Fast work important in trading

08:26, July 25, 2011      

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Last week the price of natural gas plunged 8 percent in a few seconds in the early hours of Asian trading. Then the price rebounded. In the past this would be called a "fat finger" trade. It would be assumed this was a trade price entered by mistake - a typing error. Now this type of rapid plunge is often the result of a high frequency trading (HFT) algorithm and it brings up some important questions for trading, market analysis and market regulation. As the United States debt situation develops we can expect to see more sudden index moves accelerated by HFT activity.

The largest futures exchange in the US, the CME group, is building a new data center so thousands of customers can trade at lightning speed. They will allow traders to place their computers next to the exchange's trade matching engine so traders can shave a millisecond off trade execution times that are already measured in tiny fractions of a second. The delay between placing an order and getting the order executed is called latency. Low latency, or fast order execution matching, allows automated computer trading at lightning speed. Traders using slower systems may miss the opportunity to enter the market at their preferred price.

Such speed also allows people to make stupid mistakes more quickly. The temporary plunge in natural gas is an example. Some traders are now using these as a signal to enter the market and buy the quick recovery for a fast short-term profit. Reuters reported that a New York-based hedge fund manager literally ran to his computer and started buying.

"It was clear it was an HFT algorithm gone bad and I could profit on the rebound off the lows," he said.

The sudden price plunge followed by a rapid recovery is also called a pile driver pattern. It is most often seen on a daily chart of price activity and it is a leading indicator of a longer-term price collapse. It is created when an investor learns of bad news. He is very desperate to sell before the rest of the market also hears the news. He instructs his broker to sell, or dump, the stock at any price. The result is a down candle with a very long tail. The pattern is completed when the market recovers the next day and ignores the very low price.

Smart traders see this pattern, and they also start to sell before the bad news hits the market. The lowest downside price touched by the pile driver pattern is the long-term minimum downside price. Some traders use this pattern to open short trading positions.

The price dip in natural gas looks exactly like a pile driver pattern on the daily chart, but the analysis of the market behavior and the result is very different. Traders will be more cautious when they see this behavior because the price fall may be temporary as a result of high frequency trading.

The effect of HFT on price behavior is a hot topic of debate among traders. One group of traders believes HFT increases the liquidity in the market because there are always buyers and sellers at every price level. The increase in market volatility gives a good trading opportunity because it is always easy to find a buyer or a seller.

Another group of traders believes HFT increases erratic volatility, such as sudden isolated price rises or dips that take just a few seconds to develop. This makes it very difficult for traders to use stop-loss because the stop-loss may be triggered by a short-term false price move created by HFT traders. The danger comes when the false price drop triggers a cascade of many stop-loss orders so the temporary price fall develops into a sustained price fall. This is caused by the HFT trading method, and not by any change in the condition of the stock.

A third group of traders believes HFT is not important because it has lost its advantage and will soon be commonplace. When there were only a few HFT traders there were many larger opportunities. Now there are many HFT traders and opportunities are quickly identified. The size of the opportunity is shrinking and the profit margin is falling.

In the late 1970s some option traders seized a technological advantage by using the new and expensive TI-58/59 Texas Instruments handheld scientific calculator to rapidly apply Black-Scholes options pricing analysis. They enjoyed a significant advantage until other traders started to use the same tools. Large profits quickly disappeared through technological arbitrage. There were some changes to options market trading methods but the foundation of options market activity remained the same.

HFT is here to stay but already its effect may already be waning. Opportunities like the fall and rebound in natural gas will occasionally develop but they will become less frequent. After the market index plunge in early 2011 was blamed on HFT trading, market regulators introduced circuit breakers that suspend trading in unusual circumstances. This is designed to prevent the cascade of stop-loss sell orders.

HFT and algorithmic trading do not mean the market will become a vast computer game dominated by computer trading. The history of the financial market is a story of advancing technology always being outsmarted by human ingenuity.

Speed-of-order execution is always important. No trader likes to miss buying at his preferred price because he was too slow to click the mouse button. HFT takes this a few steps further. Like any new tool or method in the market, it will quickly lose its edge and become commonplace. New patterns of opportunity will develop and this is the challenge for traders. It seems the more things change the more they stay the same.

The author is a well-known international financial technical analysis expert.

Source:China Daily
 
 
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(Editor:陈乐乐)

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