I always find it interesting how much vitriol there is against automated trading, even among programmers. Too many people seem to believe that a small number of, ultra resourceful, nefarious folks are using unfair means to "game the system." The truth, as usual, is less interesting.
Doing this type of trading doesn't require millions of dollars and teams of PhDs. You don't have to know the right people and you don't have to know any secret handshakes.
Critics of high frequency trading are almost always misinformed. Some of the most informed critiques I have read about this stuff are the following books:
"A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation" by Bookstaber
"Traders, Guns and Money: Knowns and unknowns in the dazzling world of derivatives" by Das
And Nasim Taleb's work.
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More to the point, the author is explaining something very basic (which journalists don't seem to understand):
-Algorithmic trading is NOT a general term for all trading done with algorithms/computers. It refers to telling a computer to EXECUTE a specific trade. In other words, when your retirement fund decides to buy A LOT of AAPL, they naturally need to spread that trade over the whole day (or even several days). In the old days, human traders used to do it. Now it is mostly done by computer programs.
This is different from the kind of trading where a computer decides WHAT to trade (NOT HOW to trade). This kind of trading involves so many different strategies that it is silly to lump them together.
There seem to be other misconceptions:
-The best and the brightest are working in Finance, instead of doing things more beneficial to society.
A quant colleague of mine, who has a PhD in Physics from an Ivy League school told me that he, and many of his friends, left academia because there were simply no positions for them.
-75% of trading is now automated, it is just computers trading with each other.
I hope someone will correct me if I'm wrong but I have never figured out if this 75% includes algo trading. If it does include algo trading (my guess is that it does), then I'm surprised it is not 100%. That is like saying 95% of TV channels are controlled by remote-control devices.
-People seem to think that wall-street traders make their money by "trading ahead" of mom & pop investors: your Dad buys 1000 shares of microsoft, a wily trader puts your dad's order on hold, buys it for himself, raises the price, sells his shares to your dad at a higher price...thereby making money off your dad.
Your broker is not allowed to 'trade-ahead' of you. At least in the places where I have worked, this is taken very seriously. Interestingly, high frequency traders (who are most frequently accused of this) don't actually have access to customer order-flow. High frequency trading hedge funds don't generally have any client orders. Places where the two co-exist are forced to have seperation. Traders from one department cannot share information with the other. As more and more client facing firms (sell-side) become automated, the chance of them actually coding up such cheats is even dumber.
Flash trading is often given as an example of people, in cahoots with exchanges, trading on others' order information. As far as I know, "flash" functionality exists to help clients trade more effectively. Large traders are VERY concerned about letting the whole market know that they are interested in some stock. Some exchanges offered the following functionality: if you are interested in buying a stock, you have the OPTION of giving other members of the exchange a chance to trade with you. If no one takes you up on the offer, then the order goes to the wider market.
I have to admit that a laywer friend told me that he opposes this functionality at his firm. If someone _really_ needs to know more, I suppose I could ask him to explain.
-High frequency traders trade so fast that mom & pop simply can't compete with them. Their computers/networks are just too fast and they can get closer to the exchanges than anyone else.
High frequency traders are not competing with mom & pop, they are competing with market makers. If two people hear a news item, the one closer to the exchange will naturally get the trade done faster (presumably at a better price). The same is (generally) true of people on the East Coast vs rest of the country (let's assume US financial system). The same is true of people who can click their mouse faster. Besides, there is no moral reason your Mom should be able to dump her Enron stock faster than Joe Trader.
etc., etc., etc.
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I should add that I am actually not at all comfortable with the role finance plays in world economy. I can't call myself a critic since being critical requires more complete understanding.
I am specifically opposed to things like direct market access. This is where any Joe Blow can use an API to setup his trading system. If he accidently leaves an infinite loop in his code, he can cause real problem. I remember sweating bullets (and almost trembling) when my boss asked me to flip the switch on the trading system I wrote. In reality, there are at least some protections built in to keep this from happening. However, I would like to see more uniform, consistent and better advertised rules.
I am also against the ability to trade by borrwing money from brokers (margin trading or leveraged trading). If an individual trader screws up, they wipe themselves out. If they borrowed money, then the consequences of their bad trades starts to seep out to others. If more than a handful of traders, trading on margin, go belly up, the lender could be in trouble as well...you can see how this could ripple across a system.
Closely related to allowing trading on margin is reliance on models. Say you have calculated that two stocks always move together. You _and your lender_ are so sure of this correlation that they think of it as the truth. What if your calculations or your assumptions were wrong? The consequences of this mistake may not be linearly related to the risk you thought you took. Read Nasim Taleb's work on this for more.
Finally, those who smell something fishy should broaden their concern beyond just modern trading system or even complex derivatives. I can see no principal, within the framework of free markets and individualism, which leads to condemnation of ever more automated and faster trading, more complex instruments and more dependence of finance. The best moral principal, I can think of, which opposes the current state of affairs, is the one uttered by Martin Sheen's character in the movie Wallstreet: "Create, instead of living off the buying and selling of others."
Re: the "best and brightest" it's more at the undergraduate level then the PhD level. My brother has tippy-top grades in physics at one of Harvard/Yale/Princeton and legit research experience in nano-tech, and he like many of his friends in similar positions are choosing between going into industry or R&D and going into finance. The lure of $120k the first year out of school and guaranteed admission to a Harvard/Stanford/Wharton MBA is hard to compete with.
A big part of the problem is systemic. The researcher that discovers new technology gets a nice $30k bonus. The owners of the capital get the millions of dollars resulting from that invention. So if you're a bright physics student in the US, why on earth would you pursue R&D? It is far more remunerative to work for those who own the capital figuring out new ways to move money around.
There aren't jobs in academia, but there are jobs in industry. Intel, IBM, etc, hire people with physics backgrounds to work on new types of memory cells, etc.
But why would you? If you're a 1 in 100 physicist, you might make a discovery that will net your company tens of millions of dollars, but our laws are such that you won't see any of that money. Anything you invent will automatically belong to your employer. Meanwhile, even a 1 in 10 trader can stick with an investment bank long enough to bring in some $1 million/year paydays until exiting to a cushy corporate finance position.
In other words, as long as it's more profitable to play with the government's Ponzi scheme we're going to suffer brain-drain from R&D and other actual industry.
"-75% of trading is now automated, it is just computers trading with each other.
I hope someone will correct me if I'm wrong but I have never figured out if this 75% includes algo trading. If it does include algo trading (my guess is that it does), then I'm surprised it is not 100%. That is like saying 95% of TV channels are controlled by remote-control devices."
From the Foresight project homepage (http://www.bis.gov.uk/foresight/our-work/projects/current-pr...): "For example, today, over one third of United Kingdom equity trading volume is generated through high frequency automated computer trading while in the US this figure is closer to three-quarters."
>A quant colleague of mine, who has a PhD in Physics from an >Ivy League school told me that he, and many of his friends, >left academia because there were simply no positions for >them.
Then why not work in any other industry? Going from the worst paid to the best paid occupation is not really something you have to push most people to.
A good friend of mine became a quant simply because they where the only people remotely interested in hiring someone with an MSc in math and then letting them actually work with interesting high level math. The money or any actual desire to work in finance never really factored into it.
btw, the work is not always less interesting. Think of it this way, this industry has ambitious people from pure science PhDs, mathematicians, statisticians, programmers, MBAs, idiot nephews of rich uncles...everyone is competing.
If you are successful, you can justify building a huge Hadoop cluster, experimenting with hardware TCP/IP processing, buying (or storing) petabytes of data for statistical analysis. Pretty interesting stuff for a geek.
Obviously, not every one in the industry gets these chances and all this not necessary. I know of people who earn their living doing automated trading in ... visual basic (not VB .NET) :)
We all can agree that increased liquidity is good for everyone, mom and pop, traders, investors, America, etc., Of course one can argue whether we really need sub 100ms liquidity but that is not the biggest problem.
The biggest problem with HFT provided liquidity is that it is far from a sure thing as the Flash crash proved. The liquidity dried up so fast, because most players algorithms "said" the situation was too unpredictable so the easiest thing to do was to close up shop temporarily.
In older days, market makers on the floor were allowed to make the money from the spread with the understanding that if the things got rough they would HAVE TO stay in the game. Some got rich, some died broke, some jumped out of windows, but overall the game continued.
Increasingly, the role of a market maker has been delegated to HFT firms, but without any obligations placed on them.
Who is to blame for such state of affairs is a question someone else can answer better than me.
As far as I know, market makers still have this obligation.
I believe Taleb has argued that HFT liquidity disappears when it is most needed, like seat-belts which work all the time, except during accidents (his metaphor may have been different)
Paul Wilmott argued that this much liquidity is actually not necessary. If someone will have trouble getting out of a stock, maybe they will think twice about getting into it.
Of course, an HFT practitioner doesn't need to prove to anyone why their activity is beneficial to society. The burden of proof is on the critics to show why this activity is harmful.
> I am also against the ability to trade by borrwing money from brokers (margin trading or leveraged trading). If an individual trader screws up, they wipe themselves out. If they borrowed money, then the consequences of their bad trades starts to seep out to others. If more than a handful of traders, trading on margin, go belly up, the lender could be in trouble as well...you can see how this could ripple across a system.
In theory, shouldn't those giving the loans account for the risk and thus be protected from wiping out themselves?
This is exactly what happened during the stock market crash of 1929, and regulations were put into place in the 1930s to prevent excessive margin leverage that might result in liquidity problems at brokerages (and in the banks that lend to them). These regulations have been in place since then and probably mitigated the effects of the dot com crash in 2000. See http://en.wikipedia.org/wiki/Regulation_T as a good starting point for research.
Interestingly, I read somewhere that there were similar regulations regarding residential mortgage loans that were repealed during the 1980s, does anybody have a reference to this? I think that requiring a 20% equity/debt ration when originating or refinancing a mortgage loan probably would have made the 2008 real-estate crash look a lot more like the dot com bust and would have saved a lot of economic pain.
Even theoretically there are agency problems in many situations re: evaluating credit risk. And as we have learned in practice, people are just bad at gauging credit risk. Finally, the traditional theory doesn't incorporate behavioral economics, which IMHO turns a lot of the traditional precepts on their head.
This sounds reasonable, but I simply don't know enough about trading to determine whether it's true or not. Anyone care to comment on it? It seems that if there were no trading at all, the world would be worse off.
It's completely wrong, because it ignores both time and risk. It's worth real value to me to have money now rather than later. It's worth real value to me to give you some money, and you take some risk off my hands. And on the other hand, if you think my risk is lower than I think it is, and if you have money to spare, let's make a deal.
Remember, if both parties aren't better off, why would the trade even happen?
> Remember, if both parties aren't better off, why would the trade even happen?
That certainly is true for goods and services, but it just seems awfully abstract from, say, high frequency trading as a profession. How much value is that adding to the world, compared with, say, going out and creating something? I'm not saying it should be banned or anything along those lines, just that I'm not convinced that it's adding much to the world. Even things like games or movies make people happy, even if they're not 'productive'.
Well, party A says "I will be hurt if the price of this asset falls" and party B says "Well, I don't think it will, so if you pay me a smaller fee upfront, I'll cover any losses you make for the next T time". Multiply by thousands of assets (which a big mutual fund may well hold) and thousands of updates a second as everyone else in the market trades to their own ends, and you have the essence of HFT.
The material facts that stock values are supposedly based on do not change 1000's of times a second, though - it seems like it's trading for the sake of trading, rather than trading to best distribute goods and services to where they're desired and will be most effectively used.
One thing is deciding that IBM has a brilliant future and that the stock is a steal at the current price, and trading with someone who feels the opposite, another entirely to have thousands of transactions a second. Even the former transaction seems a bit zero-sum in that one of the people involved has the wrong idea and is going to either lose money or lose potential money.
That said, maybe I'm missing something - I don't know that much about HFT and stocks/finance in general, so I don't claim to have everything figured out.
It's not clear to me that the financial system as an enabler of liquidity/commerce/trades/etc. would be significantly worse if the granularity were slightly reduced, though. Say, run exchanges in a discrete-time world of 100ms timesteps. Are there real-world use cases where this would make the finance system unable to facilitate the economy?
If there are ways to make profit by trading at sub-100ms resolution, but a 1ms-resolution exchange is not any better at facilitating the outside-finance economy than a 100ms-resolution one would be, then it seems like HFT is solving problems of the exchange's own creation. It could even genuinely be solving those problems, but if they're problems that only arise in the context of extremely-high-granularity exchanges, and there is no practical benefit to such high time resolution, then why not just axe the problems?
Doing this type of trading doesn't require millions of dollars and teams of PhDs. You don't have to know the right people and you don't have to know any secret handshakes.
Critics of high frequency trading are almost always misinformed. Some of the most informed critiques I have read about this stuff are the following books:
"A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation" by Bookstaber
"Traders, Guns and Money: Knowns and unknowns in the dazzling world of derivatives" by Das
And Nasim Taleb's work.
------- More to the point, the author is explaining something very basic (which journalists don't seem to understand): -Algorithmic trading is NOT a general term for all trading done with algorithms/computers. It refers to telling a computer to EXECUTE a specific trade. In other words, when your retirement fund decides to buy A LOT of AAPL, they naturally need to spread that trade over the whole day (or even several days). In the old days, human traders used to do it. Now it is mostly done by computer programs.
This is different from the kind of trading where a computer decides WHAT to trade (NOT HOW to trade). This kind of trading involves so many different strategies that it is silly to lump them together.
There seem to be other misconceptions: -The best and the brightest are working in Finance, instead of doing things more beneficial to society.
A quant colleague of mine, who has a PhD in Physics from an Ivy League school told me that he, and many of his friends, left academia because there were simply no positions for them.
-75% of trading is now automated, it is just computers trading with each other.
I hope someone will correct me if I'm wrong but I have never figured out if this 75% includes algo trading. If it does include algo trading (my guess is that it does), then I'm surprised it is not 100%. That is like saying 95% of TV channels are controlled by remote-control devices.
-People seem to think that wall-street traders make their money by "trading ahead" of mom & pop investors: your Dad buys 1000 shares of microsoft, a wily trader puts your dad's order on hold, buys it for himself, raises the price, sells his shares to your dad at a higher price...thereby making money off your dad.
Your broker is not allowed to 'trade-ahead' of you. At least in the places where I have worked, this is taken very seriously. Interestingly, high frequency traders (who are most frequently accused of this) don't actually have access to customer order-flow. High frequency trading hedge funds don't generally have any client orders. Places where the two co-exist are forced to have seperation. Traders from one department cannot share information with the other. As more and more client facing firms (sell-side) become automated, the chance of them actually coding up such cheats is even dumber.
Flash trading is often given as an example of people, in cahoots with exchanges, trading on others' order information. As far as I know, "flash" functionality exists to help clients trade more effectively. Large traders are VERY concerned about letting the whole market know that they are interested in some stock. Some exchanges offered the following functionality: if you are interested in buying a stock, you have the OPTION of giving other members of the exchange a chance to trade with you. If no one takes you up on the offer, then the order goes to the wider market.
I have to admit that a laywer friend told me that he opposes this functionality at his firm. If someone _really_ needs to know more, I suppose I could ask him to explain.
-High frequency traders trade so fast that mom & pop simply can't compete with them. Their computers/networks are just too fast and they can get closer to the exchanges than anyone else.
High frequency traders are not competing with mom & pop, they are competing with market makers. If two people hear a news item, the one closer to the exchange will naturally get the trade done faster (presumably at a better price). The same is (generally) true of people on the East Coast vs rest of the country (let's assume US financial system). The same is true of people who can click their mouse faster. Besides, there is no moral reason your Mom should be able to dump her Enron stock faster than Joe Trader.
etc., etc., etc. -------------
I should add that I am actually not at all comfortable with the role finance plays in world economy. I can't call myself a critic since being critical requires more complete understanding.
I am specifically opposed to things like direct market access. This is where any Joe Blow can use an API to setup his trading system. If he accidently leaves an infinite loop in his code, he can cause real problem. I remember sweating bullets (and almost trembling) when my boss asked me to flip the switch on the trading system I wrote. In reality, there are at least some protections built in to keep this from happening. However, I would like to see more uniform, consistent and better advertised rules.
I am also against the ability to trade by borrwing money from brokers (margin trading or leveraged trading). If an individual trader screws up, they wipe themselves out. If they borrowed money, then the consequences of their bad trades starts to seep out to others. If more than a handful of traders, trading on margin, go belly up, the lender could be in trouble as well...you can see how this could ripple across a system.
Closely related to allowing trading on margin is reliance on models. Say you have calculated that two stocks always move together. You _and your lender_ are so sure of this correlation that they think of it as the truth. What if your calculations or your assumptions were wrong? The consequences of this mistake may not be linearly related to the risk you thought you took. Read Nasim Taleb's work on this for more.
Finally, those who smell something fishy should broaden their concern beyond just modern trading system or even complex derivatives. I can see no principal, within the framework of free markets and individualism, which leads to condemnation of ever more automated and faster trading, more complex instruments and more dependence of finance. The best moral principal, I can think of, which opposes the current state of affairs, is the one uttered by Martin Sheen's character in the movie Wallstreet: "Create, instead of living off the buying and selling of others."
Wallstreet 2 was a piece of shit.