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Apr 29

Beating The Machines – How to Win in Spite of HFT

I know that previously I haven’t shown much love toward whingers, but today I’m feeling unusually sympathetic.

Not sure why; you should definitely make the most of it while it lasts. ;)

Behind every whinger some whingers is actually a deeply frustrated trader who is at the end of their tether; and it’s those desperate whingers that I’m reaching out to today.

So, High Frequency Trading.

It seems the machines are ruining everyone’s fun. (Well, everyone else’s fun – personally, I’m good thanks.)

Barry Ritholtz did a piece yesterday with loads of links to various articles on HFT, with the take-home point being that HFT accounts for 84% of all stock trades.  This, by anyone’s book is a huge proportion.  But the big question is –  for a trader, does it actually matter?  

In this Zero Hedge article, Paul Wilmott outlines some of the negative effects HFT has had and can have in our markets.

Thus the problem with the sudden popularity of high-frequency trading is that it may increasingly destabilize the market.

This is possible, but tell me there is no opportunity for traders in that!

From the same article –

“…high-frequency algorithm trading will distort the underlying markets and perhaps the economy. It has been said that the October 1987 stock market crash was caused in part by something called dynamic portfolio insurance, another approach based on algorithms.”

I don’t know if the ’87 crash was caused by algo’s, but if it was does it make any difference?

Bubbles and crashes have been happening forever – look at the Dutch Tulip crash in the 1600’s.  I’m pretty sure they didn’t have HFT back then, but what they did have was a lot of people buying tulips, who then stopped.

Essentially, it’s the same thing with HFT.  A lot of people, or a lot of machines all doing the same thing at the same time has exactly the same effect. After a bubble comes a crash, and it’s always been that way.

According to Washington’s Blog, HFT gain an advantage by getting a sneaky peek at real orders in the market, and then use that information to profit.  So, if the market crashes it was always going to anyway.

Take-away Point  - The implication for traders here is actually positive .  If the market was going to crash anyway, all the HFT selling will make the crash a crazy good one to profit from.

“VOLATILITY WILL INCREASE ENORMOUSLY AT TIMES FOR NO ECONOMIC REASON

Traders should be used to this.  They know that market does not equal the economy.  People who try to predict the market by looking at the economy fail because they are two entirely different things.

Excess volatility can be frightening, but it holds enormous opportunity for traders who have the ability to turn on a dime and take what the market gives them.

Take-away Point - If our markets are going to be characterised by occasional huge increases in volatility, it makes sense to adapt your approach.  Make a plan so you’re ready to hit the ground running when volatility spikes.  And do you know what?  Sitting out is a valid plan.

At least HFT don't have guns.

Joseph Saluzzi was quoted on Washington’s Blog regarding HFT –

“The program traders make money from making trades, regardless of whether stocks go up or down.” (Italics theirs!)

Is it just me, or is this really funny?  Whoops, sorry – my sympathy disappeared for a moment there.

It’s just that I make money in both bull and bear markets and no-one has ever written an article about me making money in a down market.

Traders should be well acquainted with strategies to profit from bear markets, and if they’re not – well, they’re selling themselves short :)

“The program traders claim that they are providing liquidity for the markets. But they aren’t. They’re simply providing volume (remember, 70% of the volume in the stock markets are from computer program trading). This distorts basic information about the markets, and confuses real investors’ view of what is going on.”

I know most traders/investors use volume spikes as part of a trigger for entry, so what can we do?

Seeing as HFT are machines and not prone to taking holidays or getting sick, I’m going to assume HFT are consistently making up 70% of volume like Saluzzi suggests.

In which case there is actually nothing confusing about it at all, is there.  What would really make things confusing is if HFT randomly took the day off without telling anyone.

But if for whatever reason you’re convinced it matters, you could always exclude volume from your analysis – after all if it’s affecting your profitability and not adding to your strategy like it used to, it’s dead wood and needs to be cut.

This is from another Washington’s Blog post

“(HFT) is where all the money is getting made,” said William H. Donaldson, former chairman and chief executive of the New York Stock Exchange and today an adviser to a big hedge fund. “If an individual investor doesn’t have the means to keep up, they’re at a huge disadvantage”…

Mr. Donaldson is right.  As humans we can’t keep up with HFT computers, it’s simply not possible.

An important lesson I learned when I worked in sales was “if you can’t beat the competition, stop competing.”

Don’t get me wrong here – it doesn’t mean quit.  There was a competitor across the street from us who stocked the same product and would sell it at a loss simply to under-cut us.   We couldn’t go any lower on our price and didn’t want to sell at a loss so we started stocking a different product instead.  We stopped competing and started playing a different game.

The same approach can be used with HFT.  Computers are the best in the HFT space, and we can’t beat them at that game.  But we can play a different game.

Take-away point  - Stop trying to compete with HFT, and get out of their space.   Trade in way that minimises its impact to a point where the influence is just part of a price bar.

What about You?

If you have an opinion, please tell me how HFT affects your trading in the comments section below.  Or if it doesn’t bother you in the slightest I’d love to hear that too. :)

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