8 ms·

Algorithmic trading -- the positive side

48 points by gabaix 15y ago

gabaix 15y ago
"The conclusion, then, is that algorithmic trading (at least in the time period studied, in which stocks were generally rising) does improve market efficiency in the sense of higher liquidity and better price discovery."
- markbnine 15y ago
  But the paper also rightly ends with a further caveat: While we do control for share price levels and volatility in our empirical work, it remains an open question whether algorithmic trading and algorithmic liquidity supply are equally beneficial in more turbulent or declining markets.
  - cma 15y ago
    Its pretty much a tax; take out all the day traders and whether you gain or lose due to the spread is more or less random; day traders and hft traders narrow the spread, but since whether you gained or lost was random and they are now capturing a piece of that spread, they (err, ashamedly, we) are basically just taxing everyone. A nominal transaction tax would eliminate most of the ultra-high frequency stuff and could be put to better use. Volumes would drop and spreads would widen, but it wouldn't really matter up to some reasonable amount.
    - puzzler314 15y ago
      I'm not sure a nominal transaction tax would eliminate high frequency trading. HFT guys already pay fees to the exchanges and regulators. Either way, you're right, an increased fee would simply be passed to investors in the form of an increased spread.
      - jessedhillon 15y ago
        Some HFTers execute thousands of trades a day which are cancelled within a few ms -- they are just pinging the market to see how liquidity is at certain price levels, or looking for an opportunity to get out in front of a large quantity trade. This would prevent or impair such traders.
    - fr0sty 15y ago
      In what way is gaining or losing the spread "random"? Buyers pay the offer, sellers the ask. If you want to save the spread you can leave a resting order and wait for someone to take you out but you have no guarantee of a fill (or at least a timely one).
    - nandemo 15y ago
      Wait, what? Individual traders who are value-oriented or technical traders, as well as mutual funds etc, gain money on "buy low, sell high". Of course mutual funds and the like do so on a very long term basis. In any case, they pay the spread. So if the spread is narrower then they make more money in average. Example: if the Apple's quote is 95/105 (buy/sell) today and 105/115 tomorrow, an invidual trader buying and selling would just break even (buy at 105 and sell at 105) even though Apple's notional fair value has risen. But if there are more market makers, the quotes would be 99/101 and 109/111. Then our individual trader would make 109 - 99 = 10 in the same market conditions. You're right that a wider spread wouldn't matter much to an individual trader, but that's mainly because their main cost is trading fees (paid to the broker) anyway. For mutual funds, though, a 1 basis-point change in the spread means a lot of money.
      - cma 15y ago
        What if the only participants were mutual funds and individual traders with no significant market microstructure strategies. Half of all orders would still be resting orders, the other half would hit the bid/offer in some way. Sometimes you'd lose more due to this, sometimes you'd make more. But it would be a "fair" coin. Let's say on average it was $0.01 per dollar. As soon as someone entered the market with some microstructure expertise and strategy, everyone but the microstructure guy starts making (say) $0.005 half the time and losing $0.006 the other half. Reducing some of the randomness and providing more consistency is certainly worth something; you can imagine an example where it was +/- $0.50 per dollar reduced to +$.005, - $.006, but note (assuming the same dollar volume) that the HFT guy would still be making the same amount of money as in the previous example, where he was providing much less value. I.e. the cost that HFT commands isn't strongly tied to the value it provides. This is without even delving into the latency-arbitrage arms race cluster fuck.
        nandemo 15y ago
        > What if the only participants were mutual funds and individual traders with no significant market microstructure strategies. Half of all orders would still be resting orders, the other half would hit the bid/offer in some way. No it wouldn't. Unless you make some really odd assumptions (like the traders are monkeys), you could still have tons of limit orders and NO executions. That's what happens to iliquid stocks.
- joe_the_user 15y ago
  Ah, But is it real liquidity or the illusion of liquidity? Liquidity is, more or less, money ready to be invested. The question of whether sophisticated strategies really provide this is complex, like the strategies themselves. If you want background, I think Doug Noland's Credit Bubble Bulletin has done a good job of addressing these questions over the years. At the same time, I think we can see simple things. The big question isn't day-to-day-liquidity but liquidity-when-you-need it. By that measure, when we look at recent and older wild-swings in the market and especially the "flash crash", it seems fairly evident that the spectrum of "sophisticated strategies" don't provide liquidity-when-you-need-it and that is increasingly a problem.
  - joshu 15y ago
    No. Liquidity is the measure of the ease with which it is easy to trade a given item. That is to say, shares of IBM are pretty liquid, treasury bonds are very liquid, and dollars are extremely liquid. But your car is not particularly liquid. The rest of your analysis is nonsense.
    - joe_the_user 15y ago
      Liquidness - has easily a thing can be liquidated, how easily it can be turned into cash. Liquidity - cash waiting to buy the thing and liquidate it. A "liquid market", though, is normally a market with lots of liquidity rather a market which can be easily sold. The existence of money to be invested is what makes a stock markets liquid... Money to be invested is the necessary ingredient of a "liquid market". And a liquid market is a complex thing to measure. A market can easily seem liquid if lots of shares trade. But if it's the same shares over and over again on a day-to-day basis and if any time a large block appears, the price goes way down, then the market has an illusion of liquidity rather than real liquidity.
      - joshu 15y ago
        http://www.investopedia.com/terms/l/liquidity.asp#axzz1UscLt1Wj http://www.investopedia.com/terms/l/liquidity.asp#axzz1UscLt...
- albertsun 15y ago
  But does higher liquidity lead to more efficient allocation of capital? Or does it only lead to more productive markets up to a certain threshold?
georgieporgie 15y ago
My understanding of liquidity in the stock market is that it refers to being able to quickly sell stock, and minimally affect the price of said stock by the sale. I see the value of the former, having an asset you can't sell means its value is rather pointless, but I'm not sure I seed the point of the latter. Isn't money made in the stock market by price volatility? Doesn't algorithmic trading simply smooth out price fluctuations to the point that individual traders receive nothing, while HFT houses skim immense numbers of tiny slivers? It seems to me that we're moving toward the future that some people want: that we only invest in companies which we believe have real growth or dividend payout potential over the long term. Meanwhile, money will continue to be made by "gambling" on price fluctuations, but only by high frequency traders. I can't help thinking that liquidity has diminishing returns, and I definitely think that claims of HFT value are heavily undermined by their tendency to drop out of the market during crashes. If I'm wrong in these views, I would love to be enlightened.
- eru 15y ago
  > having an asset you can't sell means its value is rather pointless Not completely. There are still dividends. (Or being able to live in a house, or rent it out, if we are talking about real estate assets.)
- yummyfajitas 15y ago
  Doesn't algorithmic trading simply smooth out price fluctuations to the point that individual traders receive nothing, while HFT houses skim immense numbers of tiny slivers? Yes. Good speculation smooths out price fluctuations to the point that bad speculators receive nothing, while good speculators receive all the alpha. This is true not only of HFT, but of any good strategy. ...claims of HFT value are heavily undermined by their tendency to drop out of the market during crashes. If you don't want HFT and other speculators to drop out of the market during crashes, don't break trades after the fact. During a crash, most HFT's should make money hand over fist. But if the market centers break trades, HFT's are in danger of stabilizing the market and being heavily penalized for it. I.e., if an HFT pushes accenture up from $0.05 to $1.00 and sells at $35, following which accenture eventually goes up to $40, they run the risk of having their $1.00 buy trade broken. Then they are stuck with a short sale at $35, while the price of accenture went up to $40.
jessedhillon 15y ago
For further reading, here is a survey of different professors and practitioners in the field, and their take on questions related to the market impact of HFT. It's a very thorough discussion: http://www.conatum.com/presscites/HFTMMI.pdf http://www.conatum.com/presscites/HFTMMI.pdf

48 points by gabaix 15y ago

"The conclusion, then, is that algorithmic trading (at least in the time period studied, in which stocks were generally rising) does improve market efficiency in the sense of higher liquidity and better price discovery."

markbnine 15y ago
But the paper also rightly ends with a further caveat: While we do control for share price levels and volatility in our empirical work, it remains an open question whether algorithmic trading and algorithmic liquidity supply are equally beneficial in more turbulent or declining markets.
- cma 15y ago
  Its pretty much a tax; take out all the day traders and whether you gain or lose due to the spread is more or less random; day traders and hft traders narrow the spread, but since whether you gained or lost was random and they are now capturing a piece of that spread, they (err, ashamedly, we) are basically just taxing everyone. A nominal transaction tax would eliminate most of the ultra-high frequency stuff and could be put to better use. Volumes would drop and spreads would widen, but it wouldn't really matter up to some reasonable amount.
  - puzzler314 15y ago
    I'm not sure a nominal transaction tax would eliminate high frequency trading. HFT guys already pay fees to the exchanges and regulators. Either way, you're right, an increased fee would simply be passed to investors in the form of an increased spread.
    - jessedhillon 15y ago
      Some HFTers execute thousands of trades a day which are cancelled within a few ms -- they are just pinging the market to see how liquidity is at certain price levels, or looking for an opportunity to get out in front of a large quantity trade. This would prevent or impair such traders.
  - fr0sty 15y ago
    In what way is gaining or losing the spread "random"? Buyers pay the offer, sellers the ask. If you want to save the spread you can leave a resting order and wait for someone to take you out but you have no guarantee of a fill (or at least a timely one).
  - nandemo 15y ago
    Wait, what? Individual traders who are value-oriented or technical traders, as well as mutual funds etc, gain money on "buy low, sell high". Of course mutual funds and the like do so on a very long term basis. In any case, they pay the spread. So if the spread is narrower then they make more money in average. Example: if the Apple's quote is 95/105 (buy/sell) today and 105/115 tomorrow, an invidual trader buying and selling would just break even (buy at 105 and sell at 105) even though Apple's notional fair value has risen. But if there are more market makers, the quotes would be 99/101 and 109/111. Then our individual trader would make 109 - 99 = 10 in the same market conditions. You're right that a wider spread wouldn't matter much to an individual trader, but that's mainly because their main cost is trading fees (paid to the broker) anyway. For mutual funds, though, a 1 basis-point change in the spread means a lot of money.
    - cma 15y ago
      What if the only participants were mutual funds and individual traders with no significant market microstructure strategies. Half of all orders would still be resting orders, the other half would hit the bid/offer in some way. Sometimes you'd lose more due to this, sometimes you'd make more. But it would be a "fair" coin. Let's say on average it was $0.01 per dollar. As soon as someone entered the market with some microstructure expertise and strategy, everyone but the microstructure guy starts making (say) $0.005 half the time and losing $0.006 the other half. Reducing some of the randomness and providing more consistency is certainly worth something; you can imagine an example where it was +/- $0.50 per dollar reduced to +$.005, - $.006, but note (assuming the same dollar volume) that the HFT guy would still be making the same amount of money as in the previous example, where he was providing much less value. I.e. the cost that HFT commands isn't strongly tied to the value it provides. This is without even delving into the latency-arbitrage arms race cluster fuck.
      - nandemo 15y ago
        > What if the only participants were mutual funds and individual traders with no significant market microstructure strategies. Half of all orders would still be resting orders, the other half would hit the bid/offer in some way. No it wouldn't. Unless you make some really odd assumptions (like the traders are monkeys), you could still have tons of limit orders and NO executions. That's what happens to iliquid stocks.
joe_the_user 15y ago
Ah, But is it real liquidity or the illusion of liquidity? Liquidity is, more or less, money ready to be invested. The question of whether sophisticated strategies really provide this is complex, like the strategies themselves. If you want background, I think Doug Noland's Credit Bubble Bulletin has done a good job of addressing these questions over the years. At the same time, I think we can see simple things. The big question isn't day-to-day-liquidity but liquidity-when-you-need it. By that measure, when we look at recent and older wild-swings in the market and especially the "flash crash", it seems fairly evident that the spectrum of "sophisticated strategies" don't provide liquidity-when-you-need-it and that is increasingly a problem.
- joshu 15y ago
  No. Liquidity is the measure of the ease with which it is easy to trade a given item. That is to say, shares of IBM are pretty liquid, treasury bonds are very liquid, and dollars are extremely liquid. But your car is not particularly liquid. The rest of your analysis is nonsense.
  - joe_the_user 15y ago
    Liquidness - has easily a thing can be liquidated, how easily it can be turned into cash. Liquidity - cash waiting to buy the thing and liquidate it. A "liquid market", though, is normally a market with lots of liquidity rather a market which can be easily sold. The existence of money to be invested is what makes a stock markets liquid... Money to be invested is the necessary ingredient of a "liquid market". And a liquid market is a complex thing to measure. A market can easily seem liquid if lots of shares trade. But if it's the same shares over and over again on a day-to-day basis and if any time a large block appears, the price goes way down, then the market has an illusion of liquidity rather than real liquidity.
    - joshu 15y ago
      http://www.investopedia.com/terms/l/liquidity.asp#axzz1UscLt1Wj http://www.investopedia.com/terms/l/liquidity.asp#axzz1UscLt...
albertsun 15y ago
But does higher liquidity lead to more efficient allocation of capital? Or does it only lead to more productive markets up to a certain threshold?

georgieporgie 15y ago

My understanding of liquidity in the stock market is that it refers to being able to quickly sell stock, and minimally affect the price of said stock by the sale. I see the value of the former, having an asset you can't sell means its value is rather pointless, but I'm not sure I seed the point of the latter. Isn't money made in the stock market by price volatility? Doesn't algorithmic trading simply smooth out price fluctuations to the point that individual traders receive nothing, while HFT houses skim immense numbers of tiny slivers? It seems to me that we're moving toward the future that some people want: that we only invest in companies which we believe have real growth or dividend payout potential over the long term. Meanwhile, money will continue to be made by "gambling" on price fluctuations, but only by high frequency traders. I can't help thinking that liquidity has diminishing returns, and I definitely think that claims of HFT value are heavily undermined by their tendency to drop out of the market during crashes. If I'm wrong in these views, I would love to be enlightened.

eru 15y ago
> having an asset you can't sell means its value is rather pointless Not completely. There are still dividends. (Or being able to live in a house, or rent it out, if we are talking about real estate assets.)
yummyfajitas 15y ago
Doesn't algorithmic trading simply smooth out price fluctuations to the point that individual traders receive nothing, while HFT houses skim immense numbers of tiny slivers? Yes. Good speculation smooths out price fluctuations to the point that bad speculators receive nothing, while good speculators receive all the alpha. This is true not only of HFT, but of any good strategy. ...claims of HFT value are heavily undermined by their tendency to drop out of the market during crashes. If you don't want HFT and other speculators to drop out of the market during crashes, don't break trades after the fact. During a crash, most HFT's should make money hand over fist. But if the market centers break trades, HFT's are in danger of stabilizing the market and being heavily penalized for it. I.e., if an HFT pushes accenture up from $0.05 to $1.00 and sells at $35, following which accenture eventually goes up to $40, they run the risk of having their $1.00 buy trade broken. Then they are stuck with a short sale at $35, while the price of accenture went up to $40.

jessedhillon 15y ago

For further reading, here is a survey of different professors and practitioners in the field, and their take on questions related to the market impact of HFT. It's a very thorough discussion: http://www.conatum.com/presscites/HFTMMI.pdf http://www.conatum.com/presscites/HFTMMI.pdf