From the May 01, 2011 issue of Futures Magazine • Subscribe!

Algo trading in the liquidity mirage of high-frequency trading

Firing all cylinders

Many systems are programmed with 17 to 20 risk parameters to take into account the number of concurrent systems, some that will send buy-orders and some that will send sell-orders. The objective is to fire all cylinders where there is an element of trades that match each other, others that create a net-short in some markets and others that create a net-long . The algo wants to find that level where the trades create a slight movement that triggers competitors’ orders to participate in the price discovery process.

These days, high-frequency algo trading strategies also have been designed to analyze competitors’ orders to try to take advantage of either size or speed. This creates an additional element of algos feeding off each other.

The long-term effect will be a fundamental change in market structure. Unless regulatory authorities step in and somehow prevent orders designed to create the impression of activity, eventually the machines will have nothing to feed off. However, authorities do not know where to look or even what questions to ask. The elusive needle in the haystack is buried so deep within millions of lines of code that no audit trail could find it. Additionally, all notions of churning, which in regulatory terms refers to the excessive buying and selling of securities by a broker for the purpose of generating commissions, are being ignored, as is order front-running, something machines have finessed. All this is perceived as liquidity, but in reality it is a mirage. When the machine is overwhelmed, such as on May 6, 2010 when the Dow dropped 1,000 points in less than an hour, then chaos occurs.

Strategies

For retail traders, taking advantage of the algo trading landscape is a challenge. However, there is some hope. The retail traders’ objective is to align themselves with the high-frequency algo traders rather than fight them. In other words, determine when the algos are buying or selling and trade directionally with it.

This is a difficult proposition. The high-frequency algo trading systems are not designed to be directional, but like the old floor local working the bid/offer spread to its maximum advantage while nevertheless moving price up or down like a game of Chutes and Ladders. The VWAP is one of the more simplistic tools for retail traders to follow that taps into some of the order-flow peculiarities of the algo-trading phenomenon.

The VWAP, available as an indicator on nearly all major charting programs, is calculated by dividing the sum of the dollars traded (price multiplied by share volume) for every transaction by the total shares traded for the day.

The VWAP formula is below:

image

Where:

Pj = the price of trade j
Qj = the quantity of trade j
j = each trade taking place over the time period

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