I never doubted that there was manipulation going on in the markets, but I honestly thought it was mostly confined to low-liquidity markets like penny stocks and low volume markets like gold & silver. The Flash Crash of May 6 proved me wrong. The crash and bounce occurred across all sorts of instruments – high volume, low volume, high liquidity, low liquidity, stocks, futures, forex – nothing was immune.
The combination of high-frequency trading, co-located servers, illegal front-running, Federal Reserve money, volume rebates, sub-pennying and moral hazard has turned what used to be a legitimate market into a rigged casino. Frankly, I think my odds in Las Vegas might be better. In Vegas, at least the house is upfront about how the game is tilted in their favor.
With that said, here are my thoughts about how to succeed as a trader in a rigged game:
1. Do not pay any attention to fundamentals. Fundamentals mean nothing in this market. John Paulson was widely praised for making a billion dollars shorting the housing market. His fundamental analysis was spot-on. But we now know that he made a lot of that money because he bought credit default swaps on bonds that he helped Goldman Sachs put together – bonds literally designed to fail. Even with accurate fundamental analysis, he essentially worked with GS to rig the game. The only qualifier I would give to this recommendation is that certain overwhelming trends cannot be manipulated away by the banks and the government. All the new money that the Fed and ECB have pumped into the banks will eventually show up in the economy, and you can be certain that we will eventually have severe inflation. The problem is – as Lord Keynes is reputed to have said – the market can stay irrational a lot longer than you can stay solvent. The Too-Big-To-Fails – banks, insurance companies, car companies – will be bailed out someway, somehow. Even though they are fundamentally insolvent and their stock isn’t worth the paper it is printed on – they will NOT go to zero. Fundamentals mean nothing.
2. Trade on technical patterns only, but don’t trade them blindly. Most technical patterns are well-known and heavily traded: head & shoulders, double tops, double bottoms, moving average cross-overs. Part of high-frequency trading is technical trading, and those computers can read and react faster than you can. Some of the more well-known patterns have quit working. I’ve only been trading for three years, and in that time, I have discerned at least three different markets, markets that behaved unlike other markets. I started trading the ES in January 2008. From that point till March 2009, the market behaved as I expected it to. From March 2009 till around February this year, the character of the market completely changed, and the indicators I had been using and relying on quit working and others started working. Around February this year, the character of the market changed yet again, and again the patterns I was trusting quit working and others started working. The moral of the story is this: in a technical market, you have to trade on technicals – but always beware that the very nature of the market can change.
3. If you are a program trader, then you must immediately test and implement your self-protection plan for the next occurrence of Flash Crash. The computer programs that generated the crash are still out there, still cranking, still front-running, still sub-pennying and still not smart enough to understand how to react in every situation. I was a programmer for 10 years, and I know from experience there is no way that developers can anticipate and test for every possibility – especially the kind that happened on May 6. You must be prepared to override your programs and protect yourself. When spreads on the ES are 40 times wider than normal, stops get blown, accounts get blown and lives get blown. Protect yourself.
4. If you hold positions overnight, hedge. Just because the Flash Crash happened during American market hours doesn’t mean it could ONLY happen during American market hours. I know some traders who hedge their positions with options. I know others who hedge their positions with correlated instruments, (like hedging the ES with the DAX). Whatever you do, you must protect yourself. It has been demonstrated again and again that the so-called regulators will not punish the major players, so you must assume that the major players will do everything within their power to manipulate whatever market you are in. Protect yourself.
5. Don’t expect justice. When the mafia ran a protection racket in a neighborhood, it didn’t make business impossible, it just made it more expensive and less just. You must have the attitude of a shop owner in a mafia-controlled neighborhood. You know they are going to shake you down eventually; plan and prepare for it now. If you find it impossible to be a businessman in such a neighborhood, then get out now before something violent and ugly happens to your war chest. But if you are able to accept the fact that the crooks run the neighborhood and the cops won’t do anything to stop them, then you must figure out how to do business with the crooks. The metaphor holds: the mafia needed the shopkeepers to keep doing business, otherwise they would have no one to shake down. Just know that they are going to take an unjust, unfair portion of your profits. Another way to express this thought is: bring your expectations in line with reality.
6. Don’t give up. It is still possible to make money trading in a rigged market. You have to be nimble, you have to trade defensively, you have to be humble. Even though this market is rigged, it still speaks and will still tell you what it is going to do – you just have to learn the language. If you have not already made the decision to be a student of your market, you must now decide to be a student, always be a student of the market you trade. If you are not willing to be a life-long student, then find another profession.