In the past three months, I’ve received a lot of emails which all asked the same question. “Why isn’t the liquidity returning to treasuries?” Most people thought the change had something to do with the summer months usually being a bit slower than the rest of the year but this is not the case.
Markets change. I say this in all my material. I place emphasis upon it during my webinars. I talk about it till I’m blue in the face. But one cannot fully appreciate this statement until one has seen the change with his or her own eyes.
The changes we are seeing are due to a fundamental shift in the underlying forces, those forces being: changes in economic conditions around the globe, trade talks, Brexit, a possible impeachment of the president, the upcoming 2020 elections, funds shifting capital from stocks to cash, etc. Markets go sideways and/or trend in one direction when the majority of traders and investors are all thinking the same thing and the future is fairly easy to predict. When the future is no longer easy to predict and opinions start to differ, things can get weird. And when fund managers are more interested in protecting assets rather than making profits, they start reducing their exposure. This translates to a reduction in trading activity from heavy hitters which translates to less liquidity and thinner markets overall.
On average, during the last few years, the treasury markets have been quite thick. When things were slow, it was not uncommon to see 30,000 contracts trade between two prices in the 10-year with no push to either side. Now, during faster and more volatile periods, we are sometimes seeing the 10-year move 5+ ticks on just a few thousand contracts and the bonds moving 7+ ticks on just a few hundred. The average daily range has increased dramatically. The liquidity has decreased which, in turn, has caused the volatility to increase. This happens. Markets cycle. It’s not a summer thing.
This is similar to what I saw when I first started trading treasuries. It wasn’t exactly like this but the volatility was close to what we are seeing now. It is not new to me but it is very new to most of my students.
Let’s say you’ve been trying to identify the occasional high probability trade here and there, risking a tick or two while attempting to make three or four in the 10-year as 50,000 contracts trade over four prices. Maybe you spot a few trades a day and on some days, no trades at all because the action is so slow. You’re grinding but doing alright because you trade a little size. This is much different than firing multiple trades a day in a high volatility environment while watching sharp snaps and reversals and runs of 20 ticks in one direction. Now you’re noticing that the 10-year may move 8 ticks on only 10,000 contracts. You’re noticing similar behavior in the ES and gold and most other markets.
This is what you need to know: the same concepts apply but you have to consider the averages and take that into account. As some say in parts of Asia, “Same same but different”.
You’re still trying to anticipate possible momentum areas where stops may be located and the domino effect may happen. You’re still watching for higher volume areas which may stop the momentum. You’re still looking at the macro picture in an attempt to determine what kind of day it may be. You’re still looking to note when the action is “good” or “bad”. But now you have to factor in the increased volatility and lighter liquidity. Waiting for the optimum spot is still key but you need to know that you might not be able to identify the perfect, exact price. The optimal spot may be an area of three or four prices and you may have to simply step up and take the shot somewhere in that area without getting solid confirmation at one particular price. Therefore, a bit more risk is needed from a tick perspective but the flip side is you are getting paid more when your call is correct. A reduction in your trading size is encouraged. If you’ve been trading a 10 lot, maybe knock it down to a 5 lot or even a 3 lot. These days, you (usually) cannot risk 1 tick on a 20 lot while attempting to scalp 2 ticks if and when 10,000 contracts move the market in your direction. That’s not the play right now. It’s not possible given the conditions.
The real point is…don’t panic. And don’t think things are suddenly going to back to the way they were because that’s probably not happening. The markets may stay like this for the next two years. Or maybe the liquidity will increase again in three or four months. There’s no way to know but changes like this are normal in the world of trading. Don’t freeze and throw your hands up in disgust and tell yourself it’s stupid and impossible to trade this action. That gets you nowhere. You just have to accept it as a reality and not fight the change. Adaptation is crucial in this business. Don’t make random trades just to trade but also don’t view it as a complete negative. Watch, wait, learn. Go with the flow, so to speak. The fact that it’s possible to catch big runs more frequently is actually a good thing.
While it is true that highly erratic movement is not typically conducive to consistent profitability, some kind of volatility is needed to make money. There has to be movement. We’re seeing a lot of it now so do your best to take advantage of the situation.