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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 sal

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.
- copper 15y ago
  > 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. Shouldn't both trades be broken, though? Breaking just one sounds like the kind of behaviour that would be a strong disincentive to trade at all in the first place.
  - yummyfajitas 15y ago
    Shouldn't both trades be broken, though? Under current market rules, no. Besides, this would quickly become a combinatorial disaster. Think of your counterparty who bought at $35 and sold at $36 - now one leg of his trade gets broken, and he has a short position. Or maybe we break both of his trades? Where does the chain end? And of course, this still hurts people doing stat arb. If you want to go long accenture, short IBM, and your accenture trade is broken, you find yourself with an unhedged IBM short. Breaking just one sounds like the kind of behaviour that would be a strong disincentive to trade at all in the first place. This is why HFT's pull out of the market under circumstances where broken trades become likely. Most of the HFT's that stayed in the market during the flash crash made huge money - volatility rocks.
    - copper 15y ago
      Thanks, thats interesting. It seems unfair to use the HFT to create stability, and then penalize it for that. I suppose that can't be fixed easily, though.
antrix 15y ago
> minimally affect the price of said stock by the sale. [snip] I'm not sure I seed (sic) the point of the latter This generally affects sales involving large quantities. Say you want to sell 10000 of IBM. The current order book at the exchange looks like: 165.55 - 10 165.54 - 20 165.53 - 200 165.52 - 500 165.51 - 100 As you can see, the current market is 165.55 and you decide to place a SELL order for your 10000 IBM. You have two options - place a limit order or a market order. Market Order: As soon as you place your order, you are going to sweep the order book above. End of those 5 transactions, the market has moved to 165.51 while you've only liquidated 830 of your 10000! Worse, people are noticing a lot of sell activity so the folks who wanted to buy start placing bids at lower & lower prices. By the time you liquidate all your 10000 stocks, the average price you end up getting would be 165 or 164 or lower! You've moved the market by virtue of your sale & made less money as a result. Limit Order: If you place a limit order for SELL 10000@165.55, then you sell the first 10 to the current highest bid. After that, everyone knows there's a seller looking to offload 10000 units. So they lower their bids. You are worse off! By now, I hope it is clear why you should care about not moving the market by your sale. The way to solve this problem is to sell in small chunks periodically in ways that does not signal to the market what your actual quantity is. As you can imagine, computers are pretty good at doing this kind of grunt work. Hence Algorithmic trading :-) Specific examples would be VWAP, TWAP, etc. Just Google for them. PS: this has nothing to do with HFT algos.

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.

copper 15y ago
> 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. Shouldn't both trades be broken, though? Breaking just one sounds like the kind of behaviour that would be a strong disincentive to trade at all in the first place.
- yummyfajitas 15y ago
  Shouldn't both trades be broken, though? Under current market rules, no. Besides, this would quickly become a combinatorial disaster. Think of your counterparty who bought at $35 and sold at $36 - now one leg of his trade gets broken, and he has a short position. Or maybe we break both of his trades? Where does the chain end? And of course, this still hurts people doing stat arb. If you want to go long accenture, short IBM, and your accenture trade is broken, you find yourself with an unhedged IBM short. Breaking just one sounds like the kind of behaviour that would be a strong disincentive to trade at all in the first place. This is why HFT's pull out of the market under circumstances where broken trades become likely. Most of the HFT's that stayed in the market during the flash crash made huge money - volatility rocks.
  - copper 15y ago
    Thanks, thats interesting. It seems unfair to use the HFT to create stability, and then penalize it for that. I suppose that can't be fixed easily, though.

antrix 15y ago

> minimally affect the price of said stock by the sale. [snip] I'm not sure I seed (sic) the point of the latter This generally affects sales involving large quantities. Say you want to sell 10000 of IBM. The current order book at the exchange looks like: 165.55 - 10 165.54 - 20 165.53 - 200 165.52 - 500 165.51 - 100 As you can see, the current market is 165.55 and you decide to place a SELL order for your 10000 IBM. You have two options - place a limit order or a market order. Market Order: As soon as you place your order, you are going to sweep the order book above. End of those 5 transactions, the market has moved to 165.51 while you've only liquidated 830 of your 10000! Worse, people are noticing a lot of sell activity so the folks who wanted to buy start placing bids at lower & lower prices. By the time you liquidate all your 10000 stocks, the average price you end up getting would be 165 or 164 or lower! You've moved the market by virtue of your sale & made less money as a result. Limit Order: If you place a limit order for SELL 10000@165.55, then you sell the first 10 to the current highest bid. After that, everyone knows there's a seller looking to offload 10000 units. So they lower their bids. You are worse off! By now, I hope it is clear why you should care about not moving the market by your sale. The way to solve this problem is to sell in small chunks periodically in ways that does not signal to the market what your actual quantity is. As you can imagine, computers are pretty good at doing this kind of grunt work. Hence Algorithmic trading :-) Specific examples would be VWAP, TWAP, etc. Just Google for them. PS: this has nothing to do with HFT algos.