May 28th - Friday

No practice trading today. Day-job in the morning then tiling a bathroom floor in the afternoon. Grouting on Saturday (later today).

Also included is a photo of my wiring handiwork.

Later in the day...

I added this practice-trade short in RIG during its last big push down at the 2:10 candle. I took it as it just started to break to a new LOD. Covered a bit early because I chose yesterday's late top (3:00 candle) as support. 25 cents off the low was close enough for me, considering the dayrange was $4.72. Turns out that the 1:50 to 2:50 pm base highs were the support of choice for the traders with enough juice to reverse a stock from its big daily slide.

This week so far...

Day job was busy Tuesday and Wednesday and I was out of the office while the market was open.

On Monday, however, I was able to practice-trade some in the afternoon. I held some shares of TNA overnight, mostly by accident. I couldn't close them the past two days for reasons I mentioned above.

The market has popped today so I've sold them with a limit order at $48, close to the top at open. I have to return to other duties so I am shutting down the computer for the rest of the day. I look forward to a day when trading takes precedent.

May 21 - Friday

It's Saturday and I'm just getting a moment to post yesterday's practice trades. In TNA, I made three trades investing about an hour and 15 minutes of my time. The first two trades were especially good for me in that as soon as I put them on, price moved away from the entry in positive territory and never looked back. I ended both trades far too soon although I didn't have time to sit and watch the second one because of other responsibilities. No excuse on the first one other than inexperience.

On the first trade, I had the presence of mind to think about going WITH the momo instead of counter to it, and I waitied for a pullback to do so. The second trade was nice in that I anticipated the reversal at the 12:20pm candle because of the near-doji. In the 12:25 candle, I waited for price to break below the close of the near-doji in the prior timeframe then took the short. Price just dropped away from the entry point. It was perfectly timed, and after closing out the trade and coming back later to the computer, found it to be well-timed on a longer time-frame.

The third trade long originated after seeing the large volume spike at 2:45 pm plus the next candle (2:50 pm) ending at its low point. My gut told me to wait for price to press down again before taking a reversal trade off those two signals. One thing I have learned with the 3x ETF's is that they are often like stopping and turning an oil tanker... the change of direction takes a little longer. I went long and price did move down against me some, but within an acceptable range, given the volatility of TNA throughout the day. The trade went positive and finally, I exited too soon but as has been the case recently, I don't have time to hang out and watch.

-

An even better indicator of reversal came approx 25 mins later at 3:15pm with that volume spike after a run. Volume = trader activity. Activity tells me to "pay attention" as people smarter than me are making decisions; shorts cashing in their gains.

By this time, however, I had already stepped away from the computer.

May 19

I spent most of the day out of the office but had a chance to look at the markets in the later afternoon. Because of Scott Farnham's attention to the VXX of late, I called it up and thought I'd have a look at the chart. I liked the chart immediately... my forst impression was of how "clean" it looked. But, upon entering, I found it to be rather squirrely. Maybe it was just that it was EOD and the intra-candle volatility was increased.

In any event, my first trade was a scalp for short money paper-gain. My second paper trade was completely against grain, that's woodworker speak for going against the flow. (poor choice #1). For some reason, my first impulse is to look for reversals. Occasionally I ignore this impulse but for some reason, it is how I am wired. Too bad, because this as well as my initial entries over the past few days would have been nice winners had I gone "with the grain," in the direction of momentum. I held the trade (poor choice#2) as I have the past few days and found a good area to really hit hard to bring average price down. Then, as I have done recently, I sold the pop for a modest gain. It was around this time that I found the price really twitchy. Looks like a lot of traders were uncertain and it translated into short-term volatility.

What did I learn today?

1. I have to make my first thought to "go with momo" instead of counter to it. Doing so would have given me very nice gains on each of the past few days. My pattern of being "early" on reversals continues. Which is to say, a pattern of being "wrong" initially.

2. I must sell those losing trades. One of my weak spots is recognizing when I am wrong versus when I am caught in consolidation and need to hold onto my trade idea.

3. Be patient. Await my familiar signs of direction change in order to increase my probablity of a timely entry. After all, if I haven't seen such a sign, why should I play for a reversal of the current momo? Go with the flow instead.

May 18 - Tuesday

I did have a chance to sit in front of the computer after completing my bids and sending them to customers. Still, I didn't spend very long with the markets. As I did yesterday, I played some practice trades in RIG around 3:00pm. I went long, looking for the pop that comes after a protracted down move. It hadn't retraced with any significance since 1:00-1:30. The long was premature and I held it as it dropped. (Poor choice #1)

10-12 mins later, I felt momo start to wane on increasing volume so I found what would be a high probability reversal spot. I took four trades long at this spot, and the move paid off. I went long within 2-3 cents of the LOD. This brought my average price way down, allowing me to scale out four of the five parts of my long position. I kept the last position and sold it at the 7 EMA. (poor choice #2). Price continued rising and I left a lot on the table. Hindsight tells me I should have kept this final part of my position until breakeven before selling.

Again, poor execution by holding a losing trade then averaging down in price. This is a suckers' play and is not the pure, clean method of trading I am seeking. I will continue to fight my "demons" as the weeks and months progress.

May 17 post: Fixed the typos and bad syntax

I re-read yesterday's post and discovered what happens when I type and post without proof reading! It was barely intelligible. I've fixed the mess.

I have no customer appointments today but have two large project bids to produce before day's end. And, I am now tiling floors on my construction project. Maybe some face-time in the markets during lunch break, if I take one.

May 17

With about an hour available to paper-trade, I took a short at/near the LOD in RIG in anticipation that it might continue its drop. It didn't, finding nice support at my entry area and reversing. Instead of exiting, I held. Poor choice there. At a point where movement away from my price seemed to slow and in anticipation of a move back toward my entry, I shorted heavily and averaged a much better price. Poor choice number two. While price did spike up against me after that, the area of that multi-position short held up as the "settled price" of the reversal (see the near-doji of the 3:40pm candle). Price then dropped nicely over the next 10-15 minutes and I exited the second time price pushed my position into the money; a $57 dollar paper-gain for each of the nine parts of my position. The exit was 5 cents from the bottom of the move I was playing.

A short time later in the same candle, a reliable exit sign appeared when the candle ended at its low on a volume spike. The smart play would have been to go long for a scalp here in the last minutes of the day.

There is a repetitious theme in my practice trading. An acceptable feel for movement but poor response to what I sense and in some cases, poor execution. There is certainly room for improvement, so I will endeavor to persevere in that direction.

May 13 EOD update

I got a call from a day-job customer and had to come back to the desk & fire up the computer as a result. The market is closed for the day so I checked the LVS chart, curious as to where my trade placed in terms of later movement. The chart above shows that my short nailed the top of the second peak in a double-top formation. I'm posting this chart, then back to the building project...

May 13

I took just a few minutes again today to practice-trade. Took two trades, one in RIG and the last in LVS, basically just using S/R and volume clues to try to play the probabilities as best I could. Both trades were successful but more scalps than anything. I liked that I picked what appears right now to be a reversal point to short LVS... $24.85. If this turns out to be a double-top formation, it will have been a great entry at a primary reversal point. If not, it will be a successful pegging of a minor reversal point. Time will tell. After blogger uploads the chart, I can't stick around to find out, there's work to be done elsewhere!

Still waiting for Blogger and it's 15 mins later. Chart of LVS still showing red as price approaches the 17EMA $24.70. Nice... but now retreating from that level back toward $24.75 S/R.

May 12th

Finally, a chance to sit at the computer. albeit for only an hour or so. My construction project has been keeping me busy because of a mid-june deadline, along with day-job because the Spring is one of my busiest seasons.

The paper-trades yesterday were in RIG. First was a long as soon as I logged in, with an eye toward just jumping on momo and looking for the turn to get out. That is exactly how I played it, a near perfect trade for me. But, then I went long again at a spot where I thought a reversal might occur. Wrong idea... in retrospect, I didn't wait for a signal. I only guessed. I am not quite ready for prime-time, it seems! I held the position and added to the losing trade at points where I thought a turn might occur, again not waiting for a signal. Finally, I saw my signal at approx 67.15, then added three positions there. That spot ended up being the low of the day for RIG; a primary reversal. I exited with a decent gain on all but one position, then went to a day-job appointment. One of my weakest skills is recognizing when the momo is moving against me. I haven't really ever set stops but have tried to train myself to "see" when a trade is bad then trust my judgement. Of course, this is too risky a strategy for real money. I'm hoping to refine my senses to know when the trade is bad but stops must be set and adhered to, if I am going to have any shot at trading survival.

Although it has been part-time, I have been watching the market enough over the past year to recognize the signals of reversal, minor and primary. My method needs refinement and I still am fighting the urge to average on a losing trade rather than reverse the trade or exit and wait for a better spot to enter. This urge to hold a losing trade definitely corresponds to times when I am under the stress of daily life. This is a pattern in my trading I've observed more than a few times. The first step in fixing something is recognizing the problem.

We don't trade in a vacuum.

May 6th

I got to the markets late today, but not too late to miss history being made. Wow is all I can say. That was something to see, reminds me of Fall 2008 and March 2009.

Sure wish my charts hadn't frozen up. I took a short in my live trading account in TNA but the charts froze solid as price moved on my IB platform. Scared the hell out of me to be entering blind. So, I cancelled the trade at 35 shares. The total preset entry and exit is for 500 shares in my live account (1000 shares in my practice account). There was no way on a day like today I was going to "wing it" with Quote Tracker "locked up."

So, I am pleased to say I took 22 cents out of the market in my real-money trading account, the most in a day since last summer, if my memory serves. The bad news is that it was 22 cents on only 35 shares. So, gains today of $5.70. Pretty disappointing but on the other hand, I am not skilled enough to be messing with a market doing what it was doing today while my charts were a mess.

Also, got a cancelled trade bulletin from IB when I signed on to make this post. I've put it up for everyone to read... looks like all trades of a certain type and at a certain time are officially busted.

Saw it, Liked it, Reprinted it here...

Dr. Brett is as astute an observer of markets and behavior as anyone you will find. His swan song at http://www.traderfeed.blogspot.com/ has included some reprints and references to real gems of wisdom from years passed and today had a link to May 2nd, last Sunday. I have highlighted in red a couple things which caught my eye, then explained why in the parenthesis which follow. I am sure going to miss this guy as he winds down his blog for good.


Sunday, May 02, 2010
Core Ideas in Trading Psychology: Implicit Learning and Somatic Markers
Previous Posts in This Series:

Mirrors and Corrective Emotional Experiences

Solution-Focused Change

Changing Problem Patterns Briefly

Trading as a Performance Activity

Introduction to Trading Psychology



Perhaps the most common psychological change that traders need to make is the ability to quiet their minds and focus their concentration. Many of the problems described by traders, from emotional frustration to negative self-talk, distract traders from their best trading practices and plans.

One of my earliest observations as a psychologist working with traders was how common it was for experienced traders to go through periods in which they traded like rookies. How could that be?

The literature review that I conducted to write the Trading Performance book led me to an interesting conclusion: the skills that are central to trading involve frequent exposure to subtle patterns in the shift of supply and demand. Over time, these patterns are internalized, so that experienced traders develop a "feel" for markets. This is known as implicit learning (see the Performance book for a full description): the trader recognizes the pattern, but cannot necessarily verbalize it.

*(bluecollartrader commentary: Scott Farnham has referred to his "gut feel" as tacit knowledge. See the comment section of his July 28th, 2009 post entitled, "The Enemy Within" as well as this follow-up essay entitled, "The Spark" from August 3rd, 2009. When I see things repeated over and over, I take note.)

There are many patterns in life that we sense, but cannot fully place into words. My favorite example is the young child who creates grammatical sentences when she talks, but cannot tell you the rules of grammar she is using. Similarly, I can sense clearly when a person is talking in a very sincere or insincere manner, but cannot necessarily tell you all the subtle cues--the changes in vocal inflection, the nuances of facial expression--that lead me to that conclusion. As for the experienced trader, for the seasoned psychologist, it's a gut thing: the result of thousands of exposures to patterns that recur, but rarely the same way twice.

Once the concentration of the psychologist or trader is broken, the access to those subtle gut hunches is lost. In that situation, the experienced professional loses contact with years of experience and, indeed, becomes a rookie. Caught in frustration, worries about profitability, or distracted by family turmoil, the trader is no longer attentive to somatic markers, the felt cues that tell us that a pattern is present.

This is why, in the Trading Coach book, I highlighted exposure methods as particularly promising for traders. Those methods train us to stay calm and focused, even as we are mentally rehearsing (or actually undergoing) stressful situations that typically trigger our problem patterns. It isn't that we need to remove emotion from trading--our feelings provide our best somatic markers. Rather, we need to ensure that self-relevant emotional turmoil does not overwhelm the intuitions that are present when we are focused on markets.

All this having been said, I would estimate that 80+% of traders fail because they have never developed implicit learning in the first place--not because their gut hunches are swamped by distracting thoughts and feelings. Trading is indeed a performance activity and it takes many concentrated months of exposure to patterns to make them our own. Placing money at risk before cultivating that implicit learning is no different from entering a battlefield without military training. You'll be so busy looking for setups that you'll never realize that you're the one being set up.

*(bluecollartrader commentary: I have posted the Mark Douglas interview on a number of occasions over the months of blogging, including recently. This is a long interview video but he makes a point of mentioning the importance of paper-trading/practice trading prior to putting real money at risk. This is something which Scott Farnham of FNG Day Trader, someone who has had a strong influence on the direction I want to go, did when he first started. I believe he went roughly 1.5 to 2 years without trading real money during his learning process. If someone is telling you that you must have real money at risk as you learn to day-trade, your bullshit detector should be going off like mad. Not that they all are charlatans, but seriously, are they trying to sell you something? A subscription? A chatroom? A course of study? Wouldn't your losing money add perceived value to their... (fill in the blank) ...that they are trying to sell you?
When one of the best traders in the blogoshpere who doesn't try to sell anything to you, as well as the two top trading psychologists who have penned the best, most respected books on the topic tell you the importance of practice-trading before putting real money at risk, shouldn't you take heed?)


For more on the topic of implicit learning, check out the posts on Implicit Learning and the Unattached Mind, Implicit Learning and Single-Trial Learning, Building Market Intuition, Intuition and Trading Decisions, and Somatic Markers and Trading. Cognitive and behavioral exercises to aid trading performance can be found in the Trader Performance book, along with a detailed account of implicit learning.

May 5th

No trades today, day job was very busy.
Hope all had a profitable day, monetarily or educationally.

May 4th - EOD

No more trades beyond the one I made earlier in FSLR. However, I did take some time to see what happened to FSLR after I exited and shut down the computer. My trade wound up having a potential of $1730, had I held through the top at 11:00 am and if bid had hit the price high (unlikely). But, what might have been is irrelevant... in fact, it is all irrelevant considering that it is paper-trading. But, I like my entry price and am satisfied with it as a practice trade.

May 4th - AM

Early practice-trade before I begin some painting on my constructon project. I liked the spot to go long in FSLR, though it appears that once again, I am out early, based on what the chart shows as I upload my screen shot and type this. As it continues to climb here, I REALLY like my entry! Ha! I got out at bid $138.95 Bid currently is at $139.77... Which brings me to mention the spread on this stock. Ouch, that is a tough spread to play if this were real money. This is a stock which can really punch you in the mouth.

May 3rd

Got a tiny piece of today's big volatility in RIG, practice-trading in the last half-hour or so.

This trade idea to go short came after the large price pop, and after the close near the candle bottom, and an ultimate tight open/close ratio in relation to the overall price range in the 3:20 candle. Buyers could not sustain the price and I figured it for an upcoming drop. It did, though I didn't stick with my trade idea long enough, taking only 24 cents out of 66 cents available in the same candle. Patience, patience, patience; as mentioned before.

Trader Education: A Little "inside baseball" on the big boys.

I found this White Paper by Arnuk and Saluzzi at www.highprobability.blogspot.com and found it enlightening. Take a gander at how the "big boys" do it...

Toxic Equity Trading Order Flow on Wall Street
The Real Force Behind the Explosion in Volume and Volatility
By Sal L. Arnuk and Joseph Saluzzi
A Themis Trading LLC White Paper

INTRODUCTION
Retail and institutional investors have been stunned at recent stock market volatility. The general thinking is that everything is related to the global financial crisis, starting, for the most part, in August 2007, when the Volatility Index, or VIX, started to climb. We believe, however, that there are more fundamental reasons behind the explosion in trading volume and the speed at which stock prices and indexes are changing. It has to do with the way electronic trading, the new for-profit exchanges and ECNs, the NYSE Hybrid and the SEC’s Regulation NMS have all come together in unexpected ways, starting, coincidently, in late summer of 2007.
This has resulted in the proliferation of a new generation of very profitable, high-speed, computerized trading firms and methods that are causing retail and institutional investors to chase artificial prices. These high frequency traders make tiny amounts of money per share, on a huge volume of small trades, taking advantage of the fact that all listed stocks are now available for electronic trading, thanks to Reg NMS and the NYSE Hybrid. Now that it has become so profitable, according to Traders Magazine, more such firms are starting up, funded by hedge funds and private equity (only $10 million to $100 million is needed), and the exchanges and ECNs are courting their business.
This paper will explain how these traders – namely liquidity rebate traders, predatory algorithmic traders, automated market makers, and program traders – are exploiting the new market dynamics and negatively affecting real investors. We conclude with suggestions on what can be done to mitigate or reduce these effects.
To illustrate most situations, we will use a hypothetical institutional order to buy 10,000 shares of a stock at $20.00 that has been input into algorithmic trading systems, which most buy side traders use. Algorithmic or “algo” trading systems chop up big orders into hundreds of smaller ones that are fed into the market as the orders are filled or in line with the volume of the stock in question. Typically, such orders are easy to spot as they commonly show that the trader has 100 or 500 shares to sell or buy.
LIQUIDITY REBATE TRADERS
To attract volume, all market centers (the exchanges and the ECNs) now offer rebates of about ¼ penny a share to broker dealers who post orders. It can be a buy or sell order, as long as it is offering to do something on the exchange or ECN in question. If the order is filled, the market center pays the broker dealer a rebate and charges a larger amount to the
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broker dealer who took liquidity away from the market. This has led to trading strategies solely designed to obtain the liquidity rebate.
In this case, our institutional investor is willing to buy shares in a price range of $20.00 to $20.05. The algo gets hit, and buys 100 shares at $20.00. Next, it shows it wants to buy 500 shares. It gets hit on that, and buys 500 more shares. Based on that information, a rebate trading computer program can spot the institution as having an algo order. Then, the rebate trading computer goes ahead of the algo by a penny, placing a bid to buy 100 shares at $20.01. Whoever had been selling to the institutional investor at $20.00 is likely to sell to the rebate trading computer at $20.01. That happens, and the rebate trading computer is now long 100 shares at $20.01 and has collected a rebate of ¼ penny a share. Then, the computer immediately turns around and offers to sell its 100 shares at $20.01. Chances are that the institutional algo will take them.
The rebate trading computer makes no money on the shares, but collects another ¼ penny for making the second offer. Net, net, the rebate trading computer makes a ½ penny per share, and has caused the institutional investor to pay a penny higher per share.
PREDATORY ALGOS
More than half of all institutional algo orders are “pegged” to the National Best Bid or Offer (NBBO). The problem is, if one trader jumps ahead of another in price, it can cause a second trader to go along side of the first one. Very quickly, every algo trading order in a given stock is following each other up or down (or down and up), creating huge, whip like price movements on relatively little volume.
This has led to the development of predatory algo trading strategies. These strategies are designed to cause institutional algo orders to buy or sell shares at prices higher or lower than where the stock had been trading, creating a situation where the predatory algo can lock in a profit from the artificial increase or decrease in the price.
To illustrate, let’s use an institutional algo order pegged to the NBBO with discretion to pay up to $20.10. First, the predatory algo uses methods similar to the liquidity rebate trader to spot this as an institutional algo order. Next, with a bid of $20.01, the predatory algo goes on the attack. The institutional algo immediately goes to $20.01. Then, the predatory algo goes $20.02, and the institutional algo follows. In similar fashion, the predatory algo runs up the institutional algo to its $20.10 limit. At that point, the predatory algo sells the stock short at $20.10 to the institutional algo, knowing it is highly likely that the price of the stock will fall. When it does, the predatory algo covers.
This is how a stock can move 10 or 15 cents on a handful of 100 or 500 share trades.
AUTOMATED MARKET MAKERS
Automated market maker (AMM) firms run trading programs that ostensibly provide liquidity to the NYSE, NASDAQ and ECNs. AMMs are supposed to function like computerized specialists or market makers, stepping in to provide inside buy and sells, to make it easier for retail and institutional investors to trade.
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AMMs, however, often work counter to real investors. AMMs have the ability to “ping” stocks to identify reserve book orders. In pinging, an AMM issues an order ultra fast, and if nothing happens, it cancels it. But if it is successful, the AMM learns a tremendous amount of hidden information that it can use to its advantage.
To show how this works, this time our institutional trader has input discretion into the algo to buy shares up to $20.03, but nobody in the outside world knows that. First, the AMM spots the institution as an algo order. Next, the AMM starts to ping the algo. The AMM offers 100 shares at $20.05. Nothing happens, and it immediately cancels. It offers $20.04. Nothing happens, and it immediately cancels.
Then it offers $20.03 – and the institutional algo buys. Now, the AMM knows it has found a reserve book buyer willing to pay up to $20.03. The AMM quickly goes back to a penny above the institution’s original $20.00 bid, buys more shares at $20.01 before the institutional algo can, and then sell those shares to the institution at $20.03.
PROGRAM TRADERS
Program traders buy or sell small quantities of a large number of stocks at the same time, to trigger NBBO or discretionary algo orders, so as to quickly juice a market already moving up or down into a major drop or spike up.
Because so many algo orders are pegged and are being pushed around by other high frequency traders, program traders are like a fuse. When they light it, that’s when things get really going. This is especially so in volatile markets when things are very shaky and people are very nervous like they are now. Keep in mind that many algo orders must achieve a percentage of volume that matches the market in the stock. So if the program traders can increase the volume on an individual stock just enough, they will trigger even more algo buying or selling.
Program traders profit by having an option on the market. Their objective is to push that option into the money by a greater amount than what they used to get the market moving.
MARKET CENTER INDUCEMENTS FOR HIGH FREQUENCY TRADERS
Most high frequency trading strategies are effective because they can take advantage of three major inducements offered by the market centers and not typically accessible to retail or institutional investors.
1.
Rebate traders trade for free. Because they are considered to be adding liquidity, exchanges and ECNs cover their commission costs and exchange fees. This makes it worthwhile for rebate traders to buy and sell shares at the same price, in order to generate their ¼ penny per share liquidity rebate on each trade. Exchanges and ECNs view the order maker as a loss leader in order to attract the order taker. In addition, the more volume at different prices, even if that means moving back and forth a penny, the more money the market center makes from tape revenue. Tape revenue is generated by exchanges and ECNs from the sale of data to third party vendors, such as Bloomberg for professional investors, and Yahoo for retail investors.
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2.
Automated market makers co-locate their servers in the NASDAQ or the NYSE building, right next to the exchanges’ servers. AMMs already have faster servers than most institutional and retail investors. But because they are co-located, their servers can react even faster. That’s how AMMs are can issue IOC orders – immediate or cancel – sometimes known as “cancel and replace.” They issue the order immediately, and if nothing is there, it is canceled. And that’s how AMMs get the trades faster than any other investor, even though AMMs are offering the same price. AMMs pay large fees to the exchanges to co-locate, but it obviously has a decent return on investment. According to Traders Magazine, the number of firms that co-locate at NASDAQ has doubled over the last year.
3.
People often wonder whether it is fair or legal for program traders to move the market the way they do. Everybody forgets, however, that in October 2007, just a little more than a year ago, the NYSE very publicly removed curbs that shut down program trading if the market moved more than 2% in any direction. The NYSE said it was making the change because “it does not appear that the approach to market volatility envisioned by the use of these ‘collars’ is as meaningful today as when the Rule was formalized in the late 1980s.” On a more commercial level, the NYSE had been at a competitive disadvantage because other market centers that didn’t have curbs were getting the program trading business.
What Is The Effect of All This Toxic Trading?
1.
Volume has exploded, particularly in NYSE stocks. But you can’t look at NYSE volume on the NYSE. The NYSE only executes 25% of the volume in NYSE stocks. You’ve got to look at NYSE listed shares across all market centers, such as ECNs, like the NYSE’s own ARCA, or dark pools, like LiquidNet. Traders Magazine estimates high frequency traders may account for more than half the volume on all U.S. market centers.
2.
The number of quote changes has exploded. The reason is high frequency traders searching for hidden liquidity. Some estimates are that these traders enter anywhere from several hundred to one million orders for every 100 trades they actually execute. This has significantly raised the bar for all firms on Wall Street to invest in the computers, storage and routing to handle all the message traffic.
3.
NYSE specialists no longer provide price stability. With the advent NYSE Hybrid, specialist market share has dropped from 80% to 25%. With specialists out of the way, the floodgates have been opened to high frequency traders who find it easier to make money with more liquid listed shares.
4.
Volatility has skyrocketed. The markets’ average daily price swing year to date is about 4% versus 1% last year. According to recent findings by Goldman Sachs, spreads on S&P 500 stocks have doubled in October 2008 as compared to earlier in the year. Spreads in Russell 2000 stocks have tripled and quoted depth has been cut in half.
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5.
High frequency trading strategies have become a stealth tax on retail and institutional investors. While stock prices will probably go where they would have gone anyway, toxic trading takes money from real investors and gives it to the high frequency trader who has the best computer. The exchanges, ECNs and high frequency traders are slowly bleeding investors, causing their transaction costs to rise, and the investors don’t even know it.
WHAT CAN BE DONE?
Forget about short sale restrictions. From a regulatory point of view, we believe two simple, but powerful rules would help to eliminate much of the problem.
1.
Make orders valid for at least one second. That will eliminate the pinging. High frequency traders will expose themselves. One second would destroy their ability to immediately cancel it if nothing is there.
2.
Reinstate the 2% curb on program trading. When the market is down 3% or 4%, that’s when the program traders can really juice it. The SEC, however, has to institute the curb across the board so no market center has an advantage over another.
With these two rules, at least half the volume of the exchanges and ECNs might go away. The market centers, however, will surely fight it because they don’t want to lose the trading volume and the resultant tape revenue.
Until then, what can investors do?
While there’s little action that retail investors can take, we urge institutional investors to not “walk away from the machine” after they have entered an algo order.
Algo and other electronic trading systems have lulled many institutional traders into a false sense of security. These traders like the electronics because they can enter orders directly and they don’t have to bother with sell-side brokers. The trades are cheaper, at 1-2 cents per share versus 4-5 cents. And the performance seems adequate, in that the trades get done in line with standard metrics, such as the VWAP (the volume weighted average price). These traders, however, may not realize that the VWAP itself might have been 1 to 3 cents per share higher or lower because of toxic order flow. So in the end, institutions might be really paying 5 cents per share or more for their trades.
We also recommend that institutions use algo systems only for the most liquid of stocks. Anything less must be worked, the same as in the “old days.” Institutions need to re-learn how to “watch the tape” and take advantage of, or work around, high frequency traders.
Achieving best execution has never been more challenging.
Sal L. Arnuk and Joseph Saluzzi are co-heads of equity trading and co-founders, along with Paul S. Zajac, of Themis Trading LLC (www.themistrading.com), an institutional agency broker. For more information, call 973-665-9600
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