Stay Away from Crowded Markets

Asad Dossani
I recently backtested a particular trading algorithm on two related but different markets. The first market was Crude Oil trading in US Dollars. The second market was Crude Oil traded in Indian Rupees. My initial guess was that the performance should be very similar across both markets.

But that turned not to be the case at all. The algorithm was significantly more profitable for the rupee market as compared with the dollar market. Keep in mind that these markets are not the same. Due to exchange rate fluctuations, the daily movements across each market are different.

I tried to think of a good explanation for why this occurred. One major difference between the US and Indian crude oil markets is trading volume. Trading volumes in the US market are much higher. What does this have to do with it?

All traders have the same objective. They come to the market to make money. As simple as that. They may have different methods, different strategies, different risk tolerance, and so on. But their objective is always to make money.

Whenever you trade, you are competing against other traders. Derivatives trading is effectively a zero sum game. One man's loss is another man's gain. This means that not all traders will make money. Traders can still make money as a whole since they are not the only participants in a market.

But in general, the more traders there are in a market, the harder it is to make money. And the more sophisticated those traders are, the harder it is to make money from them.

Now this is just at theory. And I'm interested in testing how true this is. As part of my research, I apply the same trading algorithms to various different markets. The objective is to understand how the performance of the same algorithm differs across markets. And whether there is any pattern to it.

I tested two algorithms, a simple one and a complex one. And I tested across different markets, ranging from low volume to high volume markets. Here is what I found:
  1. Simple algorithms work in low volume markets, but they do not work in high volume markets.
  2. Complex algorithms work in both types of markets, but are more profitable in low volume markets.
The results are in line with what we'd expect. To make money in a high volume market, you need a more sophisticated algorithm. And on the whole, it is easier to make money in a low volume market.

This does not mean we should avoid trading in high volume markets. But it does mean that we need a sophisticated trading strategy to make money in high volume markets.

These results also provide an excellent opportunity to tap into low volume markets. These markets that are less crowded have the best trading opportunities.

There is a one caveat here. If market volume is too low, then we can't trade at all. When market volume is very low, then liquidity is low, and bid ask spreads are high. These high spreads would erode any profits we could make.

In practice, it means we should look for trading opportunities in low to medium volume markets. The markets should have enough volume that it is liquid, but still not be too crowded.

What type of markets have you found it easiest to make money in? Share your views in the Club or share your comments here.

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3 Responses to "Stay Away from Crowded Markets"
Subramanian Ram
05 Dec, 2014
My honest view is that it is never easy to make money in any type of market.A little bit of luck will always help. As you have very rightly pointed out in your previous articles on trading human emotions clouds rational judgement & it is very difficult to be detached when a trading position moves adversly. How would you rate your current algorithm ? Is it simple or complex ? How about the voulmes in MCX ? Is it low or high ? Like 
05 Dec, 2014
Very well explained with sound reasoning.Like 
Gautam Rao
05 Dec, 2014
I am not sure I understand this example. My observation is that the price movements on Indian Markets of global commodities like Crude, NG mirror exactly the movements of the corresponding commodities in the US markets like NYMEX. In such a case, a pattern based algorithm should provide similar results in both the markets. Can you please help me understand?Like 
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