Discretionary Traders in the Brave New HFT World

Monday, June 14, 2010

Robot on computer screenLast week's high frequency trading conference by the World Research Group helped me form a much greater understanding of HFT systems and the future of the industry. (My summaries of the event here: Day One & Day Two) Much of the discussion focused on the race for the lowest latency which I suspect was somewhat due to the high number of vendors in attendance and on panels. Yet it was reiterated by actual practitioners multiple times that the clear victors in the end will be those with the most creative and innovative programming uncovering and exploiting inefficiencies in the financial system. While hardware will always be important, it has been of an out-sized focus for the last couple years and T3 Capital's Sean Hendelman, in particular, does not believe that will continue. Software will reign supreme in the end and the brightest computer scientists will garner the largest share of the profits. Jeremy Muthuswamy, Professor of Finance at Kent State University believes we have only "scratched the surface" on HFT computational complexity and expects quantitative modeling to evolve incredibly in the coming years.

The Brave New HFT World
The takeover by the machines was overlooked by many active traders as HFT grew rapidly during the 2008 crash because the human trader still had ample opportunity to profit in a wildly volatile equity market. As market conditions have dramatically changed over the last 18 months, the edge computers have has reeked havoc on the P&Ls of traders unwilling to adjust their strategies. In my personal opinion, dedicated scalpers are a dying breed. The most difficult part of the equation for a hyper-scalper is maintaining discipline and emotional control under an impulsive, rapid fire strategy of buying and selling. Not only is the opponent now an unemotional black box, it is faster, much faster. Trades are now happening in nanoseconds, far faster than the couple microseconds required for a human eye even to see a bid or offer appear in the Level II. With that speed comes an inability for the human scalper to control their downside risk as positions move out of their favor far too quickly. This of course causes a high degree of stress and blurs judgment. Scalpers have found themselves outmatched on speed, emotion and risk control as HFT has grown. For the most part, a scalper's edge has been stolen from them.

There was decent amount of discussion during the conference on deciding the target latency to achieve through hardware investment. Latency is of importance only relative to what the strategy requires. HFT practitioners distinguish between strategies needing ultra low latency and those only needing low latency and those not as concerned. Regular traders often think of HFT simply as fast computers yet there is a high level of differentiation in terms of latency even within the HFT universe. The thought of being able to beat the computer on speed is almost comical as they are discerning among themselves the varying levels of latency.

Also worth noting is the much more complicated manner in which a computer can rapidly and accurately assess risk and reward scenarios. Typically a trader will judge risk and reward based on perceived levels while watching a Level II or by gauging trading levels on a chart. Yet, black boxes can calculate risks immediately based on percentages not dollars, the bid and offer interaction, the frequency of bids hit/offers paid in a manner far more sophisticated than the human daytrader attempting to measure trades through visual interpretation of the Level II and a chart.

As I have stated in the past (here) HFT is requiring traders to become more sophisticated. The computers will win in the very short-term trading game, there is no doubt. That does not preclude discretionary traders from finding a way to be profitable. It simply forces traders to study, learn, adapt and evolve.

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Ultimately, not being an HFT programmer myself the question is: how does the discretionary trader live in this brave new world? In a recent interview on Wall St. Cheat Sheet with President of First New York Securities, a prominent NYC-based proprietary trading firm, Joe Schenk made his business model clear: "Contrary to popular belief, our business is proprietary trading not day trading. Though we may trade intra-day, we are not day traders." This is a very important distinction and firms ahead of the curve have invested in HFT infrastructure while refocusing the manual trading to strategies beyond the very short-term.

Later in the interview with First New York was an excellent recognition by Donald Motschwiller: "But the guys who truly trade the markets the best — the most talented guys in the firm — they trade the markets intuitively. They’ve seen it so many times and are so confident in the decision making process that they’re not reacting." From my experience, this is absolutely true. The best traders have an unexplainable gut feel that they are in tune with and trust in their decision-making process. Any technical or fundamental analysis does not represent hard and fast rules. The rules only work within the context of the overall direction and movement of the tape. Fundamental guys buying financials in 2008 without respect for the downward momentum would have seen painful losses. Likewise technicians highlighting a head and shoulders pattern in June 2009 failed to respect the incredibly strong bid that had entered the market. Intuition can certainly trump strictly quantitative strategies.

Simply put you will not win in the quantitative space; your approach must be different. In order for traders to succeed in a highly quant-driven tape they must develop a feel for the overall market and understand the ebb and flow of particular stocks and markets. Feel is very abstract, nearly impossible to teach and for the most part will only come through years of experience. But there are two particular daily activities I believe traders can do to help significantly shorten the learning curve. First, follow prices. Making a purposeful effort to memorize prices will allow you to contextualize any movement over time. This includes internalizing charts in order to know the history of prices. Second, read read read. The only way to understand the prevailing psychology is to gauge price reactions against headlines. There are many great financial blogs out there that help in determining broad sentiment.

In general traders need to understand trend and volatility. Trading with the trend is more important than ever as programs often exacerbate moves far beyond anticipated levels of support and resistance. Volatility is absolutely crucial in predicting the possible reward scenarios. While reward is measured in a pure dollar or percentage sense, traders must also appraise the probability of that reward coming to fruition. Lower volatility times yield lower returns and therefore require tighter stops.

Beyond developing feel, I believe traders are well-served by studying fundamentals. Trading plans must be arranged well before the stock hits the buy or sell points. Most important for me is background research on the underlying companies. My best trades have always occurred when I have the greatest amount of conviction in the idea. This conviction is only gained by putting in-depth research on the idea. Holding stocks for longer periods of times will only be consistently profitable if you are correct on the motivating factors behind the buying or selling. While it is probably not necessary to know the long-term debt to capitalization ratio of a given firm for example, it is important to recognize catalysts and know their impact in order to swing trade effectively. With technical levels becoming more fluid than ever before, the ability to hold through tumultuous volatility is only possible by intertwining fundamentals into the equation in order to maintain confidence in the trade.

At the end of the day, as argued by Muthuswamy, "so went the pit trader for the electronic trader, so will the quant human trader go for the robo trader." Admitting the inability to compete as a human is the first step, the second is to find a new method. There is huge opportunity in swing trading as volatility remains elevated currently at 27%. High beta names have huge ranges on daily basis. The keys for out-performance over the next few years will be those that are in tune with the tape and those that generate fundamental conviction for their trades.

Backlink: Wall St. Cheat Sheet
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