Farley: Piggyback Algorithms, Make Money - TheStreet

This was originally published on RealMoney. It is being republished as a bonus for TheStreet.com readers.

Staring at the ticker tape all day can be downright painful in a good summer market. (Don't miss "

10 Tips for ReadingTape

") Add in a major world crisis, and this time of year feels like a root canal with no meds. Cramer said it best when he called recent price action "repulsive," noting the public has completely vanished from equities. I don't expect they'll be returning any time soon.

We can also blame computer algorithms and thousands of lemming-like hedge funds for a good deal of the market's current misery. In combination, they've taken greed and fear out of the buy-sell equation, replacing it with size and speed that pushes the intraday bid-ask in whatever direction they want it to go.

Expect more of the same in coming years because profit incentives in this new era of market manipulation are just too great to ignore. But the environment would greatly improve if the SEC took their heads out of the sand and finally established fair-play rules that eliminated phantom pricing and forced the display of real size.

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This brave, new computerized market is a double-edged sword for public traders. On the one hand, it forces them to ignore support and resistance, focusing instead on the quality of relentlessness pricing in the intraday market. On the other hand, piggybacking computer algorithms can be a great way to make money.

What do I mean by relentless pricing? This term refers to the signature of computer programs on trend days, when markets fail to turn at natural pivot points that would have triggered reversal activity in prior years. Price channels are the telltale signatures of these lopsided events, usually showing up on the index futures.

Characteristically, the only countertrend movement in these types of sessions happens around the lunch hour and in the final 30 minutes, when a sometimes-violent counterswing shakes out positions ahead of the close. In between, every wiggle against the trend runs into a synthetic wall of pressure that forces pricing in the other direction.

These are the trend days that post 80:20 or 90:10 down:up volume, or vice versa. Historically, these lopsided readings have occurred rarely and usually signaled major reversals. But that's no longer true. The markets have posted at least 20 of these events since February 2000 and most have failed to trigger big market turns.

S&P 500 E-Mini Futures

Click here for larger image.

Source: eSignal

Piggybacking is an efficient way to align trading strategies with these relentless computer programs. After identifying their signature early in the session; sell all the rallies or buy all the dips, as the case may be. Assume no reversal will take place that day, as long as advance-decline number stays on the far side of plus or minus 1200 on both exchanges.

I know what you're thinking. But in reality, these algorithms are easy for most traders to see in action. In fact, I'm amazed that folks still ask me to explain what they look like because their intraday footprint is so heavy that it literally makes the forest shake. In any case, here's a down-and-dirty method to identify active computer programs.

Start with a quote screen that includes the index futures (or related ETFs) and a selection of liquid equities across a wide variety of sectors. Add in bid, ask, last price, and price change. Color-code the numbers so the downticks are red and the upticks are greens. Then sit back and watch the first 90 minutes of the new trading day.

You'll quickly notice buying and selling waves passing through the majority of instruments. These can be extremely rapid pulses, lasting a few seconds, or stomach churning air pockets that persist for minutes. The main thing that will catch your eye (and drive you crazy) will be lockstep price action between dissimilar stocks and sectors.

Exchange-traded funds are primarily responsible for this eye-popping alignment. Through these liquid instruments, algorithms buy or sell huge baskets of equities in microsecond bursts. The light-speed activity then forces the stocks to get bought or sold. Add in a half-dozen cross-markets, and you have a typical program strategy.

Have you noticed how market depth information, commonly referred to as the Level II screen, has turned into a blur of rapid pricing in the last year, making it nearly useless for analysis of short-term supply and demand? The culprit is SEC Regulation NMS, also known as the trade-through rule, which went into effect on March 5, 2007.

The stated purpose of the directive was to ensure the most advantageous bid-ask pricing for the public investor. But the law of unintended consequences came into play and destroyed whatever was left of the market's level playing field. In its place, all that's left is a violent window into an electronic world that we small fry are forced to navigate.

At-home traders have no choice but to adapt to this computerized marketplace, or they won't survive. This is especially true if common technical analysis strategies provide the basis for risk-taking because the eggheads writing these algorithms have deconstructed every major book on the subject.

In other words, they see you coming, sucker. Better to swim with the current than fight against it, I think.

This was originally published on

RealMoney

on August 21, 2008. For more information about subscribing to

RealMoney,

please click here.

At the time of publication, Farley had no positions in the stocks mentioned, although holdings can change at any time.

Farley is also the author of

The Daily Swing Trade

, a premium product that outlines his charts and analysis. Farley has also been featured in

Barron's

,

SmartMoney

,

Tech Week

,

Active Trader

,

MoneyCentral

,

Technical Investor

,

Bridge Trader

and

Online Investor

. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks.

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