The butterfly effect in e-mini trading systems

E-mini futures, commonly referred to as simply e-minis, are among most popular trading vehicles out there. Their popularity is particularly high among day traders, especially those on tighter budgets.

Because of their relatively low intraday margins, sometimes as low as $300-500 per contract, many a retail trader has taken his chances to make money day trading these instruments.

One of the best ways to approach trading e-minis is through mechanical trading systems. A system like that consists of a set of objective rules that determine how to open a position in the emini market and then how to close it.

It is possible to make money trading e-minis in a purely mechanical fashion. This author has designed several successful and relatively simple, robust emini systems so this opinion is grounded in his considerable experience.

Financial markets, futures markets included, are said to be nonlinear. This is, obviously, also true about e-mini markets. It is because of this nonlinearity that the markets are largely unpredictable. One of the classic hallmarks of nonlinear dynamical systems is their chaotic behavior, which can be described by the following analogy.

Every soccer game starts pretty much in the same way: one of the players kicks the ball from the center of the pitch to another player on his team who is nearby. There are not so many possible variations on how this can happen. Yet despite this, despite the relatively limited number of distinct ways of starting the game, there is virtually an unlimited number of ways the first goal is scored, which is, certainly, one of the reasons why soccer is such a hugely popular sport. Sports that produce predictable events are no fun to watch for they tend to be rather boring.

What we just said can also be put in mathematical parlance: in a nonlinear system, small variations of initial conditions (in this case, when the game starts) tend to produce large variations in the system evolution (in how the goals are scored, in our example). This kind of behavior is referred to as chaotic or exhibiting chaotic characteristics.

The chaotic behavior is often illustrated by the butterfly effect. Imagine that a butterfly somewhere in Texas flips its wings. However small this effect is, it does cause some air disturbance and since the weather system is highly nonlinear, even a small disturbance like that can, in principle, lead to a desert storm in the Middle East. Again, a tiny change in initial conditions (air disturbance) can cause dramatic changes in the weather pattern in another place on Earth.

What can all this have possibly in common with e-mini trading systems? The answer is: a lot.

Imagine that you are trading the S&P 500 e-mini futures market, often referred to as ES, which stands for its ticker symbol. You put on your position at 1363.75. At first, the market moves your way. At some point, you begin to trail your position with a stop-loss that it purposely wide so that you don't get shaken off of your position too easily. And yet the stop-loss gets triggered, for a loss of 1 pt. Soon after that the market takes off again and it closes for the day 15 pts from where you entered it. You check your entry and you see that had it been different by 1 tick only (no matter which way), you would have made 15 pts instead of losing 1 pt. Such a small difference of 1 tick only, the smallest you can have in this market, can cause the life or death difference in your bottom line.

Impossible? Too contrived? The reality is that something like that did happen to this author in actual trading. Yes, needless to say, things like that can be extremely annoying, no doubt about it. Unfortunately, there is precious little that we can do about it because this kind of behavior in trading systems is rather normal, though it does not have to be frequent. It is simply a reflection of the nonlinear nature of the markets such systems are applied to. It's because these markets are chaotic. And an annoying effect we mentioned that is nothing more than yet another example of the butterfly effect. The butterfly effect in emini systems.