By David Sheppard and Jonathan Spicer
NEW YORK (Reuters) - When natural gas prices dropped by 8 percent in a matter of seconds in the early hours of Asian trade last week, one New York-based hedge fund manager said he didn't have to think twice.
"The moment I heard, I ran, literally ran, to my computer and started buying," he said. "It was clear it was an HFT algo gone bad and I could profit on the rebound off the lows."
He wouldn't have been the only one.
Since the infamous "flash crash" in equity markets in May 2010, that was exacerbated by high-frequency trading (HFT), seasoned traders say that violent, often inexplicable price moves are becoming more common, and allow those who are fast enough to book a quick profit as prices bounce straight back up.
In commodity markets, which have been hit by a series of mini flash crashes over the last 18 months, experts say there could now be an influx of more high-speed computer-based traders that have honed their techniques in the cut-throat equities markets -- the fastest and most electronic on earth.
Though such firms have traded commodities for years, some traders and experts say they are now applying new and more aggressive strategies that have stunned traditional players.
Such high-frequency trading -- in which rapid-fire machines place thousands of very short-term bets, making markets and profiting on tiny price imbalances -- could double from around 15 percent in two to three years, leaving commodity exchanges and regulators running to catch up.
Jeffrey Sprecher, CEO of commodity futures powerhouse IntercontinentalExchange Inc <ICE.N>, told reporters last week exchanges are working on ways to target "unintended" price spikes, without losing the benefits -- and volumes -- HFT firms bring.
"I think it's incumbent on the exchanges to solve this. I think customers are going to lose faith in us if we don't."
HFT AND THE MAY 5 OIL CRASH
Commodity traders are increasingly blaming computer-driven activity for a series of anomalous price movements ranging from quick blips in natural gas and cocoa to deeper, longer-lasting jolts like the one that shook oil on May 5.
On that day, traders were shocked by the speed and violence of a record $13 intraday plunge, as sell-stop after sell-stop was triggered, despite the absence of a major news event.
"I think there are some new algorithms in commodities that we've seen in currency markets before that are designed to sniff out the stops," said Paul Rowady, a senior analyst at TABB Group, a firm that specializes in capital markets research.
"Whenever there is an event that causes prices to move they try to sniff out the stops in both directions. The market can suddenly shoot up, and then back down again after an event and it leaves traders disoriented, wondering what happened."
High-frequency traders are frustrated by the criticism and what they call mischaracterizations. Several told Reuters they reduce volatility by quickly bringing prices back in line after larger, long-term players place their bets.
"May 5 was a price discovery process influenced by real fundamental changes in people's views on the oil market. It wasn't a liquidity blip," said an oil-market high-frequency trader who requested anonymity.
And yet some of the world's biggest oil hedge funds appeared to have been victims of the slide, not catalysts.
SEEKING NEW PASTURES
All signs point to continued growth of HFT in commodities.
It is partly in response to increased competition and narrowing profit margins in U.S. equities, where high-frequency trade is estimated to have declined from a year ago, along with lower volumes and volatility. It is still, however, thought to be involved in more than half of all trading in the market.
Additionally, for HFT, there is an allure in playing in markets where heightened volatility is becoming the norm.
"Whenever there are spikes in markets, high-frequency traders gather data on it," said Louis Liu, founder of Matrix Trading Technologies LLC, a New York-based high-frequency trading technology firm. The May 5 oil crash "could encourage them to enter" energy futures trading, he said.
William McNeill, managing director of trading at HTG Capital Partners, a Chicago-based proprietary HFT firm echoed that view: "I think you'll definitely see an increase in people market-making in the oil product set. If there's moderate volatility ... there's probably ample opportunity to take risk."
Rowady at TABB Group said he wouldn't be surprised to see HFT volumes double in energy markets in the next two to three years, saying oil and natural gas "fit the bill" for HFT firms.
But the growth of HFT, while undoubtedly bringing some benefits to the wider market like lower trading fees, won't be without risk.
"When you have highly complicated automated systems operating in highly complex markets then there is the risk that the permutations of what can occur are beyond what you're able to model," Rowady said. "Sometimes the only way to find that problem is to stumble over it."
HFT firms in commodity markets have found themselves under intense scrutiny before.
In 2009, the U.S. Commodity Futures Trading Commission charged traders in the Chicago office of Netherlands-based HFT firm Optiver with attempting to move oil prices to their advantage with a rapid-fire trading tool they nicknamed the "Hammer."
And in 2010, HFT firm Infinium Capital Management found itself under investigation after its newest trading algorithm ran amok, sparking a brief surge in oil prices that racked the firm with a million dollar loss as the program sent up to 3,000 buy orders a second.
While experienced high-frequency traders agree that causing sudden movement in prices is not in their collective interest, the Optiver case is a reminder that HFT firms can shift prices either by practice or design.
CME Group Inc <CME.O>, which runs the New York Mercantile Exchange (NYMEX), home of the world's most actively traded crude oil contract and the natural gas contract where last week's 8 percent crash occurred, said automated trading, including both HFT and slower computer-generated trades, accounted for almost a third of energy futures volume in the fourth quarter of 2010, in a report published on its website.
The Aite Group consultancy estimates that specifically high-frequency trade in energy futures already accounts for around 15 percent of all volume.
But illustrating the controversial nature of growing HFT trade, CME Group told Reuters it had decided not to make its first-quarter report available to the public.
"Ultimately what they're doing is within the rules," said Tim Quast at ModernIR, which advises many S&P 500 companies on the impact speculation, HFT and fund flows can have on their stock price. "They're just faster and better at operating within the rules than others."
(Reporting by David Sheppard and Jonathan Spicer; additional reporting by Janet McGurty in New York; editing by Jonathan Leff, Marguerita Choy and Lisa Shumaker)