Monday, December 28, 2009

Adapting to High-Frequency Trading Algorithms

Hats off to Mike Bellafiore of SMB Capital who has written one of the few insightful articles I've read on how traders can adapt to the high-frequency trading of algorithmic programs. Mike's firm trades individual stocks and ETFs, using strategies that rely on both technical setups and a reading of order flow. They are active in training traders in those strategies and have seen first hand how the computerized trade has posed challenges for short-term traders.

The key word in Mike's article is "adapt". Setups that might have worked very well in the past become marginal when trade is dominated by the algorithms. Conversely, variations on those setups can become quite successful once one adapts to the high-frequency trade.

If, for example, we know that programs are buying new lows in stocks, we can wait for those bounces before going short, rather than aggressively selling weakness. In other words, you wait for the algorithms to do their thing and then act on opportunity.

As one savvy trader (who has adapted well to changes in the market wrought by high-frequency trading) told me recently: "Programs change the path, not the destination."

It's an important lesson for short-term traders.



Matt Fahmie said...

Wow, I step away from the computer for a couple of days and come back inundated great post after great post from your blog. With the amount of work I already put on my own plate to complete before the new year, I will have to set aside time to read each one. For each of your posts offers unique insights that I cannot seem to find anywhere else with the same price tag.

This quote alone immediately caught my attention, as the wealth of knowledge contained within a single sentence is striking. The next step is is to look deeper into how that path is altered, when it is altered the most, when is it altered the least, and how can one identify it in the heat of trading and ultimately use it to ones advantage.

"Programs change the path, not the destination."

Great stuff.

-Matt Fahmie

Globetrader said...

Hi Brett,

thank's for pointing me to Mike Bellafiore's article. It really was one of the first to make sense to me describing patterns as result of HFT, seen in the market over and over again, while I was struggling to accept these as real.
I have struggled the last few months with my trading setups, as they did no longer work as expected. Nothing to really put my finger to, just a feeling in my stomach, that the futures I follow do not move as expected. Taking longer to break out, testing levels again and again only to spike, after I covered my position for scraps. I adapted by scaling back on my trading to nearly zero. Just placing one or two trades a day to not lose the feeling for having money on the line at all and if these did not work (or if they worked - but after I covered) I left the market to itself. I reworked my charts, to find something better fitting, but nothing feeling right so far.
I know the market will be here tomorrow or the day after, when I will have found the confidence again to trust my signals and therefore trade more aggressively.
I know exactly why I wasn't able to rework my charts the way they should be. I'm an engineer -not by profession, but by heart- and I need a logical explanation, before I trust something.

…and I had none. I couldn’t explain multiple V moves, breaks which happen only to get reversed 100% only to break again and reverse again. The moves no longer spoke to me. I was still able to formulate longer term plays, but those I don’t trade with futures. Like a Euro/USD trade which I made with my account itself moving from Euro to USD when Euro broke down below 1.48 sometime before Christmas. This trade made sense at the time I took it and still makes sense. Nonetheless it went against me 80 or so ticks at first and in futures I would never ever held such a position.

I have my further work cut out it seems. Sure, it all comes back to trust what you see all along on your charts. But, the mind can put so many doubts in your decision making process, that the opportunity is gone, once you have put them all aside.
Best regards and happy new year,

yours Chris