Analysis, Perspective, Trading Strategy
Trading the HFT Algo Chain Reaction
By Joe Duarte on March 24, 2018
volatility genie is out of the bottle again.
As I’ve noted in the last few weeks, the global economy is slowing,
perhaps heralding a global recession. Indeed last week’s news of increasing
economic weakness in Europe and U.S. weakness in last Friday’s PMI
data suggested that American economic expansion may also be rolling
over. This made the Fed’s announcement of no more rate increases in
2019 more meaningful, causing three days of rapid up and down sizeable
moves in the markets.
But that’s the new normal. Only the headlines matter to the high
frequency trading (HFT) trading algos. Moreover, algos respond to headlines
at the speed of light while the Fed sleeps like Rip Van Winkle. Accordingly,
the major indices whose individual component stocks are favorite vehicles
for algo trading programs get clocked when there is bad news and rally
in a major way when there is good news.
HFT Chain Reaction Accelerates Prevalent Trend
Specifically, when news hits, the HFT algos react by buying or selling
in the futures markets. Then “old fashioned” program trading by big
hedge funds and trading kick in and the cash markets follow. This causes
individual traders to jump in due to technical stops being hit and
the ensuing changes in asset allocation trading models. Then the selling
becomes systemic as everyone tries to cut their losses or maximize
their shorts and the cycle repeats.
As a consequence because HFT algos have preferential access to all
exchanges, they often execute their trades before individual trades
hit the market. The result is that when you and I sell, the algos see
our orders as they arrive and sell their shares or sell shares short
ahead of us creating a self perpetuating cycle which then feeds on
itself as more trades come in.
Only when there is short covering or actual buying on the dips at
substantial levels does the general trend change as the algos, seeing
the change in the order flow, flip to buy mode. In this case, they
buy before you and I and are ready to sell at a profit when our slow
poke orders finally hit the exchange. It’s all legal thanks to the
SEC and was described in detail by Michael Lewis in his book Flash
Boys. The point is that when the selling hits, in this market it doesn’t
always stop easily, especially when there is no one willing to buy
the dip. The reverse is true on the buy side.
Furthermore since all the pros and experienced traders now know how
the game is played, when bad news hits the wires everyone knows what’s
likely to happen, so they sell or stand aside, which again makes the
market thin and accentuates the down draft. This is why the bear market
in the fourth quarter of 2018 was so vicious. No one was buying. Everyone
was selling. And the algos accelerated the trend.
From an individual portfolio standpoint, what used to be small losses
can turn into bigger intraday losses since there is little buying support
across the board when the algos hit the indexes. So even if your stock
is fundamentally sound, the odds are that on that particular day, if
the market gets hit, so will your stocks.
- Calendar : Federal Reserve speakers hit the trail
as Regional Fed Business surveys hit the wires. U.S. GDP, housing
and mortgage data along with consumer confidence surveys will be
released. Key German, UK, Italian and French economic data is due
out. ECB president Draghi will speak.
- Big Picture : The third year of the Presidential
Cycle (2019) is traditionally bullish for stocks. But seasonality
alone can’t hold up stocks. Moreover, central banks and governments
are moving too slowly on fiscal, trade, and monetary policy and the
markets are getting impatient. Questions of institutional competency
are likely to be raised in the next few weeks to months if things
- Risk : Headline risk remains. Think U.S.-China
trade war, global tariffs, slowing economic data, politics.
- Market Behavior : Volatility remains tied to
the headlines. Expect swift and until proven otherwise shallow pullbacks
with buying of the dips. A reversal of this trading pattern would
be very negative moving forward.
- What to do : Stay cool. Expect wild swings in
the market. Hedge. Manage positions individually. Sell if your stops
get hit. Get ready for whipsaws.
Market Breadth hangs on 20 and 50-day Day Threads
The New York Stock Exchange Advance Decline line (NYAD) made a new
high on 3/21/19 but rolled over aggressively on 3/22/19. On the positive
side NYAD closed the week above its 20-day moving average which has
been an excellent support level since the 2016 presidential election.
Thus, if NYAD breaks below this key support in the next few days,
as it did in Q4 2018, the odds of a more serious pull back will rise
as the algo chain reaction will go into full deployment. Furthermore,
if it breaks below its 50-day moving average the odds of even worse
selling are very likely.
The S & P 500 (SPX) closed at 2800 on 3/22/19.
Unfortunately SPX is weakening at a faster pace than the Nasdaq 100
(NDX), which means that we may see at test of the 200-day moving average
and the 2700-2750 support area before we can make better trading decisions
about the long term.
The Nasdaq 100 Index tumbled along with the, but
the decline is not really surprising. For one the index rallied in
a big way on 3/22 and NDX closed above its upper Bollinger Band. That’s
usually a sign that the market travelled too far and that a correction
was likely. So for now, as painful as it will be to endure, the pull
back is likely to remain in place until the 20-day moving average and
the 7200 support levels are tested.
Trading in the New HFT Reality
Since HFT trading is legal, there is nothing anyone can do about
it except to adjust. Indeed you have two choices, make the most of
it or quit trading.
Here is the bottom line. Because algos are digitally precise and
relentless, it’s important to expect wild market swings and to focus
trading on key technical support and resistance levels such as the
20, 50, and 200 day moving averages when making long term buy, sell,
and hold decisions.
In this market, focusing on the New York Stock Exchange Advance Decline
line as a macro trend indicator and managing each individual stock
or ETF position separately from others is a good place to start portfolio
decision making. Furthermore, by using options as a hedge you could
buy yourself more decision making time.
No matter what, because individual investors can’t act as rapidly
as HFT traders, it is likely that portfolio swings in your portfolio
and mine, to the up and the down side, will be larger than we were
used to in the past. As a result, a successful trading day in this
market may be one in which you still have some money left in your account.
But don’t fret too much. Tomorrow there will be more headlines.
And here is just a bit of cold comfort to dwell on. While the Fed
naps Algos never sleep. The flip side is when the Fed finally caves
in and eases, the algos will read the headline and buy stocks like
there is no tomorrow.
Joe Duarte has been an active trader and widely recognized stock
market analyst since 1987. He is author of Trading
Options for Dummies, rated a TOP
Options Book for 2018 by Benzinga.com - now in its third edition, The
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