Know yourself & your opponents

According to Sun Tzu (Art of War):

• If you know only yourself or the enemy, you are expected to win about half of the battles.
• If you know both yourself and the enemy, you are expected to win most of the battles.

How does that apply to trading?

Simply crunching numbers, trying to find gratuitously complex patterns alone is not enough. There is no edge, profit, trying to blindly forecast what other traders are likely to do going forward. People improve their execution algorithms almost everyday (at least I do), just so no pattern based traders couldn't exploit them.

You must understand and create trading strategies based on what other traders are doing, they are the enemies who work day and night to take your money.

An example of monitoring what the NYSE traders are up to:
 

full size link: http://oi40.tinypic.com/mk8bhc.jpg

High Liquidity ~ High Efficiency (not good for trading)

Financial products of very high liquidity are often unfavorable by professional traders, mainly due to increased price efficiency. I am going to point out a few ideas on why this may be so from personal experience. I may be wrong, and would welcome any contrasting ideas, as long as we all end up learning something contributing to larger trading profits going forward.

Benefits from high liquidity

High liquidity implies lower transaction costs for exchange participants who engage in purely liquidity-taking executions. This segment of participants includes the following segments:

1)      New traders, often with no positive expected alpha

2)      Buy & hold funds, with no positive expected alpha

3)      Short & hold funds, with no expected alpha in the short term

4)      Pure/Statistical Arbitrageurs, who generate almost purely alpha, and depend on multiple executions simultaneously.

* OTC (Over The Counter) products such as spot FX, CFDs, or CDS do not always offer lower transaction costs despite high liquidity.

So having high liquidity is great, right? Let’s see how that might not be the case.

Liquidity and level of competition

Exchange traded products of high liquidity usually indicates an increased number of smarter, significantly capitalized competition who specialize in liquidity provision and short term alpha. This group of participants is usually institutional in nature, full of very smart analysts and traders working to squeeze every penny out of any inefficiency available.

A more efficient market system is undesirable for less capitalized professional, private traders. Using poker as an analogy, you are expected to make more money playing against newbies than a table full of pros.

Low to mid liquidity conditions, opportunities

From my experience with exchange traded derivatives, a lot of “easier” money making opportunities tend to arise in periods of low liquidity. Here are some examples of opportunities available only in periods, products of relatively low liquidity:

1) Liquidity Provision: Make the market, and get that wider bid/offer spreads from careless, desperate traders who close their eyes, hit the market, and hope for the best. Some exchanges offer a rebate for liquidity provision orders, as a bonus.

2) Pure arbitrage: Different derivative contracts of identical underlying products get out of line against fair values more easily with respect to supply and demand.

3) More “honest” momentum: Easier-to-read tape and orderbook balance for intraday trading success.  

Many other forms of price inefficiency exist in low, mid liquidity exchange traded products, it only takes a bit of digging to find them. Basically, low liquidity ~ more exploitable inefficiencies. It may be counter intuitive, but makes sense right?

Adding to Winning Directional Bets

Having seen many documentaries of professional (directional) traders talking about adding to winning positions, I had a little brainstorm of why this helps with profitability of trades. Here’re some reasons I’ve come up. 

So the basic idea is to only add to a winning position, and reduce position size as it moves negatively. We can already see how this replicates option delta, where the trade becomes essentially long Gamma, without risks around Vega, Theta, and other Greek uncertainties.

 

1)      It gives a convex payoff; it creates monster winning trades with respect to average losing trade size. (Convexity vs. Concavity)

2)      Having a convex payoff requires much lower win-rate for a trading strategy to be net profitable i.e. maintain a positive EV.  

3)      The trade would have a significantly reduced probability of taking relatively large losses. We’ve all heard stories of people blowing out from short Gamma trades, such as adding to losing positions, selling naked options.

4)     Counter-Intuitive, and we know going against the crowd is usually a GOOD thing in this industry.