Goring Oxen in Natty Gas

Jerry Dicolo of the WSJ has a piece on allegedly disruptive high frequency trading strategies that have been employed in the natural gas futures markets immediately surrounding the release of the weekly storage report.  Exactly what is going on here is hard to surmise, but what makes most sense to me is that the HFT traders at issue are gunning the stops.  That is, they are entering big orders to blow through the standing limit orders, moving prices, hoping to trigger buy stops (if they are buying) or sell stops if they are selling: the triggering of the stops creates the kind of short term momentum that the HFT traders can profit from by taking the other side of the stops.

Another example, as if one is needed, of the dangers of stops.

And it should be noted that gunning the stops is not the product of this newfangled electronic trading.  It happened on the floor with some frequency.  There are manipulation cases from the 1960s, if memory serves, related to gunning stops.

It’s also worth noting that there is exactly one data point in the story, August 16th.  It would be worthwhile to see if similarly allegedly anomalous price action took place prior to late-2006 when the market migrated to the screens.  I’m betting you could find more than one.

The article suggests that what is attracting HFT to the gas market is not the opportunity to play games for a few minutes once a week.  Instead, entry of HFT is being spurred by wide spreads in the gas market, as compared to equities.  HFT competition has narrowed spreads to virtually nothing in equities, so HFT traders are looking for markets with fatter margins.  Which is why they are moving into commodities:

High-frequency firms—whose activities can range from market-making on behalf of clients to trading for their own accounts—have wrung profits from the stock and other markets for years. But recently, their increased action in commodities, natural gas in particular, is spooking some veteran traders. That could leave the market reliant on computerized trading systems and potentially reduce liquidity when it is most needed.

“We can fight over fractions of a penny in stocks, or full pennies and more in natural gas,” said a programmer at a New York high-frequency trading fund.

Uhm, that’s the way markets are supposed to work.  Entry reduces prices and drives returns to just cover the cost of capital.  Which is exactly why some “veteran traders” are “spooked.”  They can’t compete against HFT.  Their oxen are being gored, just as traditional market makers’ oxen were gored in equities.

The new entrants may play shenanigans like gunning stops-but “veteran traders” did that too-another reason for “veterans” to resent HFT, for elbowing in on their racket.  Such shenanigans should be addressed by more targeted deterrents, rather than Euro-esque attempts to hamstring HFT.

I expect that spreads in natural gas, and commodities generally, will narrow as HFT technology and capital moves into those markets.  As for fears that this liquidity will dry up when it is needed most, again, this is not unique to electronic markets or HFT.  It is a feature of market making general.  Market makers reduce their supply of liquidity when they suspect order flow is toxic, or when risk is rising substantially.  It was so when market makers wore handle bar mustaches and button up shoes and stood in trading pits.  It will be so when market makers are co-located servers.  It’s inherent in the nature of market making, not in the technology.

About Craig Pirrong 228 Articles

Affiliation: University of Houston

Dr Pirrong is Professor of Finance, and Energy Markets Director for the Global Energy Management Institute at the Bauer College of Business of the University of Houston. He was previously Watson Family Professor of Commodity and Financial Risk Management at Oklahoma State University, and a faculty member at the University of Michigan, the University of Chicago, and Washington University.

Professor Pirrong's research focuses on the organization of financial exchanges, derivatives clearing, competition between exchanges, commodity markets, derivatives market manipulation, the relation between market fundamentals and commodity price dynamics, and the implications of this relation for the pricing of commodity derivatives. He has published 30 articles in professional publications, is the author of three books, and has consulted widely, primarily on commodity and market manipulation-related issues.

He holds a Ph.D. in business economics from the University of Chicago.

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