Date: 6/30/2022
Author: Chris Hood
Be sure to check out new episodes of my video podcast each week, where my ace pupil Brian Jones and I talk the ins and outs of options trading- and give you insights and strategy that you can immediately put to work for you in the markets.
Back in the 1970s, a revolution began in the trading world.
Stock exchanges began to utilize computers to process orders, paving the way for software that could replace humans for buying and selling equities.
By the mid-1980s, this software, or algorithmic trading, continued to rise in popularity as more and more institutions jumped on board.
Fast forward to today.
Most market participants are not people but computer algorithms (algos) that trade based on strictly defined rule sets. How these algos trade varies widely, but understanding a bit about them is necessary for modern traders.
Have you ever wondered WHY it behaves around key moving averages?
I mean, what’s so special about the 13-day, 21-day, or 34-day EMA?
In an uptrend, these levels act as key support points for pullbacks. Some stocks tend to bounce off the 13-day EMA, and others pull entirely back to the 34-day EMA.
The computers set to trade those equities are programmed to buy at those points.
Remember that you and I don’t move the tape.
Unless you’re trading illiquid penny stocks with an extremely low float (or number of shares available), it takes massive buying and selling to cause the price to move.
Institutions buy and sell large batches of shares…millions of dollars worth.
The dozens or even hundreds of shares you move around in your account have no effect on price. The market doesn’t even notice.
During my banking and hedge fund management career, I learned how most of these algos operate.
They buy or sell at these key moving averages.
If a stock is trending up, when the price dips, that’s just algo profit taking. The software will wait until its buy orders trigger on pullbacks to particular moving averages. Then you’ll see large blocks of orders go into the market, and the price will rise.
Some algos may trigger at the 8-EMA, while other institutions that play longer swings at the 34 or even lower.
Many funds won’t bother buying until the 50 or 100-day SMA level.
And as a rule, institutional support for a stock disappears once the price is below the 200 SMA. Below that, level moving averages tend to be selling or shorting.
Notice how SPY keeps hitting the 34 EMA and bouncing off in our current downtrend?
This isn’t to say that algo trading isn’t happening in this bear market. However, these programs are sophisticated and often scalp profits off each little rally or dip.
Using this info, I’ve even built my own trading robots for cryptocurrency, stocks, and options.
So can these algos outperform human traders?
In the long term, the algo will always win. The reason is that computers never second guess the rules. So when a signal to buy appears, the program immediately does so, and it will always sell on a sell trigger.
Assuming the algo is designed correctly, it outperforms people because it operates entirely without bias or emotion.
However, in the short term, the discretion and experience of a human trader can outperform any computer.
No algo is more advanced than the human brain.
But this is a double-edged sword.
We can never be free of our emotions. Our biases, greed, fear, and mistakes add up, causing losses.
The ultimate goal is to apply cold logic to the market and follow the rules we set for our trading system. Suppose we can use our market knowledge while simultaneously following the technical signals as unemotionally as a robot. In that case, we can beat the algos.
A tall order, but one that every trader should aspire to.
Cheers,
Chris Hood
The early bird gets the worm.
Top financial advice and stocks to watch in your inbox each morning…FREE
Click here to sign up.
