Exchange Traded Funds - The Technical Analyst · the strategy performs over a period of time. In...

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.technicalanalyst.co.uk wwwThe publication for trading and investment professionals

Markets TechniquesPattern price

targets revisited

SoftwareBond analytics and market

data from TradeWeb

What will trigger the next correction in equities?

Exchange Traded Funds

Interview:New point & figure fund

High jump indicator

The way ahead for execution algorithms

Roundtable: A bright future for the UK market

© 2007 Global Markets Media Limited. All rights reserved. Neither this publication nor any part of it may bereproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical,photocopying, recording or otherwise, without the prior permission of Global Markets Media Limited. While thepublisher believes that all information contained in this publication was correct at the time of going to press, theycannot accept liability for any errors or omissions that may appear or loss suffered directly or indirectly by any reader as a result of any advertisement, editorial, photographs or othermaterial published in The Technical Analyst. No statement in this publication is to be considered as a recommendation or solicitation to buy or sell securities or to provide investment, tax or legal advice. Readersshould be aware that this publication is not intended to replace the need to obtain professional advice inrelation to any topic discussed.

CONTENTS 1 FEATURES

The Ian High JumpIndicator

Establishing when a stock is extended and due for correction.

Exchange Traded FundsRoundtable

Five ETF experts discuss all aspects of the UK market

InterviewRusty Cannon of RKC Capital talks about the

Point & Figure strategies behindhis two new funds

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WELCOMEInterest in exchange traded funds (ETFs) has been gathering pace in the UK overthe past few years with the number of new issues increasing rapidly. In this issue

we bring together 5 market experts including representatives from a tradinghouse, issuer and exchange to discuss the growth of the UK market and the out-

look going forward.

As the number of algorithmic execution strategies proliferates, the need for astandardised way of presenting these algos on order management systems

becomes ever more important. We speak with a key member of the FIXAlgorithmic Trading Working Group and learn how the new proposed standard will

work and what it will mean in terms of finding the best way to operate in the highfrequency trading arena.

We hope you enjoy this edition of the magazine

Matthew Clements, Editor.

May/June 2007 THE TECHNICAL ANALYST 1

TM

TM

Editor: Matthew ClementsManaging Editor: Jim BissConsultant Editor: Trevor Neil Advertising & subscriptions:Louiza Charalambous Marketing: Vanessa GreenEvents: Adam CooleDesign & Production:Paul Simpson & Thomas Prior

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INDUSTRY NEWS

MARKET VIEWS Medium-term outlook for commoditiesLooking for the next equity market correction

ROUNDTABLEExchange traded funds

TECHNIQUES The Ian High Jump indicatorRelative strength: Normalisation & currency adjustmentPatterns: New guidelines for determining target price

INTERVIEWRusty Cannon, RKC Capital

SOFTWARETradeWeb market data & analytics

BOOKSEvidence-Based Technical Analysis by David Aronson

RESEARCH UPDATE

AUTOMATED TRADING SYSTEMSThe new standard in algorithmic tradingPegging profits with FX algorithms

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4 THE TECHNICAL ANALYST May/June 2007

Industry News

CQG is the first independent vendorto complete FIX certification for theDubai Mercantile Exchange Limited(DME), the Middle East's first ener-gy futures exchange. CQG will beginconnecting traders to the DMEwhen the Exchange launches onJune 1, 2007 and will cover theOman crude and NYMEX Brentand WTI/Dubai Oman spread.

CQG LINK WITHDUBAI EXCHANGE

RTS RELEASE TANGO BACKTESTER Real Time Systems Group (RTS) haslaunched a new backtesting tool,RTD Tango Backtester. The productallows traders to test their tradingmodels by simulating transactions viaa set of historical market data. Thisallows the user to see exactly howthe strategy performs over a periodof time. In undertaking the backtestthe user is able to specify a range ofdifferent strategy parameters to

determine which would haveachieved the best success (or otherbenchmark as defined by the user)over that time frame. The backtesteris optimised to run in an acceleratedmode such that 2 years of backtest-ing can be achieved within an hour.The data is either already collected,purchased from a third party or col-lected manually using RTS's data

BEAR STEARNS' NEWMECHANICAL HEDGE FUND CLONE

MTPREDICTORLAUNCH ON NINJA PLATFORM

LYXOR ISSUES FIRST FTSE ALL-SHARE ETF Lyxor Asset Management, a divisionof Societe Generale, has entered theUK ETF market with the launch onMay 15th of three new funds basedon FTSE indices. These include the

first ever FTSE All-Share ETF, plusFTSE 100 and FTSE 250 products.

Bloomberg codes are L100 LN,L250 LN and LFAS LN respectively.

The European ETF market grew lastyear by 61% to almost $100bn.

PATSYSTEMS ADDCHARTS TO J-TRADER

Patsystems has announced therelease of new charting functionswithin their J-Trader front-end. Thecharting tool includes technical indi-cators such as candlesticks, barcharts and Market ProfileTM. It alsooffers a backtesting facility usingcustomisable data.

HIGH-SPEED TRADING SOARS IN USThe volume of market trade datamessages is set to grow from under4 billion messages per day in 2006to nearly 130 billion by 2010,according to the US based TabbGroup. Last year over 50% of insti-

tutional equities trades in the USwere executed through direct marketaccess (DMA), algorithms, programsor crossing networks which isexpected to increase to 64% by2008. The group says that, as a

result, both buy and sell side firmsare expected to increase spendingon advanced trading technologyfrom $860 million this year to $1.3billion by 2010.

Bear Stearns has launched a newhedge fund clone based on an auto-mated fixed income strategy. The'Mast Index' trades the spreadbetween 10-year and two-year euroswap rates based on a model using amoving average crossover strategy.In backtesting the bank claims thistrend-following strategy would havegenerated annualised returns of5.1% above Euribor since 1997,with a Sharpe ratio of 1.76.

Elliott Wave software specialistsMTPredictor have announced thatthe latest version of its product nowaccepts data feeds compatible withthe NinjaTrader platform. UsingNinjaTrader's Market Analyzer win-dow, MTPredictor RT can identifycomplete trade set-ups and displaythem on the trader's NinjaTraderscreen with full set-up, risk/rewardand trade management analysis.

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Market Views

MEDIUM-TERM OUTLOOK FORCOMMODITIES by Gregory Troccoli

Gold - Figure 1The market is teetering on a serious break belowthe up-trend line, which dates back to October (itbarely remains intact). The recent sell-off inNYMEX Gold may be an indication the trend isin jeopardy. The MACD is currently short, aswell as the DMI. The slope of the MovingAverage line has turned slightly negative.Another close below $670.00 could signal mas-sive selling.

Silver - Figure 2Through its highs and lows, NYMEX Silver hasmaintained a median price near $13.65 for thelast seven months. At this point, the marketappears somewhat weak. The slope of the 21-day moving average line is currently slightly neg-ative. The MACD is short as well. Overhead, the$13.72 level is well defined and weighs heavily onthe market. Only a close above $13.90 (repre-sented by the top of the gap from mid-April)would shift all indicators positive. Until then, ral-lies may be opportunities to sell.

Crude Oil - Figure 3The critical support region near $60.50 forNYMEX Crude Oil has, thus far, held. The mar-ket has recently traded within 25 cents of thatpivot and found support. The moving averageline is still on the cusp of turning negative.However, the market is nearly $2.00 above thatpoint at this time. Buyers could come out inforce, but overhead resistance toward $64.75 isweighing on the market.

Gregory Troccoli is director of technicalresearch at Opalesque Ltd, a publisher ofnewsletters and briefings for the hedge fundindustry. He is also managing director atBear Stearns Asset Management.

Figure 1.

Figure 2.

Figure 3.


Market Views

EQUITY MARKET CORRECTIONS: ARE THERE MORE ON THE HORIZON? by Richard Batty

We are entering the fifth yearof the current bull market,although many indices such

as the US S&P500 or FTSE100 haveyet to reach their all-time highsachieved about the turn of the millen-nium. Since 2003, momentum in globalequity markets has been punctuated byperiodic 'normal' corrections of at least5 to 10%, such as in May-June 2006,but there have been no 'major' correc-tions. The most recent correction,though short lived, took place inFebruary-March 2007. Investors shouldprepare themselves for more of theseperiodic setbacks in the coming quar-ters.

This article analyses the likely impactand potential triggers for such a correc-tion. These can be broadly split intoeconomic and behavioural factors.Equity investors face the twin problemsof slowing profits growth and higherinterest rates. We argue that from a pol-icy viewpoint investors should focusmore on the factors affecting centralbanks in the UK, Europe and Asia,than solely on the US.

There are signs that investors appearto be increasing their risk appetite, per-haps in an irrational way, as they scram-ble to invest in, for example, yen carrytrades or Chinese new equity issues.Additional examples include the rushto invest in historically expensiveemerging markets; low grade creditnames; or so-called infrastructure com-panies that appear to offer stable earn-ings prospects. Some of the proprietarytechnical indicators which we monitorsuggest that investor positioning isbecoming more extreme and 'compla-cent' regarding the outlook for equities.Looking back historically, this rise in

risk appetite at a time of modestmacro-economic concerns looks to bea set of risks that would warrant a 'nor-mal' correction in the global equitiesmarkets of the order of 5-10% (seeupper portion of Figure 1) whichshows the average profile of such cor-rections).

If we continue to experience 'normal'rather than 'major' corrections, theseset-backs should be viewed as anopportunity for investors to reviewtheir allocations to equity markets. Thisis because we do not currently see evi-dence of excessive equity market valua-tions, inflation or credit pressureswhich normally signal a 'major' correc-tion at the end of the business cycle.

Behavioural factors After asset values have risen stronglyover a sustained period there is always achance of profit taking. Investors withshort time horizons, such as somehedge funds, may want to book profitsor believe that share prices now fullyreflect all the immediate good news oncorporate earnings growth.

Given the recent strong rises in equi-ty markets that have taken many ofthem to new six year highs, it is tempt-ing to conclude that they have run-ahead of themselves. Here we can useour Focus on Change analysis to lookback at the momentum in the overallglobal equity market on a 4-weekrolling return basis. Positive momen-tum for 10 weeks or more in a rowoccurred on 29 separate occasionssince 1980 (see Figure 2). Hence, it isnot unusual for the stock market to riseon a sustained basis.

In the lead-up to the March 2007 cor-rection our conclusion at the time was

that positive momentum, which startedin October 2006, had lasted for 21 con-secutive weeks. This was the fourthlongest uptrend since 1980. Two longerperiods of 22 and 27 weeks occurred inthe second half of 2004 and in the firsthalf of 1987, respectively. These wereyears characterised by robust corporateearnings growth and benign interestrates. The other sustained momentumperiod was the 29 weeks between Apriland October in 1980. This was drivenby rapidly falling interest rates, follow-ing a sharp correction earlier that yearcaused by a US credit crunch, rapid oilprice rises and expectations of an eco-nomic recession.

Fundamental factorsApart from the behavioural factorsrelated to risk aversion, there are otherfundamental reasons for volatility toappear in financial markets in the formof further 'normal' corrections. First,corporate profits growth is slowing -although it should remain in positiveterritory - in the case of the US, fromaround 20% p.a. in Q3 2006 to closerto 15% p.a. in Q4 2006 and to singledigit growth rates in 2007. The consen-sus estimate is for only 6-8% in the firsttwo quarters of 2007. Secondly, thecentral scenario is for US interest ratesto remain on hold for the foreseeablefuture and eventually fall. If the USeconomy and inflation re-accelerate,there is a serious risk that interest ratesrise again. Further falls in equity mar-kets in the order of 5-10% could beexpected.

After such a fall, historical precedencesuggests equities could recover swiftly,normally within a few months, asinvestors come to realise that the busi-


Market Views

ness cycle remains intact and the inter-est rate environment remains sanguine.This type of short lived correctionpresents an interesting investmentopportunity for multi-asset investmentmandates such as pension funds, sinceasset returns usually exhibit lumpy ormore extreme returns around correc-tion periods. Once the stock marketstabilises at lower levels, then equityreturn expectations may be higher than

normal over the medium term. Asshown in the upper portion of Figure1, global equities typically achieve theirpre-correction level within six months.

Major correctionsWhat factors could turn a 'normal' cor-rection into a 'major' event? Historyindicates that more extreme events arerequired, focusing on the end of thebusiness cycle. Triggers include the

prospect of an economically disruptivewar, persistent concerns about stockmarket valuations, a recession in corpo-rate earnings, or unduly high interestrates affecting corporate or householdborrowing. The lower portion ofFigure 1 shows the average profile ofperformance seen during such eventssince 1980. Here equity markets fall byup to 10% on average, but they have inthe past taken several years to recoverto their original pre-correction levels. Arecent example of this is the US NAS-DAQ technology index, which evenseven years after its peak has recoveredto just half of its all-time high. Even ifit continues its current 4-year path ofappreciation it will take another fiveyears to get back to its old highs of2000.

Investment conclusionsOur House View is more downbeatthan the consensus on the fundamentaloutlook, as we do not believe theimpact of slower economic and profitsgrowth has been fully priced into stockmarkets. We retain a positive biastowards equity markets, although wehave adjusted our positions in recentmonths to favour the more defensiveor lower beta markets, such as the UKand the US. These traditionally outper-form the more aggressive or higherbeta markets, such as emerging marketsand the Pacific Basin, during correctionperiods. The UK market is now ourpreferred equity market. It should ben-efit from attractive levels of cash flowand dividend growth, as well as beingmore 'defensive' in the context of acorrection in global equities.

Richard Batty, Global InvestmentStrategist, Standard LifeInvestments

Figure 2. Momentum in global equities

Figure 1. Profile of ‘normal’ and ‘major’ corrections in a global equities since 1980

“POSITIVE MOMENTUM[IN GLOBAL EQUITIES]

FOR 10 WEEKS IN A ROWHAS OCCURRED 29 TIMES

SINCE 1980.”


EXCHANGE TRADED FUNDS On the eve of Lyxor Asset Management's entry into the UK market with the launch ofthree exchange traded funds (ETFs) based on FTSE indices - including the first ETF togive access to the entire UK market - we brought together five leading market expertsto discuss all aspects of the market, including specific factors to consider in tradingETFs and the future for trading volumes and new issues.

Matthew Clements

SPONSORED BY:

Chair: Matthew Clements – Editor, The Technical Analyst

Hugh Brown Product Management and Development,London Stock Exchange

Dan Draper Head of ETFs, UK and Ireland,Lyxor Asset Management

Jonathan LawrenceDelta One Product Sales Trading,Merrill Lynch

Justin Urquhart Stewart Director,Seven Investment Management

Peter ThompsonExecutive Director, Equities,Goldman Sachs


Perhaps we can begin with an overview of the growth of the ETF mar-ket in the UK over the past few years.

Dan Draper: The ETF market in the UK really started in2000 and got off to a decent start but market conditions atthe time such as the dotcom crash certainly didn't contributeto the growth of the market. What is interesting is that therewas a move from traditional stock selection in the late 1990'susing both technical and fundamental analysis towards assetallocation. This helped but it must be remembered the ETFmarket started from a very small base.

Peter Thompson: We certainly started from a small baseand we are still some way from having a mature product inthis country. Originally some market players such as myselfperceived Europe as being a regional ETF market focusingon listings of European indices and underlying markets. Infact what has happened over the past couple of years is thatalmost all products are now available in Europe includingsuch markets as Asia and Latin America, plus a wide range ofcommodities markets. We now have a situation where therange of listings in some markets is wider than that in the USmarkets. However, it may be argued that the sheer number oflistings in the early days caused some confusion to potentialusers and fragmented liquidity. This is being addressed nowas professional market markers such as Susquehanna havecome into the ETF market and are making money onexchange, trying to catch the bid/offer spread.

Jonathan Lawrence: On the issue side, most of our majorclients because of the confusion just mentioned will alwayspick up the phone now, even for small and medium sizedorders, because they have two, three or four options.Normally the right option would be the people with thelargest assets under management, the tightest spreads and themost liquidity. You can usually spot who is doing the businessand who isn't so we try and encourage clients to stick to anissue so they will then remember the code etc.

Hugh Brown: Europe is bringing more variety to the ETFmarket than you can get elsewhere. For example, ETF com-modities are now 25% of ETF volume on the London StockExchange and Lyxor is coming on board with their FTSEissue. On the other hand, we probably don't need sevenEuroStoxx issues.

Why is it that the ETF market in the UK hasn't matched the US mar-ket in terms of rate of growth?

Justin Urquhart Stewart: From the retail perspective, theUK is not a nation of share holding investors in the sameway the US is. Furthermore, the depth of knowledge aboutthe markets and investment products is, on the whole, prettypoor. ETFs work so well for the retail investor it is astonish-ing that they haven't got across more than they have,

Peter Thompson

“IF YOU WANT EASY EXPOSURE TO[EMERGING MARKETS] … BUT

YOU’RE NOT COMFORTABLE PICKING STOCKS THEN ETFS ARE

THE IDEAL VEHICLE.”

- PETER THOMPSON, GOLDMAN SACHS

→→


especially given their tax advantages now. This is an issue ofinvestor education not one of marketing by the issuers. Assuch, IFAs have a very important role to play here.

Dan Draper: The retail market in the US also had a bigimpact. I believe that last year, two thirds of new money wasfrom the retail community. Having said that, the market stillneeds the initial push from the institutional side as liquidityshould drive the market. Up until now many of the issueshave instead been supply driven. Another important factorhas been the big asset allocation shift which began with thedotcom burst where there were over 80% of UK pensionsallocated in equities. Clearly, fixed income ETFs weren't mak-ing an impact. We have seen over the last five years or so areallocation down to the mid 60% equity allocation which hasopened the door for new ETF demand.

Jonathan Lawrence: The big reason from my position hasbeen the stamp duty. But with the change in the stamp dutylegislation from the UK Treasury last February, we nowexpect to see issuance expand rapidly and an increase in thenumber of firms marketing ETFs.

Peter Thompson: 2001 was really the time that ETFs werebeing born in Europe and the markets were on the waydown. Compare that to the equivalent period in the US ETFmarket, 1998 and 1999, when the equity market was boom-ing. This explains, in part, why the US market took off sorapidly. It was a very positive macro environment. Anotherfactor is the hedge funds: in the US they were the first insti-tutions to really embrace ETFs, using them, for example, asan alternative to futures. Here in Europe, hedge funds are asignificantly smaller proportion of the ETF market.

Where do ETFs stand as a retail product at the moment?

Hugh Brown: They are perfect products for the retail mar-ket because stamp duty is such a big issue and they can nowtrade UK ETFs without paying duty. However, they are com-peting with unit trusts and the heavy marketing that goeswith them in the Sunday papers and such like. With activeselling, ETFs should replace unit trusts in the long term. Theretail market is more sophisticated in the US but we wouldlike to see the retail market in the UK getting more involved.

Dan Draper: There's not doubt that for the UK ETF mar-ket to compete with the US in relative terms, the retail mar-ket is key. The UK however has a fragmented IFA communi-ty and it is difficult to get one message across to the end user.

Justin Urquhart Stewart: IFAs don't earn commission onETFs and stockbrokers prefer dealing with individual stocks.There are remarkably few exceptions to this attitude, which ispartly profit motivated and partly tradition. Whilst this factorhas been an impediment to the growth of the market, ETF

Hugh Brown

“IT HAS TO BE STRESSED THATFUND MANAGERS NOW HAVE THEBENEFIT OF ATTRACTING LENDINGFEES FROM ETF SHORT SELLERS.”

- HUGH BROWN, LONDON STOCK EXCHANGE

growth should be demand driven so the brokers will adjust.

What impact, if any, is MiFiD likely to have on the ETF market?

Hugh Brown: Under the secondary trading volume trans-parency rules, ETFs are not covered at the exchange.However, we have that transparency already across our mar-kets and we don't intend not having that for ETFs justbecause they are not covered by MiFiD. With creations itdepends on whether that counts as a trade or not; the trans-fer of the underlying to do the creation does look a bit likethe transfer of MiFiD securities to an authorised entity.

One of the advantages of using ETFs is the ability to short them. Whatissues need to be considered with regard to shorting ETFs?

Peter Thompson: While we have said there are no liquidityissues as such, there may be on the short side. This is poten-tially a problem when trying to short a fund and there aren'tenough shares available in the lending market. The shortingof ETFs takes place less in the UK compared with the US asthat side of the market hasn't developed yet to the sameextent and some of the funds aren't big enough to support it.

Hugh Brown: It has to be stressed that fund managers nowhave the benefit of attracting lending fees from ETF shortsellers. This is a major advantage of ETFs on the institution-al fund side that isn't getting the publicity it should be.

What are some of the other advantages of using ETFs other than thetax benefits and shorting?

Jonathan Lawrence: For us its ease of settlement and exe-cution in high velocity trading compared with other productssuch as swaps, futures and warrants. It's on the screen andcan be traded just like a share; although it doesn't have thesame level of customisation as other products, the ETF is theperfect access vehicle to gain exposure to the wider world.Moreover, no additional technology is required to tradethem. Another important factor I believe is market volatility.Things have been pretty smooth recently but as markets getchoppier it becomes hard to manage a basket of 50 or soselected stocks and so tools like ETFs become very effectivein dealing with this particular market condition.

Peter Thompson: It's difficult to get information on howand to what extent hedge funds in the UK are using ETFsbut the market basically trades sectors and many of them willtrade the US sectors using ETFs because they are cheap andyou have the volume. However, the same funds will often usesomething other than ETFs to trade the European sectors.There has been some confusion regarding liquidity whenlooking at average volumes in the ETF market but the insti-tutions are getting over that hurdle and understanding thatcash market liquidity is what matters.


Jonathan Lawrence

“… WITH THE CHANGE IN THE STAMPDUTY LEGISLATION FROM THE UK

TREASURY LAST FEBRUARY, WE NOWEXPECT TO SEE ISSUANCE

EXPAND RAPIDLY.”

- JONATHAN LAWRENCE, MERRILL LYNCH

→→


Are emerging markets playing a more important role in ETFs?

Peter Thompson: Anecdotal evidence suggests there ishuge interest in emerging markets ETFs. This is a growtharea and I think one of the reasons is that if you want easyexposure to one of these areas and you don't have theresources or you're not comfortable picking stocks or findinga good fund manager then ETFs are the ideal vehicle and youcan do it in your local currency on your local stock exchangefrom the local and regional benchmark indices to oil pricesand beyond.

Jonathan Lawrence: At Merrills we do a lot of businesswith the Turkish ETFs - the emerging markets are particular-ly interesting here because clients don't want to have to selectindividual stocks in Turkey and take on the risk associatedwith that in an unknown market but they do want exposureto a booming Turkish market. ETFs are perfect for this.

What still needs to be done in the UK to ensure the continued growth ofthe market?

Jonathan Lawrence: It really comes down to a partnershipbetween the issuers, managers and traders. ETFs are not acomplicated product but misconceptions undoubtedly stillexist, for example with tracker error. You can have positive aswell as negative tracker error but it is still perceived as beingnegative. Also, 70% of the funds I have spoken to say man-agers can outperform the index just by using skill. The appli-cation of ETFs from an asset allocation perspective is notalways understood so education is key here.

Peter Thompson: Also with traditional funds, all informa-tion on the fund is provided by the manager. With ETFs youhave the exchange, issuer, index provider and the broker allof whom can provide information on the product. All theseparticipants have a role to play in making it easier for users tocompare the benefits of using ETFs against other products.

What is the panel's outlook for the growth of the UK market over thenext five years? Are there any ETFs that you expect to see in the nearfuture?

Hugh Brown: There are 53 ETF issues in the UK now andwe expect that to go to three figures over the next couple ofyears. The impact ETFs are now having can be seen from theeffect of the launch of the gold ETF. Previously the goldprice was set by a few investment banks flagging if they hada net position to buy or sell. Within a few weeks of the goldETF being launched, that just disappeared. Also, I am confi-dent that the London Stock Exchange will become the cen-tre of the European ETF market.

Jonathan Lawrence: We expect the market to quadru-ple in the next 5 years to around $2 trillion globally. However,

Dan Draper

“I BELIEVE THAT ETFS HAVE THEPOTENTIAL TO TAKE A SIGNIFICANTPROPORTION OF THE £3 TRILLION

UK INVESTMENT MARKET.”

- DAN DRAPER,LYXOR

→→

The new Lyxor ETFFTSE All-Share

Bloomberg code: LFAS LN<Equity>

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I don't think the number of new issues over this time is goingto have that much impact on the overall volume of the mar-ket. Growth areas are commodities ETFs, private equity andnow property. Needless to say, interest in all these is all afunction of activity in the underlying. Also, whilst the lend-ing market is developing generally I think we can expect neg-ative performance ETFs appearing soon as well. Preciousmetals is another area of interest and with the recent listingsclients and colleagues are beginning to be concerned aboutthe impact on the underlying and how it can be hedged etc.This is an important sign of the increasing interest the ETFmarket is having.

Peter Thompson: ETFs will be a multi-trillion dollar marketgoing forward and will have a growing percentage of theinvestment pie. The rate of issuance will continue but hedgefunds will also start creating their own ETFs and we havenow started seeing bespoke ETFs. In the US, indices have

been created just in order to list an ETF so new issues of allkinds are being both supply and demand driven. The poten-tial pension crisis in the West should provide an incentive forpeople to take a more active role in investing for themselveswhich should be another impetus to the market from theretail side.

Dan Draper: At present there are 305 European listed ETFsin a market now worth around $100bn. This compares with874 listings in the US and a total market value there of$450bn. However, Europe is catching up fast and I believethat ETFs have the potential to take a significant proportionof the £3 trillion investment market. Nevertheless, a lot morecan still be done out of London as its not only recognized asthe world's leading financial centre but the major ETF mar-ket makers are based here so it should be a natural marketplace.

Justin Urquhart Stewart


Techniques

THE IAN HIGH JUMP INDICATOR™ REACHING EXTENSION FOR PROFIT TAKINGby Ian Woodward


Techniques

The Ian High Jump Indicator wasdeveloped to establish when astock is extended and due for a

correction. There are three elementsthat can act as a guide to when a stockis fully valued: these relate to the % dis-tance of the stock's price from its 17day, 50 day and 200 day moving aver-ages. Just as the fundamentalist is con-cerned with when a stock is overvalued,and generally applies the yardstick ofthe P/E ratio to establish this, we canalso use technical analysis to arrive atthe same conclusion. The concept isvery simple and can certainly be a goodguide for extended stocks. Let us take itin several simple steps:

A stock is said to be extended whenits price meets or exceeds the followingbenchmarks: (See Table 1)

When a High Growth Stock rises tothese numbers, it will invariably correct.They are quick rules of thumb and willvary from stock to stock, but are suffi-cient to raise the warning flag that astock or an Index is getting overvalued.That does not mean that the stock willbe trashed, but it will be sufficientlyextended that profit taking is inevitable.The extent of the correction willdepend on how far it has moved upwithout major interruption or re-basingto move sideways, before it goes upagain to the next plateau. It will correcteven further if the industry group it isin is being rotated out of and a lotmore when the overall market indexesare themselves extended and are in theprocess of correcting.

If you cannot remember all thesenumbers, a strong tip is to make sureyou remember that when a stock is100% above its 200-dma (daily moving

average), professional fund managerswill invariably look to lightening up ontheir investment. Taking half off whena stock reaches a 100% gain means thatyou have preserved your entire invest-ment in the stock and the rest is pureprofit with which you can decide to dowith as you wish.

The Ian High Jump Indicator Taking this concept to the next level,we come naturally to the Ian HighJump Indicator. Rather than looking ata snapshot at a time, the concept is tolook at a panoramic picture of how thestock has behaved over time relative tothe extension from the 17 day MA, the50 day MA and the 200 day MA - thevery yardsticks we use to decide whento buy and sell stocks using moving

average crossovers.You might wonder why I call it the

Ian High Jump Indicator. If you look ata panoramic picture of the above for-mula on any stock, or for that matter,any industry group or market index, itis a peculiar and interesting fact that atcertain times in a stock's drive up fromits recent base low, the stock will invari-ably come to rest at the same peaks andvalleys. These peaks are rarely beatenand more importantly, are at around thesame level though they may be reachedthree or four years apart. In otherwords, they are difficult benchmarks toexceed.

It seems the same occurs with stockswhen it comes to the degree of exten-sion over several years. They usuallypeter out at around the same levels;usually one can see three levels which Icall High, Higher and Highest. Take alook at Figure 1 and you decide for →→

Extended Very extended

The current price from the 17 day MA is

> 15% > 30%


> 30% > 50%


> 70% > 100%

Table 1.


Techniques

yourself if the highs and the lows areor are not usually around the samelevel. In other words one can use theselevels as early warning signs both onthe high and the low side. Understandthat these highs do not mean that thestock is about to die; but it does meanthat the stock is about to correct. Inother words, these peaks do not neces-sarily mean that the stock should beautomatically "sold" or "bought" whenthe peaks or valleys are reached. Ratherit does say that the odds of a profitablesale or a good buy are in your favor. Wemust then determine how the marketitself and the industry group are alsobehaving to decide whether it is pru-dent to enter or exit a stock.

The Ian High Jump Indicator forthe S&P 500With that as a background let us nowlook at an example with the S&P 500Index. Now is an opportune time to beturning to the High Jump Indicator toshow you the overall extension (%High Jump) for the 200-dma. The

green line on the chart is the weeklyS&P 500 and the blue line is the dis-tance of the S&P 500 Index from the200-dma as shown as a percentage.The High Jump is north of the zeroline and the limbo bar (negative read-ings) is below. Note that in earlier yearsthrough 1998, the High Jump as shownby the blue line invariably reached 15%and occasionally crept up to 18 to 20%at its highest point. Since the bear mar-ket of 2000 to 2003, the best the highjump has done for the 200-dma is 15%and more recently has struggled ataround 9% to 10%.

High Jump targetsThe upside target recently has been9.6% above the 200-dma which wouldput it at 1495, or 1500 betweenfriends…a nice easy number to remem-ber, should the S&P overshoot thepotential double top it is currently atoff its recent low. Moreover, as youwill see from the chart, the limbo bardrops for Low, Lower, and Lowest arewell defined at -6%, -12% and >-20%,

respectively from the 200-dma. Thishas been true for all of the years I havemeasured this since 1974, which is nowover 30 years.

Assuming that we use the currentS&P 500 Index value of ~1484 (LastFriday, April 21 Close) then the expect-ed drops would be to 1395, 1306, and1187, respectively for the % dropsshown above. The percentage dropsand numbers are shown on Figure 1.

One can expect a major drop onceevery 13-14 years as shown by thesevere drops at the 1987 Crash and thetechnology bubble bursting in 2000 to2003. Unless there is a major fall out ofthe loans debacle affecting the entireeconomy or some similar surprise, it ismost unlikely that we should fall tothese depths this time. Naturally thosewho are more bearish want to see as biga correction as possible before they tip-toe back into the market.

Ian Woodward manages a researchfirm, highgrowthstock.com

Figure 1.

Techniques


The value of 100The Normalised Relative Strengthchart takes exactly the same shape asthe chart you get from dividing oneinstrument by another but normalisesits value to 100 at a chosen date. Forinstance you may select the start of theyear or the 2003 low in most equitymarkets as your datum. This meansthat your current value on the righthand scale gives you the percentage rel-ative performance since your start dateat a glance. Moreover you can see themaximum and minimum levels of out-performance and underperformancequickly over the period.

The left hand scale of Figure 1 showsthe performance volatility relative tothe Eurostoxx in an easy to read for-mat. The stock outperformed the mar-ket by 40%, then lost momentum andunderperformed for two years, reach-ing its low at about 15% below theindex in August 2005. By the end oflast year Lufthansa managed to returnto its best outperformance mark andoutperforms the index currently byabout 30%.

Currency adjustingRelative strength analysis is fairlystraight forward when all your con-stituents are priced in the same curren-cy as your index, such as the S&P 500or the FTSE. But what happens whenyou have instruments quoted in variouscurrencies within an index like theMSCI World Index, which is calculatedin US dollars or the Eurostoxx 600

RELATIVE STRENGTH:NORMALISATION AND CURRENCY ADJUSTMENTby Melanie Schmidt

While most traders and technicians look at relative strength charts, fewincrease the depth of this analysis with the simple process ofnormalising the data and adjusting for currency.

Figure 1.

Figure 2.→→


Techniques

Index based in euros?Taking a closer look at the Eurostoxx

600 Index, which has become thebenchmark of choice for analysingEuropean stocks, there are many con-stituents quoted in their local currency;not only in euros. The effect of curren-cy may not be that great when the UK,Scandinavian and Swiss currencies aremoving broadly in line with the euro,but if there are big variations over timeyou should seriously consider adjustingyour relative strength charts to takeaccount of the currency anomaly.

Currency adjusting the relativestrength chart adjusts the price chart ofa stock (not changed visually) to thecurrency of the denominator (index)and then makes the division of one bythe other. So instead of comparingapples and pears, you are truly compar-ing like with like.

Comparing like with likeTake the chart of Holcim (Figure 2).The recent trend in the Euro-Swissrranc rate has had an effect on relativestrength in currency terms. The blueline is non currency adjusted and thered line is currency adjusted (basingHolcim in euros first). Now Holcim ismaking new relative strength highs…oris it? The currency has had an impacthere. We are not making new highswhen we adjust for currency. The stock

has shown a 19% outperformancesince the start of last year with the peakin recent weeks but with the currencyadjustment, a 20% outperformancehappened a couple of months ago. Incurrency adjusted terms we still need acouple of percent to take out the topperformance earlier this year.

Scanning with currency adjust-mentMany fund mangers immediatelyequate the use of identifying this cur-rency anomaly to the underlying cur-rency of their fund, but that is not itstrue value. Where currency adjustedrelative strength analysis really comesinto its own is when you are scanninglarge universes of stocks. For instance,if we are scanning for 12 month rela-tive strength highs, do we want to flagstocks such as Holcim?

To study the effect we looked for newhighs in both; relative strength and cur-rency adjusted relative strength acrossall 600 members of the Eurostoxx,picking the stocks that made new 12month RS highs in the last month. Thescan results (Figure 3) came up with ashortlist of stocks in a couple of min-utes. While most stocks made newhighs on both criteria, notice the differ-ences in the first few. Tesco forinstance made a new high on the rela-tive strength but failed to do so under

currency adjustment. Conversely, ICIdid make new highs currency adjustedbut not unadjusted.

When running relative strength scansnormalise your charts at the very leastfor better clarity of historical relativeperformance in percentage terms. Ifyou can do the currency adjustment inyour scanning, all the better.

Melanie Schmidt CFTe, MSTA, hasrecently joined Updata specialisingin the development of tradingstrategies.

“CURRENCY ADJUSTING THE

RELATIVE STRENGTHCHART ADJUSTS THE

PRICE CHART OF ASTOCK TO THE

CURRENCY OF THE DENOMINATOR.”

Figure 3.

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Techniques


There is a wealth of literature onthe subject of stock chart pat-terns with generic guidelines on

how to place trades when one of theseformations is identified. It is generallyaccepted that patterns can provide arough guideline for how far the pricemay move and how long it might takefor the stock to reach that target price.

A target price is gauged by measuringthe height of the pattern and projectingthat distance vertically on the chartstarting at the "breakout" price for thepattern. The time horizon to reach thetarget is roughly estimated by measur-ing the length of time over which thepattern formed and projecting that dis-tance horizontally from the date thepattern is confirmed by a "breakout"(see Figure 1).

These guidelines have been developedover the years as expert technical ana-lysts document their techniques andobservations. But the real question is,do patterns work? Can patterns be usedto make more profitable trades? And ifso, should we be using the generalguidelines from the literature asdescribed here or is it time for newguidelines?

Some of the technical analysis booksattempt to address these questions withanecdotal comments on the frequencyand reliability of certain types of chartpatterns. Some books even provide sta-tistics, although many of the studiesfrom the past were based on manuallyidentified chart patterns. This manualidentification naturally imposes a limiton the sample of patterns that can beused for a study on pattern perform-ance. Also patterns identified visuallyby analysts are subject to inconsistency

that is inherent in human nature. Ananalyst may be more or less strict aboutthe criteria they use to identify a chartpattern. An analyst may also uninten-tionally incorporate extraneous infor-mation into their decision aboutwhether or not a pattern is present in acertain chart. For example, they mayunconsciously use the benefit of hind-sight to observe how the price movedfollowing a pattern, while that informa-tion is not available to traders trying toidentify patterns as they form so theycan place trades based on them.

A historical database of automatical-ly identified chart patterns allows for arobust scientific study of pattern fre-quency and reliability, by making avail-able a thorough and consistent sampleof patterns without human bias.

A study based on automatically iden-tified chart patterns was published inone of the recent books by MartinPring, a popular author on the subjectof patterns and technical analysis. Theresults are very interesting but first theguidelines were:

The study looked at stocks from foursectors between 1982 and 2003:Financial, Retail, Transportation andEnergyOver 5000 patterns were identified ofthe following types: Head &Shoulders Tops, Head & ShouldersBottoms, Double Tops, DoubleBottomsPrimary bull and bear markets wereidentified for each sectorFailed patterns were allowed to runtheir course (no benefit of prudentmoney management such as stoploss)

The results showed that while usingtext-book guidelines indicating that thetarget price should be achieved withinthe same amount of time it took for thepattern to form, just under 30% of thepatterns reach their target price withinthat time frame. In other words if thepattern length was 50 days, 30% of thepatterns achieved 100% of their targetprice within this 50 day period. Somemay have taken just one day, and otherscould have taken 49 days, and so forth.

Looking at the results another way,approximately 10% of patterns reacheddouble their target price within thattext-book time frame. The profitpotential of these patterns can beexploited by using disciplined moneymanagement techniques such as stopsto control losses and tap into the antic-ipated price movements.

Ideally, we would prefer to find a wayto achieve greater profits from a greaterpercentage of patterns. And the resultsactually show that this is possible, ifyou are prepared to wait longer thanthe text-book time frame. Specifically,results were best when profits were


Techniques

→→

CHART PATTERNSNEW GUIDELINES FOR DETERMINING TARGET PRICEby Kathryn Griffiths

•

•

•

•

“ UNDER 30% OFPATTERNS REACH

THEIR TARGETWITHIN THE TIMETAKEN FOR THE

PATTERN TO FORM.”

Techniques


observed over a time frame equivalentto five times the pattern length. In thiscase, 70% of all the identified patternsreached their objective within 5 patternlengths. If you like big winners and areprepared to wait, the study shows thatapproximately 25%, or a quarter of allpatterns, reached four times theirobjective within 5 pattern lengths.

The above results were concludedwhen observing bullish patterns (Head& Shoulders Bottoms and DoubleBottoms) in a bullish market. A veryimportant point that all traders need torecognize is that breakouts that developin the opposite direction of the primarytrend are less likely to be successfulthan the kind of pro trend moves thatwere summarized above. While the

results for bullish patterns in a bearmarket were not as impressive, theywere still promising and showed a sim-ilar improvement when waiting longerthan the text-book guideline. 58% ofbullish patterns in a bear market reachtheir target price within 5 patternlengths following the breakout.Approximately 33% reach double thebreakout objective, and 15% reach fourtimes the objective.

The study confirmed prior knowl-edge that with-trend patterns have agreater likelihood of success, mean-while contra-trend patterns arenonetheless beneficial. Also the studyexpands on text-book theory to offerthat positions may have to be heldlonger than previously thought in order

to reap greater profits. This study is justone slice of research that could takeadvantage of automatically identifiedchart patterns to expand our under-standing how to better evaluate astock's potential. With more sectorsand pattern types to analyze and manymore characteristics to factor into astudy, there seems to be a new patternforming: a breakout in new guidelinesfor how to get the most out of pricepatterns.

Kathryn Griffiths is product manag-er at Recognia Inc., a Canadiancompany specialising in automatedchart pattern recognition software.Visit www.recognia.com.

Figure 1. Text-book guidelines measured from chart patterns

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Rami HabibKyte Group

TA: It's unusual to come across funds like yours which are root-ed in Point & Figure. Where does your attachment to P&F comefrom?

RC: While I was at Smith Barney I was introduced to Point &Figure-based research from a company called Dorsey Wright &Associates. I've been a religious follower of the Point & Figuremethodology ever since, which is for about five years now.

TA: Why do you use P&F as opposed to other techniques?

RC: The thing that appeals to me about the P&F methodologyis that it's been around for a very long time. I've found that itworks well for me and that's why I continue to use it. Relativestrength is also an important part of it. If you look at a book byJames O'Shaughnessy called "What Works on Wall Street" inthat he talks about what methods have given the best trackrecord. Positive relative strength was a part of almost every oneof the top 10 strategies. The worst strategy was buying stockswith the worst relative strength.

TA: According to your prospectus there are five steps in theinvestment process for your Equity Long/Short Fund (see Box1). The first step is to establish market stance. What do youmean by this and how do you measure it?

RC: I use a combination of short, intermediate and long-term

Rusty CannonUS-based Rusty Cannon spent the last 11 years in theretail brokerage world managing money for individualclients, first at Merrill Lynch then at Smith Barney. Heleft Smith Barney in February of 2007 to set-up his owncompany, RKC Capital, a registered investment advisor.The firm already has USD 25m under management.

RKC Capital's two new funds are remarkable for theirexplicit use of Point & Figure. The first fund- the RKCMatador Fund LLC- is an equity long/short fund usingthe Point & Figure methodology that Rusty used in thepast with separately managed accounts. The secondfund- the RKC Matador Market Neutral Fund LLC-uses the same strategy for picking longs as the RKCMatador Fund, but pairs each long position with a shortposition in the corresponding sector ETF, seeking toproduce a low volatility, absolute return. Each fundstarts with USD 1m feed capital, invested by existingclients.

Interview

28 THE TECHNICAL ANALYST May/June2007

INTE

RVIE

W


Interview

bullish percent indicators to determine market stance, themost important of which is the NYSE Bullish Percent whichdetermines the long term view. To use an American Footballanalogy, these indicators tell us whether we should be on theoffence or defence. In addition to that, if we're on offence ordefence, it also tells us the field position (see Figure 1). Forinstance, right now we're on offence but field position is notgood. Meaning that I would not be fully invested but I wouldbe close to it, and I would start laying on some shorts, rais-ing cash, selling some winners, taking some gains. But as longas the indicators are on offence I stay on offence.

TA: So how are the indicators stacking up right now?

RC: The intermediate indicators and long-term indicators arestill on offence. The short-term indicators are just now start-ing to weaken. But the short- and intermediate- term canwhipsaw back and forth, so you don't want to jump the gun.The short term indicators are really just a shot across the bowso to speak. But if the NYSE Bullish Percent turns todefence as well, then the fund would change its overall mar-ket stance, meaning that no matter how much I like thesestocks, you need to lighten up positions, do some shorting,maybe hedge the portfolio. And if things get extremely neg-ative, that's when the fund will go completely on to the shortside.

TA: What are these short- and intermediate-term marketstance indicators?

RC: For the intermediate-term, I use the Optionable BullishPercent chart. This is similar to the NYSE bullish %, but it'sbased on all stocks that are optionable, meaning they haveoptions trade on them. So it's a smaller universe and it tendsto move on a more intermediate term basis. For short-termindicators, I use the Hi-Lo Percent and the 10 Week Percent.

TA: Are you just invested in US equities?

RC: Yes, in the sense that I only invest in individual stockslisted on the NYSE. However, I do use ETFs for exposureto overseas markets and commodities. Currently, I'm invest-ed in Mexico and (through a fairly new ETF which has thesymbol EEB) Brazil, Russia, India & China.

TA: How do you generate buy/sell signals for the foreignmarkets?

RC: What I have used in the past, and this could change, is acomparison of the country's ETF versus other markets.Meaning if the relative strength of Brazil is on a buy signaland very strong versus other markets, that's your signal to bein that market. When the relationship deteriorates, that's yoursell signal.

TA: What's the second step to your investment process?

RC: After market stance is determined, then you go to steptwo which is sectors. You can see how important sectors arein Table 1, which shows the massive difference between thebest and worst performing sector in a given year. We deter-mine which sectors to overweight and which ones to avoid.And that is determined also using P&F methodology withrelative strength and also bullish percent readings on the indi-vidual sectors. You're trying to stack the odds in your favour.We may know we're on offence, but what sectors have thebest relative strength right now and which ones should weavoid. We're trying to put our long positions into thosefavoured sectors and put our short positions in (or avoid) theunfavoured sectors.

TA: Are you also trying to find sectors at extreme levels thatmight revert?

RC: Yes, we also pay attention to field position of the sector,because they can get very extended. Good examples of thatright now are steel stocks, natural gas stocks, and a lot of theutilities. These are still positive but they're way up there. I'mnot looking to come out of these positions just yet, but I'msurely not getting in to them. →→

Figure 1. Source: Dorsey Wright & Associates


Interview

TA: So is there the same 70:30 rule that applies with this kindof analysis as with many other indicators ofoverbought/oversold condition?

RC: You said it - that's the line of demarcation.

TA: So what happens after you've determined the status ofsectors?

RC: Then you drill down even further in Step 3. Within thosesectors you isolate your short and long candidates based onP&F patterns and relative strength readings on the individualstocks. So if we're on offence and we've found a favouredsector, e.g. Steel, then you use P&F methodology and relativestrength to determine which of those stocks you shouldemphasise within the sector. And if it's a very favoured sec-tor with very strong relative strength, you might not shortanything in that sector. But usually you can find some laggersto short as well, even in very strong sectors.

TA: Any examples of some favoured sectors and stocks atthe moment?

RC: The telecom sector is quite good now and within thissector, AT&T is the big one and looking extremely strong.Another stock doing particularly well in that sector isAmerica Movil (AMX) a provider of wireless communicationservices in Latin America.

TA: How much does the stock selection add to the return ofthe fund, i.e. compared to just going long an ETF of afavoured sector and short an ETF of an unfavoured one?

RC: The stock selection is critically important because thefund is more concentrated than most funds. Within a sectorI might only have 5 to 10 holdings and so it's not a very diver-sified fund. Stock selection is therefore very important. Icould run the fund using sector ETFs only but I've just foundthat I can generate a lot more alpha and better returns usingindividual stocks.

TA: What's the difference between this and the secondMarket Neutral fund?

RC: The Market Neutral fund is designed for larger institu-tional investors that want a low volatility absolute return,somewhere between an 8 and 15% annualised return, where-as the Equity Long / Short fund will be more volatile and willtarget much higher returns.

With the Market Neutral Fund I gain exposure to just aboutevery sector of the market. Then I pick good long candidatesin a similar way to the other fund. However, I pair every longstock with a short position in the corresponding sector ETF.So, for instance, if I picked 10 long candidates in the steelsector, I would then short an equal amount of whatever ETFapplies best to the steel sector, therefore trying to extract thealpha of those stocks over and above the sector index.

TA: Have you calculated your expected maximum drawdownfor the funds?

RC: The first fund is more aggressive and could easily bedown 10-15% in a month. The drawdown for the marketneutral fund should hopefully be no higher than mid to highsingle digits. That's the expectation based on some data com-

Investment Strategy - Systematic Steps

Matador Fund (Equity Long / Short) Matador Market Neutral Fund

1.

2.

3.

4.

5.

1.

2.

3.

Determine market stance - offence or defence? Based on bullish percent readings

Determine sectors to overweight/emphasize and underweight/avoid. Based on relative strength and bullish %

Short the corresponding sector ETF to assume a market neutral position

Select long stocks based on P&F patterns, relative strength, and proprietary ranking system / matrix

Monitor above and make any necessary changes to long portfolio as stocks move in and out of top spots

Isolate long and short stock candidates based on P&F patterns, relative strength, and proprietary ranking system

Review long and short candidates based on fundamentals at company level, e.g. PEG ratio, ROE, debt to capital etc

Monitor above on ongoing basis and make any necessary changes to positions

Box 1.

piled by Dorsey Wright & Associates.

TA: How exactly do you pick these long stocks using P&Fand relative strength?

RC: I use P&F buy/sell signals, trends, patterns - that'swhere the art comes in and that's where you get into the pro-prietary methodology of how I pick the long positions. Youcan have a very strong relative strength stock that can stillgive you some ugly signals that would cause you to pause,hedge or exit your position.

TA: And do you overlay your decisions with fundamentalanalysis?

RC: Not on a country basis but on an individual stock basisyes. This is the fourth of the five steps and an important one.I'm not an expert in fundamental analysis, but I know enoughto do a basic rudimentary analysis, which is what I do - typi-cally PE to Growth Ratio analysis. For example, if the PEGratio is 1.0 or lower I feel pretty safe, whereas I get worriedwhen companies get to 2.0 or higher. In a sense, what I'm try-ing to do is make sure that if a stock is technically strong, it'snot a piece of junk. So you do have to turn away from somestocks that look technically strong. However, a lot of timesthe technical picture will turn around well before fundamen-tals and these are the times where you can get some goodwinners.

TA: To what extent has the development of the ETF marketmade your hedge funds possible?

RC: It's made the Market Neutral fund much much easier.The fact that you can short ETFs so easily, that you don'thave problems of getting called away, and you don't haveissues of borrowing makes it extremely easy to execute.Moreover, ETFs have also allowed you to get quick exposureto various sectors, markets, and countries in a very efficientway. If I liked the Brazilian market and I want exposure there,I can just go buy EWZ and it's done. I haven't got the expert-ise and research capabilities to hunt down the Petrobras’ ofthe world.

TA: How frequently do you trade?

RC: It's not that much. If you adhere to trends and relativestrength, the idea is to hang on to your large winners and cutyour losers early, which means I can stay in for a long time.

TA: Point and figure is arguably one of the most objectiveforms of charting (e.g. trendlines at 45 degrees, clear buy/sellsignals) but you still have a lot of discretion with regard tobox size and reversal size. What do you use and why? Andhow much does it change your view of the market?

RC: I typically stick with traditional box sizes. You can drilldown to where you shrink the box sizes to see more activityin a stock that doesn't move a lot, but the danger is you getlots of whipsaw and you can get shaken out of a good stockor sector if you zoom in too closely. That's the constant bat-tle for most technical strategies and issues of risk manage-ment.

TA: Do you use say a 3-box size for medium-term analysis tomake the buy/sell decision and use a smaller box size tozoom in and timing the entry or exit?

RC: Yes that is accurate. In addition to zooming in on thebox size, I would also look at overbought and oversold indi-cators and daily/weekly/monthly momentum proprietaryindicators, which are fairly rudimentary. I don't get into allthe other methods, MACD, oscillators etc. There's a lot ofoverlap and much of it tells us the same thing, and a lot of itis noise.

TA: Is there a third fund on the way?

RC: It’s not something on the cards right now, but if I wereto open a third (or fourth) fund it would be to clone thefunds offshore to accommodate overseas investors.

For further Information on RKC Capital, email:[email protected]


Interview

Table 1. Source: Dorsey Wright & Associates


TRADEWEBMARKET DATA & ANALYTICS

The electronic trading of fixedincome and derivative securitiesis now commonplace across the

world's financial centres. For example,TradeWeb, the leading dealer-to-cus-tomer fixed income trading platform,handles over $200 billion of volumeeach day, operating in Europe, the USand Asia.

The display of real-time pricing hasundoubtedly increased transparency inthe fixed income market place. There isa more general trend towards price dis-covery, price disclosure and transparen-cy, and with the addition of regulatoryinfluences to the equation, the effect isclearly to quicken the move of fixedincome trading from art to science.This science relies on the GIGO prin-ciple - any conclusion about a market isonly as good as the data that is availableto derive that conclusion.

Historically, the OTC market placehad seen a degree of opacity, since mar-ket information and price discoveryhad been largely confined to a two-party discussion (mostly by telephone)that was inherently not open to otherparticipants. The arrival of widely usede-trading has shifted this information

gap and allows for much greater trans-parency.

TA analyticsThe financial markets are open andtransparent as never before and are

moving further in that direction.Transparency (the argument goes)invalidates opportunity and so the roleof the trader and fund manager in spot-ting and sizing anomalies in pricing andbehaviour has become more dominant.

We look at the range of analytics and market data now being offered byTradeWeb, a leading bond and fixed income trading platform.

Figure 1.

Software

Software


The TradeWeb charting package, forexample, delivered through the stan-dard GUI, has a set of built-in techni-cal analysis studies making use of his-torical and real time data. These rangefrom the Simple Moving Averagesthrough Bollinger Bands and FibonacciRetracements to Stochastic studies thatpermit user input for time periods andalso allow trend lines to be drawn. Anexample of a TradeWeb FibonacciRetracement screen is shown in Figure1.

For the analyst who uses his/her ownor another proprietary set of studies,TradeWeb historical and real time datamay be used to power those applica-tions. Understanding that the pre-loaded charts may not provide some ofthe more specialised (not to say recher-ché) analytics, TradeWeb encouragesusers to download market data througha number of different routes and thusallows detailed technical studies to beperformed on validated market pricesrather than generic or implied prices.

From a morass of start-up internetelectronic trading platforms, TradeWebhas emerged as the pre-eminent net-work for dealer to client business in thefixed income and derivative marketplace. Although originally recognisedfor its outstanding transaction capabili-ties, TradeWeb is rapidly becoming thesource of the most accurate pricingdata available for use by market partici-pants.

It is a measure of the speed of evo-lution in this future-world, that it is nolonger enough to offer only trade exe-cution, however efficient. Platformsmust also be providers of informationand facilitate the detailed analysis ofmarkets, transactions and of perform-ance. Fund managers and traders needa suite of analytical functions that aredirectly related to their fixed incomerequirements.

Market dataBased on the premise that efficient exe-cution is the primary requirement ofthe fixed income trader, TradeWeb hasa set of analytical functions that aredesigned to make daily tasks muchmore efficient and less burdensome.TradeWeb provides historic end-of-dayand tick data and is increasingly beingasked for this data as clients look forthe ability to back-test trade ideas, forscenario stress testing and for increas-ingly important regulatory analysis.

Whilst there is a temptation forMarket Data to be seen as the exhaustfrom successful pricing engines, forTradeWeb the quality of the pricingdata is what drives the trading platform,making their data a particularly valuableproduct in its own right. Each client hasan individual focus onto the market sothey tend to see specific demandsbased, for example, on invested curren-cy mix and location. The analytics anddata TradeWeb offers on the UK Gilt

market - including the index-linkedbonds - are very much in demand as aseparate product. However, the fixedincome market is not clamouring forthe same styles of trading as equitymarkets, although transparency andregulation may well prove catalysts fornew types of activity.

Historical performance and price datafor a security is always at the forefrontof any decision making process so it isessential to use a consistent and consis-tently accurate pricing source. TheTradeWeb composite price is recog-nised through the fixed income marketplace as being the most accurate andtimely indication of where the marketis pricing a particular security. BecauseTradeWeb has such a vast amount oftrading volume across a variety of fixedincome and derivative products

“TRADEWEB IS INCREASINGLY BEING ASKED FOREND OF DAY AND TICK DATA AS CLIENTS LOOK

FOR THE ABILITY TO BACK-TEST TRADING IDEAS.”

- ANDREW BERNARD, TRADEWEB

TradeWeb Markets

• European Government Bonds (Including GILTS)

• European Credit• €, $ and £ Interest Rate Swaps• CDS Indices (€ and $)• Pfandbriefe/Covered Bonds• US Treasuries• Agencies • Supranationals• TBA-MBS

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Software

moving through the platform each day,it is possible to validate pricing data,and move away from imputed or gener-ic pricing.

Andrew Bernard, Managing Director

of TradeWeb explains, "TradeWeb'smarket data is based on our role as atrading platform that focuses on dealer-to-client (B2C) fixed income and deriv-ative business. We see around 89% of

our transactions effected at or insidethe indicative pricing we provide. Wecarry the core products that drive thefixed income world, and this meansthat the validity of the pricing we haveis very strong."

As can be seen in Figure 2, TradeWebmakes it easy to follow the relativevalue spread between securities. Usingthe chart in the "2 security" mode it iseasy to see how the yield spreadbetween two securities has varied overtime. This enables the user to make atrading decision based on the historicalrelative value of the two bonds.

Once a trading decision or spread tar-get has been set, it is possible to moni-tor that target in real-time using thealert function on the TradeWeb viewerto see when the desired spread isachievable in the market place. ForEuropean Credit securities TradeWebalso allows the user to monitor histori-cally, and in real-time, three essentialspreads that market participants willfind very interesting - Z spread, I-spread and the asset swap spread(Figure 3).

Although algorithmic and programtrading have been used in the equitymarkets for some time, the lack of anexchange or central market place hasmeant that it they have not been socommon in the fixed income arena.TradeWeb real-time data feeds enablethe trader to fuel their algorithms orpricing engines with accurate and up-to-the-minute pricing data that makesautomatic execution and historicalstress testing of trading strategies amuch more viable proposition.

With the advent of MIFID, accuratemark-to-market and evaluation toolsare needed to enable firms to complywith the directive. No matter how goodthese tools may be, they cannot operateefficiently without the correct informa-tion. TradeWeb has pre- and post-tradedata available for use in transactionanalysis products/software that makesthe task of complying with MIFID lessof a burden.

www.tradeweb.com

Figure 2.

Figure 3.

Evidence Based TABy David Aronson

Published by Wiley 544 pagesISBN: 0470008741£65

David Aronson is a former prop trader at Spears, Leeds and Kellogg inNew York and now runs his own research house. After years of usingtraditional technical analysis in his trading he became somewhat scep-

tical of certain techniques such as Elliott wave and Gann. His main complaint isthat these studies are, for the most part, subject to subjective interpretation bytraders and analysts. As such, their true predictive power is difficult or impossi-ble to quantify. His book explains how all TA techniques should be subject torigorous backtesting and statistical analysis in order to be accepted as having anyanalytical value. Aronson advocates what he calls 'objective TA' which he definesas "well defined repeatable procedures that issue unambiguous signals".

The first half of the book focuses on two themes: behavioural finance and sta-tistical analysis. His coverage of behavioural finance relates to the errors thattraders and analysts themselves make in analysing the market; in other wordserrors due to subjectivity. These include such well known biases as anchoring,confirmation bias and the gambler's fallacy. While this is nothing new, Aronsondoes manage to discuss the subject in an interesting and practical way and, moreimportantly, relate it to the methods often employed to interpret chart patterns.He then goes on to discuss, at length, the theory of sampling, statistical analysisand significance testing. This can be found in most textbooks but also includedis some very useful material on backtesting criteria, data mining and detrending.

Part 2 is a case study examining the backtesting of 6402 trading rules on theS&P 500 from 1980 to 2005. The interpretation of his results depends on thereader's opinion of his analysis and the rules used.

Aronson's book is fascinating and an eye opener but he overstates his case. Hetakes over 500 pages to say what could have been written in a book half as long.The problem with his approach is that he insists on finding the perfect tradingrule tested under the strictest criteria and dismissing all else despite the fact thatchoosing backtesting and model testing criteria and interpreting the results can,in itself, be a subjective procedure. Technical analysis is often described as beingan art rather than a science and it is accepted, as it is in fundamental analysis, thatsubjectivity is a large part of interpreting the market. But Aronson is not willingto accept this point. While an Elliott Wave chart may be interpreted differentlyby different traders, this doesn't make any or all of their opinions invalid.Moreover, the formation of Elliott Waves is based on well understood principlesof market psychology, something Aronson fails to consider.

Despite these points, his book is well written and contains a great deal of infor-mation that is of value, especially in model building and behavioural finance.Not for traditionalists.

Evidence-Based Technical Analysis is available with a 34% discount from theTechnical Analyst bookshop at Harriman House. To order please call 01730233870 and quote, "The Technical Analyst magazine".

EVIDENCE-BASED TECHNICAL ANALYSIS


Books

Applying the Scientific Method and Statistical Inference to Trading Signals


Research Update

Volatility is MisunderstoodTwo researchers have published asharp warning that many finance pro-fessionals regularly confuse two meas-ures of volatility - mean absolute devi-ation and standard deviation - usingthe two interchangeably with potential-ly harmful consequences in decisionmaking. Daniel Goldstein from theLondon Business School and Nassim

Nicholas Taleb from the University ofMassachusetts come to this conclusionbased on a survey of 74 finance pro-fessionals and 13 Ivy League graduatestudents - "people trained to know thedifference". Their suspicion was firstaroused when they heard optionstraders says "an instrument that has adaily standard deviation of 1% should

move 1% a day on average." Not so,the authors warn. The error is moreconsequential than it seems, causing anunderestimation of 25%, and in somefat tailed market, up to 90%.Goldstein, Daniel G. and Taleb, NassimNicholas, "We Don't Quite Know WhatWe are Talking About When We TalkAbout Volatility" (March 28, 2007).

MUTUAL FUND HERDINGMutual fund herding in response torevisions in analyst recommendationshad a far greater impact on stockprices during the period 1994 to 2003than in prior periods, according tonew research out of the U.S.Furthermore, the authors found evi-dence that mutual funds appear tooverreact when they herd - stocksheavily bought by herds tend to under-perform their size, book-to-market,and momentum equivalents during the

following year, while stocks heavilysold tend to outperform. The authorspresent an investment strategy basedon the direction of both analyst revi-sions and mutual fund herding, whichgenerates a return exceeding six per-cent during the following year.Brown, Nerissa C., Wei, Kelsey D. andWermers, Russ R., "AnalystRecommendations, Mutual Fund Herding,and Overreaction in Stock Prices" (March2007).

Three U.S. based researchers havedeveloped a model of asset prices inwhich investors are subject to the"confirmation bias", i.e. the tendencyto look for information that supportshis or her original idea about aninvestment rather than seek out infor-mation that contradicts it.Interestingly, the model generatedprice patterns that were consistentwith the observations of technicalanalysis. Furthermore, the authors

found that asset prices exhibit negativeautocorrelations over very short hori-zons, positive autocorrelations overintermediate horizons, and negativeautocorrelations over long horizons,matching "the observed stylized prop-erties of US equity prices".Friesen, Geoffrey C., Weller, Paul A. andDunham, Lee M., "Price Trends andPatterns in Technical Analysis: ATheoretical and Empirical Examination"(March 8, 2007).

Confirmation Bias Creates Price Patterns

What matters to individuals when theybuy and sell stocks? To answer thisquestion, two researchers from FloridaState University surveyed 642 financeprofessors in the US on the basis that"they should be the most informedinvestors who are not professionaltraders". Interestingly, traditional valu-ation techniques (i.e. the dividend-based valuation models) and the tradi-tional asset-pricing models were allunimportant in the decision ofwhether to buy or sell a specific stock.Instead, finance professors, particular-ly those who trade stocks at leastmonthly and who admit they are try-ing to beat the market, believe thatfirm characteristics (especially a firm'sPE ratio and market capitalization)along with momentum related infor-mation (a firm's return over the pastsix months and year and firm's 52-week low and high) are most impor-tant when considering a stock sale andpurchase.Doran, James S. and Wright, Colbrin,"What Really Matters When Buying andSelling Stocks?" (April 13, 2007).

THE TRADINGTECHNIQUES OFFINANCE PROFESSORS

A study at City University Londonfound that the top 10 banks among100 quoting banks in the FX markethave a monthly average share of over70% of total market information. This

increases to around 80% during someU.S. macro announcements such asGDP and Fed Funds rate announce-ments. The authors' findings werebased on 5 years worth of indicative

GBP/USD data from the ReutersEFX system.Phylaktis, Kate and Chen, Long, "DoTrading Banks in Foreign ExchangeBusiness Know More?" (February 2007).

SMALL FX BANKS IN THE DARK

Research Update

38 THE TECHNICAL ANALYST May/June2007

SEASONALITY OF

MOMENTUM PROFITSThe Predictive Power of Head-and-Shoulders

Asset market experiments suggest thatinexperienced investors play a role inthe formation of asset price bubbles,i.e. without first-hand experience of adownturn, these investors are moreoptimistic and likely to exhibit trendchasing in their portfolio decisions.Robin Greenwood of HarvardBusiness School and Stefan Nagel ofStanford Graduate School of Businessexamined this hypothesis with mutualfund manager data from the technolo-

gy bubble. Using age as a proxy formanagers' investment experience, theyfound that around the peak of thebubble, mutual funds run by youngermanagers were more heavily investedin technology stocks, relative to theirstyle benchmarks, than their older col-leagues. Consistent with the experi-mental evidence, they found thatyoung managers, but not old man-agers, exhibited trend-chasing behaviorin their technology stock investments.

As a result, young managers increasedtheir technology holdings during therun-up, and decreased them during thedownturn. The economic significanceof young managers' actions was ampli-fied by large inflows into their fundsprior to the peak in technology stockprices.Greenwood, Robin Marc and Nagel, Stefan,"Inexperienced Investors and Bubbles"(February 7, 2007).

All papers are available from the Social Science Research Network, SSRN, www.ssrn.com

With Januaries (a month in whichlagged "losers" typically outperformlagged "winners") excluded, the aver-age monthly return to a momentumstrategy for U.S. stocks was found tobe 59 bps for non-quarter-endingmonths but a much greater 310 bpsfor quarter-ending months, accordingto Richard Sias of Washington StateUniversity. He also found that thispattern was stronger for stocks withhigh levels of institutional tradingand was particularly strong inDecember. According to Sias, theresults suggest window dressing byinstitutional investors and tax-lossselling contribute to stock returnmomentum. "Investors using amomentum strategy should considerfocusing on quarter-ending monthsand securities with high levels ofinstitutional trading."Sias, Richard, "Causes and Seasonality ofMomentum Profits". Financial AnalystsJournal, Vol. 63, No. 2, pp. 48-54,2007.

Younger Fund Managers Exacerbate Bubbles

INDIVIDUALS OUT-SPRINTED BY INSTITUTIONS

Three researchers used a modified ver-sion of the pattern recognition algo-rithm developed by Andrew Lo ofMIT to determine whether head-and-shoulders have predictive power forstock returns. Using data from theS&P500 and the Russell 2000 over theperiod 1990 to 1999 they found that,despite there being no support for itsuse as a stand alone trading strategy,there is strong evidence that the pat-tern has power to predict excessreturns. Risk-adjusted excess returns to

a trading strategy based on head-and-shoulders were 5 to 7 percent a year.The authors suggest that combiningthis strategy with a portfolio approachproduces a significant increase inexcess return for a fixed level of riskexposure.Savin, N. Eugene, Weller, Paul A., andZvingelis, Janis., "The Predictive Power of'Head-and-Shoulders' Price Patterns in theU.S. Stock Market". Journal of FinancialEconometrics, Vol. 5, No. 2, pp. 243-265,2007.

A paper in the Journal of BusinessFinance & Accounting looks at thereaction of intra-day trading volume toearnings announcements. According tothe study, institutions are most activein the immediate aftermath of anannouncement, with trading describedas "swift and aggressive". Individualinvestors on the other hand are slowto trade at the beginning but accumu-late heavy volume afterwards thateventually exceeds institutional trading

volume. The authors describe the reac-tion of individuals to earningsannouncements as slow at first, butthereafter aggressive, overconfidentand over-reactionary.Dey, Malay K. and adhakrishna, B., "WhoTrades Around Earnings Announcements?Evidence from Torq Data" (2006-05).Journal of Business Finance & Accounting,Vol. 34, Issue 1-2, pp. 269-291,January/March 2007


THE NEW STANDARD IN ALGORITHMIC TRADING

The FIX Protocol has becomethe de-facto messaging standardfor pre-trade and trade commu-

nication used to trade securities aroundthe world. Virtually every exchange,ECN, large fund manager and invest-ment bank communicates using thisstandard. Starting as a simple, mutuallydeveloped electronic message standardfor equity trades between Fidelity andSalomon Brothers in 1992, the standardwas then made available to the public,free for anyone to use. Since that begin-ning, it has greatly expanded and grownto include almost every type of tradedsecurity, including fixed income,

futures, options and foreign exchange.

TA: Why should traders and invest-ment managers be interested in thenew FIX algorithmic trading stan-dard?

RL: The most common algo ordertypes in use today are Volume WeightedAverage Price and Time WeightedAverage Price. These widely deployedalgorithmic order types are starting tobe made available to sophisticated retailinvestors. They are more or less stan-dard and have found good applicationwith anyone who needs to trade "thin"

stocks in greater than 100-500 sharequantities. If this was the end of thestory, there would be no need for analgo order standard from FIX, howev-er it's really just the tip of the iceberg.

There are also hundreds of otheralgorithmic order types currently in useat very large buy-side firms. You canget a feel for what they do just by read-ing their names such as: Wait andPounce, Participate, Iceberg, AutoReload, Dagger, Direct to Market,Dynamic Scaling, Get Me Done,IntelliShort, Relative Scaling, Sniper,Sonar, Volume Participation, etc. Astime goes on, the assortment of algo

Richard Labs is a member of theFIX Algorithmic Trading WorkingGroup, which has taken on the

task of extending the FIX standard toinclude advanced support for AlgorithmicTrading. On 14 March 2007 the workinggroup presented their proposal to the FIXGlobal Technical Committee to specify an'XML schema for algorithmic trading.'Even if you have nothing to do with theIT side of algorithmic orders, Richard'sexplanation of how the proposed stan-dard will work and the major issuesinvolved is essential reading for anyoneinvolved in, or thinking about,algorithmic trading.

order types proliferates, and the marketto use them extends far beyond the cur-rent, highly limited group of largestbuy-side entities.

The customer pays a bit more to usean algorithmic order type because it(hopefully) delivers more value back tothem versus hand working a group oforders, or managing that part of trad-ing process in-house. For algo builders,the large investment in R&D and exe-cution infrastructure (again hopefully)is more than recouped by the slightlyhigher commissions charged, earnedover time, and spread across a fairly sig-nificant user base. So, the economics ofalgo order types have already been wellestablished at the very top part of themarket.

The new algo order standard, whichis in the final steps of approval at FIX,will allow broker dealers to specifyalgorithm order types in an industrystandard XML format that is "con-sumed" by various order managementsystems. This means that as newer,more exotic algo order types prolifer-ate, the buy-side will be able to keep upwith all the latest algo offerings that arepumped out by the sell-side.

Each new algo has the potential ofintroducing new parameters that thebuy-side may select in order to create ahighly tailored order. Creating a stan-dard that allows algo suppliers to be ascreative as they like, while easing theburden on the buy-side to render neworder tickets on screens, with all thenew and constantly changing inputparameters, all without reprogrammingthe order management system, will real-ly bring some welcome relief to every-one involved in the current process. Weare trying to standardise in a way thatreduces the time and cost involved inthe development and deployment of analgo. We can eliminate the need for cus-tom code to be required for each newalgo order type and greatly reduce thequality assurance effort, risk and delayassociated with custom code being con-stantly introduced. Just as a standardbrowser can display any standard webpage, we want order management sys-

tems to be able to display and handleany new algo order types.

TA: From what you say there seemslittle doubt that an algo standardwill be welcome in the market, buthow do you actually intend to makeit work?

RL: I'll need a few minutes to explain,so bear with me. There are generallythree participants in an algo order:

Buy-side - that's the investor (or theinvestor's agent) that is making thetrades and bearing the riskSell-side - that's the Broker Dealer(BD) who is 'the middle man' pro-viding several things: (1) very highspeed, low latency links to manymarkets, (2) R&D and testing behindthe specific algorithms offered (3)sales, and (4) customer service.Unless the investor is very large andself clearing, or has a prime broker-age account, the BD also providesclearing and settlement services,margin loans, interest on credit bal-ances, etc. They also arrange to"vault" the securities and cash andkeep all that sorted out, issuemonthly statements and protect theassets from anything other than puremarket risk.Trade venue - that's where the matchbetween buy-side customers actuallyoccurs (where buyer meets seller).This can be an exchange (LSE,NYSE, AMEX, etc) or OTC, NAS-DAQ, Instinet, Bats, or any of thou-sands of execution venues aroundthe world.

And, (somewhat simplifying) there arebasically three types of securitiesorders:

Market order - Known quantity, trans-act immediately, get the best priceyou can, but move as fast as you can,do whatever it takes to get the full fill"immediately", sacrifice price forspeed of fill.Limit order - Good for a specific time

period, price is fixed, try your best toget a full fill at the fixed price or bet-ter, take partial fills if they meet thefixed price or better, close the wholething out when its totally filled or thetime period runs out.Algo order - A potentially much morecomplex combination of the abovetwo order types, often executed overa long period of time, perhaps work-ing many markets simultaneously,perhaps slicing up a huge order todisguise intention, do some "dancingaround", and ultimately getting thejob done.

In the US, and increasingly around theworld, virtually all trade venues acceptinbound market and limit orders, andreport fills in the FIX Protocol. The

entire protocol is in ASCII. As a result,the protocol is naturally quite compact.(It also can be compressed to anextraordinarily compact binary format,using an open source high performanceFIX compression technology calledFAST, but that's a whole additional dis-cussion).

In a traditional order an investor(buy-side) fills out a traditional limitorder ticket on his screen, hits enter,the order goes to the broker (sell-side),and it gets routed to the best tradevenue known to the broker at that par-ticular time, it comes back to the brokeras a FIX fill, and the broker reports thatback to the customer. The trade is

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2.

3.

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2.


→→

“LATENCY,NOT

BANDWIDTH,IS YOURKILLER.”

3.


done.In an algo order, things work a bit dif-

ferent, especially under the proposed inthe new algo standard. First the brokercooks up a very exciting new algo andspends a lot of R&D resources testingand perfecting it. That broker goes toFIX and picks up the XML schema(basically an outline form) to helpexpress all their new algo orders typesin a standard, easy to (machine) readway. They then follow that FIX schemaand render the algo specification in thatformat. An XML file is the result, andthat is then distributed to the buy-side.The buy-side takes that XML into theirorder management system (some savvyExcel users also take that XML rightinto Excel and VBA). The XML fileenables the new, complex order ticketfor the complex algo to be rendered onthe screen. There are many more checkboxes and drop down lists to fill out onan algo. They are not standard acrossthe various brokers that offer them andnew ones come out every few weeks.An algo order type is as complex orsimple as the broker dealer designed itto be. Since it is expressed in an indus-try standard XML format, it can be eas-ily translated into an order entry screen.Other than helping the OMS systemunderstand and validate the enteredparameters, that's really about the endof the XML usage.

Once a new algo order is understoodand represented on the buy-side's sys-tem its ready to be used. A trader bringsup the screen displaying the fresh newalgo order entry ticket, and fills it out.He then hits send. The order leaves hissystem in standard, traditional FIXASCII Tag=Value format, i.e. notXML. Once the XML is "consumed"by the buy-side order management sys-tem in learning about a new algo ordertype, it is no longer needed. Yes, thealgo orders that leave in FIX format areslightly larger than a standard market orlimit order, but that's because they mustcarry more parameter information.

The algo order arrives at the brokerdealer and is once again validated. (Isthis customer account, at this time, OK

to run this order? Are all the parame-ters valid and consistent with eachother?). Once accepted, the brokerthen assumes responsibility for the runtime execution of the algo. In general,that execution involves watchinginbound market data (last sale, quantity,bids, offers, news, etc.) and executing,you guessed it, simple market and limitorders at the appropriate times to vari-ous trading venues in standard FIXProtocol format.

Large buy-side customers can brewtheir own algos in house and sendorders out directly to trading venuesskipping brokers altogether. They usethe FIX standard to communicate andthe Direct Market Access ports at thetrading venues (making interfacearrangements at each one and payingthe required fees). The new FIX stan-

dard for algo orders allows these buy-side customers to organize their think-ing as to how these "in house" algoswill be displayed to their traders rightalong side various exciting externallyproduced offerings.

TA: Does a trader need a hugeamount of bandwidth to implementalgo orders?

RL: Not really, bandwidth is a fairlysimple hurdle to overcome in mostinstances. Many investors don't realizethat market data flow (including last

sale, size, bid, offer, size, contra partyfor each bid/offer, etc.) is a one wayflow OUT from trading venues, andthat it is almost completely separatefrom pretrade/trade message flow,which is bidirectional, and almost uni-versally in FIX format. The real speedchallenge is in taking IN a ton of mar-ket data from numerous trading venues,and making a decision exactly what andwhere to trade. The market data INpipes need to be much larger that theactual pretrade/trade order IN/OUTpipes.

Now, let's get down to some numbers.A trade venue can accept inbound FIXProtocol trades (uncompressed) andreport fills at a rate of about 450 persecond on a 1.5mb connection. Thenumber of entities that need higherthan 450 trades per second are very fewin number, and they just use a higherspeed connection and/or compress theFIX messages using the free, opensource FAST protocol.

Latency is however far more impor-tant than bandwidth.

TA: Why is latency so important?

RL: Again, bear with me because thiswill take a bit to explain. Let's say yourent space and collocate your serverwithin 50 feet of the bank of tradingvenue application servers and hook indirectly with a local gigabit ethernetconnection, so bandwidth and latencyare just not issues. Further, you targetdoing 2000 arbitrage trades in one sec-ond, or, one trade per ½ millisecond.Chances are you are going to want toarbitrage those trades, or at least havemarket data flowing in to your decisionmaking point, from at least one addi-tional trading venue, to be sure you areat least in sync with one other tradingmarket.

You quickly find that latency, notbandwidth, is your killer.

The speed of all electromagnetic radi-ation, including visible light, in a vacu-um is a constant (c) exactly 299,792,458meters per second. Knock off about30% for speed reduction in a glass

“EVERY MILLISECOND

YOU INTEND TOSHAVE OFF,

COSTS MORE AND MORE.”

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fiber and you have about 130 miles permillisecond. This is a theoretical mini-mum, you must also knock off some-thing for (1) real fiber runs that are notstraight lines, (2) any delays introducedby routers and regenerators (3) pulsewidening as some energy flows downthe dead center of the fiber, while otherenergy bounces off the outside walls,making that bounced route consider-ably longer. So, all the energy doesn'tarrive at precisely the same time makingreliable detection of pulse/no pulsetime consuming. Even without anydeduction for penalties 1-3 above, theNY to LA minimum travel time is 19milliseconds and NY to London is 27milliseconds, regardless of how muchdedicated bandwidth you purchase.

On the public Internet I can pingLondon from my location 3451 milesaway, with a round trip time of 90 mil-liseconds. Half of that for one way is45ms and the theoretical limit is calcu-lated to be 26 milliseconds. The maxi-mum "advantage" a huge institutionalplayer could get over a retail investorworking at the same distance is about19 milliseconds. But remember thatsame institutional player would still beat a full 26-millisecond disadvantage toa local competitor. So, where you locatethe actual decision making point onyour network becomes critical. If youcan build intelligence right into a collo-cated server that runs locally (i.e. analgo) and just message that with a high-er level instruction from elsewhere, youpick up all the advantages of zero laten-cy. However, to the extent that you rely

on massive amounts of market data,coming in from all over the world toone central decision point you sufferthree times: (1) the latency getting themarket data in to the central decisionpoint (2) CPU cycles to process moreand more voluminous high speed mar-ket data, and, (3) getting the orders outto the proper locations for executionvs. high speed local competitors.Ultimately, a complex centralized /decentralized strategy works out untilthe "locals" catch on to what you aredoing and use latency against you. So,the optimum strategy, and how muchto "centralize" is a constantly shiftingsituation.

TA: How about a few parting tipsfor those who might be contemplat-ing participation in the high speedtrading game?

RL: OK, here are a few lessons:

Never try to play up close to the netstyle tennis from a highly remotelocation.Yes, latency counts, and dedicatedpipes help, but the average Joe onthe internet already has a fairly lowlatency connection. The distance iswhat really makes the difference.Yes, you can collocate servers, andyes you can lease lower latency fiberroutes around the globe, but no, itisn't cheap. Every millisecond youintend to shave off costs more andmore.You are up against the "best and the

brightest" and extremely wellfinanced traders in the sub secondgame (or sub 100 millisecond game,sub 10 millisecond game, sub 1 mil-lisecond game, etc.). Especially in theopening one second. Some playerstake their time leisurely making cal-culations at night when the market isclosed, and then cue up the algos tofire off during the first one second,all from local, co-located servers.Get in, get out, trading is done andthere is no more exposure after thatfirst second. That's a pretty tightgame indeed! Lastly, consider letting someone elsedo the high-speed dirty work foryou. Let them give you a FIXStandard Algo that executes on a co-located server. Render that fresh newalgo right up automatically in yourorder management system, send outan order and let the other end grindaway the actual trades for you. Don'tget in the sub second game unlessyou really need to be there. Sit back,relax, and delegate the high-speedstuff to a good, standardized algo-rithm.

For further information about FIXProtocol and the AlgorithmicTrading Working Group visit fixpro-tocol.org and fixprotocol.org/work-ing_groups/algowg/documents.Richard Labs also runs a wiki sitethat provides free documentation tocoders of open source Investmentand Trading Systems available atITSdoc.org

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4.

“…WE WANT ORDER MANAGEMENT SYSTEMS TO BE ABLE TO DISPLAY AND

HANDLE ANY NEW ALGO ORDER TYPES.”

5.


PEGGING PROFITS WITH FXALGORITHMS by Sean Gilman

Pegged ordersPegged orders are unique in that theorder is managed by an algorithmictrading processor that acts as an inter-mediary between the trader and themarket. Because pegging is a passivestrategy, this type of order only worksin anonymous trading venues whereparticipants can match orders withother participants.

A pegged order is an order that is"pegged" to a certain identifiable mar-ket rate, typically the bid or offer.Available on the more sophisticatedplatforms, Pegged Orders allow a trad-er to enter an order that will follow thetop of book. Order pegging strategiesare ideal tools for buying or selling largeamounts of currencies with minimalmarket impact and cost. A peggedorder is simply a good-until-cancelledlimit order positioned near the top ofbook. As the market moves, the peggedorder is automatically adjusted relativeto the top of book. Whether an order

will be immediately marketabledepends on what kind of peg is utilizedand if a peg offset or discretion is used.Pegged orders can be entered as limit,iceberg or hidden order types.

Typically, a pegged order will be com-bined with an iceberg order (also calleda reserve order) so that the entire sizeof the real order is not shown to themarket in order to avoid disclosinginterest and potentially creating marketimpact. There are many variations onpegged orders that provide additionalflexibility. For example, Peg Offsetsallows for the peg to be above or belowthe market, and discretion allows forthe order to reach across the bid/offerif the market is sufficiently tight.

Pegged orders have several distinctadvantages over order slicing algo-rithms. Because a pegged order isalways passive it never "pays" the bidoffer spread. This can make a signifi-cant difference in the execution costs.Also, because pegged orders stay pas-

sive they are generally only transactedupon by non-market makers. This pro-vides a benefit in that the counterpartyis much less likely to hedge the trade,potentially creating market impact.

Some ECNs provide pegged ordersas an integral feature while on otherECNs it is necessary to emulate apegged order using an algorithmic trad-ing tool. When available, integratedpegging is vastly superior because iteliminates latency between the peggingstrategy and the matching engine whichwill improve execution efficiency.

Examples of Pegged Orders:

1. Pegged Order - OffsetsThe offset value is added or subtractedto the specified market rate to establishthe rate at which the pegged order issubmitted to the market. For example,EUR/USD is 1.2050 - 1.2052 and a buyorder is pegged to the bid with an off-set of +1. The peg is submitted to

As institutional traders move toward automating theexecution of large order blocks, ECNs are respond-ing with new order types that provide algorithmiccapabilities, including first generation order slicersthat provide an approximation of TWAP (TimeWeighted Average Price) execution. Order slicers aresimple and provide predictable execution time-frames but do not take advantage of buy side liquid-ity. Customers are demanding more, and ECNs areresponding with complex algorithmic order typesthat improve execution quality and minimize marketimpact.

→→

the market at 1.2051 (Bid + (Offset)) or1.2050 + 1.

2. Pegged Order - DiscretionThis feature allows a trader to takeadvantage of a temporary narrowing ofthe spread by allowing the peggedorder to aggress the market up to thespecified discretion amount. For exam-ple, EUR/NOK is at 8.1650 - 8.1660.A trader places a buy order pegged tothe bid, with discretion of 5. The trad-er now has a buy order at 8.1650 (bid).If at any point the spread narrows to 5Pips or less, the pegged will be adjusted5 Pips up to capture this liquidity. If themarket became 8.1650 - 8.1655, theorder will automatically change to

8.1655 and capture as much liquidity aspossible. Once the spread widens togreater than 5 Pips, the peg will revertback to the bid rate.

3. Pegged Order - At-OOr-BBetterThis value sets a floor (sells) or ceiling(buys) on the peg rate. For example,EUR/USD is 1.2050 - 1.2052 and a buypeg order pegged to the bid with an"At-Or-Better" rate of 1.2060 isentered. This sets a ceiling rate of1.2060 on this pegged order. As the bidrises, the pegged order will continue tofollow the bid up to and including therate of 1.2060. However, if the bidgoes higher this peg will remain as alimit order at 1.2060. If the bid declines

to below 1.2060, the peg will follow thebid down again.

4. Pegged order - protected pegThis value protects a trader's orderfrom representing too much of thetotal volume at a given rate. It protectsa trader from being "spoofed" intoentering an order that betters the mar-ket only to be hit by an opposing orderfrom the spoofing trader. Your volumeis determined by the total amount ofthe trade, or by the iceberg showamount, with hidden orders being non-applicable to peg protection. By speci-fying protection and setting a percent-age, your order will be adjusted to a ratethat satisfies your constraints, or it willbe temporarily withdrawn from themarket. For example, if you enter a pegorder to buy 10m pegged to the bid,with protection of 25% enabled, yourorder will only be pegged to the top ofbook bid if the total volume, inclusiveof your order, is at least 40 million. Ifthe top of book bid doesn't meet theseconstraints, your order will fall back tothe next rate that does. If no rates havesufficient liquidity available, your orderis withdrawn until a bid with sufficientadditional liquidity is available.

While pegged order strategies areprobably the most complicated class ofexecution models, they provide greatbenefits in terms of reduced marketimpact and transaction costs. In fact,the only real downside of pegged mod-els is that the time required to executeis difficult to predict. While this mayseem like a large disadvantage, in prac-tice it is easily mitigated through tuning.In most cases, pegged orders can beconfigured to execute as fast as orderslicing by tuning the peg offset and dis-cretion to the particular currency pairand time zone. Given that pegged exe-cution is always highly automated, theadditional complexity is easily managedand is well worth the effort in improv-ing the reduction of execution costs.

Sean Gilman is Chief TechnologyOfficer at Currenex in New York.

Figure 1.


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