Thursday, July 15, 2010

Culprits and scapegoats

Over last few months, on several occasions  I found myself involved in the (often heated) discussion of High Frequency Trading (HFT), Liquidity Providers (LPs) and related topics, ranging from false bids to flash crash. The exchange  almost invariably involves angry accusations of HFT as the cause of many market ills. Since I get involved by pointing out the flaws in those accusations and errors in technical assessments of HFT impact, I've got asked a few times: Why do you insist on defending HFT and LPs, what's in it for you?

Here is the deal: because I've seen it already and I know where it's going. Let me expand on that.

Remember tech boom of 1998 - 2000 and consequent crash of 2001-2002? As in all boom-bust cycles, a lot of people lost a lot of money; as always in such cases, blame game followed. Now, do you remember who was chosen as a guilty party and what measures were taken? Funds chasing prices to stratospheric highs, throwing newly contributed money in to support the run created by old(er) money, thus creating what can be called an unsustainable pyramid? Market commentators and TV personalities hyping "new economy" and promoting useless companies with no substance? Monetary policies leading to yet another bubble? Lack of any meaningful oversight allowing any hack with computer in the basement to create a website and call himself a company? Yeah right. Powers That Be elected day traders as a scapegoat. They, day traders, run the market up to those insane and unsustainable highs, you see. In the process they also caused abnormal volatility, those bas****s. And of course, they don't contribute anything to society, ya know... darn parasites.

Stunned day traders meekly objected. We can't run the market anywhere in any more or less meaningful time frame, they said - being very short term participants we are generally net neutral by the end of the day, thus fully eliminating our directional impact. If market goes up day after day, it's surely someone else's buying that causes it. And we jump in with out bids and offers on intraday basis, thus providing liquidity for longer term players, narrowing the spreads - after all, each lower time frame players serve as liquidity providers for higher time frame ones, isn't it ABC's of the market?

It all made perfect sense for anyone who understands what market is and how it functions. But since when making sense mattered any? Blame had to be assigned, fingers had to be pointed and measures had to be taken. Scapegoat was chosen. What did we get as a result? Why, $25K rule. Remember? Can't day trade unless have $25,000 in your trading account. What a fix, eh? Mission was accomplished - as far as political expedience of the moment required.  Did anything got fixed in reality? Well, we moved right to the next bubble; market went through another run-up and consequent crash; volatility during that crash reached unprecedented magnitude; destruction of wealth occurred at the breathtaking scale and speed. Oh, and just to add insult to injury - those same TV personalities continue their hype, never bothering to acknowledge ever being wrong. Can you call that blaming day traders anything but distraction?

Fast forward to these days. Is it time for new blame game to start? You bet. Will Powers That Be try to find another scapegoat, allowing real culprits escape spotlight once again, thus dooming us for another boom-bust cycle? That's exactly what is happening in front of our very eyes, with the same arguments and purpose. This time it's HFT. They cause unsubstantiated  direction (never mind that they scalp tiny spreads, often less than a cent, not causing any direction). They cause volatility (never mind that in order to earn their rebate they must ADD liquidity by putting in bids and offers, not taking someone's; thus they do provide liquidity for higher time frames as design intends). They cause crashes when withdraw their orders (never mind that if it were so then forbidding their activity would have caused crash right away). There are many other accusations, most of them based on complete lack of understanding how market mechanisms function. There are probably valid ones  too but it's hard to hear them in the choir. Nor there any interest in meaningful discussion - just as there wasn't any back then, after tech boom. Just as back then, there are those who fuel all this finger-pointing with purpose of shaping up yet another scapegoat and diverting the spotlight from real culprits, while imitating activity instead of resolving real problems. Then, there are those who simply misdirect their anger, believing that it's HFT that really causes troubles in the market...

Are there negative sides to HFT in my eyes? Sure, and they must be dealt with. Quote stuffing (practice of submitting a bunch of orders and immediately cancel them in order to overwhelm the system and take advantage of faster computing) must go - and is very easy to deal with. Establish min time for an order to remain valid (1/2 sec to 1 sec, for instance) - problem solved. Exchange presenting order information to an HFT firm before order goes to open market - if that happens, it's simply illegal (and it would be illegal with any other market participant so it's not HFT-specific violation);  jail them if you caught them doing that. Etc. But no, HFT opponents insist on transaction tax and/or widening the spreads as a method of reigning in the HFT. Talk about scorched earth tactics - cover the ground with napalm to eradicate the mosquitoes; bears, rabbits and birds be damned.

So there you go. Instead of real solutions we are going to get tweaks to what needs no tweaking, and measures that will harm retail investor. Blood-thirsty angry crowds will be satisfied. Officials charged with market oversight will demonstrate that the measures have been taken. Mission will be accomplished - once again.

That's why I express contrary view on this topic so adamantly. I've seen it already. Same arguments, same volume increase, reaching crescendo soon. Same purpose. Same outcome, too.

Monday, May 10, 2010

Market reversal setup

On Apr 30 I made this post describing my conditions for the market reversal:

Today's selling

Submitted by Vadym Graifer (1179 comments) on Fri, 04/30/2010 - 15:12 #61968

... is much closer to what I'd like to see for a trend reversal than anything we have had in quite a while. Slow, orderly, sustainable... Not ready to call it full blown reversal yet, but if SPY doesn't go over 121 and loses 118.20, that should do it.

Let me show the setup I had in mind making that call. To provide a background which is fresh in memory today but will be a bit murky for readers in a while, the market had huge rally for about 13 months, and last couple months we had almost no pullbacks - just day after day of relentless upward climb. Search for the reversal and calls for the top, made all too often during whole rally, became almost hysterical. Time and again asked if "we are there yet" I was answering that I saw no signs of reversal. This post above though described a trigger for market reversal. Let's have a look at the chart where you will see a horizontal line showing the trigger:

Looking at the top of the few bars forming the mini-range just above the breakdown line, you can see also where the resistance $121 came from. So, what we have here is: high at $122.12 made on 04/26, sharp retreat next day bottoming out at $118.25, a few days of consolidation forming a range between $118.20 and $121. That's the range that presented the setup mentioned in the call.

From here we had two scenarios. First is hypothetical now: SPY breaks $121 thus invalidating the breakdown. From there would would be watching for possible double top or abandon short idea if new high were made. Second is what took place: support was broken, and the rest is history.