This week Gilbert “Gman” Mendez — Head Trader at SMB Capital — offers instruction on trading the open:

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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!

We are proud to have hand-selected SMB Capital as a partner to offer our audience products and services to become better traders. To learn more about their new Reading the Tape course, click here.

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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The word on the street is that intraday traders are frustrated. The rules of the game have changed. Most high probability chart setups in between important levels are being manipulated by the high frequency algorithms. If you are an active intraday trader reading this, I guarantee you have been a victim to what I call the screw job program. Let me explain.

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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This is a guest post from Texas Holdem Investing.

Steven Begleiter is the latest (ex-)investment professional to hit the headlines for exceptional performance at the Texas Holdem Main Event at the World Series of Poker which starts on November 7^th at the Rio Hotel in Las Vegas.

However, there is a twist with Begleiter because his investment background is quite different to past investor participants in the WSOP who have been successful.

The “Texas Holdem Investors” who achieved success (and money) at previous WSOP event finals were typically from backgrounds in trading, fund management, or hedge funds.  Here are some examples:

• David Einhorn – Einhorn runs Greenlight Capital and is one of the most successful hedge fund managers of recent times.  Einhorn came 18th in the 2006 WSOP and won $659,000 which he donated to charity.  The amazing part of the story is that Einhorn had only taken up playing poker a few years previously.
• Bill Chen – Chen is a serious mathematician who works in the statistical arbitrage department of Susquehanna, the poker-friendly options trading firm.  Chen won $785,000 in two events at the 2006 WSOP but even with that level of winnings still decided to keep the day job.
• Robert Varkonyi – Varkonyi won the last World Series of Poker Main Event before television coverage of the event became widespread.  He studied Electrical Engineering at MIT and then went into investment banking in options trading.  Varkonyi now trades options for Gargoyle Strategic Investments which is a hedge fund.

The common theme is that these players usually work in an environment where they are risking at least some of their own capital in a fund where trades are generally made over shorter time frames ranging from days to months, but seldom years.  It is easy to make the connection between this type of investment process and poker.  Ari Kiev, a respected trading coach, describes the similarity based on the necessity in both fields to make “high probability bets in an instant with insufficient information”.

There is now hope when it comes to poker for the current poor relatives in the financial world – the investment bankers (like the Masked Financier).  Many years ago the investment bankers were the heavy hitters of Wall Street, mastering massive merger and acquisition transactions with no capital at risk, until over the last 20 years the traders took over the reins of profit (and capital).  And the traders were cleaning up at the World Series of Poker too, even though they didn’t do so well at the banks trading CDOs and similar instruments.

But now along comes Begleiter who worked in corporate strategy at Bear Stearns before he was shunted aside after the forced takeover by JP Morgan.  And Begleiter now works for a private equity firm – Flexpoint Ford, where he may well be using the skills that he gained in investment banking (and perhaps poker).  As with trading, there are a number of parallels between the process of private equity (and venture capital) investing and poker.  Begleiter himself compares the all-in showdowns of Texas Holdem poker to the high stakes bidding wars that often take place during merger and acquisition transactions in investment banking.

The Masked Financier, and all the other investment bankers out there perhaps including The Epicurean Dealmaker, will be rooting for Steve Begleiter at the Rio Hotel this Saturday.

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This is a guest post by Trendsman Research.

When it comes to Gold, there is actually too much focus or incorrect focus on the US Dollar. The fact is that throughout this bull market, Gold has been leading the US Dollar. In other words, the breakouts in Gold occur well in advance of the breakdowns in the dollar. Also, bottoms in Gold occur in advance of tops in the dollar. See the chart below.

Just take a look at this year! The peaks in Gold and the dollar occurred within days of each other! The bottom in Gold occurred four months prior to the top in the dollar.

A falling dollar is not necessarily a good thing for the leverage in gold shares. In this chart, I compare the HUI/Gold ratio to the US Dollar (inverted). We can see that the dollar significantly lags the HUI/Gold ratio. By the time the dollar starts to fall (rise in the lower chart), gold shares have already gained materially against Gold.

There are two reasons why a falling dollar isn’t necessarily positive for gold shares. First, many gold companies operate outside of the USA. A falling dollar means stronger local currencies, which means higher costs. Second, after a while a falling dollar creates cost inflation, which ends up hurting the margins of gold companies.

Conclusion

A significant breakdown in the US Dollar will come AFTER a major breakout in Gold. Gold has been consolidating for months, even as the dollar has trended down. The recent bottom in the greenback confirms that Gold is still in a consolidation phase. In March we asserted that Gold wouldn’t break 1000 because money would pour into stocks and commodities, thereby diverting Gold’s strength.

Gold’s relative strength has been poor due to the ensuing recoveries in stocks, commodities and foreign currencies. In recent weeks we noted this to subscribers as well as the fact that dollar sentiment was too bearish. Hence, we didn’t see a major breakout in gold or a sustained breakdown in the dollar.

Where will demand come from (to push Gold to breakout) if Gold is underperforming currencies, commodities and stocks? In other words, money is favoring the other asset classes. This is why relative strength matters. And it also matters because it shows the “real” price of Gold (something that Bob Hoye talks about). If Gold is rising against foreign currencies, oil and commodities it means stronger leverage for the Gold companies. We can compare and contrast all of these things with charts. Technical analysis is very effective if you know how to use it.

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