Mechanical Trading Systems: Pairing Trader Psychology with Technical Analysis

LIQUIDITY AND VOLATILITY

Although the benefits of diversification among various asset classes are indisputable (as illustrated by the tables in Chapter 3), when we shift our time frames from long or intermediate term to short term, the trading of most assets becomes impractical. There are two basic reasons behind the failure of various assets in short-term systems trading: illiquidity and lack of volatility.

Illiquidity in the context of short-term systems trading means that the total net profits generated by a system are insufficient to compensate for the wide intraday slippage (or bid/ask spreads) plus commissions of a particular trading vehicle. Because the average per-trade profit for a day trading system will necessarily be significantly smaller than trades held for one to six months, the deduction of $100 for slippage and commissions often turns a successful long-term methodology into a losing short-term strategy. Consequently most trading instruments are not liquid enough to compensate for the loss of a typical bid/ask spread plus commissions. As a result, unless traders are market makers or own a seat on the exchange floor, intraday bid/ask spreads and commissions will automatically disqualify the vast majority of assets from implementation as successful short-term trading systems.

Inexorably tied to the concept of a lower net profit per trade is the prohibition against assets that lack superior intraday volatility. Although many vehicles provide traders with an adequate ...