Gilbert "Gman" Mendez

It seems the chatter about High Frequency Algorithms has gone down a fair amount. Maybe as intraday traders we have become desensitized to their shenanigans and have learned to live with the frustration they bring to our business. Or maybe there really isn’t much to talk about. How many times do we need to hear the schpeel about how they make the market more efficient? yada, yada, yada. Instead of writing – complaining even – about the HFTs I want to talk about some of their characteristics.

I have been a bit out of the loop in the past few days due to health reasons. I am currently battling a silly case of the flu. And let me tell you there are only so many 16-hours days of sleeping I can handle. So as I lay here awake in the middle of the night staring at lady liberty I can’t help myself to think about how these dopey programs work. I can’t imagine them being that complicated. I mean speed is the name of the game, so overly complicated mathematical computations are out of the question.

Thinking back on my engineering days and the cheerful lectures (sarcasm?) on computational nonsense I recall a few things. Linear systems are easy to program and computational friendly. From a mathematical standpoint this boils down to average price and rate of change in price of a stock (think fear/greed thermometers if you will). Further, common sense tells us these algorithms are dependent on volume and liquidity to run their show. So an accumulation/noise algorithm tries to keep a low rate of change in the stock while there is light volume, giving a chance to a magical moving average to catch up to it provided there is enough liquidity in the stock.

I know I have now lost some of you with all this mathematical gibberish. The point I’m trying to make is simple. The more controlled a stock is (low rate of change) the more likely it is for HFT algorithms to run us over. Think of consolidations, these were levels where we as traders would take considerable positions in anticipation of bigger moves. We would over-leverage our positions knowing our risk was well defined. As the rate of change in price would pick up in the opposite direction we had thought we would exit assuming we were wrong.

But what if the program would just drop the level right before the magical average was about to catch up to it? Then as traders start to puke positions the algorithm is able to get significant volume at a slight discount. Those who just exit their positions realize what happened and scramble to get back in now altering the rate of change in the stock all together leading to the actual move. Just “simple and elegant” as my calculus professor would say.

How this is useful information to trading is the important part of the puzzle. I chose to trade a bit aggressively during times of high volatility (steep rate of change) and when there isn’t much or too much liquidity for programs to run their show. That only seems to take place in premarket, after hours and the first 15-20 minutes of the open. At all other times I am very careful of not getting in plays that “seem too obvious” or when the rate of change seems to be about flat. I rather wait for the volatility and volume to manifest itself to come out and play.

That doesn’t mean I am suggesting that you should consider start chasing moves in a stock as profitable strategy. I am suggesting that those struggling should consider developing momentum trading skills. I am also suggesting being cautious around points of low volatility.  These are the levels where stocks can be often “manipulated” or as the SEC would put it, more efficient. For now, I am off to pop some Nyquil to make my immune system more efficient hoping I can sleep this off and make it to the open tomorrow. Happy Holidays!

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Characteristics of Some High Frequency Trading Algorithms

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In front of a crowd of cadets at West Point Military Academy last Tuesday, President Obama signaled for the escalation of the war in Afghanistan that most of us saw coming many miles away. This escalation, dubbed Obama’s “surge” by some (including myself, apparently) is set to consist of 30,000 additional troops on the ground, all of whom are scheduled to arrive by next summer.

Not one to sell himself short, Pres. Obama has outlined an equally ambitious plan to begin drawing troops out of the Afghan countryside within 18 months. So the big question remains, which companies are best positioned to profit off of this approx. 2-year military frenzy?

Because the President decided to go down the mega-troop-influx route rather than the special forces-based route that was supported by Vice President Joe Biden, the beneficiaries should be the suppliers of conventional warfare.

Among them are Alliant Techsystems (ATK), which already has a contract to provide munitions to the Afghan forces, General Dynamics (GD), which provides primarily armored vehicles and ammunition, and L-3 Communications (LVLT), which is “looking to renew an agreement to support special operations forces that’s worth $500 million a year.”

In addition to suppliers of warfare, battlefield contractors are poised to profit from Obama’s surge as well. These contractors aren’t the paramilitary contractors that have made headlines in past, but rather the contractors that “will continue to provide a wide range of tasks essential for operations including maintenance, construction, transportation, security and base support.” And considering the lack of viable infrastructure in Afghanistan, there should be a fair amount of money ready to go around.

Two companies perhaps best positioned to profit in this respect are Fluor Corp. (FLR) and DynCorp International Inc. (DCP). The two hold “what is effectively the biggest Defense Department contract supporting U.S. forces in Afghanistan which could be worth as much as $7.5 billion to each company in the coming years.”

All of the companies mentioned herein are almost certain to benefit from the surge in Afghanistan, but what is actually certain is that there will be many more as well. So, keep your eyes peeled and keep up on the news and you’re sure to find a winner or two.

Disclosure: No holdings in the companies mentioned.

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An Updated Look at Government Defense Spending

Dr. Brett Steenbarger

A few people have asked me why I covered my swing trade (selling S&P 500 Index on Friday and adding to the position Tuesday morning). Three reasons stand out:

1) I had set an initial profit target at the weekly S1 level. We hit that level and, per my discipline, I always take profits on one unit when the first target is hit. (Note: this presumes a system for unit sizing of positions; I will be blogging on this topic shortly. The basic idea is that you divide your capital for a particular idea into several portions or units. This enables you to systematically scale in and out of trades.)

2) When I saw that we were having a labored time hitting the second, S2, target, I took the position off entirely. My concern was that we were seeing significant selling pressure (negative NYSE TICK, volume at bid exceeding offer in the ES futures), but that the pressure was having a difficult time moving stocks meaningfully lower in the afternoon.

3) I knew we had a strong momentum day to the downside. Recall that the proprietary Demand/Supply measure is an index of the number of stocks trading above and below the volatility envelopes surrounding their short-term moving averages. We hit 200 on the Supply side, which means that a very large number of stocks had closed below their short-term bands. This has only occurred 30 times since late 2002 when I first began collecting the data. When this has happened, the S&P 500 Index (SPY) has closed up the next day 20 times, down 10 for an average gain of .60%. That told me that, short-term, I might be able to re-enter my position at better prices. (Note: I update Demand and Supply every day before the market open via Twitter; follow Dr. Brett’s tweets here).

Everyone has different ways of trading and different disciplines. Mine calls for me to let positions run to their targets, but–once they hit targets–be proactive in harvesting profits when my edge seems to have dwindled. It’s a nice illustration of trade management and its role in helping traders maximize gains, but also protect them.

This article was originally posted at TraderFeed on Wednesday, September 2, 2009.

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Dr. Brett Shares When to Exit a Trade

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Economic Calendar for This Week

With the US dollar falling down a precipice, spare a thought for non-US investors invested in US stocks and bonds.

The graph below shows the performance of US 10-year Treasury Notes since the beginning of March in both US dollar terms (red line) and euro terms (blue line). Whereas US investors are showing a poor return of -2.8% for the period, European investors are completely under water to the tune of -17.5%. For the year to date the figures are -4.8% (US dollar) and -10.5% (euro). (Although I am using the euro in this example, the same logic applies to most other non-US dollar currencies.)

The next graph illustrates the same principle for equities by comparing the performance of S&P 500 Index in US dollar terms (red line) with the same Index from the viewpoint of a euro investor (blue line). Whereas US investors have every reason to be very pleased with a return of +64.1%, euro investors are lagging quite far behind with +39.2%, which becomes more pronounced when compared to a return of 55.4% for the European Top 100 Index. For the year to date the figures are +22.9% (S&P 500 – US dollar), +15.6% (S&P 500 – euro) and +21.9% (European Top 100).

It is understandable that European investors are not ecstatic about the greenback’s slide and will keep having reservations about committing funds to US assets until they see signs of the dollar forming a bottom.

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Picture du Jour: Plunging dollar erodes non-US investors’ returns

The highest probability trade for a well capitalized algorithm is the trade where it is guaranteed emotional order flow. By emotional I’m referring to the order flow that comes out of positions where traders just want out – our stop orders.

Consider all of the high probability plays: flags on strong/weak stocks after a drive, consolidation, support/resistance at important levels. We all trade them. We size up as the play develops in our favor and we trade them quite similarly when the play goes against us. We bang out of the stock when we assume we are wrong (especially when we have size).

Let me offer an example of a common screw job program. A stock drives on the open, comes off very little and starts to consolidate close to the high of the day on a tight range for a significant period of time. You can spot plenty of buy interest on the bid, the buying is clear. The stock spends so much time consolidating that the VWAP and moving averages start to catch up to the price action. You see a tremendous opportunity to “load the boat” with little risk on the consolidation calculating the stock has another leg higher.

The stock takes the top of the consolidation with volume and you add to your position. You know you are in the driver’s seat. I start the theme music to “Jaws”, and our desk’s group of traders I have affectionately termed the Shark Tank, communicating an excellent trading opportunity to the firm. Then out of nowhere there is more selling interest, the bottom of the consolidation drops and you bang out of the play. 15 minutes later the stock is making new highs without you in it. Talk about getting bitten by the market. Sound familiar?

Check out these charts of BAX to illustrate my point from above. One shows the intraday price action on a 3 minute chart while the 15 min and 60 min chart give us a clue of the upside of the play.

I know I have been a victim to this screw job algorithm at least 30 times in the last month.  But lately I have started to catch up to their nonsense and have had to make some adjustments.

1. Increase the stop loss on the position
2. Trade with less size until witnessing the screw job then lay into the position when it gets back above the level.
3. Stay light or flat on the setup, wait for the screw job and then add while the screw job is taking place. Then lay into the position when the panic subsides.
4. Trade more in premarket and after hours when there are very few/no algorithms.

Dr. Brett Steenbarger once told me:  turn frustration into opportunity. Doing the steps above have helped me tremendously. Clearly the algorithms have some advantages but the trader who adapts will always come ahead. Happy trading!!

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1. The Economic Crisis Takes a Virulent Turn

The word credit comes from the Latin “credere” which means “to believe, or to trust.” That’s really all you need to know about the modern financial system. When the “credere” is gone, the whole thing unravels, and it works both ways, from lender to borrower, and from borrower to lender.

Now we’ve arrived at the point where that belief, “credere” — stretched to its limits by policies of endless credit expansion over the past two decades — has been weakened to such an extent that it has developed what may be likened to an autoimmune disorder; a condition where the immune system mistakenly attacks itself, destroying even healthy  tissue in the process.

I was reminded of that comparison this morning when reading the text of Federal Reserve Chairman Ben Bernanke’s economic outlook speech delivered to the Economic Club of New York today. Bernanke didn’t make it through the first sentence without referring to the financial crisis as a virus.

“When I last spoke at the Economic Club of New York a little more than a year ago, the financial crisis had just taken a much more virulent turn,” Bernanke said. The comparison isn’t at all far-fetched, and understanding how a virus operates, and how doctors treat it, is helpful in grasping the nature of our own economic autoimmune disorder.

Under normal circumstances, say, without excessive credit expansion policies, the system’s immunity defenses would attack and destroy toxic substances — such as subprime mortgages — and leave the healthy tissue alone. Unfortunately, an autoimmune disorder often results in the destruction of the body itself (the financial system), or abnormal growth of an organ (government and regulation), and/or changes in an organ’s function (the banking system).

As government bureaucrats trapped within the framework of their fiat currency-based operating systems, central bankers have little choice but to focus on the symptoms our virus presents, a virus that was unleashed on the patient by their own doing, without recourse to either irony or shame. And so they attempt to cure the symptoms of the virus over and over again without recognizing that the cure is worse than the disease itself; it only suppresses the symptoms for a brief time before they return with greater severity.

Bernanke sounds more like a physician than a central banker when he says the following:

The flow of credit remains constrained, economic activity weak, and unemployment much too high. Future setbacks are possible. Nevertheless, I think it is fair to say that policymakers’ forceful actions last fall, and others that followed, were instrumental in bringing our financial system and our economy back from the brink.

After all, he’s talking about a circulatory system — one in which credit functions as the blood flow — where the flow remains restricted, the body weak, fever high. Unfortunately, while the severity of the symptoms has temporarily passed, the virus lingers, building up strength for the next attack. Judging by retail sales, that attack may begin sooner than Bernanke and other optimists think.

2. The Entrails of Retail Sales

Optimists were out in full force after retail sales were reported this morning, citing the fact that headline retail sales rose more than expected in October. Sure, the usual caveats — “mostly  due largely to a big rebound in auto sales” — were present, but the headlines were largely positive … and with the market itself quickly tacking on more than 1.5 %, it was hard not to think maybe they were correct.

The reality, however, is that when you look inside the report, it is clear that broader consumer spending remains under pressure. Excluding auto sales, retail demand rose 0.2%, half of the expected 0.4% rise. The main sticking point, however, is that the government revised the September performance down to show a 2.3% decline, from the 1.5% drop initially reported. Ooops.

The 0.2% increase in retail sales excluding autos was down from a 0.4% rise in September and was the weakest showing since a 0.5% drop in July. Sales also fell 0.8% at furniture stores and 0.6% at electronics and appliance stores, Associated Press reported.

Click here for Page 2 of this article.

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The Economic Crisis Takes a Virulent Turn

With the dollar losing more value and commodities attracting more investors, we take Bernanke’s comments to imply that “The trend is your friend.” By the looks at the chart of Gold ETF (GLD) below, inertia is in control:

Disclosure: GLD was the Featured Trade in the October issue of the Wall St. Cheat Sheet Premium Newsletter.

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