The second part in Nathan’s interview series with me focuses on the role of high frequency trading in the markets and testing trading strategies. If you missed the first automated trading interview in the series, you can read it here.
(Nathan):
Do you have any specific thoughts or opinions on HFT (High Frequency Trading)? This is such a hot topic among traders and I would imagine you have a unique insight into algo trading in general.
Do you see machines eventually replacing the “human” trader or could HFT eventually get banned from the markets? At least for day traders it seems to give quite an unfair advantage to the HFT camp for executions?
(Shaun):
There is a huge difference between algorithmic trading and HFT. HFT is obviously automated due to the speeds involved, but that does not imply that all automated trading is HFT. It’s only a subgroup.
(Nathan):
Sure, there are plenty of automated systems that are not HFT. I bring it up under the context that HFT uses deceptive algorithms for their order posting tactics.
(Shaun):
HFT is uniformly destructive to capital markets and their purpose. It nickels and dimes investors and traders through market manipulation. Just last week Nanex detected a single organization that pushed through 4% of all the order flow on US equities quotes. Even worse, not a single one of the orders executed. Posting orders without the intent to trade is blatantly illegal.
The other negative consequence of HFT comes from the rebates that the dark pools and exchanges pay to “liquidity providers,” which are really the HFT bots. The arrangement tangibly alters the motivation for participating in markets. Rather than investing or even speculating on price, the HFT algos generally do not care about market movements. They just want the liquidity rebate.
(Nathan):
This to me is the bigger issue. The whole arrangement is shady and as you said it alters the motivation for market participation. What steps or changes do you recommend?
(Shaun):
The Market Ticker blog is one of my favorites on that subject. Karl Denninger advocates a regulatory rule of a two second minimum order time. I support the idea. Nobody can plausibly claim that an order placed for such a short duration is for any trading purpose. If an order is not intended to be filled, it should be not permitted.
(Nathan):
I cannot argue with that logic. Back to testing, how important is accounting for commissions and slippage to the integrity of any back-testing data in your opinion? To me, as you go down the scale from longer term trading to day-trading the importance grows exponentially.
(Shaun):
I fully agree. The consequences of trading costs pile up with increased frequency. Shorter time frames multiply the frequency, which as you pointed out, grows exponentially.
My personal preference is to skip trading costs and commissions on short time frames so that I can obtain a sufficient sample size for my analysis. I do not foresee myself ever trading on one minute charts, but I almost always use one minute tests to analyze randomness within a strategy. Unlike most systems developers, the profitability of a system is a backseat concern.
I read a newsletter this morning written by a multi-million dollar businessman. He concluded today’s article saying that if you start a business to make a lot of money, you’ll more than likely fail. You have to excel at providing a quality product and service in order to succeed over the long run. When the inherent business excels, only then does the long term money follow.
Trading is a business in precisely the same sense. Most traders rush through the system development process to spit out quick profits. They rarely, if ever, consider a strategy’s performance over a lengthy period of time. Everything is about the here and now. Additionally, good systems frequently lose money. You need something more in the toolkit besides the random scorecard of profit and loss.
(Nathan):
Good systems do have losing periods, yet many traders seem to be convinced there is a “holy grail” approach out there that will buck this fact. If some of the most successful traders ever have posted losing periods (or even years) and have been around for 20+ years it seems hard to fathom beating their performance from day 1.
Regarding testing platforms, you were one of the first people that really explored the issues with back-testing Forex – can you provide more detail on the problems for those that are interested in developing and back-testing a system for FX (MetaTrader platform)?
(Shaun):
You’re opening a can of worms on this one. MetaTrader is hands down the worst platform available for backtesting. The data is notoriously unreliable. Even when good data is at hand, the instructions for importing it and turning it into something usable fill a dozen pages of instructions.
You’re much better off doing real analysis in NinjaTrader, TradeStation or MultiCharts. The metrics are vastly superior and require a tiny fraction of the effort. I still think that MetaTrader is sufficient for live trading most strategies.
(Nathan):
I am a huge fan of live testing/trading alternate strategies. One of my biggest “A Ha” moments came during live testing alternate exit strategies. I traded my account with my original exit approach but also demo traded alternate exit strategies in real time. There is value gained that you don’t always get from a back-testing print out. How do you compensate for slippage when testing a strategy?
(Shaun):
Forex is thankfully unique in that it doesn’t come with unique problems other than rollover. The markets are the most liquid in the world. As a retail forex trader looking at charts longer than five minutes, you can generally assume that the historical prices are reasonably reflective of executable prices for the strategy.
I compensate for slippage and bad ticks by doubling my expected transaction costs. For example, I pay 1.5 pip spread on the EURUSD. When I test a strategy, I demand that it must hold up on 3 pips transaction cost on every trade.
(Nathan):
Before we wrap this up, are there any specific strategies or common parameters that you have noticed in systems that make it? We both know how small of a percentage of traders become successful, but as it relates to mechanical systems are there recurring themes for those that are profitable?
No, there are no recurring themes that I see. The lowest common denominator is that they do not overtrade and that they use low leverage. Other than those two items, each successful strategy differs substantially from all the others.
The most important ingredient in system development is the developer. I have yet to program a successful trading system for someone without years of full time trading experience under their belt. You have to go through the school of hard knocks if you’re going to make it. Almost all of us are too stubborn to listen to good advice.
(Nathan):
Shaun, I can’t thank you enough for providing such honest responses and sharing your insight. If you are interested in learning more or considering coding your system, go to MetaTrader Programming for more information.
John M says
Excellent conversation…
thanks for sharing your insights, both of you…