Forget Support & Resistance, Areas of Volatility in High Frequency Trading

Friday, July 02, 2010

Support and resistance can be seen as the entire basis of technical analysis. While most technicians would distinguish between these two levels based on expected buying or selling pressure, T3Live's Sean Hendelman sees them quite differently as a high frequency trading practitioner:

"Support and resistance are one in the same. Namely, points of increased volatility. These areas increase the uncertainty of future direction and therefore volatility."

Short-term Support in the Past

Traders have long used support levels as areas where they expect buyers to step in and hold because there were buyers at that level previously. Price levels exist because people, consciously and unconsciously, create them. Traders and investors remember their entry prices, or at least they see the cost basis on their brokerage statement. These prices are therefore breakeven levels for many with a vested interest in that price.

Often, by expecting others to be buyers at the level, technicians only work to further solidify the existance of support through their own buying. The idea of a vested interest is also why breaking a support level is seen as a sell signal. Those that accumulated expecting the level to hold ditch their positions and eager shorts enter believing no buyers remain.

Support in the High Frequency Trading World

Support and resistance have become far more elusive and the risk of entering trades based on them has drastically increased in the last 18 months. Short-term technical levels are now extremely fluid.

Volatility increases opportunity and the wild oscillations around technical levels grant HFTs the ability to profit by beating manual traders in and out. Consider the 2008 crash with the VIX reaching a high of 89%: short-term traders were offered incredible opportunities as volatility soared. Think of a large whole number in AIG as a microcosm of this type of uncertainty and volatility. The high frequency trader jumping in and out in microseconds, even nanoseconds, can scalp pennies back and forth.

Two unprofitable scenarios now occur much more often at support levels with the influence of HFT: 1) rapid breakdowns and 2) false breakdowns.

A trader does not risk to a level, he risks to whatever price he receives upon exit when the level breaks. As high frequency traders are typically first to the trade in the downdraft when a support level breaks, the price to exit is often much further away than anticipated. By the time he has hit the bid, the manual trader has lost far more than his pre-determined stop.

False breakdowns occur when a support level is broken but the stock does not continue lower, at least not within the trader's timeframe. How often does today's discretionary trader short the low only to find the stock subsequently swept higher? High frequency traders will buy new lows and force weak hands to cover as the stocks pushes back through the short price.

The high frequency trading world has very different interpretation of support and resistance and given their speed, it is tough to compete in that world.

Adapting Trading Strategies

Running stops is as old as trading itself. Floor traders on the NYSE used to run stops intentionally for bucket shop owners so the shoe string margin players would be wiped out. Squeezing out larger, weaker players is a tactic used since the day Wall Street was paved. High frequency traders' manipulations around technical levels are just today's modern application of an age-old strategy to beat others at the same game.

Short-term traders had it easy for a long time, buying breakouts and shorting breakdowns to make predictable profits. But this strategy in a more range-bound tape coupled with high frequency traders can be disastrous. Avoid the temptation, don't battle the machines. Let the machines kill each other and don't step in the ring.

Traders must anticipate moves to much greater degree and they must be happy with the size they have accumulated once the trade gets under way. Adding through levels can and will destroy many potentially profitable trades as HFT throws the trader in for a spin.

Backlink: Wall St. Cheat Sheet
blog comments powered by Disqus