A Look At Trading Algorithms

The Market Gage - Dillon Gage's Precious Metals Newsletter

We are often asked about how various entities conduct their trading business. I thought I’d discuss the larger trading firms in this edition of the Market Gage. Several books have been written on this topic. Below is my take on the subject and why the standard investor should be aware, but not concerned.

Traders and large institutions use complex algorithms to take advantage of micro differences in trading prices at any second when significant news hits the wires. Fund managers along with programmers develop a trading strategy in order to be the very first in line to either buy or sell a particular stock or commodity. Some may view this as an unfair advantage to the average retail investor. I couldn’t agree more, but unfortunately this is what happens when we create a market largely dependent on electronic execution.

Computers far exceed the ability of one human to react to the news and trade because computers execute their trading strategy in milliseconds. I find it fascinating how programmers compete to figure out a way to just edge the next guy in getting their program to react faster than anyone else’s. I expect these algorithmic programs to be adjusted from time to time to reflect a fund manager’s strategies. One can imagine how much money must be invested to obtain the fastest computer hardware available. My concern is: how can the average guy compete even on his laptop with what he thinks is the fastest trade execution on the planet? In reality, even with the electronic programs offered by many institutions, he or she will always be late to the party. Unfortunately, I don’t have any answers on how to combat this, and unless you are one of the big guys, you will always be NEXT in line.

Some might argue that being the next in line is not such a bad thing as one person or institution is never bigger than the market as a whole.

Understand that the difference between being able to read and react to that data faster than anyone else can mean billions of dollars lost or gained. These tiny fractions of a second make all the difference in either making a significant amount of money or taking a bath. That’s why as I said before, millions of dollars are being spent to obtain the best hardware and software available to compete In this technology.

Another potential challenge is what they call a “fat-finger error.” A fat-finger error is defined as a human pressing the wrong key when inputting data. Remember the May 6, 2010 crash when a significant, rapid and unexpected drop in the Dow occurred. It was first suspected that a trader enter an order incorrectly by adding a few extra zeros was to blame. I thought that couldn’t happen because all institutions have implemented safeguards so this would not happen. Nonetheless, it did happen and the Dow dropped 998 points at one point, most within minutes, where some stocks dropped in values to a penny a share in the so-called “Flash Crash.”

Five years, yes, five years after the “Flash Crash” the U.S. Justice Department put through 22 criminal counts, including fraud and market manipulation against one trader. The charges were for the use of spoofing algorithms just minutes before the crash as he placed thousands of E-Mini S&P Stock index futures which he planned on cancelling later. These combined orders which exceeded 200 million dollars worth of bets that the market would fall, were replaced and modified 19,000 times before they were cancelled. After that crazy day of what’s called spoofing, layering and front running, these tactics were banned. So can it happen again? One never knows.

For those who are curious “Spoofing” is defined by using a disruptive algorithm program where traders try to outpace other market participants and manipulate commodity markets. When trading in the futures markets, Spoofers engage in tactics creating the illusion that many bids or offers for size are being inputted and then cancelled. When one looks at the depth of the market and sees the size of a bid or offer, one would think there is a significant amount of support or resistance at a particular level. These tactics are illegal and the CME is watching closely to make sure no one’s playing this game.

There are so many times in our market, such as right after a comment from a Fed president or a unexpected jobs number report is released, when we see gold go up or down in a blink of an eye. Sometimes $20 or $30 dollars. After reading this do you think it was done by a guy buying a couple of future contracts? Obviously, algorithmic program trading kicked in and caused the market to move as it did.

Algorithms are programs for the professional institution trader. One reason why the traditional physical metals investor should not be overly concerned about program trading is that these programs are short term strategies that involve significant risk. For the standard investor, buying precious metals is a long term investment used as a portfolio diversifier and hedge against other investments. Milliseconds generally do not make a material difference when holding metals for the long term.

Have a wonderful Wednesday.

Disclaimer: This editorial has been prepared by Walter Pehowich of Dillon Gage Metals. This document is for information and thought-provoking purposes only and does not purport to predict or forecast actual results. It is not, and should not be regarded as investment advice or as a recommendation regarding any particular security, commodity or course of action. Opinions expressed herein are current opinions as of the date appearing in this editorial only and are subject to change without notice and cannot be attributable to Dillon Gage. Reasonable people may disagree about the opinions expressed herein. In the event any of the assumptions used herein do not come to fruition, results are likely to vary substantially. All investments entail risks. There is no guarantee that investment strategies will achieve the desired results under all market conditions and each investor should evaluate its ability to invest for a long term especially during periods of a market downturn. No part of this editorial may be reproduced in any manner, in whole or in part, without the prior written permission of Dillon Gage Metals. This information is provided with the understanding that with respect to the opinions provided herein, that you will make your own independent decision with respect to any course of action in connection herewith and as to whether such course of action is appropriate or proper based on your own judgment, and that you are capable of understanding and assessing the merits of a course of action. You may not rely on the statements contained herein. Dillon Gage Metals shall not have any liability for any damages of any kind whatsoever relating to this editorial. You should consult your advisors with respect to these areas. By posting this editorial, you acknowledge, understand and accept this disclaimer.