HFT and illiquidity – Part 1 (English Language)

The present article continues a series dedicated to High Frequency Trading (HFT) and program trading, from which I derive my trading edge. In the previous articles I have briefly introduced HFT and program trading and I showed how computerized algorithms are very widespread and, in some cases, they even regulate and ‘run’ markets. If these statements look extreme then I invite you to read my previous articles linked here below:

‘In the last few weeks I have introduced the topic of HFT and Program trading to my newsletter subscribers. HFT is so important going forward because it really affects markets health and their normal functioning. A trader with decades of experience I value and respect, Joe DiNapoli, studied profoundly the effects of HFT and lack of liquidity on the markets. I urge you read his article ‘Illiquidity and the danger it fosters for World Equity markets©‘ and that you request all the other links to free stuff he distributes on his website. Even if I don’t use DiNapoli levels and his method because I think the trading method of measured moves better explains price structure and, moreover, I don’t believe in the use of indicators (however you blend and displace them, they should have a very small part in a trading method, in my humble opinion). However, I am firmly convinced Joe DiNapoli has really got a deep understanding on how the market works and what’s going on the markets with regards to the effects of HFT.

Joe DiNapoli was there in 1987 when we had the firts market crash after 1929 and, actually, he predicted the crash (500 points lost in the Dow Jones index, or -20% in just one day) by observing lack of liquidity in the pit. In his very interesting article DiNapoli reports on several other market crashes he has witnessed, including the recent Flash Crash happened in 2010. That was not a surprise to those who understand markets and its mechanics from the bottom up, i.e. the bid, the ask, and the size. All of these crashes have one common cause: illiquidity. In a crash HFT computerized programs front-run bids and actually steal business to professional traders who intend to establish long positions in financial instruments now at much lower prices. Phantom bids appear and disappear (induced by HFT) in the process and a professional trader never has the possibility to participate. So either traders ends up owning a position when he/she are wrong (i.e. the market continues lower) or they never have the possibility to participate (they cannot establish a long position in a flash crash). For instance a trader bids $20 for a stock and HFT programs input a sub-penny bid at $20.001, so the trader does not get filled only to witness that bid disappear few seconds later. This process steals liquidity from the markets because in a such rigged market traders decide to reduce risk, i.e. position size, or not participate at all. The overall effect is even lower liquidity, and increase in trading costs, because of wider bid-ask spreads. With  decreased participation prices take on an non-natural shape where there are fewer or no retracements.

When there are less or no retracements in market structure, the overall market is less efficient. Those who are wrong have less opportunity to exit their positions and the market becomes over-punishing. Traders must be very precise in their entry and take partial profits frequently. Entering the market is more difficult too and it is very common to not get filled when you are right about market direction.
Among other reasons Joe DiNapoli brings to our attention that exasperate this tendency are the significant reduction in the number of traders (both professional and private) due to the economic crisis, sub-penny pricing and fraudulent denial of service trading techniques of HFT, computerized trading taking near riskless profits out of markets by exploiting time differentials in micro-second intervals in various markets, fraudulent naked short selling and less freedom in the markets that are no longer free to trade normally because of government and central banks policies (e.g. QE3).

What regulators are saying about HFT? While traders like DiNapoli believe regulators are well behind the curve and do not understand market structure and how market works, I would agree that the effect of HFT on the markets should not be studied only by academic personnel or government bodies. Real traders who understand the markets as auctions know what is really going on and, of course, know very well the psychology reactions of the group they belong to. Moreover we cannot exclude the existence of conflicts of interest as suggested by the lack of success regulators have showed in handling the financial crisis now 4 years old. Therefore the impression is that conditions are not in place (just yet) to tackle the HFT phenomenon in the right way. The approach is still reactive and not proactive: circuit breakers and forensic software helpful only ex-post (and not ex-ante), i.e. after the fact, in limiting the outcomes and analyzing issues, are the solutions proposed at the moment.

In particular, the adoption of software for forensic analysis of extreme market events, includes synchronized timestamps that could allow regulators in different countries to detect the sequence of trades. In fact some researchers conclude that regulating the algorithms used by computer traders would be too costly and cumbersome. Costly? Do we know how much banks running computer algorithms are making out of this bad practice? It could be in the millions every day. Other researchers found that high-frequency trading is not  spurring broad increases in volatility even as it sometimes creates “instability” that may lead to crashes. I think instability could lead to a crash like in 1987. By today’s definitions that would simply be a form of ‘instability’. As you can see I tend to stigmatize the blatant inaction of regulatory body with regards to the effects of HFT on markets’ health because I trust more direct experience of traders. However to get the full picture I will take a look at what researchers have found so far on HFT and what their reccomendations are.

In conclusion, it is key to keep monitoring the effects of HFT and the steps of regulators because HFT can affect market liquidity, the very functioning of the markets we love and know how to trade. For this reason it is also good to stick to futures or forex markets having the highest liquidity like the EUR/USD and the S&P500, as well as, to stocks with high volume.’

The above article appeared on my free Newsletter sent out last Sunday, November the 4th along with other information typically including: a weekly review for the Euro-Dollar cross and other Forex, indices or commodities futures, articles on my trading method, market commentaries and HFT/Program Trading articles like the one you just read. Please, register here to receive the free weekly newsletter.

If you like this article, please share it with your friends and fellow traders. Thank you.

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Filed under Articles, English language, Newsletter, Program Trading

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