— volume-sensitive trade sizing —
Given the thin profit margin, the strategy needs to trade large volumes. However, there are 2 upper limits on the trade size. The engine computes both limits and adopt the lower.
1) First limit is market impact. The trading engine has a parameter known as participation rate. It’s set to a value below 1%. If on a thin day ES total daily volume is, say, 4320 contracts, then the engine won’t trade more than 1% of that, otherwise the ensuing market impact would be too large — we risk getting filled at a worse price than planned.
Using the participation rate, the strategy determines how many futures contracts to sell. If that quantity turns out to be 0 then the engine won’t enter the market.
2) The other upper limit is post-trade market risk.
Prior to market entry, if our cash balance is worth, say, 44 futures contracts, then the strategy would trade up to 10x. If we ignore this limit and recklessly trade a gigantic quantity (like 700 x 44 contracts), then over the holding period a ES price surge, magnified by our large position, could wipe out the entire portfolio i.e. unrealized loss exceeding the cash balance. (Note even though our equal-dollar ETF position should in theory hedge our futures position and insulate us from broad market move, the two prices could go out of sync by a significant margin for a short period.)
(In fact, when we ignore this limit, our StopLoss would get hit.)
There’s no separate limit for the ETF trade size. The ETF trade size is always equal to the futures trade size in dollars. For example, if I short 5 futures contracts worth $900 x 5, then I would long 50 ETF shares worth $90 x 50. (Note the ETF unit price is 10% of the Futures contract.)
Using equal dollar value on both the long and short legs provides a nearly perfect hedge against broad market movement. When the overall market moves down (or up), one leg loses $x and the other leg gains $y which is very close to $x. However, as stated earlier, “very close to” doesn’t mean $x = $y, and the difference (x-y) would be magnified by our position size. It could be a very large unrealized loss and could force close the entire account.
— leverage and borrowing cost —
Graph above shows the interest paid on each trade. We only borrow money when we enter the market and immediate stop the borrowing when we exit the market. We basically roll the loan over night. If we hold a position for 9 days, we would pay 9 day’s of interest, no more no less.
The daily interest rate is based on the US Fed Fund rate. We don’t assume to be a top-rated bank, so we pay a 100 bps premium over the FF rate.
Without borrowing, futures contract margin requirement is hard. We start with only $1000 and need to leverage 5 times by borrowing $4000. In a sense, borrowing is needed in the early phase when our initial capital is small. It’s possible to make do without the loan when our realized profits boost our cash position to beyond $100,000. However, we actually implemented an yearly reset whereby all realized profits are taken out of the trading account, so at start of each year capital is reset to $1000. We always need to borrow $4000.
— dividend collection —
Graph above shows the dividends collected over the years.
The ETF actually generates quarterly dividends. It can be profitable to trade for dividend capture, but it requires market timing and luck. In our strategy, we collect dividend by chance not by design. Benefit is lower risk and extra return, depending how we look at it.
If on a dividend date, we happen to hold the ETF, we would recieve the dividend as a ‘bonus’, which boosts our investment return. Nevertheless we don’t rely on such bonus dividends to enter/exit the market. In other words, the strategy is designed to be robust even with zero dividend each time. A strategy that relies on dividend capture is sensitive and could potentially be hit by unexpected low dividend or adverse price movement, which is a potential risk factor. Our strategy sidesteps those tricky questions because we treat any dividend received as a bonus.
Given the thin margin in our strategy, the bonus dividend income is small but helpful.
— exchange fee (including commission) —
Graph above shows the fees incurred over the years. Given the thin margin in our strategy and the relatively large trade size, exchange fee is rather significant. When commission rate doubles, the profit drops by at least a third.
Higher fees also lead to more stop-loss triggers. Each trigger leads to a major realized loss.
It’s not easy to find exact commission rate. I assume the 2 instruments are very liquid and high-volume, so commission should be lower.
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