Can You Play the HFT Game Too?

11/18/2011 8:00 am EST

Focus: STRATEGIES

Andy Waldock

Founder, Commodity & Derivative Advisors

Although electronic trading has undermined certain strategies, most of the underlying trends are still profitable. Understanding how the strategy works is key.

Futures Truth magazine is the de facto industry standard for the mechanical trading system vetting process. They’ve been publishing and independently testing trading systems since 1985, and currently track and publish the results of more than 700 trading systems.

Their magazine is not one that I subscribe to. However, as a former contributor as both an author and mechanical trading system developer, I still receive the random copy from time to time.

Obviously, the reception of their most recent issue fueled a round of intellectual inquiry into the age-old question, “Will a properly designed and tested mechanical trading system withstand the test of time and the evolution of the markets it trades?” I believe the answer is an unequivocal, “sort of.”

The answer really has two parts. All things being equal, a properly designed system will continue to perform in a statistically characteristic manner in the future just as it has in the past. Unfortunately, when it comes to market evolution, all things are rarely equal.

My first published trading system was called, “DCB-Bond.” It debuted in January of 2000 and has been in and out of the Futures Truth Bond Market Top ten since release. The system was ranked 16th in the most current issue and has averaged more than $3,000 per contract in annual profits for the last five years. This trading program was designed to capture medium term trends and trades about once a month.

All things being equal, searching for medium-term trends in the bond market is still an exploitable niche. The evolution of electronic trading, along with the corresponding shift in trading from the pits of Chicago to the computer screens, hasn’t affected the basic strategy the system uses. While the dynamic nature of the mathematical equations it uses as triggers allow it to adapt to the ever-changing nature of the market’s volatility.

Unfortunately, the evolution of electronic trading and high frequency trading (HFT) has dramatically affected the performance of a suite of short-term trading systems I developed that was published in December of 2005.

Historically, markets only traded during their open-outcry market sessions. For example, the grain markets only traded from 10:30 am through 2:15 pm, Monday through Friday. Therefore, overnight market developments or weekend surprises would build up pressure that couldn’t be released until the market actually opened for the next trading session.

The build up of pressure frequently caused the markets to open at a price significantly different from the previous day’s closing price. The suite of systems that I had developed was designed to capitalize on this market behavior.

The program was able to predict with a high degree of accuracy when a market would generate a build up of pressure and open in a predicted direction at a significantly different price than the previous day’s close. The advent of 24-hour access to the markets has eliminated this build up of pressure and undermined the effectiveness of my, “first profitable open” exit technique.

Mechanical trading programs offer many advantages, such as the ability to quantify risk, diversify a portfolio, and provide access to markets one might not normally trade. The downfalls of mechanical systems are faith in the system, discipline, and how to determine whether a system is still viable or has, “blown up.”

The key to the successful utilization of any trading system is understanding how and why it works. Therefore, when the fundamental premise of the system is no longer valid, and all things are no longer equal, it can be taken offline prior to an inevitable drawdown.

Andy Waldock can be found at Commodity & Derivative Advisors.

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