MAILBAG QUESTION:

"What I use for charting doesn't show me weeks back on 60 minute charts unlike ones i've seen with your saturday articles. Maybe you can include one of these hourly charts each week? I missed seeing this yesterday.

Also I get concerned about big swings in stocks that I trade options on like happened last week. Anything changed to prevent computer trading from creating crazy prices like happened last year?"

MY RESPONSE:

Hourly Stock Index Charts

I can include a representative HOURLY index chart each week for the foreseeable future in my initial 'Bottom Line' commentary in my Saturday Index Wrap. Probably a good idea as I find reference to the closeness (or not) of either an overbought OR oversold extreme based on a 21-hour Relative Strength Index or the 'RSI' on the major indexes (NOT on individual stocks) to be a valuable trading practice. Especially so when we have wide two-sided trading swings during lower volume trade such as in summer or around holidays AND when we have frequently changing news on events external, but important to, stocks in the US. For example in recent months of course has been European stock market action, interest rate developments and political news/events in recent months.

Either because of less volume or because of external news from Europe or China, there have been substantially MORE shorter-term price swings in recent weeks and months. Shorter-term trend REVERSALS often occur on the heals of 'overbought' (e.g., 21-hour RSI hits 70/70+) or 'oversold' (21-hour RSI falls to 30 or below) extremes.

A REPRESENTATIVE HOURLY INDEX CHART: S&P 100 (OEX)

As I didn't show an hourly index chart in my recent (8/4/12) Index Wrap column, I'll slot it in here. I generally pick the Index that is either the strongest and/or is showing the most 'regular' technical pattern such as the one that has traced out the most well-defined uptrend or downtrend price channel. The chart I select may have also had the most consistent reversals from either a high or low 21-hour RSI extreme.

This next chart shows a slice of the 1000 most recent days of hourly OEX data I keep with my charting application. Since the trend is up (the trendline and trendline channel slopes up), use of the 21-hour EXTREMES could be used only to add to call positions when the rare 'oversold' extreme occurs. Or, someone might chose to exit OEX calls at the more numerous (for the period shown) 'overbought' extremes and/or enter puts for short-term plays on the downside. Currently as you can see for yourself, the RSI isn't at the highlighted extremes that normally would suggest a counter-trend trade, although another shot up would get the RSI to an upside (overbought) extreme.

Trades I generally feel most confident about or perhaps go into with a heavier position occur when there's BOTH a move that stops at a trendline such as either the upper or lower end of a price channel like highlighted below AND when there's an overbought or oversold RSI extreme that also occurs.

My goal is not to trade more often but more selectively, I wait for ideal opportunities. Of course I tend to trade outright positions such as being long calls or puts. I admire those who do spreads and straddles to take in premium when there's a trading range, etc. It's not me but I've always have worked on 'timing' trend changes. My book (Essential Technical Analysis) was all about that. My ideal trades may occur only a few times a year. If that's true for you also well, great, hopefully, you have a good profit for the year for YOU. If you have a broker-friend (rarer these days), he/she will always have many traders who can't stay away from the gaming tables and will rake in many commissions.

WILD WEST OF TRADING WITH COMPUTERS; A BRIEF HISTORY

It used to be back in the (good/not so good?) 'old' days there were New York Stock Exchange Specialists who were individual NYSE members who were charged with maintaining an 'orderly' market in the stocks assigned to them. They were the buyer and sellers of last resort so to speak. If a huge buy order came in for IBM before the opening, the specialist could both call a trading halt while they put out this info to interested sellers and/or they could take the sell side to some extent. If the order imbalance occurred during the day, the specialist could also call a trading halt until more orders came in that would maintain an 'orderly market'. (I'm not talking about a trading halt due to pending company news; that's different).

In the Nasdaq market, Market Makers occupied a similar role in maintaining an orderly market in their stocks. In the 1987 crash when I happened to be at the CBOE floor on what was then called 'Black Monday', the Nasdaq market makers stopped answering their phones; the NYSE specialists probably wished they could have!

Over time, individual specialists or Nasdaq market makers became mostly FIRMS. Whether the old style Street partnerships or big Wall Street companies, firms had more capital.

Over still more time, specialists and market makers have been largely replaced by high-frequency traders using computer technology and specialized trading algorithms that react to orders in nano-seconds. Exchanges offered such trading companies, who can take the opposite side of customer orders, discounts in their execution costs and desired physical proximity to Exchange computers (really).

However, such high-frequency trading firms have NO obligation to stick around and can cancel their orders, also in nano-seconds. They won't continue to make a market when things get crazy. In fact, the same computer programs and algorithms they use are expressly designed to shut down in the event of wild price disparities. The result is that in certain instances the markets become far LESS liquid than more liquid. Which brings us to the infamous 'Flash Crash' of not last year (2011), but May 2010.

2010 'FLASH CRASH' and RESULTING RULE CHANGES

To get the advantages that come from being listed market makers, high-frequency firms were required to have bids and offers posted to buy or sell the stocks in which they supposedly 'made' markets in. This rule led to something called a 'stub' bid. If things were going crazy, the firm could and would put in a nominal bid of $1 a share for a stock that closed the prior day at say $50. This met the technical requirement, but no PERSON would be crazy enough to sell at that price. Unless that 'someone' was a COMPUTER! During the flash crash, sell orders in certain stocks overwhelmed demand for those stocks. Computers looked for the best bid and eventually that bid was a buck a share! So trades were executed at that price. You know what havoc resulted!

In OPTIONS, there are market makers and they can stop trading in particular options. Not so with the high-frequency trading firms in their stocks since they are NOT authorized to halt trading. Eventually, the Exchanges suspended trading in those stocks that got slammed the hardest in May 2010 but it was pandemonium for a lot of that day. 'Stub trades' are no longer allowed but there's still other stuff that can cause stocks to get out of whack.

And that's what happened this past Wednesday (8/1/12) when Knight Capital rolled out new software that wasn't adequately tested and by mistake the firm's computers placed runaway offers to buy and sell shares of around 100 big companies. Their prices weren’t so out of whack but some huge volumes were which led to significant distortions.

The Market recovered fairly quickly and didn't end the day with huge losses; unlike Knight, which lost hundreds of millions of dollars on all the trades it had to cover; the firm is now shopping for a buyer. It took the NYSE 45 minutes to shut down Knight's trading. Makes you wonder why Knight didn't shut it down sooner than 45 minutes! Hey there's the automated part of the equation I suppose. Live by the computer sword, die by the computer sword.

The NYSE was somewhat hampered as they had limited authority to take action. Orders coming from Knight weren’t off the mark in terms of price so much as they were orders with way above average volume. Moreover, the NYSE circuit breakers that halt individual stock trading don't work during the first 15 minutes of trading.

By the way, some high-frequency trading firms made out big in that they profited from Knight's errant trades. In poetic justice I suppose you could say, the head of this firm was a very aggressive proponent of computerized trading and criticized others who ever bungled their computer-driven trading; e.g., as with the first day's trading in Facebook.

REFORMS; "LIMIT UP, LIMIT DOWN", ETC.

Before computer trading became dominant, if a flood of unusual orders came in, specialists and market makers could question these orders and call a trading halt in the stock(s). Regulators, to mimic the role of specialists and market makers are introducing a type of circuit breaker called 'limit up, limit down'.

Limit up or limit down is a term from commodity futures exchanges whereby a futures contract cannot trade more than X amount above or X amount below the prior day's closing price. When that price is reached, trading can ONLY occur at the limit up or limit down price. If no trades can be transacted at that price, volume equals zero for that period of time or the rest of the trading session.

With the proposed 'limit up, limit down' in stocks, trade in a stock is paused if trading starts occurring OUTSIDE a 'normal' price range. THE LIMIT UP, LIMIT DOWN MECHANISM WILL START IN FEBRUARY 2013.

As a long answer to the above question, I hope this gives some assurance that more is being done to halt stock trading if price swings get really crazy; and to keep you from being driven crazy because stock options pricing goes haywire because the underlying stock is being whipped around in some wild fashion. Moreover, you and I, the individual trader or investor, probably are not sitting in front of a computer all day. With other business to attend to, I can't and don't want to do that myself any more. I suspect you are the same. If you feel you can't trade UNLESS you can sit in front of that screen all day, our markets are the poorer because of it.


GOOD TRADING SUCCESS!