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Cheese or Wine? Your Choice

Many traders coming into the Futures markets often ask if there is a minimum number of contracts that should trade each day before a Futures market should be traded for liquidity reasons.  This question usually comes from Equities traders because they have been taught to look for good daily volume to provide liquidity.  For example, a stock that has at least 1 million shares or more traded daily is said to have good liquidity.  Once a trader starts to trade stocks with less volume they run into problems with trade execution due to liquidity problems.

The problem with using that type of formula to determine a good Futures market to trade is that each Commodity has different types of participants and trading styles.  The Stock Index Futures typically have a large speculator base as well as commercial (hedgers).  This would increase the daily volume tremendously.  A market like Live Cattle on the other hand has fewer short term (day traders) speculators than commercial traders (long term hedgers) typically.  Comparing the average daily volume of the mini S&P (ES) about 2 million contracts to Live Cattle about 65K contracts does not do much to say if a market is liquid or not.

Some Commodity markets are better for day trading than others.  Until the Live Cattle market sold off, partially due to the health issues associated with pink slime, the average daily range was only about $400 from high to low (currently it is much higher).  If a day trader came into this market using a $100 stop and a $300 profit target (1:3 risk/reward) they would have to consistently buy the daily low and sell the daily high to make this work.  If they entered the trade in the middle of the daily range there was not much profit margin left on a normal trading day.  Just imagine how difficult it would be to pick the high and low of a market every day.

The ES on the other hand has an average daily range of about $1,000 from low to high.  This larger range would allow traders to enter the market in multiple places during the day and still have a good risk/reward ratio.  This is one of the reasons you will find more day traders in the ES than the Live Cattle market.

The question becomes: “How do we know if a market is liquid enough to trade?”

My choice is to identify the market you are interested in trading and then determining if you are going to have good cheese or perhaps a great wine.  We have all seen chunks of Swiss Cheese at your local deli.  Have you ever noticed all the holes in it?  How about a good Cabernet wine, after it is poured and had a chance to breathe a little.  A good Cabernet will be full bodied with a consistent color from top to bottom of the glass. We can look for the same qualities on a Futures chart to tell whether we should be trading a particular Futures contract.

First we must determine the Regular Trading Hours (RTH) session times.  This is usually during the day when there may or may not be a trading pit open.  The RTH will be the most liquid (high volume) time of the entire session.  When looking for the RTH a trader should visit the Exchange website that the Futures contract trades on.  There they will find a contract specification sheet that will list these trading hours and all other related information about this Commodity.

Once we have the RTH information we can begin examining some charts for cheese or wine.  Figure 1 will demonstrate the ES contract (highest volume contract in the world) on an intra-day chart of 1 minute duration.

(Figure 1)

By using a 1 minute chart we can see the detail of the chart more clearly.  The first thing you look for is after a 1 minute candle closes, the open of the next candle should be at the same price or just 1 tick (up or down) from the close of the previous candle.  Figure 1 demonstrates that on almost every candle, making this a good candidate to trade.  Notice how each candle has good body structure.  Each having wicks and bodies that could be used to identify levels of potential market turning points on larger timeframes.  To me, Figure 1 looks like  a good full-bodied Cabernet wine that I would enjoy experiencing.

Now let’s look at a market that might not be such a good experience.  Figure 2 will illustrate a market that is lacking the better qualities of Figure 1.

(Figure 2)

Figure 2 is a 1 minute chart of the July Platinum contract.  Immediately we see that between each of our 1 minute candles there are gaps.  This means there is not much liquidity between the bid and ask spread.  If a trader were to enter a Market or Stop Order they will probably have a lot of slippage (bad price fills).  A tick value in Platinum is $5.00.  The minimum tick for Platinum is .10, but as you can see it trades on a larger tick size than that the majority of time.  Does this mean you cannot trade Platinum?  Absolutely not!  To me it just says that Platinum would be a better swing trading market than a day trade market.

Some traders might think these little gaps don’t mean much.  As we look at this Platinum chart there was really no fear in the market and we still had these gaps.  Just imagine if several Platinum mines were to go on strike.  What do you think this chart would look like then?  These are the things we must always be aware of when it comes to managing our risk.  Will there be somebody on the other side of my trade when I want to get out?  Sure there will ultimately be somebody to step up and take you out of your trade, but I can assure you your loss will be much larger than you had expected in an illiquid market.

When I look at Figure 2 I see Swiss cheese on the chart with all the holes (gaps).  While there is nothing wrong with a good Swiss cheese I would rather have it with my wine than to see it on my charts.

The next time you want to know if a Futures contract is tradable just open your 1 minute chart and look at the RTH’s and see if it looks like a good wine (full-bodied).  If it does, then you have a candidate to trade.  If it looks more like Swiss cheese (gaps) then perhaps you should skip this appetizer (market).

“Win without boasting, lose without excuses.” Albert Payson Terhune

– Don Dawson

DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

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