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Shattering Trading Illusions
Every successful algo starts out as a piece of science and ends up as a work of art. The art of algorithmic success often lies in NOT trading. An algorithm is simply a codification of some repeatable market behaviour but every algo is implicitly based on the assumption of continuous pricing.
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Unfortunately for those of us who trade in the real world the concept of continuous pricing is a Platonic ideal rather than an everyday reality. Currency markets which are supposed to trade round the clock five and half days per week, are discontinuous all the time -- often on a daily basis.
What all those lovely charts rarely show -- even on 1 minute increments -- are the constant gaps in price as currencies react to the daily newsflow. Guess what? Market makers never want to assume actual risk. Just like insurance companies who want to sell you the “illusion of safety” by collecting your premiums but minimizing payouts, so too do the market makers want to sell you the “illusion of liquidity” but provide as little of it as possible when you actually need it.
Here is how discontinuous markets can hurt you when you are both right and wrong. When you are wrong its easy to understand the dynamic. Say you are long EUR/USD into the IFO release with a very tight 10 pip stop. The data surprises to the downside and the next bid on the books is not 5 or 10 or even 20 pips down but sometimes 50 or 70 pips lower. Oops your stop just got done at -70 instead of -10.
Yet that example is easy. All of us are familiar with slippage on exits. What can be even more maddening is the slippage on entries. Suppose you were right and were bearish EUR/USD and were trying to sell it at days lows. Here again the absence of liquidity can kill you. Instead of selling at the prior low you may be executed at -30 or -50 below your actual stop entry. To add salt to the wound, if you attached a stop and a take profit to the order it may be closed out for a loss right away.
Here is how it works in real life. Say you have an order to sell EUR/USD at 1.2990 with a stop at 1.3010 and a target at 1.2970. However because of discontinuity the actual sale is done at 1.2950. SInce that is below your take profit target the system will look to close your trade right away. So it is very possible to be right on direction but get done at 1.2950 and then bought back in at 1.2960 for a -10 pip loss.
Welcome to the forex market.
Discontinuity is a fact of life you will have to accept if you want to trade FX. However, you don’t have to fall victim to its traps every time. The art of choosing when to step in and when to step out of the market will be the subject of my next week’s column.