Saturday, November 19, 2011

To succeed in trading you have to think like HFT

Every experienced trader knows by now that HFT (high frequency traders) have taken over the markets. It is widely documented that super computer-generated trading contributes to roughly 70-75% of daily stock market volume. So how are small individual traders like us supposed to keep up with these powerful machines? Let me try to answer this very important question asked by so many traders today.

"A man can fail many times, but he isn't a failure until he begins to blame somebody else."
- John Burroughs

Traders complain that these evil computers are impossible to beat, and pretty soon will displace humans out of the trading biz altogether. Investors complain that HFTs are killing the market, and very soon there will not be any investors left on the planet, and how it will all be super computers duking it out between intra-day support and resistance levels, with no human interaction and real fundamental investing involved. Influential market players are also complaining that what used to be investing has already been replaced by trading for pennies, with no long-term holding period in mind, which jeopardizes the primary purpose of stock markets - business capital generation.
While I agree with everything said above, I refuse to join the crowd in this blame game. I refuse to lay my arms down and stop fighting for my place to participate in financial markets. So I have done my part to adjust to the shenanigans of HFT. My trading is now solely swing and position. I realized that I can not be going after 4-5 SPX points during the day, when I am merely a fly on elephant's back. I extended my holding periods, widened my stops and profit targets, and methodically scale into and out of all of my trades. But I want to go further and try to use HFT for my gain. I want to use HFT for entries on my swing positions at correct levels. Following is my thinking in detail.

"If you can't beat them, join them."

What is HFT? These are quant super computers. They process enormous amounts of data very quickly, which is impossible for humans to do. But these computers are programmed by humans. These are people like you and I, who input the data into the machine, which then acts on occurrence of that data and generates a trade signal. So if we know what data is inside the machine, we can join it on the trade. The problem is these highly guarded algos are impossible to get, unless you want to end up in jail. Therefore we are left guessing what is inside the HFT machine. So here is my educated guess.

My idea is that algos are nothing more than a confluence of different indicators, support and resistance levels, volume, correlation between various asset classes, and as silly as time of the day generated signals. You do not have to have Ph.D. in mathematics to program your trading to do the same. This is something a well-educated trader can do on his own. The only advantage these machines have (or more correctly, their owners) is that they have 30 milliseconds to see our orders before they get executed. I do not know how to fight against that. I will leave that part to SEC and CFTC to deal with.

And now that I have a rough draft of what these HFT firms do, I will lay out the case where this market is going to go in the near future. My idea has always been - follow the leader. The leader of the market has been NDX. While many have said (myself included) that it is lagging in the last few weeks or so, I now think it is actually leading the market to a pullback. It is not letting SPX and Dow go where they want to go - up. Once NDX does what it has to do (described in detail in the next paragraph), it will then lead the market on the turnaround and year-end rally. This NDX weakness can be attributed to many reasons. AAPL and AMZN have been underperforming. Overall tech is weak due to some year-end related selling and cash raising by fund managers. If you can't sell losers you sell what you can - winners in this case are tech and gold. Also this past week we got some pretty crappy tech earnings-related performance from NTAP, DELL, CRM, and AMAT. But the most important reason for all of this weakness is - HFT can not do anything when the index is stuck in no man's land, where I think NDX is currently. With HFT being over 70% of trading volume and not generating any buying interest for a breakout to higher levels, NDX is drifting lower. This notion is being confirmed by anemic volume in the last few weeks. HFT are waiting for a signal to buy.

So now lets look at what HFT will do with NDX and therefore the whole market. While entire investing community is glued to SPX levels, I strongly think that we will get the buy signal from NDX. Following is my assessment of where HFT will possibly buy NDX and send it significantly higher. I am expecting that strong rally will last between Thanksgiving and Christmas and will take NDX to new 2011 high. SPX and Dow will come for the ride. In my previous post I described why am watching "4 Generals of Tech" (AAPL, AMZN, GOOG, and IBM), which have heaviest weighting on NDX (and one of them on Dow), for possible culmination of this market pullback. They all have gaps to fill, which are also laminated with major moving averages, where in my opinion HFT will be buying those stocks.
Now back to NDX itself. There is a Buy Zone between 2184 and 2228 where in my opinion HFT will come in strong. Remember I said confluence? Here is the breakdown:

1. 2184 is 61.8% fib of rally from Oct 4 low to Oct 27 high
2. 2188 is a double bottom from March and June
3. 2203 is an open gap from Oct 7, which has not been filled
4. 2218 is flat on the year
5. 2228 is 50% fib of rally from Oct 4 low to Oct 27 high
6. Formerly broken trendline (from 2011 high) backtest is also located in this buy zone
7. Buy zone is further supported on weekly chart by lower trendline of Bull Flag

So with all of the above parameters, here are the resulting charts: 

HFT buy zone
(click on images to enlarge)


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