Are Spikes in the FX Market Caused by Computer Algorithms?

08/01/2013 11:00 am EST

Focus: TRADING

Rob Booker

Author, Man Vs. Market: Lessons from Trading on the Road

Host Rob Booker speaks with “The Coach”—Scott Welsh, co-creator of the Bossilator course and a peak-performance instructor who resides in Columbus, Ohio. Rob and Scott tackle an e-mail from an inquisitive and concerned listener who has been hearing more and more lately that there are spikes in the FX market that have been caused by computer algorithms, so Rob and Scott address the veracity of this theory.

 
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Rob Booker: Hello, Scott.

Scott Welsh: Hey Rob, greetings to you.

Rob Booker: We got an email, Scott, and only you can answer it.

Scott Welsh: Well then you called the right person didn’t you? 

Rob Booker: Dear Jason, I’m going to read Jason an email now.

Scott Welsh: Okay.

Rob Booker: Hello Jason, people have just stopped writing me, I have been hearing it more and more recently that there are spikes in the FX market that have been caused by computer algorithms, would love to hear about it if you guys ever decide to put together an episode about this. Love the show, Space Pip (on Twitter). I guess off of Twitter he is not Space Pip, Scott.

Scott Welsh: So that’s not his given name, not on his birth certificate per se.

Rob Booker: Right, so if you meet a guy in a bar and he’s like my name is Space Pip, don’t say is that the guy from Twitter? 

Scott Welsh: So the question is all of the spikes are created by algorithms, is that what we are discussing, is that out on the table for tonight? 

Rob Booker: Is that on the table? 

Scott Welsh: I’m not sure what’s he’s asking, the spiking or the wild action? 

Rob Booker: First of all, I like Space Pip, so hi, Space Pip. Second of all, I think it’s all open for interpretation. I think what he is saying is that lately when he, first mistake, reads the news, he then interprets, second mistake, that more and more spikes—undefined term, third mistake, in the FX market have been caused by computer algorithms. Fourth mistake—artificial intelligence, computer algorithms are running amok on the streets of Chicago, wildly throwing pips everywhere, like glitter, pips, they are just throwing pips up into the air. They just went public and they have lots of money these computer algorithms.

See I think the matrix is faulty for this reason Jason, if computers were able to take over the world, they would just party all the time, they wouldn’t create this desolate landscape, they would be partying down, they would be going public, they would be like doing lines of cocaine off of each other’s super amyloid screens and stuff like that. So the matrix puts them down as once they got control they were no fun at all, whereas most humans once they get a lot of money that could actually be a lot of fun, so I just thought I would clear that up. Scott, I think what he is saying is, and the reason you are qualified to answer this is that you run “computer algorithms,” you run money using computers; I mean they have a mind of their own now. You just let them loose on this stuff and they go wild, so do you cause the spikes, Scott? 

Scott Welsh: Well, first of all, to answer your question of one way first or at least comment on the question, and that is I’ve always wondered like Daniel Tosh always says, how come Tourette’s is never happy?  You know, you have a nice hat, how come it’s always a foul language word?  I always wonder, too, why computers if they are going to take over the world why are they killing John Connor and sabotaging alien vessels, why aren’t they making everything nice? 

Rob Booker: Right, exactly.

Scott Welsh: First of all, I don’t know why the computers have to be evil, isn’t it at least 50/50? 

Rob Booker: It’s a 50/50 chance. Yeah, why isn’t it more Weird Science and less Matrix, exactly.

NEXT PAGE: Are Algos Causing Spikes?

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Scott Welsh: God, I love Kelly LeBrock, that’s true, but you’re absolutely right. I’m in the market literally every single day and I am running computer algorithms, although I’m not sure what an algorithm is, but I do know that there are set parameters that I have eight robots or more running in the market every single day. If the forex market is really $4 trillion or $5 trillion or whatever it is, I guess my little lots aren’t causing anything, but I guess I’m just worried about the perception that the world is out to get you and when you say things like that it seems like well so and so I can’t beat the market because so and so has an algorithm or there is super computers on Wall Street somewhere making all these spikes and taking all these trades.

I mean my computers are taking trades.Honestly, I don’t see these spikes; I mean there is some movement today. I’m looking at the charts right now and I see movement, but I don’t see anything I haven’t seen yesterday or the day before, so I’m worried. I’m worried when people say things like that. I’m worried when people say I want to be great at something if only I didn’t have a job. I’m just worried about any excuse whether it be computer algorithms or anything when people say I can’t do it because of this when we don’t even know what this is or if it is really doing it.

Rob Booker: Yeah, it calls into question the idea that first of all there is a spike that is any different than any other spike that you ever saw. If you look at the currency market in the 1990s, it is like watching Robert Downey, Jr., star in a movie in the late 80s; it’s just all cocaine. It’s just all over the place, it’s bouncing up and down; it has no adult supervision. There are swings of hundreds of points in a single day. You think George Soros caused some kind of stir. It was like every day in the currency market in the 90s compared to today was a wild swing and today’s movements seem tame in comparison.

In fact, most currency traders long for the days to come back when the swings were wider and there were trends that lasted longer and went farther. By comparison, the market is actually quite tame, so that is first on my mind. Second of all, from when do spikes come if they don’t come from algorithms, what is a spike?  A spike is in any market it’s, I mean, I don’t want to get this wrong, someone is going to write in and tell me that I don’t know what I’m talking about, but let me preface the entire definition by admitting to you I don’t know what the hell I’m talking about.

I imagine, Scott, that somebody somewhere presses a button and every spike represents someone getting fired because they pushed a button, they pushed the market in a certain direction. So they traded enough size to move the market to a high or a low, but then nobody came in after them—hey everyone, let’s go swimming in the lake and he strips down to his bare bottom, jumps in the lake, and everybody is just standing around the lake looking at him like we’re not going in the water with you naked. I think that is what a spike is, Scott, it’s someone making a move that everyone else wasn’t ready to take. I think that’s where spikes still come from.

Scott Welsh: Well news too, right?  I mean, when we trade the NFP it’s not a super spike, it’s not hundreds and hundreds of pips, but at 8:30 on Fridays, one Friday out of every month, there is a “spike,” right, I mean it goes up and it goes down. We have a bunch of people watching that report, maybe some computers are watching it, too, but something happens and a lot of people have a lot of reactions, so there are a lot of buttons being pressed. I don’t think that’s anything untoward, I don’t think there is anything wild going on there, it’s just there is something going on, so it spikes. I mean, the stock market gaps every day, that’s just another example, and the same with the forex market, that’s a spike; it’s people who want to be in and then overnight something happens and they want to be in more or less.

NEXT PAGE: What is Causing the Spikes?

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Rob Booker: That brings up a good point, Scott. I looked at GLD the other day, the ETF, I think it’s tradable from a technical perspective and I would like to develop some things to trade it, but what the hell, everyday there is a gap in the gold ETF, I mean how does anybody cope with that?  You can’t even, at the open it moves up so many points that it goes from below where my entry was to above where my profit target was, I mean how is anybody supposed to do any of that crap?  What is that?  Is that the market pricing in something that happened overnight in a market that wasn’t open enough?  Is that happening? 

Scott Welsh: It’s people. There are a bunch of orders that pile up and overnight as soon as they open there is more a demand and supply; therefore, it goes up, I mean that’s my understanding of it.

Rob Booker: Yeah, so somebody that makes the market in this says that with all of the orders to get in stacking up at market, market needs to go higher to balance the supply and demand, we don’t have enough supply for this demand. You said at market, so market is going to be here and anyone who makes a market whether with a computer or otherwise has to make a market that they can profit from, so they are going to raise the price on that, so they get a shipment of X in and they know they can sell it for this high price up here. That is exactly what they are going to do so that they have enough money to turn around and buy more of that supply later on. I mean, remember, that is what they have got to do with the money. It has to come from somewhere.

The other part about this that really fascinated me follows the line of reasoning where they are out to get us. It supposes that there is a computer algorithm that spikes so that we get faked into a trade on the opposite side of what is correct and that a computer is doing that, and the answer to that is no; if you are a retail trader, there are no computer algorithms per se by institutional traders spiking you into or out of trades. Now your broker may be doing this. You may have a broker that uses computer algorithms as an excuse to screw you out of some money, and your broker may claim it is computer algorithms or whatever, but that is a possibility, Scott, it is possible still in the world of spot currency trading that this individual’s broker is pushing them into a trade just to create more flow, just to create more orders, and the broker knows that this individual or most individuals are unlikely to manage this trade successfully, so they are probably going to make money. I mean that is a little bit of a stretch these days, but I guess that is the closest I can get to saying that that is maybe what happened.

Scott Welsh: Yeah, I suppose, and again, but that is human, isn’t that human generated?  I mean what you described was a human deciding that we are going to try and chase this stop or there have got to be stops above this high.

Rob Booker: Well yeah, okay, when I worked in the industry, I always wondered why the dishonest brokers weren’t running a computer algorithm that said database, find all the traders with less than x number of months of experience that have a losing percentage that is greater than 90% and that have less than $3,000 in their account. Push the price on their platform high enough to enter them into an order. That would be a disgusting tendency, but I always wondered if that was what was going on, and everywhere I traveled, Scott, there wasn’t one broker smart enough to program that. They all still did it with some greasy haired slime ball sitting at a desk watching Matrix-like orders come through the system and they would manually approve orders as they came in very quickly, and these guys were shady and weird and I’m sure they stopped people out, but they weren’t smart enough to figure out who to do that to, which is why oftentimes they got caught.

NEXT PAGE: Is HFT Causing the Spikes?

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Scott Welsh: Well, on the other side, I mean I’m not in the office with the greasy-haired guy, I’m looking at my computer screens and what about the tens, if not 100s of trades that I’m in personally, live trades that I’m in and it’s doing nothing, it spikes up and I just got a winning trade, I mean this happened two days ago. I was just in a trade and it spiked and that went right to my profit target, so again, that’s why I worry about this negative mentality of the world is against us. I mean I get lots of spike winners, I mean the trade was doing nothing, it was dead in the water and it spiked right into my profit, so how do you explain that? 

Rob Booker: Yeah, okay, so we’re on the same page about that, and I think it’s true that there are spikes in the stock market with individual stocks that are caused by computer algorithms. There is a huge debate now about whether high frequency trading should be legal and this is the process of stacking one’s computers for your hedge fund and parking those right in front of the computers from the exchange paying a lot of money to park those computers right next to each other, being first in line to dramatically decrease the time it takes for your orders to reach the exchange and to put out a bunch of false orders that you don’t really intend to make so that they pop up on everybody’s computer screens that there is lots of demand for something, which entices others to get and put their orders in. Then you remove your orders and then take the other side of the orders that popped up and you could program a computer to do all that so quickly that nobody even knows what hit them, and I know that there are those kind of shenanigans that are really peeving off retail traders that are trying to make money in the stock market.

Now none of what I do in the stock market is short term enough to be affected by any of that, Scott. I just don’t see myself trying to compete on a millisecond basis. If I’m going to trade a stock, it is going to be from a longer-term chart with a time horizon that is much greater, or even I would use an option to make a bet on the direction of the financial instrument and then also hedge my risk, so I don’t think I really put myself in that class. The more we talk here, the more I realize that you are off the hook. I don’t think you need to worry that Space Pip is trying to find you and take you out.

Scott Welsh: Well I am 100% in disagreement with the HFT, the high frequency trading, that you said front runs. That is garbage. I mean the fact that they are just faster and that they are getting orders that other people can’t. That is a problem and I understand that, but I guess I would love for you to paint me a picture of exactly how the HFT would cause me trouble. I mean, I’m sitting at my computer screen, I guess I’m reading a Level II or I’m reading the orders, I mean it’s almost like playing poker where you are reading the bluffs and all of that, so I see a bunch of orders and so I take it and I just keep getting stopped down and stopped out, I mean this has literally never happened to me, I program robots for stocks and for currencies and I’m not sitting there. Anyone who flashes a bunch of orders on my screen means nothing to me. I’m trading patterns or I’m trading what I believe are fundamental, you know, go with the trend and buy in a retracement, so I guess is that what they’re doing?  I mean, I don’t even know.

Rob Booker: Yeah, they are doing that, they are being accused also of other shenanigans, such as you put your order in, but their order runs in there faster than yours, so what they do is you never get yours filled and they do because they are faster, they overwhelm the servers and you can’t ever get in, so you miss the price you wanted and you don’t get in and you miss the trade and whatever else. I find all of those things difficult and sad, I really do. I find all of it despicable. I hate people that cheat and I hate people who can beat me at what I like to do

NEXT PAGE: What’s the Pool Defense?

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Scott Welsh. I hate losing and I don’t like it when someone is faster than me. I also hate being a stupid idiot and trying to compete at a game I can’t win. I mean really, are we all so sad that we aren’t fast enough to compete in the Olympics in the 100-meter dash, I mean, I don’t complain about that either. So there are games that you can win and there are games that you can’t win. There is insider trading that is clearly illegal for a good reason, that someone is making money from information that you don’t have access to and they are cheating, they are getting out of it before you could ever find out or the public could find out. That is cheating and those people actually should probably be executed. That would solve insider trading pretty quickly, or you cut the genitals off the men who are engaged in insider trading, you know, take something that is precious to them.

Scott Welsh: Well unless they take calls when they are by the pool. If they take the call and they are by the pool then they never could have done it, sorry. Steve Cohen specifically says that if he’s by the pool he can’t insider trade, so either take away their pools or cut off their genitals; I think either one of those would work great.

Rob Booker: Did he really say that that if he is by the pool? 

Scott Welsh: Yeah, that’s his defense; it’s called the pool defense, yeah, he couldn’t possibly have done something wrong because he took his call by the pool and couldn’t have been by his computer. I just read that yesterday; you can look it up.

Rob Booker: That guy produces 30% returns over 25 years and everybody is like putting their hands on their cheeks like Macaulay Culkin in Home Alone like oh my gosh, he was doing something untoward, like everybody is so fascinated. So behind the curtain we have this, you know behind door number three is another cheating liar who stacked up billions of dollars in personal wealth by getting information that wasn’t accessible to you and thought that he would never get caught. He paid $600 million dollars earlier in the year to settle one string of cases brought against him by the securities and exchange commission, I mean just like otherwise known as the porn quality control division of the United States Government, where all day long they just surf for porn on the Web instead of defending the integrity of the financial markets, but that is another topic for a different day. Anyway, he settles for $600 million, penalizing a person like that financially doesn’t change anything. You have to take everything away from Steve Cohen in my opinion, everything, you have to take all of it, whatever he has, his boats, his art, his house, everything, you have to take it all away. That’s it; you have to shut him out forever. I mean look at the financial crisis of 2008 it is a repeat of what happened in 1998, it is a repeat of every other time it happened, slap them on the wrist, let them keep about half of what they had and move on to the next thing. I mean you never catch up with it. Not that I care anyway. Do you even care, Scott?

Scott Welsh: Absolutely not. I mean I’m fascinated, I’m interested, but no I don’t care, what Steve Cohen does or doesn’t do, or sits by the pool or can’t read emails fast enough to act on the information, whatever the excuse is, it means absolutely nothing to me because I’m not trading in a way that he can do anything to affect me. If he piles in on an order and I’m in a stock he likes, that is fine for me. If it’s going to stop out, it’s going to stop out. I find that it’s easy to get wrapped up in this stuff and it’s super interesting, but it means absolutely nothing about being a successful trader for an individual in my opinion.

Rob Booker: I mean and the whole pool thing now has really got me on a roll here because I have a lot of inappropriate thoughts at the pool.

Scott Welsh: Yes, backstrokes, doggy paddle.

NEXT PAGE: How Scott’s New Trading Robot is Working Out

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Rob Booker: I can’t keep my mind off of bad, I mean that’s a terrible defense, he should have said he was at the proctologist, I mean that would be a moment when you would be like listen, my doctor’s thumb was up my bum hole, there is no way that I did that and they would go well let’s just confirm he was at the doctors having somebody’s finger up his bum hole and they are like yeah, we got it back. No jury is going to convict a guy of, I mean anything he did while that doctor’s thumb was up there is excusable.

Scott Welsh: It would be, true, it would be hard for me to convict, absolutely.

Rob Booker: I guess you would call that an algo or whatever. Anyway, how are your computers doing lately? 

Scott Welsh: Well, I have a long-term that you and I helped develop in our course whatever the Bossilator that is long-term and that is break out from fair value and those take forever, and even though it is making the amount of money I need it to make, of course being a human I wanted something that I liked even better, don’t ever be satisfied with something that is fine.

My personality is such that it is hard for me to be in a trade for five days, 10 days, 15 days, you know, 20, it’s hard for me to be in a trade. I just feel like if I’m in a trade for 14 days I’d feel like I’d lost the reason for me to be in that trade. If it’s going to break out from fair value, it will do it in a week. It just bothers me. There is nothing wrong with the numbers, I just had a successful trade yesterday, it is doing what I need it to do, it is helping me pay bills, I mean it’s fine, the reason I mention that is my personality would like it to be over today. I would like to have a reason to be in a trade today and I would like it to end today and I would like to go back to work. I would like to go to sleep and I would like to get back to work.

While I was trading for six to seven months trading the longer-term Bossilator system, I just have been working and working on developing something that just gets it over with in the same day and that is what I have started trading live and that was last Monday. It is doing great. I don’t want to say that, the trading gods, because I know they are trading gods, I mean I just don’t want to say it out loud even though it doesn’t make any difference, but they are up over 250 pips or whatever in the last week or so, which is in line with testing. That could all change; I’m perfectly open for it to not to work, but it is working as I have tested, so there is your long answer. I’m doing more and more, spending more and more of my capital on the shorter term robots because it is nice to see a trade that is over in a couple of hours, so that is my update.

Rob Booker: Are we talking about like $1,000 that you have an account like this?  I guess everybody probably wonders this when we are talking on the podcast. I will give you a way to answer this tactfully. Are you managing of your own or whatever it is, I don’t want to know who gave you money, I know you took a trip to Columbia recently, I don’t want to know.

Scott Welsh: That’s for sport.

Rob Booker: Are we talking about more than $100,000? 

Scott Welsh: All total for all the accounts? 

Rob Booker: Yeah.

Scott Welsh: Yes, sir.

Rob Booker: Yeah, okay, so we’re not talking about you dorking around on a demonstration account here, this is real money.

Scott Welsh: This is people’s money that they have given me, bonus checks or savings, this is my money that I’m going to live on, you know. It’s real, it’s not $1 million, but this is real money, this is my life, if this goes the way it is tested then you know what is going to happen, you know what I’m going to do.

Rob Booker: Yeah. Do you still want to do that thing? 

NEXT PAGE: What Scott Looks for in a Trading System

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Scott Welsh: I do. I love my students, I do, but I love trading so much that it almost makes me sad when I can’t sit around and test something. If that sounds weird, and it’s not a cliché, just talking about it with my girlfriend the other day, I just love sitting around testing and working on stuff. If I love it then I need to make my life doing that at some point. I don’t know when that will be, but you know where I’m going with it.

Rob Booker: Are you doing more of your own programming?

Scott Welsh: Not yet, I’m studying that. If I had time, for example, if I didn’t have students that I needed to tend to, I would learn how to program. I still use the programmer that you helped me with.

Rob Booker: Yeah.

Scott Welsh: I have ideas and I talked to him and he’s great, he gets it done right away, but that is on my list. If I had time, I would learn to program it. If I learned to program, good gracious, I may never, I don’t know what I would do with myself.

Rob Booker: Well I have one last question for you, when you test a system and approve it for use on your live account with all this money or accounts with all this money, what are you looking for, a win percentage, a drawdown, an annual gain? 

Scott Welsh: Well it’s change and it evolves and if you are really into your trading it changes. The first thing you are looking for, the first time I started testing years ago was profit and that’s it, how much money does it make, this one makes more than that one, that one wins, you know, period. So you get that and then you start trading it live with very small trade sizes and you realize profit is great, but then that trade lost and then that trade lost, and then that trade lost, and a lot of times Rob, as you know, and I’m sure as the listeners know, that the highest profit sometimes is a lower winning percentage because you are getting huge profit targets.

As I have evolved and studied and actually traded this live, it is drawdown; it went from net profit to winning percentage to now the only thing I care about is drawdown, I mean that’s it. How much does a system drawdown?  What is the maximum drawdown?  I mean I download every single, for 10 years I have downloaded every single trade from every single day, I put it on a spreadsheet, I sort it, I go through it one by one and I just count or I make little formulas and I count the drawdown. What is the maximum drawdown this can make?  I don’t care about risking 2% of my account; I don’t care about any of that.

I start with one lot on each system, that’s just my starting point, what does it drawdown and then I add two and then I add three and then I add four, I’ve gone up to 15, I’ve come back to 8, and if I keep adding it and the drawdown goes then I trade more, so for example, I have two robots and it draws down $10,000, they’ll say that is the worst it’s done in the 10 years. So I add a third one and now the worst drawdown is $8,000, so I add a fourth one and it is $5,000. I just keep messing around and messing around.

Bottom line is all I want is the least amount of drawdown that makes a decent amount of profit, so that is everything to me. When you say what do I do, I find, I test it out over and over and over again because I love it, and then I trade it live for one month with hardly any size, I mean real money but hardly any size, almost like a mini-lot, and I see is it drawing down any different than anything I have seen in the last 10 years, and if it doesn’t draw down and if the winning percentage is similar than I turn it on and it is trading real money.

Rob Booker: My guest today has been Scot Welsh. If you are interested in getting your greedy little trader paws on Scot’s computer algorithms or maybe just talking to Scot about computer algorithms, or maybe asking Scott to sort out your trading brain, which he can do, you can contact Scot on email scotwelsh@gmail.com. You can also find Scott at bossilator.com. You can email him, do it, it’s enjoyable, it will be a good time. On behalf of my friend, Jason Pyles, who is the producer, our guest has been Scot Welsh. Scot, thank you for your time.

Scott Welsh: Anytime, I look forward to it next time.

Rob Booker: I’m gonna run off to my live trading webinar and catch up with you guys soon. See ya later.

For more podcasts from Rob Booker, visit Traderspodcast.com. You can also follow him on Twitter @traderspodcast.

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