Gas market stung by rapid traders

Veteran natural gas trader John Woods has a simple trading strategy around data on US gas stockpiles: stay away.

Woods and other floor traders on the New York Mercantile Exchange used to look forward to the weekly report of gas inventory figures by the US Energy Information Administration, widely considered the best reading of gas supply and demand in the US.

Traders would be glued to their computers before the data's release at 10:30 a.m. on Thursdays, ready to dive into the busiest trading window of the week.

But in the past few months, unusual trading patterns have pushed many seasoned traders to the sidelines. One reason for the irregular activity is a strategy known as "banging the beehive," in which high-speed traders send a flood of orders in an effort to trigger huge price swings just before the data hit.

High-frequency traders using a range of strategies target natural gas because of the wide gaps between the prices offered to buy and sell the futures contracts, which can lead to easier profits, says D Keith Ross., who runs the trading platform PDQ Enterprises and was until 2005 chief executive of Getco, a prominent high-speed trading firm. "You can make some serious money" in natural gas, he said.

Woods, head of JJ Woods Associates, says staying out of the market costs him broker fees and missed opportunities to profit from price swings, but jumping into the fray is too risky. "I just let the computers get in the ring and bang each other around," he said.

The shifting landscape in natural gas shows how high-speed traders are changing markets well beyond stocks, which so far has been the primary focus for regulators and lawmakers investigating rapid-fire trading.

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 computerised 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.

Advocates of high-speed trading say their involvement increases liquidity in the markets. But the industry has been the focus of regulators worried about market integrity after events such as the May 2010 "flash crash" and a recent trading glitch at Knight Capital.

High-frequency trading hasn't roiled the natural gas market in similarly dramatic fashion. But Gary Gensler, chairman of the Commodity Futures Trading Commission, said in March that the regulator will increase monitoring of futures markets to target high-speed-trading firms.

"We need to raise our game considerably," said Scott O'Malia, a CFTC commissioner.

Each week before the EIA report, many traditional investors place electronic orders to buy or sell futures above or below the prevailing price, called resting orders. A trader anticipating a large inventory increase might expect pressure on prices, and offer to sell natural gas at below the current price ahead of the report. If the trader is correct, the market typically would fall and the trader's "sell" order would be filled near the start of the decline, ideally at a profit.

Analysts and traders say high-speed firms "bang the beehive" in a bid to exploit these resting orders. Just before the data land, some traders flood the market with offers to fill the resting orders just above or below the current futures price. They hope to trigger enough orders to move the market in a given direction before the data hit.

If such tactics are successful, no matter what the data show, the flurry of trades will create wide swings that present opportunities for the rapid buying and selling that is high-frequency firms' stock in trade.

"You can create synthetic momentum and ride the wave," said Paul Rowady, a senior analyst with market research firm Tabb who coined the beehive phrase. "Banging the beehive" is the most visible of a variety of tactics that also includes "spoofing" and the "Boston zapper."

Eric Scott Hunsader, chief executive at market-data service Nanex, saw the strategy in action on August 16. Just seconds before the stockpile release, trading volume surged and prices dropped about four cents. Typically during that period, "you can hear a pin drop," said Hunsader. But that day, rapid traders filled resting orders before the data hit, sending prices lower, he said.

The EIA reported an inventory increase of 25 billion cubic feet, slightly below analysts' expectations, which normally would translate into a modest price rise. In the first seconds after the release, natural gas futures surged more than 10 cents to $2.84, but then immediately ricocheted lower. The fastest traders had the chance to profit from rapid buying and selling over a much wider price range as the market slowly found some equilibrium, says Hunsader. Over the next seven minutes, futures dropped to a low of $2.685. Prices didn't hit those highs or lows for the rest of the session.

When the market reaction doesn't jibe with the data, floor traders say they and their customers can't compete.

"It was always going to be volatile, but at least if you had the right idea, you'd get paid for it," said Scott Gettleman, a Nymex floor trader. "Now, you can put yourself on the line, but you're flying blind."

He stopped trading around the data about six months ago.