In my opinion, the allowance of algorithmic trading is impacting more than just markets. Speaking specifically of commodities, speculation and hedging have forever shared an integral part. Speculation provided liquidity in which the producer or purveyor of a commodity could offset price risk in the future. The hedger may wish to mitigate risk while the speculator is willing to assume the risk. From inception of trade to this day, the price for a specific commodity is founded upon the demand from consumers and the availability of the product in need. The number of factors devised by participants of the market to anticipate price direction are countless; however, they all have one commonality. This is, they are all based upon the interpretation of data by humans. Regardless of whether you think beans are going up or down due to weather, a change in technical indicator, or a development in the currency exchange rate, you derived that information from data available. If a decision to participate was made, you assumed the risk of loss, or benefited from your analysis. Your decision to trade increases the volume of contracts, helping to disseminate the risk, which in theory reduced the amount of potential price fluctuation. Hence, the public potentially benefited from the reduction in price fluctuation. The “you” in any of these instances can be an individual, commercial, fund, or lending institution. All provided liquidity to the markets. While the speculation is rank, the majority of participants have a commercial or personal interest in the commodity traded.
The rise of electronically matched orders swept the old trading floors clean of individuals that made their livelihood off analyzing markets and order flow. Many floor brokers have described the noise factor as much of a tell-tale market signal as anything. This noise was an increase in order flow that was disseminated from client to broker to clerk, to floor broker and back again. Today that noise is no longer being heard, but seen. The electronic platforms we trade on make visible our intentions to buy or sell, and how many, to all. Technology has allowed some to create computer programs that recognize the order flow and categorize its magnitude through the day. This categorization of volume at any given time produces signals to the programs to buy or sell in large quantities, with execution of orders in the thousands within seconds. No human thought was given to the commodity or the impact of supply and demand. The decision in the case of the algorithmic trader is the following: when does volume of trading exceed the magnitude needed to elect the order entry systems to buy or sell depending strictly upon the flow of, or anticipated, incoming orders.
As I perceive it, the issue is this: does the volume of trades produced by algorithmic traders help or hinder in the discovery of price? Algorithmic traders suggest they provide necessary liquidity that is no longer provided by individuals, commercial, and bank proprietary trading. No doubt, the volume of trades algorithmic traders produce is phenomenal. The exchanges boast monthly of their increases in volume; however, this increase in volume is not based upon the manufacturing, production, or procurement of commodity goods. There is no increase in commercial interest of the commodity or the production/consumption of this commodity. The function they provide is financially motivated only. A problem with this is that they provide said function at a cost that cannot be quantified. Due to the speed in which orders can be executed, their volume can overtake the opposing side of orders to cause significant price gyration in seconds. Participants outside of the algorithmic trading environment placing orders may have fills sharply lower or higher than anticipated. This higher or lower price is difficult to translate into the cost of the finished consumer goods. My personal view of their presence in the market is that the algorithmic traders are intimidating. This is not necessarily a malice form of intimidation, but more intimidation from myself and others being ill-equipped to trade in this new-found environment. Witnessing nearly daily the severity of price width and speed in which it unfolds, I conclude that most seasoned traders view their execution ability with awe. Participation of trading in this environment has been likened to walking in off the street and jumping head long into a bar room brawl with guns, knives, and broken bottles and you are naked.
While algorithmic traders may influence greatly the daily fluctuation of price, I would be very surprised that they actually influence a fundamental price direction. For example, the size of the corn harvest and perceived demand for corn in the next 12 months, suggests the price of corn would move higher or lower. A fundamental justification of price movement is as natural as the demand that drives the need for, and supply that fulfills the need. I perceive this is where we as individuals and market participants decide how much the liquidity provided from algorithmic traders helps or hinders price discovery. Volume is a necessity. Without said volume, price fluctuation would be greater regardless of the participant. The price disruption caused by the increased volume of algorithmic traders is excessive. Is there a trade off? To wrap this up, in my opinion only, I do not anticipate the exchanges to limit this trading as the volume it creates directly benefits the exchange. Therefore, algorithmic traders are anticipated to be here for a while. How market participants outside of this form of trading will adapt is unknown. The frustration of some participants will cause further decreases in liquidity provided by human beings. If the volatility continues, it is possible that more human participants will become dissatisfied with the futures markets. When this occurs, the price of bread, meat, gasoline, and other commodities will be determined by the flip of a switch and not a human depiction of supply and demand factors.
Futures trading is not for everyone. The risk of loss in trading futures can be substantial; therefore, carefully consider whether such trading is suitable for you in light of your financial condition. Past performance is not indicative of future results, and there is no assurance that your trading experience will be similar to the past performance.