How to Protect Yourself from "Algo Traders"
It was 1988 when I took my first visit to the New York Stock exchange and realized what I wanted to do with my life. Back then I just wanted to wear a cool-looking jacket and yell at my coworkers; but those frenetic men and women (also called specialists and market makers) yelling at each other and glaring at old-timey CRT screens were actually creating a sort of harmony in all the chaos.
You see, when you buy or sell a stock, there must be someone on the other side of the trade to provide liquidity; they sell when you buy and vice-versa. If there isn't anyone willing to buy at your price, it drops until someone is willing to step in.
In those days, much of the trading done was with real humans and it was hard enough to compete with them. Now you're most likely trading with an automated system that is given a set amount of risk and technical parameters, and programmed to make money by taking advantage of any mistakes made.
In fact, the majority of all the volume on the NYSE is algorithmic or program trading, which also includes H.F.T (High Frequency Trading).
Sure, humans are still involved, but to a much lesser degree, and the exchanges are shadows of what they once were as computers have taken over to facilitate the billions of shares that are exchanged daily. These programs use order flow, math, fundamentals, statistics and technical analysis to execute their trades automatically, and they don't take prisoners.
Yes, commissions have come down and orders are filled faster than lightening; but the downside is that you and your portfolio are increasingly susceptible to irrational movements in the stock market like the flash crash of 2010.
While another flash crash is probable, the bigger issue lies in the sometimes violent and unexplained movements that individual stocks make from time to time and how they can affect our investing success.
More . . .
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Below we see a monthly chart of the S&P 500 going back 40 years. The lower area of the chart is the Bollinger Band %b oscillator. It looks like the price chart above, but gives us a relative volatility perspective. The upper dotted line represents an 'overbought condition' and the lower dotted line is an 'oversold' condition.
Notice how stock prices stayed in a narrower band closer to the 'over-bought' area of the chart. Then, in the late 90s, you can see that for the first time in 30 years the market started making these wild moves, going all the way to the bottom and back, only to repeat again in 2008 and perhaps for a third time in the next couple months.
This chart demonstrates the increased volatility in the marketplace and extraordinary condition we have seen since computers began infiltrating the stock market.
If you're not prepared, you might be a sitting duck when the algorithms decide to take your portfolio for a ride. Yes, it will happen eventually.
As a trader, you need to know how to both recognize and/or protect yourself against them when they get overzealous. Here are some steps you can take to minimize losses caused by the algorithms and even take advantage of their actions.
Stop Order Danger
Stop orders have been a source of contention for traders even before the algos took over.
It's a little known fact that most 'Stop' orders are held by the exchange and are seen by both market makers and specialists. In other words, if you buy a stock at $53.00 and place a 'stop order' to sell if it drops to $50, certain pros can see that order and can 'lean' on it (use it to their advantage).
Remember that a 'Stop Order' is essentially a trigger that activates a market order to buy or sell, at the MARKET'S discretion.
So if the market is weakening and the algorithms begin to add to the momentum the specialist might remove his bid and lower it down to your stop level, triggering your stop order and then he gets to buy just below that (he'd be buying the shares you're selling) and then bring the stop back up again once the algo slowed down.
This means you not only sold at a loss, but have no position when the stock bounces back.
There are even programs that sniff orders out and use them as part of their strategy, and even 'stop limit' orders are susceptible.
One solution is to use 'trigger orders' which are held on your broker's servers and NOT seen by markets until they are active. Also try to use stop limit orders if your broker doesn't offer in-house triggers. This helps to mitigate any 'slippage' between your stop price and the price you get filled at.
I use these sorts of tactics in my own trading to keep my stop orders 'safe.'
Abnormal Volume and Movement
Most stocks have a normal rhythm or volatility range that they tend to stay within. In other words, every stock has its own unique set of behaviors that can be observed and used to profit and prevent catastrophe.
Indicators like Average True Range, Volatility, Average Volume and several other characteristics make up a stock's unique personality. If a stock is behaving oddly and there are no earnings reports or major news events, chances are that program trading may be to blame.
The average true range can tell you what a 'normal' movement is for a stock, while placing a 20 day moving average on your volume chart can help quickly identify high or low volume days. Volatility is a bit more complicated, but can be quantified with a simple tool or chart. Most option brokers offer charts in which you can see just how volatile a stock relative to past movement.
If you see elevated volume, high volatility and a stock that's outside of its normal range, it could mean that program traders have gotten the best of the stock and it may be one to avoid. It could also be an opportunity brewing if you know how to play it.
Combine Technical Analysis with Fundamentals
Many algorithms are programmed with technical indicators and use them to execute trades.
Because markets are no longer 'straightforward' and computers are making billion dollar decisions in milliseconds, you must understand at least the basics of technical analysis. I say this because you may be in a stock when it starts to go bonkers and wonder what the heck you need to do next and if you should stick to your fundamental thesis.
Even the best of stocks can see dramatic drops in price, often predicated by a technical formation (or several in the case of Apple above).
Pure fundamentalists have been buying Apple since it dropped from $750 to $700, but technical analysts and algorithmic traders saw the bearish writing on the wall when Apple breached below the 200 day moving average and gained momentum to the downside.
Notice all the volume coming in as this breach occurred in early December, and then the resistance at the 50 day moving average in early January. I even went on air TWICE and said the stock was most likely moving lower. Not just because of fundamental data, but the charts were screaming sell!
Would you rather have bought Apple at $700 or $500?
Beat Them at Their Own Game
Much of technical analysis works because so many believe in it. Those beliefs translate into self fulfilling prophecies for the underlying stocks and can create extremely powerful waves for the algorithms to ride to profits. You can either ride those waves or be crushed by them.
You must defend your portfolio as best you can. You can do it alone by learning these techniques and more, but it helps to have someone knowledge on your side or a very powerful tool to indentify the pitfalls and opportunities.
Buying quality stocks with strong fundamentals is a start, but you must have another layer of analysis in your trading. In my new TAZR trader, I have assembled some of the most powerful technical tools and combined them with a tried and true fundamental screening system, the Zacks Rank, to create the perfect strategy to counteract these algo traders. You'll receive a handful of precisely timed trades, so you won't have to become a technician yourself to beat them at their game.
I strongly suggest that you look into TAZR, Technical Analysis + Zacks Rank and its remarkable guarantee right away. Entry to the public closes Sunday, January 20.
Good Trading,
Jared
Jared Levy is a Zacks Rank Senior Equity Strategist with a broad international following and deep expertise in technical trading. He provides private recommendations and commentary for the new Zacks TAZR Trader.
