I found a 14-minute segment of the CBS show 60 Minutes aired in 2010 that explains the basics of high-frequency trading and the viewpoints on its effect on the market. Enjoy!
http://www.cbsnews.com/video/watch/?id=6945451n
Sunday, December 2, 2012
High-Frequency Trading and You
Over the past few weeks, we've explored high-frequency trading and how it has changed the stock market for good. In this last blog post for my seminar, I'm going to summarize HFT and its effect on us.
Proponents of HFT heavily favor it because it creates liquidity in the market: more than ever before, at a certain time, you can expect to buy or sell a stock for it's current price. Because of the volume of trades going on at any given second due to HFT, the value of a stock is more accurate and will not change when an order is placed on it.
However, for brokers that actually know the system, they know that there is price changing "beneath the tape", so to speak. HFT computers buy place orders on certain stocks at certain prices, but then cancel these orders just as fast as a way to test the market. This is a way that the algorithms try to use their power to see the reaction of human investors to these small changes in price. There are also dozens of private trading platforms, called dark pools, that help hedge pools and other big-money players trade in relative secrecy.
Additionally, as talked about before in this blog, with HFT there is always the issue of volatility. We know that HFTs were not the cause of the Flash Crash, but they exaggerated its effects because many algorithms are programmed to stop trading in such catastrophic situations. Recent SEC regulation and implementation of "circuit breakers" in case of another crash may help, but we won't know until these come into play.
There have been other recent developments on Wall Street in relation to HFT. Dave Lauer, a former HFT algorithm creator, wrote an interesting piece for a segment on the National Public Radio show Marketplace. Titled "High-Frequency Trading: Bad For the Markets...and the Soul?", the piece explains how Lauer felt worse and worse after making so much money from HFT while the economy fell apart. "What was I doing to add value to the world?" he writes. He questioned the value of HFT and why it pulled so many people away from noble pursuits and into financial services so they could make fortunes from the market while others suffered. After two years in HFT, he quit his job.
More recently, the entire market for HFT is declining. Profits are way down, projected to be at the most $1.25 billion this year, which is down 35% from last year and 74% lower than the peak of $4.9 billion in 2009. As a comparison, banks like Wells Fargo and JPMorgan Chase each earned more last quarter than the entire HFT industry will earn this year. Due to these declining revenues, firms are also scaling back and even shutting down in some cases. The high cost of data technologies is one reason for the decline - to keep up with its competitors every HFT firm has to have the latest data to run their algorithms on in order to keep making profits. One executive summed it up perfectly: "People think it's easy money, but it's not."
Ultimately, how does high-frequency trading affect us, individuals who have an interest in investing in the market?
[1] Linette Lopez, "What High Frequency Trading Looks Like To The Human Broker's Naked Eye", Business Insider, September 10, 2012, http://www.businessinsider.com/what-high-frequency-trading-looks-like-to-the-human-brokers-naked-eye-2012-9
[2] Dave Lauer, "High-Frequcney Trading: Bad For Markets...and the Soul?", Marketplace (NPR show), May 21, 2012, http://www.marketplace.org/topics/business/commentary/high-frequency-trading-bad-markets-and-soul
[3] Nathaniel Popper, "High-Speed Trading No Longer Hurtling Forward", New York Times, October 14, 2012, http://www.nytimes.com/2012/10/15/business/with-profits-dropping-high-speed-trading-cools-down.html?pagewanted=all
[4] Matt Levine, "Ask A Banker: High Frequency Trading", Planet Money (NPR show), November 7, 2012, http://www.npr.org/blogs/money/2012/11/07/164597638/ask-a-banker-whats-the-deal-with-high-frequency-trading
[5] Alexander Green, "Why You Shouldn't Fear High-Frequency Trading", Investment U, October 22, 2012, http://www.investmentu.com/2012/October/why-you-shouldn%E2%80%99t-fear-high-frequency-trading.html
[6] Dina ElBoghdady, "Is High-Frequency Trading a Threat to Stock Trading, Or a Boon?", Washington Post, October 25, 2012, http://www.washingtonpost.com/business/economy/is-high-frequency-trading-a-threat-to-stock-trading-or-a-boon/2012/10/25/9c39ff96-1865-11e2-a55c-39408fbe6a4b_story.html
Proponents of HFT heavily favor it because it creates liquidity in the market: more than ever before, at a certain time, you can expect to buy or sell a stock for it's current price. Because of the volume of trades going on at any given second due to HFT, the value of a stock is more accurate and will not change when an order is placed on it.
However, for brokers that actually know the system, they know that there is price changing "beneath the tape", so to speak. HFT computers buy place orders on certain stocks at certain prices, but then cancel these orders just as fast as a way to test the market. This is a way that the algorithms try to use their power to see the reaction of human investors to these small changes in price. There are also dozens of private trading platforms, called dark pools, that help hedge pools and other big-money players trade in relative secrecy.
Additionally, as talked about before in this blog, with HFT there is always the issue of volatility. We know that HFTs were not the cause of the Flash Crash, but they exaggerated its effects because many algorithms are programmed to stop trading in such catastrophic situations. Recent SEC regulation and implementation of "circuit breakers" in case of another crash may help, but we won't know until these come into play.
There have been other recent developments on Wall Street in relation to HFT. Dave Lauer, a former HFT algorithm creator, wrote an interesting piece for a segment on the National Public Radio show Marketplace. Titled "High-Frequency Trading: Bad For the Markets...and the Soul?", the piece explains how Lauer felt worse and worse after making so much money from HFT while the economy fell apart. "What was I doing to add value to the world?" he writes. He questioned the value of HFT and why it pulled so many people away from noble pursuits and into financial services so they could make fortunes from the market while others suffered. After two years in HFT, he quit his job.
More recently, the entire market for HFT is declining. Profits are way down, projected to be at the most $1.25 billion this year, which is down 35% from last year and 74% lower than the peak of $4.9 billion in 2009. As a comparison, banks like Wells Fargo and JPMorgan Chase each earned more last quarter than the entire HFT industry will earn this year. Due to these declining revenues, firms are also scaling back and even shutting down in some cases. The high cost of data technologies is one reason for the decline - to keep up with its competitors every HFT firm has to have the latest data to run their algorithms on in order to keep making profits. One executive summed it up perfectly: "People think it's easy money, but it's not."
Ultimately, how does high-frequency trading affect us, individuals who have an interest in investing in the market?
- First of all, you can easily buy or sell something in 16.5 seconds or less (this is the average execution time for an order, according to the NYSE)
- We have different motives: HFT algorithms are trying to win pennies whereas we are looking to make larger profits on fewer shares or stocks
- The SEC has "circuit breakers" now that halt trading if a certain stock suddenly drops 10% in less than five minutes
- We are similar to HFTs in the sense that we are both trying to profit from mispricing: buy low, sell high
- HFTs fill the gap between supply and demand: if there's no person that will buy something that you want to sell, a HFT will pick it up and sell it off later
- Unlike us, HFT firms can use computers to "sniff out" the market and spot trends, enabling them to jump ahead of institutional firms (for every trade that gets bought or sold, 90 offers are cancelled!)
[1] Linette Lopez, "What High Frequency Trading Looks Like To The Human Broker's Naked Eye", Business Insider, September 10, 2012, http://www.businessinsider.com/what-high-frequency-trading-looks-like-to-the-human-brokers-naked-eye-2012-9
[2] Dave Lauer, "High-Frequcney Trading: Bad For Markets...and the Soul?", Marketplace (NPR show), May 21, 2012, http://www.marketplace.org/topics/business/commentary/high-frequency-trading-bad-markets-and-soul
[3] Nathaniel Popper, "High-Speed Trading No Longer Hurtling Forward", New York Times, October 14, 2012, http://www.nytimes.com/2012/10/15/business/with-profits-dropping-high-speed-trading-cools-down.html?pagewanted=all
[4] Matt Levine, "Ask A Banker: High Frequency Trading", Planet Money (NPR show), November 7, 2012, http://www.npr.org/blogs/money/2012/11/07/164597638/ask-a-banker-whats-the-deal-with-high-frequency-trading
[5] Alexander Green, "Why You Shouldn't Fear High-Frequency Trading", Investment U, October 22, 2012, http://www.investmentu.com/2012/October/why-you-shouldn%E2%80%99t-fear-high-frequency-trading.html
[6] Dina ElBoghdady, "Is High-Frequency Trading a Threat to Stock Trading, Or a Boon?", Washington Post, October 25, 2012, http://www.washingtonpost.com/business/economy/is-high-frequency-trading-a-threat-to-stock-trading-or-a-boon/2012/10/25/9c39ff96-1865-11e2-a55c-39408fbe6a4b_story.html
Sunday, November 25, 2012
Regulation of HFT
This week, I'm going to focus on the regulatory side of Wall Street. Especially in recent years since the Great Recession, there has been much debate about the extent to which the government should be involved in regulating the stock market. The U.S. Securities and Exchange Commission (SEC) is the entity responsible for handling this.
In July 2010, after much debate in the House and Senate, the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed and put into law. This was in effect the first regulatory law on the stock market in decades, and brought about the most significant changes to the financial services industry since the regulatory reform that followed the Great Depression in the 1930s.
The aim of the act was:
"To promote the financial stability of the United States by improving accountability and transparency in the financial system, to end "too big to fail", to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes."
Dodd-Frank consolidated regulatory agencies to streamline the regulatory process and increased oversight of specific institutions regarded as higher-risk. It also included consumer protection reforms to increase investor protection. Additionally, it provided tools for financial crises so that another crisis or "bail outs" won't happen again. However, as with all laws, it still has many opponents who either believe the law was not enough to prevent another crisis or that it went too far and unduly restricted financial institutions.
What about High Frequency Traders (HFTs)?
Countries in Europe like Germany and France have already implemented their own regulatory laws on HFTs. In Germany, a new law was passed this September that affects anyone trading in Germany, regardless of origin. The law requires traders to register first with Germany's Federal Financial Supervisory Authority, collects fees from those who use HFTs excessively, and forces markets to install "circuit breakers" that can interrupt trading if a problem is detected. Most importantly, the new law grants the regulator the power to make firms detail their trading practices. What to take from all of this: Germany isn't taking any risks, and no data is private anymore.
No laws of this sort has been passed in the U.S. yet. However, there is plenty of discussion and debate about it due to highly publicized incidents like the Flash Crash and Knight Capital crash, two events I covered earlier in this blog.
The SEC, highly criticized for not knowing enough about HFT to regulate it, is starting to play catch-up. They have started initiatives that will increase the amount of data received from trading exchanges and to record orders from their origination to execution. An office of analytics and research is planned.
A mechanism known as the consolidated audit trail will track all order and trading information as it is passed between brokers and private dark pools before they're compiled or canceled. Information like this has never been compiled before. The SEC also acquired a HFT firm, Tradeworx Inc., to help it develop it's data analytics system (dubbed "Midas", short for Market Information Data Analytics System). Midas will collect trading data that trading exchanges provide to the HFTs who want information milliseconds before the public.
Hopefully, all of this will glean some more information about how HFTs work and how they are able to affect the market. But there are always pundits who believe regulation by the SEC will only hurt the market. John Steele Gordon of Forbes says that "history shows that the financial industry doesn't need the government to help with reform."
In my opinion, gathering data can only help. The SEC is only trying to do it's job and prevent unfair trading practices as well as another crash. While we may be a few years removed from serious regulation of HFT in the U.S., this is a step in the right direction.
Sources:
[1] Christopher Lawton and Andreas Kissler, "Germany to Tap Brakes on High-Speed Trading", Wall Street Journal, September 26, 2012, http://online.wsj.com/article/SB10000872396390444813104578018292059338944.html
[2] Nina Mehta, "SEC Leads From Behind as High-Frequency Trading Shows Data Gap", Bloomberg, October 1, 2012, http://www.bloomberg.com/news/2012-10-01/sec-leads-from-behind-as-high-frequency-trading-shows-data-gap.html
[3] Nathaniel Popper and Ben Protess, "To Regulate Traders, S.E.C. turns to One of Them", New York Times, October 7, 2012, http://www.nytimes.com/2012/10/08/business/sec-regulators-turn-to-high-speed-trading-firm.html?pagewanted=all
[4] Roger Lowenstein (Op-Ed), "A Speed Limit for the Stock Market", New York Times, October 1, 2012, http://www.nytimes.com/2012/10/02/opinion/putting-the-brakes-on-high-frequency-trading.html
[5] John Steele Gordon (Op-Ed), "Wall Street Can Regulate Itself", Forbes, April 23, 2010, http://www.forbes.com/2010/04/23/wall-street-regulation-financial-reform-opinions-contributors-john-steele-gordon.html
[6] H.R. 4173 (Dodd-Frank Law), January 5, 2010, http://www.sec.gov/about/laws/wallstreetreform-cpa.pdf
[7] Financial Crisis Interactive Timeline, http://www.dems.gov/financial-timeline
In July 2010, after much debate in the House and Senate, the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed and put into law. This was in effect the first regulatory law on the stock market in decades, and brought about the most significant changes to the financial services industry since the regulatory reform that followed the Great Depression in the 1930s.
The aim of the act was:
"To promote the financial stability of the United States by improving accountability and transparency in the financial system, to end "too big to fail", to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes."
Dodd-Frank consolidated regulatory agencies to streamline the regulatory process and increased oversight of specific institutions regarded as higher-risk. It also included consumer protection reforms to increase investor protection. Additionally, it provided tools for financial crises so that another crisis or "bail outs" won't happen again. However, as with all laws, it still has many opponents who either believe the law was not enough to prevent another crisis or that it went too far and unduly restricted financial institutions.
What about High Frequency Traders (HFTs)?
Countries in Europe like Germany and France have already implemented their own regulatory laws on HFTs. In Germany, a new law was passed this September that affects anyone trading in Germany, regardless of origin. The law requires traders to register first with Germany's Federal Financial Supervisory Authority, collects fees from those who use HFTs excessively, and forces markets to install "circuit breakers" that can interrupt trading if a problem is detected. Most importantly, the new law grants the regulator the power to make firms detail their trading practices. What to take from all of this: Germany isn't taking any risks, and no data is private anymore.
No laws of this sort has been passed in the U.S. yet. However, there is plenty of discussion and debate about it due to highly publicized incidents like the Flash Crash and Knight Capital crash, two events I covered earlier in this blog.
The SEC, highly criticized for not knowing enough about HFT to regulate it, is starting to play catch-up. They have started initiatives that will increase the amount of data received from trading exchanges and to record orders from their origination to execution. An office of analytics and research is planned.
A mechanism known as the consolidated audit trail will track all order and trading information as it is passed between brokers and private dark pools before they're compiled or canceled. Information like this has never been compiled before. The SEC also acquired a HFT firm, Tradeworx Inc., to help it develop it's data analytics system (dubbed "Midas", short for Market Information Data Analytics System). Midas will collect trading data that trading exchanges provide to the HFTs who want information milliseconds before the public.
Hopefully, all of this will glean some more information about how HFTs work and how they are able to affect the market. But there are always pundits who believe regulation by the SEC will only hurt the market. John Steele Gordon of Forbes says that "history shows that the financial industry doesn't need the government to help with reform."
In my opinion, gathering data can only help. The SEC is only trying to do it's job and prevent unfair trading practices as well as another crash. While we may be a few years removed from serious regulation of HFT in the U.S., this is a step in the right direction.
Sources:
[1] Christopher Lawton and Andreas Kissler, "Germany to Tap Brakes on High-Speed Trading", Wall Street Journal, September 26, 2012, http://online.wsj.com/article/SB10000872396390444813104578018292059338944.html
[2] Nina Mehta, "SEC Leads From Behind as High-Frequency Trading Shows Data Gap", Bloomberg, October 1, 2012, http://www.bloomberg.com/news/2012-10-01/sec-leads-from-behind-as-high-frequency-trading-shows-data-gap.html
[3] Nathaniel Popper and Ben Protess, "To Regulate Traders, S.E.C. turns to One of Them", New York Times, October 7, 2012, http://www.nytimes.com/2012/10/08/business/sec-regulators-turn-to-high-speed-trading-firm.html?pagewanted=all
[4] Roger Lowenstein (Op-Ed), "A Speed Limit for the Stock Market", New York Times, October 1, 2012, http://www.nytimes.com/2012/10/02/opinion/putting-the-brakes-on-high-frequency-trading.html
[5] John Steele Gordon (Op-Ed), "Wall Street Can Regulate Itself", Forbes, April 23, 2010, http://www.forbes.com/2010/04/23/wall-street-regulation-financial-reform-opinions-contributors-john-steele-gordon.html
[6] H.R. 4173 (Dodd-Frank Law), January 5, 2010, http://www.sec.gov/about/laws/wallstreetreform-cpa.pdf
[7] Financial Crisis Interactive Timeline, http://www.dems.gov/financial-timeline
Sunday, November 11, 2012
Spotlight: Knight Capital
Two weeks ago, I covered the Flash Crash of 2010. What was significant about the Flash Crash was the way the market had fallen so far in a span of only minutes, but we have to remember that the market recovered almost just as quickly. Individual firms and stocks only suffered net losses of a few percent at most. Additionally, the Flash Crash impacted lots of HFTs and so the losses were shared by the market as a whole.
What would happen in the possible scenario where some computer glitch could corrupt an individual trading firm's or hedge fund's HFT algorithm?
Fast forward to August of this year.
Knight Capital Group, a trading firm founded in 1995, had over the past few years grown to be one of the biggest "middle-men" in the market. Knight executes trade orders for retail brokers like TD Ameritrade and ETrade, and competes with the likes of UBS, Citibank and Citadel. It is headquartered in Jersey City, NJ, and had employed over 1,400 people in 21 locations around the world.
Up until this catastrophic event, according to Adam Sussman at the data company Tabb Group, Knight Capital was responsible for 11% of all trading in American stocks between January and May. This is no small fish!
On the morning of Wednesday, August 1st, crisis struck. Somehow, Knight's automated stock program flooded the market with trades. In the first 45 minutes that the market was open, a computer glitch in their algorithm caused the firm to buy and sell millions of shares of hundreds of stocks, causing the value of these stocks to soar upward. Knight blamed this on their new trading software, which was installed that same week.
Since Knight was now holding onto so many shares of these stocks, they had to rapidly sell everything to minimize losses. The problem was, however, that their shares were overvalued because of their glitch. They had to sell their losing positions back to the market and take losses, which totalled $461.1 million.
According to the New York Times, that's $10 million lost per minute. Wow.
These total losses were greater than the revenue that Knight Capital earned in the second quarter of this year, which was $289 million. Because of this disaster, Knight had to seek help from a group of customers and rivals. The Wall Street Journal reported that it's share price was down 78% as of mid-October.
Thankfully, the rest of the market wasn't impacted. This could be due to volatility controls put in place by the SEC in the aftermath of the Flash Crash.
Some questions linger after the incident. Why didn't traders from Knight Capital step in and stop the rogue algorithm? Are the current safety regulations set in place by the SEC enough to stop glitches like this from happening again?
In my opinion, I think there's a very low chance of something like the Knight Capital incident happening again. The Flash Crash happened once, and now regulators have learned to put safety nets in place to save the market in such a scenario. We learn from our mistakes, so every other firm in the market will be sure to check for bugs in their algorithms once more because they don't want to be the next Knight Capital, losing millions of dollars.
Sources:
[1] Jacob Bunge, "Knight Plans for Worst and Hopes for Best", Wall Street Journal, October 17, 2012, http://online.wsj.com/article/SB10000872396390444734804578062174162145686.html
[2] Danielle Douglass, "Computer Glitch Sent Markets into a Tizzy", Washington Post, August 1, 2012, http://www.washingtonpost.com/business/economy/computer-glitch-sent-markets-into-a-tizzy/2012/08/01/gJQAwNsMQX_story.html
[3] "How Safe Is Computer Trading After Knight Capital Crash?", The Week UK, August 3, 2012, http://www.theweek.co.uk/us-business/48304/how-safe-computer-trading-after-knight-capital-crash#
[4] Nathaniel Popper, "Knight Capital Says Trading Glitch Cost It $440 Million", New York Times, August 2, 2012, http://dealbook.nytimes.com/2012/08/02/knight-capital-says-trading-mishap-cost-it-440-million/
What would happen in the possible scenario where some computer glitch could corrupt an individual trading firm's or hedge fund's HFT algorithm?
Fast forward to August of this year.
Knight Capital Group, a trading firm founded in 1995, had over the past few years grown to be one of the biggest "middle-men" in the market. Knight executes trade orders for retail brokers like TD Ameritrade and ETrade, and competes with the likes of UBS, Citibank and Citadel. It is headquartered in Jersey City, NJ, and had employed over 1,400 people in 21 locations around the world.
Up until this catastrophic event, according to Adam Sussman at the data company Tabb Group, Knight Capital was responsible for 11% of all trading in American stocks between January and May. This is no small fish!
On the morning of Wednesday, August 1st, crisis struck. Somehow, Knight's automated stock program flooded the market with trades. In the first 45 minutes that the market was open, a computer glitch in their algorithm caused the firm to buy and sell millions of shares of hundreds of stocks, causing the value of these stocks to soar upward. Knight blamed this on their new trading software, which was installed that same week.
Since Knight was now holding onto so many shares of these stocks, they had to rapidly sell everything to minimize losses. The problem was, however, that their shares were overvalued because of their glitch. They had to sell their losing positions back to the market and take losses, which totalled $461.1 million.
According to the New York Times, that's $10 million lost per minute. Wow.
These total losses were greater than the revenue that Knight Capital earned in the second quarter of this year, which was $289 million. Because of this disaster, Knight had to seek help from a group of customers and rivals. The Wall Street Journal reported that it's share price was down 78% as of mid-October.
Thankfully, the rest of the market wasn't impacted. This could be due to volatility controls put in place by the SEC in the aftermath of the Flash Crash.
Some questions linger after the incident. Why didn't traders from Knight Capital step in and stop the rogue algorithm? Are the current safety regulations set in place by the SEC enough to stop glitches like this from happening again?
In my opinion, I think there's a very low chance of something like the Knight Capital incident happening again. The Flash Crash happened once, and now regulators have learned to put safety nets in place to save the market in such a scenario. We learn from our mistakes, so every other firm in the market will be sure to check for bugs in their algorithms once more because they don't want to be the next Knight Capital, losing millions of dollars.
Sources:
[1] Jacob Bunge, "Knight Plans for Worst and Hopes for Best", Wall Street Journal, October 17, 2012, http://online.wsj.com/article/SB10000872396390444734804578062174162145686.html
[2] Danielle Douglass, "Computer Glitch Sent Markets into a Tizzy", Washington Post, August 1, 2012, http://www.washingtonpost.com/business/economy/computer-glitch-sent-markets-into-a-tizzy/2012/08/01/gJQAwNsMQX_story.html
[3] "How Safe Is Computer Trading After Knight Capital Crash?", The Week UK, August 3, 2012, http://www.theweek.co.uk/us-business/48304/how-safe-computer-trading-after-knight-capital-crash#
[4] Nathaniel Popper, "Knight Capital Says Trading Glitch Cost It $440 Million", New York Times, August 2, 2012, http://dealbook.nytimes.com/2012/08/02/knight-capital-says-trading-mishap-cost-it-440-million/
Sunday, November 4, 2012
Financial Stability of HFT
Over the past two weeks, I've highlighted the impact of High Frequency Trading (HFT) on the stock market, including the 2010 Flash Crash example. Obviously, today HFT makes up a big part of the trading that goes on at Wall Street. In this post, I'd like to consider another ongoing issue involving HFT - what is it's impact on market volatility? Does HFT make the market more stable, less stable, or actually have no effect on volatility?
Last week, I introduced the subject of volatility as the variation of price over time. This is true, both in a specific sense of individual stocks and more generally as you look at the whole market. In a more volatile market, prices fluctuate more frequently and with more magnitude - there's more movement. Lately, especially within the past year, market executives have described the market as more volatile than ever. Their evidence are indices like the S&P volatility index (mentioned last week) that seek to measure the overall market's stability. Can we attribute this increased volatility to HFT?
This is the question that has yet to be answered in a unified way. According to an article by Forbes Magazine, HFT doesn't cause volatility in the market but amplifies it.
"High Frequency Trading feeds on volatility because the computers aim to make a profit on the spread - the difference between the buy price and sell price of the stock."
When this spread widens, the computers then go into overdrive, making more and more trades to generate profits. This, according to Forbes, creates a "snowball" effect, amplifying the market move up or down.
Similarly, another source, the Government Office for Science in the UK, points to self-reinforcing feedback loops that amplify the volatility in the market. Their paper, "The Future of Computer Trading in Financial Markets", identifies three main mechanisms by which may lead to instability in markets: nonlinear sensitivities to change (when a small event can have a big impact on the market), incomplete information (where some firms can have more information than others), and internal "endogenous" risks based on feedback loops within the HFT system. The article names six different types of feedback loops that can contribute to this endogenous risk. While these feedback loops in the HFTs may be well-intentioned, they can amplify internal risks and lead to undesired outcomes when a small change loops back on itself and triggers a bigger change which again loops and so on.
The Government Office for Science paper asserts that there is no direct evidence that HFT has increased stock volatility. Yet, using data from a large sample of firms from 1985 to 2009, Frank Zhang from Yale found that HFT increases stock price volatility. The positive correlation that he found was especially strong for the top 3,000 stocks in the market. However, does correlation prove causation? Not necessarily.
Additionally, we have to remember that there have been volatile events in the market before HFT came along. According to Forbes, the level of volatility in the Great Depression starting in 1929 was only 0.3% lower than that of the Great Recession of 2008-2009.
Perhaps the best explanation we can give is that HFT and volatility are intermingled. This is position of Jonathan Brogaard of Northwestern, who published a paper in September of last year about the subject. Using mostly data from the financial crisis separated into two swathes (HFT activity and non-HFT activity), he ran a statistical method called a Granger Causality Analysis to investigate the relationship between volatility and HFT activity. He found that the relationship goes both ways - volatility can cause HFT activity and HFT activity can cause volatility.
It goes without saying that the relationship between market volatility and HFT is a complex one. With hundreds of thousands of trades per day, all controlled by computer algorithms, it's hard for anyone to find a precise explanation for it. However, we do know that they are related in some form - and that's a start.
Sources:
[1] "Are Computers Bringing Down The Stock Market?", Forbes Magazine, August 15, 2011, http://www.forbes.com/sites/investopedia/2011/08/15/are-computers-bringing-down-the-stock-market/2/
[2] Jonathan Brogaard, "High Frequency Trading and Volatility", Northwestern University Kellogg School of Management, September 8, 2011, http://www.wsuc3m.com/HFT_and_Volatility_Final%20Brogaard.pdf
[3] "The Future of Computer Trading in Financial Markets", UK Government Office for Science, 2011, http://www.bis.gov.uk/assets/foresight/docs/computer-trading/11-1276-the-future-of-computer-trading-in-financial-markets
[4] Frank Zhang, "High-Frequency Trading, Stock Volatility, and Price Discovery", Yale School of Management, December 2010, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1691679
Last week, I introduced the subject of volatility as the variation of price over time. This is true, both in a specific sense of individual stocks and more generally as you look at the whole market. In a more volatile market, prices fluctuate more frequently and with more magnitude - there's more movement. Lately, especially within the past year, market executives have described the market as more volatile than ever. Their evidence are indices like the S&P volatility index (mentioned last week) that seek to measure the overall market's stability. Can we attribute this increased volatility to HFT?
This is the question that has yet to be answered in a unified way. According to an article by Forbes Magazine, HFT doesn't cause volatility in the market but amplifies it.
"High Frequency Trading feeds on volatility because the computers aim to make a profit on the spread - the difference between the buy price and sell price of the stock."
When this spread widens, the computers then go into overdrive, making more and more trades to generate profits. This, according to Forbes, creates a "snowball" effect, amplifying the market move up or down.
Similarly, another source, the Government Office for Science in the UK, points to self-reinforcing feedback loops that amplify the volatility in the market. Their paper, "The Future of Computer Trading in Financial Markets", identifies three main mechanisms by which may lead to instability in markets: nonlinear sensitivities to change (when a small event can have a big impact on the market), incomplete information (where some firms can have more information than others), and internal "endogenous" risks based on feedback loops within the HFT system. The article names six different types of feedback loops that can contribute to this endogenous risk. While these feedback loops in the HFTs may be well-intentioned, they can amplify internal risks and lead to undesired outcomes when a small change loops back on itself and triggers a bigger change which again loops and so on.
The Government Office for Science paper asserts that there is no direct evidence that HFT has increased stock volatility. Yet, using data from a large sample of firms from 1985 to 2009, Frank Zhang from Yale found that HFT increases stock price volatility. The positive correlation that he found was especially strong for the top 3,000 stocks in the market. However, does correlation prove causation? Not necessarily.
Additionally, we have to remember that there have been volatile events in the market before HFT came along. According to Forbes, the level of volatility in the Great Depression starting in 1929 was only 0.3% lower than that of the Great Recession of 2008-2009.
Perhaps the best explanation we can give is that HFT and volatility are intermingled. This is position of Jonathan Brogaard of Northwestern, who published a paper in September of last year about the subject. Using mostly data from the financial crisis separated into two swathes (HFT activity and non-HFT activity), he ran a statistical method called a Granger Causality Analysis to investigate the relationship between volatility and HFT activity. He found that the relationship goes both ways - volatility can cause HFT activity and HFT activity can cause volatility.
It goes without saying that the relationship between market volatility and HFT is a complex one. With hundreds of thousands of trades per day, all controlled by computer algorithms, it's hard for anyone to find a precise explanation for it. However, we do know that they are related in some form - and that's a start.
Sources:
[1] "Are Computers Bringing Down The Stock Market?", Forbes Magazine, August 15, 2011, http://www.forbes.com/sites/investopedia/2011/08/15/are-computers-bringing-down-the-stock-market/2/
[2] Jonathan Brogaard, "High Frequency Trading and Volatility", Northwestern University Kellogg School of Management, September 8, 2011, http://www.wsuc3m.com/HFT_and_Volatility_Final%20Brogaard.pdf
[3] "The Future of Computer Trading in Financial Markets", UK Government Office for Science, 2011, http://www.bis.gov.uk/assets/foresight/docs/computer-trading/11-1276-the-future-of-computer-trading-in-financial-markets
[4] Frank Zhang, "High-Frequency Trading, Stock Volatility, and Price Discovery", Yale School of Management, December 2010, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1691679
Sunday, October 28, 2012
Spotlight: 2010 Flash Crash
On May 6, 2010, the stock market experienced something that had never happened before - a market plunge of almost 1000 points in a 15-minute span. It was called the "flash crash", and scared investors and market executives alike, even after the market rebounded for the rest of the day to only finish down 3%. What really put fear in the hearts of many was the fact that they knew something like this could happen again. What actually caused this "flash crash"? Let's take an in-depth look, thanks to the help of a report of the day's events released by the U.S. Commodity Futures Trading Commission (CFTC) and the U.S. Securities & Exchange Commission (SEC).
According to the report, May 6 started as an unusually turbulent day for the markets, due in large part to news coming out of Europe concerning the European debt crisis. But nobody could have predicted what would happen that afternoon. The report breaks up the trading day into five phases, which I will summarize:
- First phase (Market Open - 2:32 PM): Stock market indices suffered losses of about 3%, perhaps due to crisis in Europe.
- Second phase (2:32 - 2:41 PM): Markets lost another 1-2%.
- Third phase (2:41 - 2:45:28 PM): Volume spiked upwards as stock prices plummeted another 5-6%, resulting in 9-10% lows.
- Fourth phase (2:45:28 - 3:00 PM): Stock indices started to recover but some individual securities experienced extreme price fluctuations. In some cases, securities were sold from prices ranging to less than a penny to over $100,000!
- Fifth phase (3:00 PM - Market Close): Trading returned to normal levels and most stocks recovered most of what was lost.
So what happened? Well, because of the news from Europe, market volatility was unusually high and liquidity unusually low just before the nosedive. Volatility is the variation of price over time - volatile stocks are normally considered risky investments. Liquidity is an asset's ability to be sold without affecting the price - low liquidity is bad because a single trade can have a big impact on a stock's trading price.
The S&P volatility index (VIX) was up 22.5% by 2:30 PM because of pressure to sell stocks. Additionally, liquidity in the E-Mini S&P 500 futures contracts as well as the S&P 500 SPDR exchange traded fund, the two most active stock instruments traded in futures and equity markets, had declined 55% and 20%, respectively.
Then, with this background of high volatility and low liquidity, a mutual fund group initiated a major trade that would sell a total of 75,000 E-Mini contracts, valued at about $4.1 billion. Although not named in the CFTC/SEC report, this firm was instantly identified as Waddell & Reed Financial Inc. Now typically, such a large sell order, when executed algorithmically (which is what they were doing), would take hours. However, their algorithm didn't take prices or time into account, it just looked at trading volume (which was already high because of the high volatility in the market). As a result, this enormous sell order took just 20 minutes instead of several hours. This is what wreaked havoc on the market - High Frequency Traders (HFTs) from around the market quickly jumped on the E-Mini contracts. They bought and sold these contracts, in milliseconds, from and to each other, creating a "hot potato" effect. Then, Waddell & Reed's sell order algorithm, seeing the increased volume due to HFTs, pumped more of its orders into the market, creating a feedback loop.
The market plunged. The Dow Jones Industrial Average, the most widely known stock index, lost 998 points, or 9.2%, in just minutes. To put that in perspective: just a 1% change in the Dow Jones, over a whole day of trading, is considered large. A liquidity crisis ensued, and many stocks lost their value quickly. Some HFT algorithms stopped trading because they had not been designed to handle such a situation; the prices were beyond their threshold of trading.
Some investors got really unlucky - a man named Mike McCarthy lost $17,000 on a single trade because his order to sell shares of Procter & Gamble was executed at 2:46 PM, when the price was at rock bottom. Some hedge funds lost millions because they placed bets at the wrong time.
The blame game is still going on - an opinion article published by Bloomberg posits that it was the HFTs, not Waddell & Reed, who sucked liquidity from the market and caused the crash. Others argue that it wasn't the HFTs' algorithms that failed, it was the one from the mutual fund.
Regardless of who caused the flash crash, we know the facts. It happened. Another flash crash is not impossible. What can be done to prevent another flash crash from happening? How is confidence in the market affected by events like this?
Sources:
[1] Buchanan, Mark, "Flash-Crash Story Looks More Like a Fairy Tale", Bloomberg View, May 7, 2012, http://www.bloomberg.com/news/2012-05-07/flash-crash-story-looks-more-like-a-fairy-tale.html
[2] Kirilenko, Andrei A., Kyle, Albert S., Samadi, Mehrdad and Tuzun, Tugkan, "The Flash Crash: The Impact of High Frequency Trading on an Electronic Market", May 26, 2011, http://ssrn.com/abstract=1686004
[4] "What Caused the Flash Crash? One Big, Bad Trade", The Economist, October 1, 2010, http://www.economist.com/blogs/newsbook/2010/10/what_caused_flash_crash
Sunday, October 21, 2012
High Frequency Trading - Good or Bad?
The stock market has changed drastically over the past few decades with the introduction of computerized systems, but also even over the past few years due to the evolution of high frequency trading - essentially, systems that can buy or sell stocks within milliseconds. Designed to profit from minuscule changes in price, these algorithms are now competing with each other in a market where everyone wants an edge. Statistics show that high-frequency trading (HFT) can account for up to 73% of all trading volume today. Everyone uses them - from small hedge funds to the big investment banks like Goldman Sachs. In the currency market alone, up to 4,000 trillion U.S. dollars can change hands in a day. While market bosses are obviously in favor of these robotic computer algorithms picking their stocks and rolling in the dough, there are obviously some downsides. Let's do an analysis of HFT. What are some benefits and drawbacks to such an intriguing new technology?
Benefits
Of course, there's many different kinds of HFT and the algorithms that make it up. This list is in no way a complete, closed book on high frequency trading. With that being said, what do you think? Is the evolution of HFT a good thing for Wall Street and the financial world, or not? Is it profitable only for investment bankers, not us everyday consumers or occasional individual investors?
I think it's safe to say that for now, at least, we'll have to live with HFT. Unless another market crash or significant government regulation is near, these algorithms will always be a part of Wall Street. Pretty soon, we could even see algorithms that can process trades in microseconds. It's getting faster than ever before. Does the machine ever stop?
Sources:
[1] "Are Computers Bringing Down The Stock Market?", Forbes Magazine, August 15, 2011, http://www.forbes.com/sites/investopedia/2011/08/15/are-computers-bringing-down-the-stock-market/2/
[2] Jeff Cox, "High-Frequency Trading: It's Worse Than You Thought", CNBC, September 20, 2012, http://www.cnbc.com/id/49102808/High_Frequency_Trading_It_s_Worse_Than_You_Thought
[3] Fabrizio Goria, "Easy Money", The European Magazine, October 15, 2012, http://www.theeuropean-magazine.com/861-goria-fabrizio/862-high-frequency-trading
[4] Bruno J. Navarro, "Vanguard CIO: High-Frequency Trading Cuts Costs", CNBC, October 18, 2012, http://www.cnbc.com/id/49434073/Vanguard_CIO_High_Frequency_Trading_Cuts_Costs
[5] "The Fast and the Furious", The Economist, February 25, 2012, http://www.economist.com/node/21547988
Benefits
- It's fast. Obviously, this goes without saying. HFT takes out human error, time delays, and anything else to complete the one task it's assigned: trade stocks.
- It increases liquidity. With so many trades being made per second and algorithms trying to constantly figure out future prices, HFT puts a more accurate value on each stock with every trade.
- It cuts costs. HFT helps investors by reducing the costs necessary to make a transaction.
- Computers can crash. The complex computer algorithms that make up most of HFT are susceptible to computer errors or sudden changes in the market; numerous examples have occurred in the past few years and I will talk about them in the coming weeks.
- It can have far-fledged effects. One author calls it the "butterfly effect" - a huge storm in the U.S. can be caused by a butterfly flapping its wings in Asia. HFT makes all markets more connected and therefore more respondent to events happening around the world.
- There's no safety net. In a number of recent reports on HFT algorithms, industry pros revealed that profits were more important than safety; often times firms would fix bad algorithms just by "tweaking old code" and then reimplementing the algorithm into the system.
Of course, there's many different kinds of HFT and the algorithms that make it up. This list is in no way a complete, closed book on high frequency trading. With that being said, what do you think? Is the evolution of HFT a good thing for Wall Street and the financial world, or not? Is it profitable only for investment bankers, not us everyday consumers or occasional individual investors?
I think it's safe to say that for now, at least, we'll have to live with HFT. Unless another market crash or significant government regulation is near, these algorithms will always be a part of Wall Street. Pretty soon, we could even see algorithms that can process trades in microseconds. It's getting faster than ever before. Does the machine ever stop?
Sources:
[1] "Are Computers Bringing Down The Stock Market?", Forbes Magazine, August 15, 2011, http://www.forbes.com/sites/investopedia/2011/08/15/are-computers-bringing-down-the-stock-market/2/
[2] Jeff Cox, "High-Frequency Trading: It's Worse Than You Thought", CNBC, September 20, 2012, http://www.cnbc.com/id/49102808/High_Frequency_Trading_It_s_Worse_Than_You_Thought
[3] Fabrizio Goria, "Easy Money", The European Magazine, October 15, 2012, http://www.theeuropean-magazine.com/861-goria-fabrizio/862-high-frequency-trading
[4] Bruno J. Navarro, "Vanguard CIO: High-Frequency Trading Cuts Costs", CNBC, October 18, 2012, http://www.cnbc.com/id/49434073/Vanguard_CIO_High_Frequency_Trading_Cuts_Costs
[5] "The Fast and the Furious", The Economist, February 25, 2012, http://www.economist.com/node/21547988
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