Friday, January 29, 2010

Algo's in action.. SanDisk case study (SNDK)

Algorithms are all over the equity markets the past year whether you believe it or not. I would like to answer two questions for you in this post: What do they do? How do they operate

 What do algo's really do?
In a nut shell they are in place to wreak havoc on momentum traders.. well no actually they are designed in theory to "add liquidity" to a thin market, while reducing the spread between bid/ask. I personally do not care if the spread is a nickel if the price is stable and not going to be whipped around by 100 shares flipped back and forth 50 times in 1 second. The wizard behind the curtain really is using these algo's to race up offers or down bids ahead of decent size resting limit orders in the book.

How do they operate?
If you look at the level II i have up on the left you will see 25 lots circled, these are the algo's benchmark limit orders. These orders never get hit and always are under and over the market 10-20 cents. The high speed computer programs uses these orders as a crutch or "out", meaning if the trade gets away from the computer it can always cross into the resting order and get out. When they are operating normally the algo's step in front of orders placing 1 lots right in front of the order. Once they get hit they hop on the other side of the market placing a bid or offer in front of the 25 lot OR the best bid and get hit. BOOM they made a rebate and a few pennies. This process is repeated over and over again, it never stops. You will notice these odd lots resting in the book in stocks like AAPL, RIMM etc. The algos are more prevalent in a slower low volume sideways trade, they usually disappear when volatility gets crazy as the chances of the aglo getting fowled up is higher.

 The firms running these algo's have done a very good job convincing the SEC and or whoever lets them run that they are harmless and beneficial to the markets. Pshh these things do nothing but make the level II data impossible and misleading and knock stocks off some of the strongest trends just because they stepped in front of a moderately sized order. The orders they exploit half the time are not even bigger than a 50 lot ie(50 x 100 = 5k shares). Be that as it may, algo's are not going anywhere fast, we might as well embrace them as hard as that may be. I know you hear me complaining about them because they do screw up a lot of great set ups but that's me, i think aloud. Have a good weekend.

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