How has algorithmic trading affected futures? Part 2

According to expert forecasts, popularity of high-frequency and algorithmic trading will continue to grow in several major global markets, since the demand for independent and private trading firms or proprietary companies and trading quantum strategies will increase. Despite a huge pressure, especially due to the HFT guilt in the Dow Jones Index flash crash on May 6, 2010 (the 1,000 point crash with further recovery to previous levels within 15 minutes), HFT algorithms do not plan to leave.

It is expected that new regulatory norms will make the markets more transparent and reduce their volatility. Experts believe that HFT is a natural direction of the financial market development. As of now, there is a multitude of studies in such fields as the regulation of risks and provision of observance of the established requirements, technology adaptation, software code optimization and so on.

The essence of these words is that the high-frequency and automated trading is here to stay with us. But what does it mean for an average retail trader, who prefers to trade from home, analyzes charts in the computer screen and posts orders manually (in fact, using electronic means)?

First of all, there is no absolutely reliable way to guarantee your protection from sharp price fluctuations, created by HFT and algorithmic trading, but you may stick to certain recommendations, which ensure minimization of losses.

Execute less trades: it doesn’t mean that you should trade less – you should rather focus on the best possible setups of your trading strategy. In the event you trade only the best possible setups, you will not only reduce losses, but would also become more selective in your trading. A smaller number of trades means smaller transaction expenses in the long-term perspective, which would help you to ensure stable income in the long run. Remember, good traders manage risks.

Do not trade at night: Periods of low liquidity in the futures market fall after closing the American and before the middle of the Asian trading sessions. A period of low liquidity means that HFT or algorithms are capable of easily moving the price just using a big volume of trades. The best variant of loss minimization is to trade during the periods of high liquidity, which fall on the complete European and American sessions. This guarantees that even if the market moves against you, the high liquidity would ensure execution of a stop loss at the price you specified in the order and not at the next best available price.

Skip the periods of a non-trend (flat) market: A big part of HFT shows itself best of all in the flat or choppy market with specific  sharp price fluctuations without a pronounced trend. HFT could make significant amounts of money using big volumes and unstable price behaviour. A flat market would leave a trader confused in the best case scenario and would destroy his trading capital in the worst case, since his trades will be constantly closed by stop losses. You should rather concentrate your trading on trend markets.

Have a sufficient trading capital: One of the most widespread reasons of failures of retail traders is insufficient trading capital or poor position management. Keep a sufficiently supportive margin and some volume of additional funds apart from the required guarantee collateral or initial margin in order to have a room for maneuver. Read our article How to start trading on the exchange. Capital calculation to learn how to correctly calculate the capital.

Mike Bellafiore is a well-known person in the world of trading and is a co-founder of a proprietary company.

Mike identified ways of surviving in the world of HFT and algorithms in one of his books. Here are some of his ideas:

The majority of your positions will be closed by stop losses. Consequently, be more scrupulous about limiting your losses. Hunting stop losses is a widespread phenomenon and HFT significantly promotes it. Mike recommends traders also to use other means, such as understanding the order flow on the basis of the Level II data analysis (Depth of Market or order book). Of course, there is a risk of spoofing, but if you combine a good risk management with a proper stop loss posting and order book understanding, you will be, at least, better prepared for an unfavourable development of the market situation.

Trading setups of the past do not work any more. Mike says that HFT continue to develop and learn to speculate in the market – retail traders shouldn’t relax with their trading strategies. Adapting to the market behaviour and constantly monitoring it, you would be able to accurately set up your trading strategy and, at the same time, would not allow yourself to think that you know everything about the market, which is usually followed by a disaster.

Institutional buy/sell orders. Everybody knows that when a major player wants to accumulate or unload his position, he uses passive algorithms for this, which buy or sell stocks without arousing suspicion from other market participants. Analysis of tendencies in the nature of institutional buys or sells will help you to stay on the right side of the market. Examples of this could be expectation of a rollback for opening a long position or a search for powerful movements during a day.

Beware of false buy/sell signals. False signals or false breakouts are widespread phenomena and it is believed that retail traders should realize these risks especially if they trade breakouts.

And finally, while HFT and algorithms destabilize the market, changing the rules of the game, a retail trader should be more attentive and rapidly adapt his trading methods to the modern market developments. It might sound as a hardship for a retail trader, but you will run risks of failing out of the market until you start constantly learning new market information and being aligned with the times!