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Adapting to High Frequency Trading

January 3, 2010 Business, Equity Trading No Comments

Pretty good article for intraday stock traders.

Excerpts Copy + Paste:

Below are seven effects… that HFT has had on U.S. equity markets. Each is then followed with a suggestion or two about how we can adapt.

1. YOU WILL GET STOPPED OUT OF MORE POSITIONS

Average daily volume has skyrocketed 164 percent since 2005, according to NYSE data. Up to 73 percent of this volume is handled by algorithmic trading programs. One unpleasant side effect is that stocks touch more price points and may cause you to be stopped out of excellent positions.

Adapt: Use better stops…

[on a stock that breaks support]…Algo programs buy almost every new low because they bet that short-term shorts will get trapped and have to cover higher.

Adapt: Learn how to read the tape. Few retail and independent traders have developed the trading skills to read the tape. Reading the tape is the craft of watching Level II quotes and being able to determine a stock’s direction based on order flow. Although use of charts and technical analysis are important, they will only take you so far. It is harder to read the tape because of HFT, but it is a critical skill to develop nonetheless.

2. PAST PROVEN TRADING SETUPS WILL NO LONGER WORK

Certain trading plays are less effective now that algorithms exist. For example, it was once a high-percentage play to buy a stock when it broke out, making a significant new high. You would get long and play the momentum to the upside… Today, it rarely works. Meet the sell-the-new-high program turned on by high-frequency traders with more money and bullying power than you.

Lately, when a stock makes an important new high, it will inch even higher until a seller finally refuses to lift for higher ground. Immediately, the sell-the-new-high program will sell much lower than you bought. The longs are trapped and squeezed out of their positions.

Adapt: Change your entries. Shorting a new intraday low for a stock in a downtrend almost never works now, perhaps only if the Volatility Index (VIX) clears 45 again. So you must make the adjustment to short such a stock into an up move. But these stocks also tend to trade just a little higher than you would expect because so many more market participants are playing games.

 3. INSTITUTIONAL BUYING AND SELLING IS BETTER

When I began trading and there was a big buy order, say 50,000 shares, the buyer just cleared the offers until the order was filled. Today, we see much better buying.

Almost all big hedge funds or mutual funds possess passive algorithmic programs that can slowly fill an order, 100 shares at a time, without making any noise. The result is a slower up move.

And after an uptrend has been created, these buyers may just turn off their algorithms, let a stock drop and then restart the passive algorithms. Because of this, momentum trading has become less profitable at times and more difficult. (Again, a high VIX could change this.)

Adapt: Focus on buying into pullbacks. Wait for strong stocks—those that are trending up on an intraday basis—to pull back before you enter positions.

 4. FALSE BUY AND SELL SIGNALS WILL BE CREATED

False buy and sell signals may lead you to place trades that are nothing more than programs gone wild. On select days, HFT programs can go at each other like punks in a bar fight. A stock may triple its volume on a given day, close above previous resistance and signal a long to you. But remember, this may just be the bots doing their thing.

Adapt: Watch the Level II quotes to confirm information. Before entering a position, make sure you see real buyers and sellers on the tape.

 5. IT CAN BE DIFFICULT TO GET STOCKS AT CERTAIN PRICES

As high-frequency trading programs chisel your bids and offers, you have to recognize the situation. See my AIG rant at the beginning of the article.

Adapt: Place your orders at the prices you want and go make a sandwich. Don’t get lured into a match you cannot win against HFTs. Play your game on your terms or sit on your hands.

6. SLIPPAGE WILL INCREASE

Slippage is greater due to HFT, which seems contradictory to all that supposed new liquidity in the market.

Say you are long 1,000 shares and seek to exit a stock if it trades below an arbitrary price of $50.50 with a stop order at $50.49. The stock touches $50.49, and you expect this to be your fill price with some slight slippage to $50.48 and $50.47. Only it isn’t. It’s 100 shares at $50.48, 100 at $50.47, 200 at $50.45, 100 at $50.43, 100 at $50.41, 200 at $50.38 and, finally, 200 shares at $50.36.

Doing the math, that is an extra $63 out of your pocket that you were not expecting. And that was just one trade!

The programs are so fast and sensitive that they drop the bids for lower prices when they sense a sell order. Where you may have exited the whole thing for no lower than $50.48 before, HFT has now made you take another trip to the ATM after its latest pickpocket.

Adapt: Reduce your manual stops and enter limit orders. Limit orders give you the control over your exit price, minimizing the likelihood of slippage.

7. MORE OF THE V

One trader at my firm always chirps the following: “Beware of the V move.”

Trading 101 teaches us that when stocks break from an important level that they should continue in the direction of the break. For example, I was trading Visa (V) in October, and $77 was an important intraday level. Visa consolidated near $77 but then broke to the downside quickly trading to $76.

The fundamental trading play is to short: If V pops after it has failed at $77, then you short. Generally, if Visa trades down to $76 and jumps to $76.50, this is an opportunity to add to a short position. I saw what I needed, and the sellers beat the buyers at $77. Visa should have trended lower.

Well not so much in this market with these programs and in this trade. As Figure 3 demonstrates, Visa went right back to the battle area of $77. The V pattern can happen from time to time, but the frequency with which it occurs in today’s market has grown. When some of the HFT strategies are done cutting each other after this technical breakdown, then the stock just goes back to where it started. It makes no sense, but it’s reality.

Adapt: Be mentally agile while you trade. When your stock is trending, consider the possibility that a V move may be about to make an unwelcome visit.

Link:
Adapt to Survive High-Frequency Trading, Mike Bellafiore, Stocks, Futures, and Options Magazine, January 2010.

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