Yesterday I was a panelist at High Frequency Trading World USA 2010 in NYC where we discussed HFTs effect on market volatility.  Some are concerned that a market overly volatile will scare investors from participating in the market.  Since HFTs are our modern middle men, perhaps market maker rules should be considered for them.  This is an idea worth exploring but will not change the real volatility from today’s market.  And since we trade in this potentially volatile market, how do we protect ourselves as traders?

We must ask what is the context of today’s market to understand our real volatility.  Most just look at the VIX and use that as the indicator to measure volatility.  As a trader of a dozen years I can share that looking at indicators and charts-a-trending works until they don’t.  And a whole lot of market context and psychology must be mastered to understand the real potential of a stock’s or market’s risk.   Sure that VIX indicator from today works for today- as long as nothing surprising hits.  But when is that ever the case?  And in our time, potential land mines cannot be undervalued.

So what is the context of this market?  We sit in an under-participated market.   Federal and State taxes have a future of increases.  Unemployment is too high without a signal of hope.  There is the housing crisis not yet over.  Banks are not lending to small businesses.  Consumers reek of too much debt.  Our businesses are increasingly global.  European governments are a news reel away from causing investor worry.  Asia and the Middle East can’t help themselves but provide bursts of instability. Information is transmitted to more at the stroke of a tweet.  Orders can be flooded into the markets by more for more size and speed with buyable algorithmic programs.  Traditional market makers were replaced by HFT market makers who have little obligation to make a market when bad news hits.  We are averaging 1.75 flash crashed in stocks a day according to a report from Zero Hedge and Nanex.  From the trading desk we see too many 80c spikes in one penny spreads.  Check out some intraday charts of the high volume, supposedly liquid LVS as Exhibit A. The market has climbed 60 percent in less than two years.  In short this is a market of potential volatility hidden.

Maybe we need to get used to a more volatile market until we straighten out the fundamentals of our economy and world politics.  We certainly as investors and traders need to weigh the above in all our trades no matter how pretty our up-trending charts appear.  Not that we need to lighten up or get flat these positions, we just need to understand the risk.  I am not calling a market top here, just asking you to consider the context of this market.  As a trader, it’s the time to sit at your trading station, ears to your news feeds, eyes on your news services, with hedges, responsible stops and Plan B’s in place.  Because there is risk that what you are seeing on your screens presently is not your real risk.

Mike Bellafiore

Author, One Good Trade