Friday, July 31, 2009

High Frequency Algorithmic Trading And How It Affects You


Two years ago, I made the acquaintance of a high-frequency algorithmic trader, and was invited to view his operations: In a small, darkened room a few doors away from our office in Princeton, NJ, three traders sat hunched over large multiple-screen computers. Colorful charts writhed across the screens like snakes, and numbers flashed and scrolled, updating in milliseconds. Just recently, such secretive operations were brought into the limelight with the arrest of the Goldman Sachs engineer who stole the codes for an algorithmic strategy. The public is now aware that at least 50 % of the trades on Exchanges across the world are algorithmically driven. That is, no humans are involved as trades are executed at the speed of 500-1000 trades per second. And large blocks of shares are broken up, bought or sold in split seconds to avoid detection. The machines send out probes and gather information to enable them to profit from statistical arbitrage i.e. differences in Bid and Ask of as small as 1/4 of a cent. It has now become an arms race and a war of the machines as rival houses' software (and hardware) battle each other for supremacy in speed and sophistication of strategy. (some traders like my Princeton friend actually move their operations to be nearer to the Exchange's servers for a small but crucial advantage in speed, even though we know electronic signals travel at the speed of light at 186000 miles per second). 10 years ago, Dr. Peter Olsen of the Forex house Oanda, gave me his seminal book on mining patterns from very large sets of high frequency data, and predicted the rapid advance of such techniques. His predictions have now come to past and the small investor had better know more about what the machines can do, and take counter-measures, or else he stands not a chance of surviving in the new high tech trading environment. Here then, are what machines have done to the trading environment, and what you the individual small investor can do to mitigate their effects:
1. High speed algorithmic trading [HSAT] causes the trading environment to be much more noisy. Being based not on fundamentals, but on Momentum and Volatility, they create illogical patterns which confuse the rational small investor who is trading on fundamentals. Even the day trader with his arsenal of technical analysis indicators like the RSI, MACD, or Stochastics will be confused by decisions and execution which are a hundred, or thousand times, faster; and which are gone by the time the real-time indicators move.
2. The liquidity which is generated by such trades gives a false picture. For small investors who look at volumes on the daily Close and make their decisions based on such volume, it is not accurate. Yesterday's liquidity may shrink to nothing today depending on the initial trades and how the machines weigh the probabilities for making a particular stock the flavor of the day, or even flavor of the hour or the minute.
3. Because of their increasing dominance, HSAT makes it possible for a market to act irrationally and out of sync with its fundamentals for a longer time. Thus what you see now, in the liquidty-driven global rally, in the price of crude oil futures, and in the Forex markets are in part due to the machines.
What you can do to avoid the machines:
Give up single stock, single currency, or single commodity picking. Invest in a diversified portfolio, playing on global megatrends. The machines will not be playing in this segment. It is too slow for them. They will be playing the daily ups and downs within the megatrends. By investing in the global megatrends, you are fundmanetally biased, thus avoiding the machines which play the noise.
What are these megatrends?
You can for example bet on a few things like: (1)the eventual decline of the US$, (2)the rise of inflation as stimulus measures create more debt for governments,(3) the almost inevitable rise of Asia and the Asian economies.
How do you play these megatrends?
ETFs [Exchange Traded Funds] are the instrument of choice for gaining exposure to global megatrends. With ETFs you can not only play whole sectors, and whole themes of investment. ETFs are also global, multi-asset class, and they can be Long or Short. And the costs of investing in ETFs is much lower than if you invested in mutual funds or a hedge fund. ETFs are traded exactly like a stock. ETFs tend to be less volatile, since they consist of a portfolio of underlying assets. You can also set aside say, 10 % of your ETF investment funds to actively trade short-term on the more liquid ETFs. Thus while the core 90 % is stable and move in a megatrend way, the actively traded 10 % can help to enhance total returns.
Examples of ETFs for the current economic environment
Ticker Symbol:
UDN (NYSE) Powershares DB US Dollar Index Bearish is one way to bet on the gradual decline of the US$.
WIP (NYSE) SPDR DB International Government Inflation Protected Bonds: Inflation-protected bonds of governments excluding the USA. You also get a yield from the Bonds besides capital gains.
AAXJ (NASDAQ): i-Shares MSCI All-Asia Ex-Japan Index. Gives you exposure to the 11 developing and emerging markets of Asia excluding Japan. A good way to ride on China and India with less volatility.
Links
A good way to start is to take a look at the Fulcrum fund portfolio of Singapore financial advisers New Independent http://www.ni.com.sg/
For trading ETFs in a shorter time frame, subscribe to ValuEngine's weekly ETF Report at http://www.valuengine.com/
For a platform which allows the trading of over 1000 ETFs across 22 Exchanges, try Danish Bank http://sg.saxobank.com/

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