Alright, I admit it. For a long time, a number of traders who are much smarter than me told me tales of stops being run and seeing mysterious outlier volume prints during the trading day. For the most part I dismissed these claims, likening them to being the stuff of conspiracy theories. You know the type.
Man never landed on the moon. Okay, sure buddy.
JFK was killed by the mob. Uh huh…..right, right.
My 45-year-old cousin who has never been married and owns a vintage dress shop called “Out of the Closet” isn’t gay. Yeah whatever….!
But about four or five years ago I slowly started to change my tune as I realized that manipulation by HFT’s and algorithmic trading was in fact true.
The seeds of this manipulation were sown when the exchanges switched to decimalization back in 2000. This meant that instead of 1/16th of a point (6.25 cents) being the smallest price change that a stock could move, they could now move in pennies.
The change was supposed to benefit the retail trader, giving them tighter spreads and ideally more liquidity, but technology began to bastardized the concept, slowly turning it into a disadvantage for the average trader.
The problem was only exasperated when the exchanges were allowed to go public and the overriding idea was more profit which meant more transactions. It has now gotten to the point where the computers for HFT firms sit next to the exchange’s servers and rivals compete to see who can have the shortest CAT 5 cable connecting them.
In addition to seeing this problem from the trading side, over the last few years as I ventured over to the brokerage side, I began to get an even clearer picture of the shenanigans that go on. Now I regularly see fill reports from the exchanges that go six places to the right of the decimal (as seen in this example of a trade in $KBH from yesterday).
What can you do as a retail trader to combat the companies, traders, and bots that have almost unlimited funds and resources and perpetuate this problem? You have to think “out of the box,” and here are five suggestions on how to do that.
Change the way you trade patterns – It used to be that trading a breakout from a traditional chart pattern was the money. But then everybody in town traded the breakout, and HFT’s took advantage of that and trading the false breakout became the money. But now, trading the breakout in the original direction of the pattern after the false breakout is the money.
Point is, you have to give patterns more leeway, even to the point where traditionally they would be considered “distorted” or “broken.” Ha, ha, ha, laugh all you want, but if you trade a pattern in the traditional way these days you might scare off a nice baby who’s ready to party. Sorry, I watched “Swingers” last night.
Embrace the “tail” – I spent twenty years trading in the opposite direction from tails; the long thin extremities most apparent on candlestick bar charts. The idea being that price had penetrated those levels, was rejected, and then should reverse away from the tail.
Back in the good ole’ days, meaning 2007, I started to see Trader X talk about the ends of tails as triggers to get into a trade. For example, using the low of a hanging man candle at support as a trigger to get short, illustrated in the chart below of $FB.
Because I used to be the “world’s smartest trader” and didn’t listen to anyone else, I brushed aside the idea. But now due to the tendency of HFT’s to “probe” past support/resistance levels momentarily, tails are more prevalent and less significant than they used to be. Try using levels created where multiple tails line up as the true support/resistance levels to trigger your entries instead of the more traditional levels.
Re-think your ideas on stops – In the past I have written about three different techniques for placing stops that can help thwart having them run by HFT’s. The concepts revolve around being more dynamic in the way you place them and using a chess like mentality to think a number of steps ahead. You can read the specifics of these ideas in my post, “How To Place More Effective Stops.”
Stick to high volume stocks – As of this writing it is still pretty hard for HFT’s to manipulate the movements of highly liquid stocks like $AAPL or $MSFT as well as many widely followed ETF’s. Keep in mind that the higher the volume and tighter the spread, the less susceptible a stock is to mechanical machinations.
Take a longer time frame – Once again, as of this writing HFT’s can only affect price in the short-term. As you go towards longer time frames, like in swing trading, you can almost completely eliminate their influence. The one codicil to that is that when you are tying to find an initial entry for that swing position you may have to scale in or give the position a little bit more room so as not to get stopped out.
BONUS TIP: (don’t say I’m not a giver)
Switch asset classes – HFT’s are most prevalent in equities and somewhat in futures. One area that they are not as involved in, or if they are don’t seem to make as much of an impact, is in options (especially weekly options) or forex.
Trading successfully always involves adaptation. It’s the nature of the game and always will be. The HFT’s and algorithmic bots that are currently running amok in the markets can cause difficulty, but with some creativity and strategy their effects can be muted to a great extent.
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