winter, or just want a quick
read on the train, this is the book to
take. Joe Kolmans Naked Option is a
fun read, steeped in Wall Street speak
and lore, mixing
just the right
amount of believ-
able suspense with
misbehaving (and
kinky) traders.
Kolman, who
founded the now-
defunct Derivatives
Strategy magazine,
is now a vice presi-
dent at AllianceBernstein Investments.
He uses his knowledge of the street and
options trading to write a suspenseful
yarn about a good trader gone bad (tut-
tut, overtrading and then putting it in a
customers account), losing his job and
crawling back from the brink by
investigating and uncovering a compli-
cated trading scheme at a huge invest-
ment bank.
The setting is New York just after
September 11, which adds a certain
poignancy to our hero, Dave
Ackerman, who loses his wits, his job,
his girl and basically his life, in the
months following the 9/11 horror.
Luckily, he has the steadfastness of a
Chicagoan. He meets a new girl at the
job and between playing sleuth and get-
ting the girl, he believes success in one
will bring him success in the other.
Kolman has an eye for the Wall
Street trader, and doesnt flinch in his
descriptions. Traders come in all shapes,
sizes and male chauvinist attitudes, it
seems. From the cock sure non-failing
super trader to the just cocky trader,
most types fill the pages here. Although
there is a strong alpha-male attitude
penetrating the trading rooms of Wall
Street, this book also looks at the still-
in-the-closet world of gay traders. This
is perhaps an unexpected turn, for when
our hero isnt exploring the new world
of orthodox Judaism to woo his new
love interest, he is using his boyish
charm to hang out on the fringes of the
rough gay sex trade to find the
villain (of course).
This book certainly has everything
for traders, and options traders might
feel particularly vindicated in being por-
trayed as the supermen of the trading
world. (Monte Carlo formula anyone?)
Having known Kolman for years, I
can appreciate that hes taken his jour-
nalistic smarts into fiction writing and
overall succeeded in crafting a good
read. But somewhere along the line the
stereotypes got a bit long in the tooth
and the ending perhaps a bit too pat.
(Does the Securities and Exchange
Commission really put its stamp on
their batteries?) Still, as a quick fun
read, its a keeper.
Ginger Szala is the publisher and editorial direc-
tor of Futures Magazine. Reach her at
gszala@futuresmag.com.
Book Reviews
Dateline
C O N T R A C T D AT E S
2 LTD: Euronext Feb Rapeseed Oil OF
4 LTD: CBOT Ethanol F, CME Currencies OF, Mexican Peso OF
7 LTD: Euronext-Liffe Corn F
10 LTD: Euronext-Liffe Milling wheat F
11 LTD: ICE Futures U.S./Nybot Orange juice F, Nymex London Copper
Grade A F, London Primary Aluminum F, London SHG Zinc F, BM&F Feb
Arabica coffee OF, Feb Conillion coffee OF
14 LTD: CBOT Rough Rice F, SA Soybeans F, Soybean Meal F, Soybean Oil
F, Soybeans F, Mini soybeans F, CME Currencies F, Mexican Peso F,
Eurodollar F, OF, Euroyen Libor F, OF, China Renminbi/Euro F, OF, China
Renminbi/Yen F, OF, E-mini Eurodollar F, Nymex Feb Russian Export blend
crude oil F, DCE No. 1 Soybeans F, No. 2 Soybeans F, Corn F, Soybean
meal F, Soybean Oil F,WCE Canola F
15 LTD: Nymex Feb Brent crude F, BM&F Sugar OF, CFE Volatility Index F,
DJIA Volatility Index F, CME Chinese Renminbi F, OF, Euronext Feb
Rapeseed OF, Feb Rapeseed Oil F
17 LTD: CFE S&P 500 Buywrite Index F, CME Eurozone Index of
Consumer Prices F, TGE Soybean meal F, Coffee F
18 LTD: BM&F Gold O, Euronext-Liffe American style stock O, Equities O,
Cac 40 F,OF, KCBT Value Line OF
21 LTD: CME Milk F,OF
22 LTD: Nymex Feb Light sweet crude oil F, Feb Gulf Coast gasoline F, Feb
Gulf Coast ultra low sulfur diesel F, JSE All Constant Month Contracts F
23 LTD: Euronext-Liffe Feed Wheat F
25 LTD: KCBT Feb Wheat OF, MGEX Feb Wheat, Nymex Feb Singapore
Fuel oil 380 swap F, Tocom Rubber F, Feb Gasoline F, Feb Kerosene F
28 LTD: Nymex Uranium F, TGE Azuki F, Raw Silk F, Vegetable F
29 LTD: CBOT Silver F, Mini Silver F, Nymex Palladium F, Platinum OF,
Silver OF, Copper OF, Gold OF, Aluminum OF, Feb Natural gas F, Feb
Asian Gold F, Feb Asian Platinum F, Feb Asian Palladium F
30 LTD: BM&F Live cattle OF, Nymex PJM Electricity F
31 LTD: BM&F Live cattle F, Mini Live cattle F, CBOT 30-Day Fed Funds F,
OF, Ethanol forward month swap F, CME Feeder cattle F,OF, Class IV Milk
F, OF, Mid-size Milk O, Nonfat Dry Milk F, OF, Cash-settled Butter F, Dry
Whey F, Feb Real F, OF, Feb Ethanol F, Euronext-Liffe Robusta coffee F,
MGEX HWI/NCI/NSI F,OF, Nymex Feb Heating oil F, Feb Gasoline F, Feb
New York Harbor Ultra low sulfur diesel F, Feb Propane F, BM&F Feb Euro
F, Feb Gold F, Feb IDI F, Feb U.S. Dollar F, O, OF, Feb Ethanol F, Euronext
Feb Rapeseed F, TGE Mar Raw sugar F, Tocom Feb Gold OF
MONDAY TUESDAY WEDNESDAY THURSDAY FRIDAY
7 8 9 10 11
14
15 16 17
21 22
23 24 25
Australia production index.
France production index. U.K.
Merchandise trade.
Cotton ginnings, Livestock
slaughter, Feed on cattle. Japan
CPI, Merchandise trade.
J A N U A R Y
18
1 2 3 4
28 29 30 31
U.S. Holiday
Germany employment
PPI. Crop summary. France
CPI. Germany balance of
payments. U.K. CPI.
France merchandise trade.
Germany production index,
Merchandise trade.
Crop summary. Japan
employment.
Australia PPI. Germany PPI.
Employment
U.S. Holiday
Cotton ginnings, Annual crop
production, Grain stocks. U.K.
production index.
Australia CPI
Crop summary
France balance of
payments. U.K. PPI.
CPI. Germany CPI. Japan PPI.
Balance of payments. U.K.
employment.
Japan production index
France PPI
Australia employment,
Merchandise trade.
Crop summary
SPONSORED BY:
MONDAY TUESDAY WEDNESDAY THURSDAY FRIDAY
1
4 5 6
11 12 13 14
19 20 21
25
Crop summary
Crop summary. France
balance of payments.
France CPI
F E B R U A R Y
26
15
28
8
27
7
29
18 22
PPI. Crop summary.
Germany balance of payments.
Japan PPI, Balance of payments. U.K.
employment.
Cotton ginnings. Germany
production index, Merchandise trade.
France merchandise trade. U.K.
production index.
France employment
Germany CPI. Japan
employment, CPI.
Livestock slaughter, Cattle on
feed. Japan merchandise trade.
Australia Merchandise trade.
Australia employment
France PPI. Germany
employment. Japan
production index.
Crop summary. Germany
PPI.
France production index.
U.K. merchandise trade.
CBOT
30-Day Fed
Funds F, OF ..................01/31......02/29
Silver F ..........................01/29 ............-
Mini Silver F ..................01/29 ............-
Gold F....................................-......02/27
Mini Gold F............................-......02/27
Ethanol F........................01/04......02/05
Ethanol swap F..............01/31......02/29
Rough Rice F ................01/14 ............-
SA Soybeans F ..............01/14 ............-
Soybean Meal F ............01/14 ............-
Soybean Oil F ................01/14 ............-
Soybeans F....................01/14 ............-
Mini soybeans F............01/14 ............-
CFE
Volatility Index F............01/15......02/15
DJIA Volatility Index F ..01/15......02/15
S&P 500 Buywrite Index F01/17 ........-
CME
Weather F......................02/04......03/03
Currencies F..................01/14......02/15
Currencies OF ..............01/04......02/08
Eurodollar F, OF ............01/14 ............-
Euroyen Libor F, OF......01/14......02/15
China Renminbi/
Euro F, OF......................01/14......02/15
China Renminbi/
Yen F, OF........................01/14......02/15
Chinese Renminbi
F, OF ..............................01/15......02/19
E-mini Eurodollar F......01/14 ............-
Eurozone Index of
Consumer Prices F ......01/17......02/14
Housing Index F....................-......02/25
Feeder cattle F,OF ........01/31 ............-
Live cattle F ..........................-......02/29
Milk F,OF........................01/21......02/28
Class IV Milk F, OF........01/31......02/28
Mid-size Milk O ............01/31......02/28
Nonfat Dry Milk F, OF....01/31......02/28
Cash-settled Butter F ..01/31......02/28
Dry Whey F....................01/31......02/28
Live cattle OF........................-......02/01
Pork bellies, frozen F ..........-......02/26
Pork bellies, frozen OF ........-......02/01
Lean hogs F,OF ....................-......02/14
ICE Futures U.S. / Nybot
Orange juice F ..............01/11 ............-
KCBT
Value Line OF ................01/18......02/15
MGEX
HWI/NCI/NSI F,OF..........01/31......02/29
Nymex
PJM Electricity F ..........01/30......02/28
Palladium F ..................01/29......02/27
Platinum OF ..................01/29......02/27
Silver OF ........................01/29......02/27
Copper OF......................01/29......02/27
Gold OF ..........................01/29......02/27
Aluminum OF ................01/29......02/27
ABOUT THE CALENDAR Dates are believed to be correct but sometimes do change. Holidays may affect government offices or banks
but not trading. Check with your broker or the exchange. Reports are U.S. reports unless indicated otherwise. Contracts traded are for
current month unless indicated. Abbreviations used with contracts: F futures. OF options on futures. O options. LTD last trading day. FND first notice day. LND last notice day.
Last trading day
Contract month JAN FEB
Last trading day
JAN FEB
Last trading day
JAN FEB
Last trading day
JAN FEB
Last trading day
JAN FEB
Last trading day
JAN FEB
U.S. Holiday
The International Traders Expo. FEB. 16-19,
2008. Marriott Marquis Hotel, New York.
Managed Funds Association Network 2008,
FEB. 11-13, 2008. The Ritz-Carlton, Key Biscayne, FL.
ADVERTISER PAGE ADVERTISER PAGE
Alaron . . . . . . . . . . . . . . . . . . . . . . . . . . . .c3
CME Group . . . . . . . . . . . . . . . . . . . . . . . .c2
CMS Forex . . . . . . . . . . . . . . . . . . . . . . . . .15
eSignal . . . . . . . . . . . . . . . . . . . . . . . .18a-18b
eSignal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .37
Fidelity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7
Field Financial . . . . . . . . . . . . . . . . . . . . . . . . . . . .53
Futures I-Trade Show II . . . . . . . . . . . . . . . . .31,41
Futuresmag.com . . . . . . . . . . . . . . . . .19,45
Futures Magazine . . . . . . . . . . . . . .25,44,53
Global Forex Trading . . . . . . . . . . . . . . . .25
Global Forex Trading . . . . . . . . . . . . . . . .29
Interactive Brokers . . . . . . . . . . . . . . . . . . .3
ITradeFX . . . . . . . . . . . . . . . . . . . . . . . . . . .9
MF Global . . . . . . . . . . . . . . . . . . . . . . . . .c4
PBOT . . . . . . . . . . . . . . . . . . . . . . . . . . . . .27
Page Trader . . . . . . . . . . . . . . . . . . . . . . . .44
Proshares . . . . . . . . . . . . . . . . . . . . . . . . . .11
TradeStation . . . . . . . . . . . . . . . . . . . . . .4-5
Traders Expo . . . . . . . . . . . . . . . . . .34a,34b
SEE CLASSIFIED ADVERTISING ON PAGES 6165
Uranium F......................01/28......02/25
London Copper
Grade A F ......................01/11......02/15
London Primary
Aluminum F ..................01/11......02/15
London SHG Zinc F........01/11......02/15
BM&F
Gold O ............................01/18 ............-
Sugar OF........................01/15 ............-
Live cattle F ..................01/31......02/29
Live
cattle OF ........................01/30......02/29
Mini
Live cattle F ..................01/31......02/29
IBrX-50 F ..............................-......02/01
Alcohol OF ............................-......02/01
Alcohol F ..............................-......02/12
Sugar F..................................-......02/12
Ibovespa F ............................-......02/13
Mini-Ibovespa F ..................-......02/13
Feeder cattle OF ..................-......02/15
Soybeans OF ........................-......02/15
Feeder cattle F ....................-......02/29
DCE
No. 1 Soybeans F..........01/14 ............-
No. 2 Soybeans F..........01/14 ............-
Corn F ............................01/14 ............-
Soybean meal F ............01/14 ............-
Soybean Oil F ................01/14 ............-
Euronext-Liffe
Robusta coffee F ..........01/31 ............-
Feed Wheat F ................01/23 ............-
Corn F ............................01/07 ............-
Milling wheat F ............01/10 ............-
Equities O ......................01/18......02/15
American style stock O01/18......02/15
Cac 40 F,OF ..................01/18......02/15
JSE
Constant Month Conts F01/22......02/20
KRX
KOSPI 200 OF........................-......02/14
US Dollar F, OF......................-......02/18
Japanese Yen, Euro F..........-......02/18
Gold F....................................-......02/27
TGE
Azuki F ..........................01/28......02/26
Soybeans F ..........................-......02/15
Non-GMO
Soybeans F-..................02/26 ............-
Soybean meal F ............01/17 ............-
Coffee F..........................01/17 ............-
Raw Silk F......................01/28......02/26
Vegetable F ..................01/28......02/26
Tocom
Rubber F........................01/25......02/25
Crude Oil F ....................02/01......03/03
Precious Metals F ................-......02/26
Aluminum F ..........................-......02/26
WCE
Canola F ........................01/14 ............-
Last trading day
Contract month JAN FEB
Last trading day
JAN FEB
Last trading day
JAN FEB
Last trading day
JAN FEB
Last trading day
JAN FEB
Last trading day
JAN FEB
EVENTS COMING UP
Call the numbers listed for more information. For other seminars, see the classifieds on pages 61-65.
AD INDEX
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www.futuresindustry.org.
Dateline continued
Next month in Futures
Energy outlook
How high can crude go and what is
the new bottom?
And what of
natural gas? We
will look at the
dynamics of this
volatile market as well as the entire
energy complex.
Five ways to read a close
We will show you how the opposing
close pattern can help you better
assess the price action dynamics of
the energy markets.
Tops and bottoms
I t was another wi l d year i n the
futures industry and some of the
most intriguing stories didnt quite
make the regular issue. Futures takes
an off-beat, tongue-in-cheek look at
industry events over the last year.
Are U.S. capital markets still
competitive globally?
We di scuss whether or not the
current market structure leaves U.S.
capi tal markets at a competi ti ve
disadvantage.
THE FCM IB NETWORK
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Dorman IBs enjoy the same personal
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Online Account Opening
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Numerous Trading Platforms
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We encourage you to contact us
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T
he first time Gregory T. Weldon saw the Comex trading
floor in 1983, he found himself in awe of the excite-
ment and the physicality of the pit and of how much it
reminded him of playing basketball for Colgate. Thats the
lane, he remarked, pointing to the floor. I want to get in
there and throw elbows, he said to Stanley B. Bell, founder
of Stanley B. Bell and Company. Bell loved the analogy and
after conferring with Craig Bell, offered Weldon his shot to
become a trader. I got a top position because Im 610; so I
could hand paper over people, sling it to the back of the
booth and throw elbows. It was trial by fire, he says.
He went on to trade for ber trader Louis Moore Bacon at
Moore Capital Management, and there learned to watch for
and trade macro-economic trends, which was not a typical
approach at the time, and to think
through multiple scenarios and
plan responses for multiple out-
comes, And perhaps more impor-
tantly, to be extremely disciplined
about managing risk. In 1992, he
was up more than 25% for the year.
He later traded for the
Commodity Corp., which he
describes as a think tank environ-
ment, where people discussed the
art and philosophy of trading and
dissected good and bad trades. Its
there that he developed the confi-
dence in his methodology, and in
1996, his best year there, he was up
more than 27%.
My methodology is multi-
pronged, Weldon explains. First,
he looks for secular trends based on
macro-level geopolitics or economic
themes. Then he looks for micro-
technical confirmations against
market data; and all while he actively manages his risk with a
statistical approach, stressing diversification within his preferred
markets, which include fixed income, stocks, foreign currencies,
petroleum products, agricultural commodities and gold.
To produce a theme, Weldon relies on his own research,
which he publishes in multiple newsletters that he writes for
hedge funds and risk managers and uses in his recently
launched commodity trading advisor. Weldon tears into the
data. You go right to the source, wherever these statistics are,
he says, rifling off a long list of agencies that includes the
Bureau of Labor Statistics and the Peoples Bank of China.
From there, he tests and retests his ideas against the market.
Next, he hones the strategy based on discretion and the syn-
chronization of the market with his macro-economic thesis.
That crystallization is what drives my decision making on the
implementation side, he says. And through that process he
anticipated recent moves in the Japanese yen, 10-year note
and the huge correction in equities. Its a simple methodology,
and it requires a lot of work, he says.
Because of the increase in available information and the
speed with which it is disseminated through the market,
Weldon says that everything, even the minutia, matters,
and that it is critical to plan for several potential outcomes
to any scenario.
Nowhere is that more important than in his money manage-
ment process. It is the third prong, Weldon says, and
explains that he uses a statistical overlay for each trade, portfo-
lio and sector. I go at it from a statistical basis where I am
looking at risk to stop, variations of volatility, VAR, and stan-
dard deviation to monitor the risk as it applies to individual
positions, sector risk and the overall
portfolio risk. While he warns that
risk can always be greater than you
think, by following his statistically
derived process, he can calculate
risk based on where his stops are
and where potential volatility is,
with a degree of confidence.
If you get the idea that Weldon is
an unemotional trader, youre right.
Weldon funnels that energy into his
research and analysis. I come from
the old school; when you are up big,
if you allow yourself to be euphoric,
you are not going to be able to deal
with this. You have to maintain an
even keel. Theres always some
emotion involved and youre going
to feel it. I channel it into digging
and digging and digging.
Thats not to say that he cant
make mistakes. But Weldon under-
stands his potential weaknesses.
One potential data mistake is to look for things that reflect
your opinion, he says. You have to look at everything and
when it doesnt reflect what you want it to, you have to change
your thinking, he says.
Another, because trends start at the micro level, would be
entering a trade early, which he did in April 1997. The Asian
currency markets were pegging, de-pegging and the volatility
was crazy, resulting in his worst drawdown, 11.18%. I tend to
be early, so the recovery time tends to be quick, he says. We
made that money back in two months, adding that when
emerging trends are buried in the micro data, it can take some
time to manifest in the market, and the experience didnt
cause him to question his methodology.
I pour my heart and soul into doing what I do, Weldon
says. And with his pedigree, research and confidence, his
customers should benefit.
GREGORY T. WELDON
BY CHRI S McMAHON
Trader Profile
Weldon: Old school trading
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