A question all brokers want an answer to and a topic which has been messed around with for years, generally by senior management panicking and not understanding the business model they are in. A sideways trading market is the nature of the beast but how do you react to it?
Market making and particularly retail market making where a large portion, if not all, trade flow is internalised requires volatility, flow, direction and duration to be profitable. If you have a sideways trending market with no break outs you are stuck in no man’s land, which can feel never ending sometimes.
Dealing desks should be proactive in preparation for volatility, the better ones are aware of the need to monitor their risk assessment and abatement strategies and refine them as required. They may like to use VAR scenario planners and “what if” models as part of their market due diligence. They will have P&L cuts and lock ins. Intraday and weekend exposure limits, but nothing really gets them prepared for the monotonous sideways market.
When situations like this present themselves, many desks will buckle under the pressure to try and “trade” the ranges, therefore taking proprietary positions in the market to try and shore up the P&L drain. This rarely works out well. Without question you will always have the wrong position exactly when the breakout happens. The loss on the “hedge” position destroying any profits on your client positions and compounded by whatever profit share agreement you have with your partners, its horrible situation to be in.
Follow your risk strategy look to potentially reduce risk exposure to the market but don’t ever try and trade yourself out of a sideways market.
Believe it or not when a broker internalises a vast amount of their flow and clients are in a positive position, it is a good thing. You require clients to make money, to participate to get a feel for the market because 8 times out of 10 they will become too confident and over leverage themselves, double up or stay in a position to long.
Trading the client rather than the market has and always will be the methodology behind a retail market making operation. Testimony to this very fact is the piece of trader success information posted along the top of many websites. The general standard being 70%-80% of retail investor accounts lose money.
So when you are having sleepless nights over range bound markets when P&L is up and down providing no consistent returns when the board start trying to interfere and play “super trader” please refer to the trader success figures, stick to your risk strategy, have good dialogue with the risk committee, implement risk exposure reductions if needs be and adhere to P&L cuts as defined by the risk policy but please don’t ever try and trade the market.
To quote a wise ex colleague of mine “Keep the faith.”
