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Stocks and the Algo Effect

Danny Riley

Over the last several weeks I have been pointing out a pickup in algorithmic and program trading volume. I don’t know what has precipitated the uptick, but it’s been very easy to see.

MTS ES 050814 1024x641 Stocks and the Algo Effect

Chart: www.pivotboss.com

Yesterday the ESM14 opened 5 handles lower and immediately went into a giant buy program. Literally there were 8 to 10 index arbitrage buy programs in a row. After a small pause at the 1879.50 level, the S&P hesitated and ran several more buy programs up to the day’s high at 1884.75.

In my mind whoever did all the buying was showing their hand. Normally, whoever was doing the buying would have more buying to do throughout the day, but after the run up the S&P (CME:SPM14) slowed and started to sell off. After running all the buy stops up to the highs the next target was… to run the sell stops under 1870- 1869, taking the S&P from one extreme to another.

Predators fighting over prey

Friends of ours who know program trading describe an “algo eat algo” dynamic that now dominates automated trading. For example, some algos hunt for areas where small retail orders (1-25 contracts) are getting printed. Once a cluster of these is filled, the algo will try to stop or “squeeze” them out. Then other algos detect the first group of algos at work and try to front-run their orders. It’s like one predator chasing down another predator to steal its prey.

That predatory action is what causes these wild price swings. It has nothing to do with finding a fair price for things, for helping real buyers and sellers exchange value, for any of what a market is supposed to do. It is computerized front-running, plain and simple. It’s illegal if a broker does it, placing orders ahead of clients. But if a computer program does it in under a second, it isn’t illegal—yet.

The Asian markets closed mixed and in Europe 10 out of 12 markets are trading lower. On today’s economic schedule are Minneapolis Fed President Narayana Kocherlakota speech in St. Paul,  JOLTS, wholesale trade and Dallas Fed President Richard Fisher speech on monetary policy in New Orleans. Earnings reports are due from Alcatel Lucent (ALU), Ralph Lauren (NYSE: RL), Bloomin’ Brands (BLMN), and Petrobras (PBR).

Our view

Yesterday we said to buy the breaks, but the only selloff was on the open. After that the S&P (^GSPC) went straight up. The 10-handle rule is quickly becoming the 20-handle rule. Call it “The Algo Effect.”

That said, if you follow the PitBull rule about a low the Thursday or Friday the week before the expiration, then we should be on the lookout for some type of low today. According to the S&P cash study, the Friday before the expiration has been up 17 / down 13 of the last 30 occasions and Monday has been up 21 / down 9 of the last 30 occasions.

These are very bullish stats. Our view is to look for a retest of yesterday’s lows; we lean to selling the early rallies and buying weakness.

As always, please keep an eye on the 10-handle rule and please use stops when trading futures and options.

  • In Asia, 7 of 11 markets closed higher: Shanghai Comp. -0.21%, Hang Seng +0.12%, Nikkei +0/25%.
  • In Europe, 11 of 12 markets are trading lower: DAX -0.28%, FTSE -0.27%
  • Morning headline: “Stocks lower ahead of expiration week”
  • Fair value: S&P -4.22 , Nasdaq -4.79 , Dow -48.82
  • Total volume: 1.75mil ESM and 2.8kK SPM traded
  • Economic calendar: Minneapolis Fed President Narayana Kocherlakota speech in St. Paul,  JOLTS, wholesale trade and Dallas Fed President Richard Fisher speech on monetary policy in New Orleans. Earnings from Alcatel Lucent (ALU), Ralph Lauren (RL), Bloomin’ Brands (BLMN), and Petrobras (PBR).
  • E-mini S&P 5001894.25+1.50 - +0.08%
  • Crude102.15+0.02 - +0.02%
  • Shanghai Composite0.00N/A - N/A
  • Hang Seng22352.381+90.771 - +0.41%
  • Nikkei 22514425.44+275.921 - +1.95%
  • DAX9754.43+51.97 - +0.54%
  • FTSE 1006873.08+21.33 - +0.31%
  • Euro1.3702
Stocks and the Algo Effect