Archive for September, 2013

Trade Smarter, Not Faster

The Race To Zero

High-frequency-trading1Since the financial crisis of 2008, the media has been in a state of constant awe of high frequency traders. High frequency traders profit by taking advantage of tiny and fleeting discrepancies in the price of exchange-tradable financial instruments. It’s an expensive game of reducing tick-to-trade latency called the race to zero.

Some, like the folks at Zero Hedge and Nanex felt it was their mission to end high frequency trading, seeing it as a parasite preying off of the honest hard work of main street investors and commercial hedgers. High frequency firms argued that they were providing the service of liquidity to the market and were rightfully deserving of their profits. Moral high ground for either side notwithstanding; no one could argue that high frequency firms were printing money fast enough to make even Ben Bernake blush.

Where Does it End?

It may be big business, but like the floor and point-and-click trader before him, the algo trader may soon be eating humble pie. In May of 2013, the Eurex exchange, under the pressure of European regulatory bodies, made changes to its matching engine that add around 100 microseconds of induced latency on GTC orders. Thus wreaking havoc on a book stacking, a favorite HFT algo. In the US, predatory practices such as dark pool pinging, stop-hunting, and even more benign practices such as stack widening are becoming increasingly illegal.

Some high-speed firms have already thrown in the towel. Getco, for example, merged with Knight to form KCG, a financial services company. It now leverages its enormous technological infrastructure for the purpose of servicing its customers. Though some internal prop trading does still exist, its a shadow of its former self. The race to zero may be coming to an end, but the technological arms race has only just begun.

Trade Smarter, Not Faster

One area of particular interest is the use of Artificial Neural Networks, or “neural nets.” Neural nets mimic the central nervous system of animals and are particularly useful at solving non-linear problem sets where there is not necessarily one right answer or one method of solving a complicated problem. A neural net can approximate an answer rather than simply throwing exceptions or saying “I don’t know.”

For this reason, neural nets are popular in areas such as facial and handwriting recognition. Google uses them to recognize street signs in their self-driving cars and Netflix uses them to guess which movies you’ll like based on what you’ve watched. They could be used to produce accurate polygraphs, predict what route would be the most efficient way to get to work, guess what freight rates might be, or as we care about in financial technology, predicting the price of a tradable instrument. Just as high speed trading algos threatened to put human trade executors out of a job, a neural net could put quants out of a job.

As a trader, what can I do to prevent being left behind?

Unskilled labor has always competed with machines for work, and technology has has always raised the bar of what constitutes “unskilled labor.” Assembly lines have made the blacksmith obsolete, robots have made assembly line workers obsolete, matching engines have made floor traders obsolete, and neural nets just may make the algo traders themselves obsolete. One thing is certain, the only playing field leveler in this rapidly changing world is education and constant reinvention. Having help and building the right tools certainly doesn’t hurt either, in which case I’d recommend calling your friendly representative at Scaled Dynamics.

Update 9/30/2013: Due to the popularity and response to this article, I will be giving away one day of my time in the form of 8 one hour consultations to discuss the evolving needs of the algo trader. Because I’m only going to set aside one day of my time for these, spots are limited. Please submit an application to explaining a bit about your trading style and how you’d like to evolve as a trader.

Dark Pools

Dark PoolsI’ve been reading Dark Pools, by Scott Patterson over the weekend and I’ve got to say that it has been the most thoroughly educating introduction to the wild and confusing world that is electronic equity trading. I’ve really had my head in the futures and options sand for way too long. No longer.

The whole experience has inspired me to spend my weekend working on writing an Interactive Brokers adapter to SD Gatekeeeper. When it’s finished, my customers will be able to trade a HUGE VARIETY of financial products instead of just futures and options, provided of course that they open an account with IB. More details to come when it actually launches!

Guest post by Randall Liss – You Give The Orders

Today’s post is by a new guest blogger, Randall Liss. Randall is an educator who specializes in options trading.

You Give The Orders

I’m posting late today because I have a new advertiser (see right column) and we had to get the ad up. The ad is for an excellent trading platform and I recommend taking a look, particularly if you trade professionally. I was gratified that a few people emailed me this morning wondering where today’s missive was. Quite flattering.

Tomorrow there will be no column as it’s Rosh Hashanah and I don’t work on the High Holidays. And now, without further ado…

am a firm believer in the power of all of you as individuals to make sound investment choices. Mutual funds and fund managers have a mixed bag of results and I promise, having met many of them, these managers are no smarter than you are. Proper financial education is your key to controlling your own financial destiny. And proper education, with an emphasis on options, is what I’m all about.

Which leads to today’s topic: Types of orders. If you are going to place your own orders (and why not?) then an overview of types of orders is fitting and proper.

Limit Order: This means that the price at which you wish to trade is fixed. If the market never hits that price the order remains unfilled and you do nothing. And there’s nothing wrong with that! Trade at your price or don’t trade at all. The alternative is the:

Market Order: This order is executed instantly at the best price available at that moment. But you have no idea exactly what price that will be. In a highly fluctuating market your execution price (your “fill” as it’s called) could be far away from what you expect. For this reason I do not believe market orders are a prudent way to trade. I prefer limit orders.

Stop Loss Order: This is a good safeguard to have as its intent is to stop your loss. Say you buy an asset at 9. You place a stop loss at 8. Meaning that if the price drops to 8 you immediately have placed a sell order to limit your loss to 1. A stop loss can also be used to safeguard a profit. This sort of order is called a Trailing Stop. Take our previous example, you buy at 9 with a one point trailing stop. If the price moves to 11 your stop loss order now kicks in if the price drops back to 10. The price goes to 17, your stop order kicks in at 16 and so on. Bear in mind, though, that when a stop loss is triggered it turns into a market order. Meaning that you might not get filled at your stop price
but perhaps much worse. Which is why I prefer the:

Stop Limit Order: Take our previous example, you buy at 9 with a one point stop limit. Now if the stop is triggered your order becomes a sell order with a limit price of 8. You won’t get filled at a random price. The danger being that if the market really runs away from you your stop loss might not get filled. I still prefer a stop limit as opposed to a pure stop loss.

Day Order: This means that your limit order will automatically be cancelled if not filled by the end of the trading session. This is a good way to place an order because it mitigates overnight risk. You also don’t have to constantly monitor this order or even remember that you placed it. As opposed to the:

GTC Order: Which is an acronym for Good Til Cancelled. This order remains in force until you take an active role in cancelling it. For that reason, I don’t like GTC orders. I’d rather start every day fresh with no orders outstanding.

So, even if you don’t wish to be this pro-active and have an asset manager that you trust, ask him/her about how they place orders and what sorts of orders they place.

Remember! You are the Boss! Your destiny is in your hands. And Education is Key!

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