Tag: HFT

HFT: The debate goes mainstream

HFT

Michael Lewis’ new book “Flash Boys” is all about High Frequency Trading (HFT.) High Frequency Traders, he says, with advanced computers make tens of billions of dollars by jumping in front of investors. ”

The United States stock market, the most iconic market in global capitalism, is rigged.

I am not sure “rigged” is the right word. Traders have been trying to get ahead of the “flow” for ages. Its just that technology finally caught up recently and now allows firms to do what they used to do more efficiently. Barry Ritholtz of TBP points out that trading has always been a zero-sum game.

One trader’s gain is another trader’s loss. Only in the case of HFT, the losers are the investors — by way of their pension funds, retirement accounts and institutional funds. The HFT’s take — the “skim” — comes out of these large institution’s trade executions.

The defense came hard and fast. William O’Brien, president of BATs Global Markets: Its like GM writing a book saying it’s unfair for the automotive industry that Elon Musk created a new car.

We welcome anyone that is building a better mouse trap for our nation’s investors but I don’t think blind accusation is the right way. I know he has a business model that says everybody but him rips you off.

High-frequency traders account for 40 to 70% of all trading on every stock market in the US. The numbers for India are said to be similar. And since HFTs only intermediate trades, it is hard for them to lose money. Tradebot, one of the biggest high-frequency traders around, had not had a losing day in four years.

How can individual/retail investors protect themselves from getting skimmed by HFTs? First, understand that you can’t avoid them. So stop trying to trade intra-day and lengthen your investment horizon to at least a couple of months. Second, know that the “skim” is a few pennies/paisas and affects you in a meaningful way only if you make a lot of trades.

Josh Brown of TRB:

The bottom line is this – there have always been insiders, unscrupulous dealers and some participants with unfair advantages over others. HFT is just the latest in a long line of shenanigans and the moment you outlaw it or modify it or babysit it out of existence, there’ll be a new broad-daylight robbery format waiting right behind it.
 
The stock market hasn’t become rigged, IT STARTED OUT RIGGED.

Source:

Will the real arbitrageur please stand up?

The first sign of active HFT involvement is that most of the low-hanging fruit would have been plucked. i.e., text-book arbitrage opportunities would not exist. In the futures market, the low-hanging fruit is the cash-futures basis. Equity futures have a ‘fair-value’:

Futures Price = Cash Price [1+r (x/360)] – Dividends; where x = days to expiration of the futures contract

So whenever the basis goes out of hand, its possible to pocket some risk-free profit.

  1. if Futures << Cash, go long futures, short cash. Or,
  2. if Futures >> Cash, go short futures, long cash.

Given the absurdity involved in shorting stocks, option 1) is not feasible for individual investors. But if HFT arbitrageurs are efficient, then scenario 2) should not exist. So I pulled up some charts and I have annotated days where HFT machines were probably in sleep mode. The filled candlesticks are the cash and the black boxes are the futures candlesticks. Ideally, the futures black boxes should coincide with the cash candlesticks.

JUBLFOOD futures and cash candlestick chart

IDEA futures and cash candlestick chart

Since August this year, there has been at least 5 instances where a risk-free profit could have been locked in by shorting futures and going long cash – if you had a low-latency trading machine.

I pulled up the charts of some of the other punter counters:

JPASSOCIAT futures and cash candlestick chart

RCOM futures and cash candlestick chart

TATASTEEL futures and cash candlestick chart

ADANIENT futures and cash candlestick chart

So what exactly is going on here? Is the cost of funding so high that the HFT guys let this one slide? Or is the liquidity so bad that this can’t be done in size, and hence not attractive to HFT? Will the real arbitrageur please stand up?

 

HFT vs. Punters

High Frequency Trading (HFT) is the natural evolution of screen based trading which was the natural evolution of open outcry. After completely decimating market makers on the floors of the exchanges, they turned their sights onto price disparities between exchanges. They have been so successful, that the arb no longer exists. Besides, you can only make so much more money once you have to use balloons to create a transatlantic wireless trading line using microwave signals.

In 2009 the entire HFT industry made around $5 billion trading stocks. Last year it made closer to $1 billion. The “profits have collapsed,” says Mark Gorton, the founder of Tower Research Capital, one of the largest and fastest high-frequency trading firms. “The easy money’s gone. We’re doing more things better than ever before and making less money doing it.”

So what’s next for the bots?

Due to a crowding effect in HFT domain and a continuous decrease in profitability a lot of those firms are now moving to momentum, swing and trend-following domains in an effort to recoup their initial investment. Thus, retail traders and fund managers should expect more competition from highly competent and well-capitalized firms with excellent infrastructure and talent. Competition is about to rise significantly.

And this is not a “macro” thing that is not going to affect Indian markets. Algo trading makes up roughly 30% of all trades through NSE. Getco, one of the world’s largest automated traders, received regulatory approval to start operations in India back in March this year.

Expect more competition in traditional timeframes soon but from high-tech participants. The days of the chart trader and the golden cross fund manager are over.

Sources:
Expect More High-Tech Competition
How the Robots Lost: High-Frequency Trading’s Rise and Fall

The Rise of The Machines

Cover of "The Terminator [Blu-ray]"

Research by Daniel Kahneman, recipient of the Nobel Prize in Economic Sciences, shows that humans are better at thinking about rational decision making than actually practicing it. Is it any wonder then that securities trading, a field that requires fast, emotionless decisions are now increasingly being handed over to machines?

Institutional investors were the first to embrace algo-trading. It offered them the convenience of entering large orders and leaving the machines to divide these large trades into several smaller trades to manage market impact, and risk. Since then, algo-trading has spread like wild fire to encompass a wide array of trading strategies like statistical arbitrage and trend following. As of 2009, Algo-trading firms account for 73% of all US equity trading volume. And according to recent disclosers from the National Stock Exchange (NSE) roughly 30% of trading in the Indian equity market could be algo-based.

That terminator is out there. It can’t be bargained with. It can’t be reasoned with. It doesn’t feel pity, or remorse, or fear. And it absolutely will not stop, ever, until you are dead.

– Kyle Reese (Terminator 1)

The biggest draws of algo-trading is speed and objectivity. Machines can make calculations faster, and they can also monitor several markets more quickly than a human can for simple market conditions to occur in order to justify taking a position. Machines follow their programming in an objective and repeatable way. They also do not suffer from the emotional and health problems that human traders can have which can affect their objectivity when trading online.

Their biggest draws are also their biggest flaws. Unless proper risk management controls are in place and regular human supervision occurs, an otherwise successful trading algo can quite suddenly rack up a substantial set of losing trades if market conditions become especially unfavorable.

Why must the fate of the world always be in the hands of an idiot?

– Grim (The Grim Adventures of Billy & Mandy)

The bigger problem though is people not understanding how these algorithms work. A majority of domestic stock brokers do not have expertise to re-write their algos and use templates from third party vendors. They do not have expertise to track as to how their algos work. So, when the techniques are closely identical, it causes chaos. It is believed that this is why a buyer was offering higher price for a security than the seller intended to sell and trading was disrupted nearly for an hour on NSE in May.

After algo trading was considered the key catalyst for some of the recent instances of market crash, including a sharp fall in Infosys shares, the NSE and the BSE have imposed separate charges on the use of algos to curb excessive speculation, misuse of the technology and also keep a check on the pace of rise in algo volumes. The exchanges have now imposed a fee of one to five paise per algo order or modification of the trade. At least 50% of algo trading is expected to be affected by this fee.

Be that as it may, algorithmic trading is here to stay. The steady march of technology and cloud computing will ensure that machine trading will become more affordable and percolate down from institutional investors to individual traders and investors.

Sunder’s List

Without money

Without money (Photo credit: Toban Black)

Central banks keep furiously pumping more money into the economy — right now in Europe, and mostly by stealth. But as soon as they do so, the price of oil goes up and that promptly takes money out again. Like hamsters on a wheel, they are running more and more furiously all the time — and getting precisely nowhere. (MarketWatch)

A sign of things to come? Head of Americas equities sales trading and cash trading is replaced by algorithms. (WSJ)

On why you should learn to invest your own money: 79% of fund managers didn’t beat the S&P 500 last year, the worst showing since 1997. If you don’t have the time to pick stocks, please consider ETFs. (CNN)

Gold down more than 5%, Silver -7%. The slide began right around the time Bernanke’s testimony gave no hint of additional easing; i.e. because Ben Bernanke did not confirm QE3. (Chart)

Good luck out there!