How has high frequency trading affected trend following and the interpretation of price/volume action?

Published : September 28 2010 at 9:55 ET

Q: I am hearing a lot about how high frequency trading is affecting the market and possibly making it very difficult for retail investors to thrive in this day and age. Specifically I have heard that 70% of volume in stocks may be due to high frequency trading programs. The thought is that this may be causing havoc on investors' ability to interpret price/volume action. What are your thoughts on this?

A: With the advent of dark pools, high frequency trading (HFT), and the like, a few rightly question whether price/volume action and trend following are still applicable. Over the last century, whenever there was a big change to infrastructure, such as the advent of radio and television to disseminate news, the move from 1/8 to 1/16 spreads, or the move to decimalization, such moves have spurred questions about the viability of trend following and price/volume action. Yes, markets did change, but the overriding principles remained sound. Thus, my answer is a resounding yes that price/volume action and trend following are still applicable. The Market Direction Model focuses on capturing intermediate term trends, whether up or down, in the general market, so while high frequency trading may derail some day trading activities, it seems to have weathered the HFT storm. It was up +55.1% from June 1, 2009 - June 1, 2010 in a test fund using actual money, with exposure to the market less than half the time. Results were audited by Rothstein Kass. In a separate account that was not using actual money, I wanted to see how my system held up against a volatile instrument such as the 3x technology ETF TYH, going 100% long on buy, 100% short on sell, and 100% cash on a neutral signal. Such instruments did not exist until the last year, so this gives big opportunity for profit that did not exist before. From March 12, 2009 (the day of the big first FTD) to June 30, 2010, the model was up +207.4%. Of course, due to the highly aggressive nature of this account, drawdowns as high as -18.5% were not unusual, which occurred when the market was trading sideways, and elicited a series of false signals, but that is the price to pay to get to +207.4%. That said, my model's Achilles' Heel are sideways markets with low volatility such as in 1976 and 1993 due to a series of false signals with very little gained from any short-lived trends, thus the model finished a year such as 1976 up less than 7%, well under it's annualized average of +33.5%/year.

The bottom line is that trends still occur even in these highly unusual times and price/volume continues to work, though it is true that many models have been knocked out of the picture since price/volume interpretation has become that much more challenging in the last few years. Michael Covel wrote the excellent book "Trend Following" which contains in-depth interviews with successful long-time trend followers John Henry, Bill Dunn, and Ed Seykota. And yes, while such noted trend followers have been encountering difficulty since 2009, they are no stranger to steep drawdowns, and in their 25+ year careers, have always more than recovered, thus maintaining the integrity of their long term track records. In their careers, there have been periods where trend following and price/volume action was declared dead but what makes them unique is they continue to apply their systems through thick and thin, knowing the markets will always trend again.

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