Recently I’ve been receiving questions from clients regarding the impact that algorithmic models might have on their trading strategies, and hence on their bottom line. I don’t run algorithmic strategies myself, but through constant interaction with industry contacts, I’ve gained a bit of insight into what kind of impact these models can have, especially for those people running short-term strategies.
“Algos” are programmed by humans, of course, and they can run off very simple logic. But in the lapse of time that it takes an algo to sense and deploy a given setup, a normal human being may have just picked up the first signs of change. Essentially, humans attempting to trade in the same place may find themselves constantly playing catchup and by the time they enter the trade, the algos are liquidating, hence negating the rationale for the trade in the first place.
Now let’s see how traders can avoid these potential traps.
Follow, Don’t Fade
Unfortunately, most retail traders attempt to pick tops & bottoms. In other words, they are constantly fading moves. This doesn’t mean that looking for reversals in certain places on the chart is a bad idea. But perhaps traders would have more success if they had a tad more patience and rather than trying to catch price spikes, would wait for the market to actually turn, and then leg into the new move.
Essentially, the first way to stay out of an algo’s way is to adopt a “follow” mindset. Let the market make it’s decision, then follow it. For example, leading into resistance, let the market turn first, and then follow it. Don’t try to anticipate the turn – that’s where most traders get burned.
A recent example from the past week was AudUsd. We’ve been in an uptrend for the past month so anyone looking to fade 7600/10 needed to first follow the market into the level, buying dips. So long as the market is showing strength, we need to oblige.
The market continued printing higher lows even on the shorter time-frames as price negotiated the level. Up to June 20th, trend followers had no reason to fret.
Then, on June 20th, the market temporarily pressured the most recent swing low. This could very much be temporary, and the market could reverse . So again, we need patience. The market may be transitioning – we just don’t have enough information to make a logical decision yet!
Into June 21st we received the first bit of information we needed: the market had rejected the most recent swing low from below (hence it has now flipped short in the very short-term) but now traders looking to short AudUsd have their first potential confirmation that something has changed.
Playing sub-hourly pullbacks on the 21st would have worked out just fine. And traders that have this slight amount of patience, will sidestep any algorithmic activity around the focal 7600/10 level.
Sensing Intermarket Movement
If you try to get into reversals early, but get beat to the punch by HFT players, you could easily get whipped. Market turns nowadays are both sharp and often come out of nowhere.
But algos need to gauge market acceleration/deceleration somehow, so many programs are most likely running off of momentum based indicators, sensing momentum slowdowns in micro-seconds but also feeding off intermarket correlation based programs which are constantly re-calculating currency drivers. Remember that FX receives influences from other markets, which is why it’s one of the most complex asset classes to trade.
For example, when crude oil prices start turning at the same time as other similar momentum censors or short-term moving average based algos, it might automatically trigger liquidation of the CAD FX positions. Add this to the notoriously less liquid spot markets and you get much higher volatility and greater incidences of overshoot. If these systems are programmed to embrace volatility and momentum, they don’t have to rely on pattern recognition like human traders because they’re lightening fast and sense the shift in price action before non-automated systems can respond.
Over to You
The advent of High Frequency Trading has not eroded the possibility to profit from the retail end. However, some practices are generally safer than others. By avoiding the fade mentality, you can avoid getting whipsawed at turning points and have an easier voyage legging into the new move.
About the Author
Justin is a Forex trader and Coach. He is co-owner of www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.