Can a trader improve his results by learning about market structure and high frequency trading?
A lot of interest in the area of high frequency trading (HFT) and market structure reform has risen since events like the Flash Crash, the Facebook IPO and the book Flash Boys. In this article I’m going to talk about how being more aware of market structure nuances can help a trader to increase his bottom line.
First let me say that learning deeply about the mechanics of modern markets won’t turn a losing trader into a winning one (most of the time). The key elements of sound trading will always be having a good methodology (with positive expectation), the discipline to follow it and sticking with position sizing limits. These elements are timeless and have to be present regardless if we are dealing with a market run by specialists/market makers or by HFT computers. In my view, knowing more about HFT driven markets can help is in two areas, first in your order execution and second in designing your methodology. Let’s go through one by one.
What market making HFTs frequently do is to monopolize the spread and force market participants to take liquidity. They achieve that by “penny-jumping” by one cent anyone who sends a passive limit order. They also buy the rights to interact first with retail order flow from brokerage houses, this prevents you and I from having a passive limit order filled because we have less order flow to interact against. What they also do is to cancel orders when traders try to take that liquidity, widen out their spreads a little bit and make more when the participant hits that spread. Anything that can prevent those things from happening can help reduce your “trading costs” and add a bit to your bottom line that way. There are many tools available to traders that they don’t seem to be aware that can help them to prevent cancelations when taking liquidity, increase their price improvement exposure, not be forced to hit the spread, etc. Using these tools won’t be the Holy Grail, you won’t all the sudden turn profitable but it will add a small percentage to your profits at the end of the year. Perhaps something in the range of 5-10%. Maybe an analogy can help to better explain this point.
Let’s say business decides to learn more about tax strategies with the help of a good accountant. The business won’t necessarily triple his profits or double the sales of his next product. It might, however, legally decrease its tax bill by 5% and have an additional capital at the end of the year that otherwise would not be there. Those small percentages compounded over the years add up to a fortune. This is very similar to techniques that prevent you from being “gamed” by HFTs. It adds up a bit to the bottom line at the end of the year and it accumulates overtime due to compounding.
What are some of these tools that traders can use? Learning about dark pools and in which situation to use them and which to avoid is one of them. Learning and using hidden orders nets, testing and using different stock market routes (like IEX for example) so you know which is best for what, etc.
Designing your Methodology
You can develop your strategy a little bit better knowing how modern markets work because right away you know what is unlikely to work for a human trader. For instance, I have interviewed a number of traders for my book “Traders of the New Era”. Most of these traders mentioned that they do not try to compete with HFTs and advise others to do the same. The reason is because these firms invest so much in getting special advantages through expensive equipment, privileges and order types. If you are not willing do to the same, making a profit at the end is pretty much impossible. When designing your methodology, you can be pretty sure that a system that tries to scalp the market around for a few cents with very short-term time horizons (a few seconds to maybe a minute) is very unlikely to succeed except in unusual circumstances.
Also, because HFTs monopolize the spread, you have to give extra care to the order routing part of the strategy. Even if you use passive limit orders in an attempt to not pay the spread. The HFT firms will increase your costs indirectly through adverse selection. You will get filled in all of your losses (because the market is going against the passive limit orders) but sometimes you will miss fills in some winning trades (because the HFTs will sit in front of your order until the market is ready to go in the direction you predicted). Unfortunately, you will only find out about this when trading with real money as a backtest is unlikely to factor that in. If you are aware about adverse selection you can avoid this problem and design a more realistic system.
Learning about market structure won’t make miracles in your trading results. It can however, help you decrease your trading costs through better order executions. It can also help direct your strategy building efforts in the right direction so you don’t fall into common HFT traps. Any trader looking to defend his orders against predatory HFTs should learn how to use tools like dark pools, hidden orders, iceberg orders, special order routes, and understand adverse selection, etc. If a trader succeeds at that, he or she might add a little bit to the year-end profitability, which over time can add up to a lot of money.
Fernando Luiz de Oliveira is a full-time retail trader who trades under Aquatoid Corp. He is author of the book ‘Traders of the New Era’ and the BeatHFT website
The views represented in this commentary are those of its author and do not reflect the opinion of Traders Magazine or its staff. Traders Magazine welcomes reader feedback on this column and on all issues relevant to the institutional trading community. Please send your comments to Traderseditorial@sourcemedia.com