Algorithmic trading
otherwise known as robots

purpose
In keeping with our philosophy of informing lone-traders of current trends you will find
    ○ an avalanche of material about algorithms in general.
    ○ some quality articles explaining what they do.
    ○ nothing about how they work.

The "majors" do not disclose their methods, which are constantly evolving, for fear of reverse engineering.


The SFE-SPI200 futures market is dominated by algorithmic trading systems.

The ability to recognize algorithmic activity is an essential skill for retail SPI200 traders.
During slow periods of intermittent activity, where the market maker simulates action with offset orders, filling the order book with spoof (tease) orders, a retail trader can execute an order, get filled, and find themselves under water in a short space of time. In these modern electronic times the need for "small" retail traders to learn the art of tape-reading has increased, not decreased. It's essential.

The skill is the recognition of the market-maker on both sides of the order-book. Before the electronic market, "locals" performed the function of market-makers. They've been replaced by a single computer system which can populate, de-populate and re-populate the order book in a nano-second. Re-arranging the order-book instantly.

lone-wanderer
The lone-trader must be able to detect when the market-maker is the sole occupant of both sides of the order book ("market depth"). During this time the market-maker will know when they have filled a lone-wanderer. During the night session when the spread is wide, 10 levels can be withdrawn from the order-book, pulling the rug out from underneath the lone-trader, testing their resolve.

If we were developing an electronic-algorithmic trading system, that's how it would be done.
See the screenshot below. We would know the total depth. We would know how many were ours.
If someone bought one off us at the front of the ask queue, we would pull our buy orders out, and sell 1 lot, 10 levels down, to see if the buyer had a stop entered.

 
electronic systems
A mechanical system is an automated set of rules operated to make a profit.

There are three type of algorithm systems
• A buy-side algorithm is an automated set of rules used for accumulation.
• A sell-side algorithm is an automated set of rules used for distribution.
• A dual-sided algorithm used by market-maker to either create or seek supply and demand.

Typically, a market maker operates both buy and sell processes, side-by-side, that are aware of one-another.

pinging
Pinging is searching for liquidity.
Orders are sent out, held for several seconds and then withdrawn.
In one reported example, in 60 seconds, 6000 orders were issued and withdrawn.
Only one successful fill was achieved.

robotics
Is there a solution?
Yes. It can be mastered.
With a long involvement in technical programming, robotics, and numerical-control systems we have a distinct advantage in this area in that the fashion is catching up with us. Or a rusty skill is coming back into fashion. We can see them. We can see it happen. There are imperfections in algorithmic systems. Our software solutions, detailed on later lessons, contain the kernel of these skills. Algorithmic trading systems are a modern application of old-style numerical-control-systems. Learn about them. Not hard.


tell-tales
The behaviour of algorithms is obvious once you know what you are looking for. The presence of an opposing robot is crystal clear to (a) another robot, and (b) institutional traders who are trading against robots. The tell-tales are there. Bigger and better than before.

If you think like a robot what would you expect when coming up against an opposing robot.
If you think like a market-maker what would you do when up against an opposing robot.

Algorithms are used by "majors" in

index rebalancing
arbitraging
market making

manifesting themselves in

sweep orders
iceberg orders
market depth dancing


some worthwhile reference material
We've done some of the research for you.

Financial Times Mandate - Algorithmic Trading
When the robots get it wrong - damage - and - opportunity

tell-tails

electronic order replenishment
order splitting, order scaling

  a tell-tail.

Scaled Orders. Just another tell-tail.
Some trading platforms feature scaled orders. An order of 100 is entered into the brokers system, but presented to the SFE system 10 lots at a time. As each block is done, it is electronically replenished, instantly, until the order is exhausted. Orders can be scaled so they are not evenly distributed. Observers can detect this activity by an order being hit and replaced at electronic speed. At the same price, repetitively. That's an alert a large order is being disguised. A high probability there are 3 orders being done at the same time. It can be seen if you look for it. Think this through from the perspective of an order of 300 split over 3 brokers. Why split it. Why scale it. Then put yourself on the other side. It's a game. Large scale "gaming tactics"


update October 2008
Over the past 4 years, the 5 major "prime broking houses" poured hundreds of millions of $ into the development of algorithmic systems and establishment of huge centralized computerized trading rooms. 3 have gone and the remaining 2 have become "banks" which means their "prop-shop" activities will be severely curtailed.

Their algorithms didn't help them. If anything, their unfailing belief in and reliance on algorithmic systems probably contributed to their demise.



the termite effect       sharks, sheep, sheep dogs, termites.
In the Market Depth Section it is stated commercial SPI traders never show their hand. Large orders appearing in the queue are placed there for a reason. What reason?. Should there be a reason?. Ask the right question.

Assume the market is going up. When a large order appears in the queue above the market, one of three responses can occur. (a) The market reverses, (b) comes to a stand still, or (c) goes straight through it. Usually, the market will trade up to but not touch the order, bouncing off it and retracing slightly. Then it has another look. And another. It will oscillate for some time, through a range of 5 to 6 points. Assume 5 points for the purpose of this discussion. During the oscillation process particular care needs to be exercised, examining the size of orders 5 points below. That's where the sheep dogs work. Sheep dogs are medium sized orders large enough to hold the market up. If the sheep dogs appear then look for a REVERSAL, otherwise look for a BREAKOUT.

THE BREAKOUT. If it is going to go through it, once that moment arrives, 1 of 2 things can occur. (a) the order is nibbled away in small chunks like termites, or (b) the large sell order will be pulled out. Once the termites start they don't stop. However whether it is pulled out, or taken out by the termites, the market will continue on through. Until the termites get to work, the market will oscillate, and the sheep dogs will not appear. So what are the sharks doing. They will feed during the oscillation process. If the commercial bid ask count is positive for this time period, they are buying, and, the sheep dogs will not appear. The termites will appear, eventually, after the sharks have had their fill.

THE REVERSAL. If it is not going to go through it then the large order will (a) never be touched, or (b) will be taken out entirely in 1 hit. If it is taken out suddenly in 1 hit the market rarely continues on up more than 1 or 2 points. If it is going to reverse (because it is a genuine top) it is likely that medium sized orders will appear 5 points below to keep the sheep penned in while the sharks get their fill. So what are the sharks doing. They will feed during the oscillation process. If the commercial bid ask count is negative for this time period, they are selling, and the sheep dogs will appear, and, will then disappear, after the sharks have had their fill. If the sheep dogs appear, then, the termites won't. And the large order will either (a) stay there, and not get touched or (b) get taken out in 1 hit. It's a probable top.

I have differentiated between a single hit and a nibble process. The single hit can be 1or 2 large hits. CAUTION: with low incidence, 1 or 2 hits can occur and the market continue on up. For the market going down, all of the above behaviour is true in reverse. Apologies for sharks feeding on sheep but it's easier than goldfish in a swimming pool with a shark and no dogs. If you read the battle of the elephants, you will realize the sharks feed on one another. Some sharks are just bigger than others. If the large order is ever pulled out it is usually a sign the sharks have had their fill and the market is going up. NB: Sharks must keep moving or they die.

All of this is null and void on ambush days, when anything can happen.

the above is achieved by use of the following orders in operation
iceberg orders
skyscraper orders
electronic scaled orders
automatic order replenishment


elephants = big hitters = smart money = major players
The term elephants is used to represent size and identify a group. The footprints are the signature. When watching elephants, remember, ½ of them will eventually be wrong. The secret is to identify the dominant group. The term "smart money" has been avoided as it denotes only the winning group, i.e. the ½ who will be right, and not the ½ who will be wrong. Whereas both groups leave their signature.


can you see the elephants
The eye only sees what the mind is prepared to comprehend. Henri L Bergson

battle of the elephants
Trading is a battle of elephants. They can't hide. A war of accumulation and distribution. It can't be hidden. When elephants fight, the grass gets trampled. Commercial traders constitute 80% of the total volume of the SPI. Because futures is a zero sum game, 80% of the activity becomes a battle of elephants trying to defeat one another. The remaining 20% represent the small traders. Commercial traders are elephants. They cant hide. They leave their footprints behind. Because of the psychological nature of sight, if you are not looking for elephants, you wont see elephants, and you wont see the footprints.

following the footprints
When elephants roam, follow the footprints (can you see the wind). Large elephants leave large footprints, small ones leave small footprints. When the market is quiet they disguise their presence by trading in small lots. They tread lightly. When the market is active they trade in larger lots. They tread heavily.

recognize the footprints
A computer can recognize the shape of an elephant. It can't identify a shadow. It can't identify the cause of a footprint. Shape, size or depth. Human perception can. Back to the grey-box solution.

Price is not a measure of size. What can be used to measure size?. Logically, it's the contract size of each tick.

the dancing elephant
can you see the wind
Yes. If you know what to look for. You can see the signs. In competition sailing it is necessary to "see" the wind. Wind vanes and telltales do not help when there is no wind. In calm conditions the sailor watches the surface of the water. Localized eddies of wind disturb and darken the surface area. As the wind moves, the disturbance, and dark shadow moves across the water. As the wind subsides, the surface disturbance subsides and the shadow disappears. The skill is to read where the wind is, its direction, and move toward it. Sailors know you cant predict the wind. After moving to the area of most disturbance (maximizing probability) the next gust often occurs in the location just vacated. Electronic devices cannot detect these phenomena. Wind vanes and telltales are useful only when there is wind.
 

can you see the gorilla
source - University of California, Santa Cruz and Monash University
If you focus your attention on a basketball game -- for example, on the number of times the white team possesses the ball -- you will be unlikely to notice the person in a gorilla-suit who walks across the court (Simons & Chabris, 1999). This is an example of what Mack and Rock (1998) call "inattention blindness" (IB).


the accumulation effect
Granville, an economist, was one of the first modern day American technical analysts. In his book "New Strategy for daily market timing for maximum Profit" 1963, said "accumulation cannot be hidden". It shows up in volume.

Example: An institution wants to buy 500 contracts at 3900.
There are two options. (a) market order or (b) limit order. Internal broker-exchange rules prevent single large limit orders sitting in the queue. A market order could be executed at that price, only if there was an accumulation of smaller orders aggregating to 500 on the offer. Which doesnt happen. .. Its done this way .. Even a part order to buy 200 would not be placed at 3900 as this would immediately signal to the market that an institution is in the market, and sellers would immediately retreat and the institution would not get filled. A single order for 500, buy, or sell will never be "seen". To accumulate a large number of contracts at a particular price of say 3900, the executing broker would place a large sell order of 100 at 3901, another 100 at 3902, another 100 at 3903. They would then place a buy order of 10 at 3900, and a buy order of 20 at 3899. The presence of the large sell orders will induce traders to sell at 3900, ie below the 3 large sell orders sitting in the sell queue. As soon as the 10 buy at 3900 is done, it is immediately replaced by another order of 10, and again, and again until filled. The constant replacement of 10 on the bid at 3900 is obvious. Like feeding the chooks. As soon as the buy order is filled, the sell orders at 3901, 3902, and 3903, not surprisingly, disappear. When this happens you know where the market is about to go.

the distribution effect

The reverse of the accumulation process. Done exactly the same way.

Additional information