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Rage Against the Machine

Machines rule the trading world, and are getting even faster, leaving us wonder if humans still play a necessary role in trading.

08/14/2012

On August 1st, 2012 at 9:30 am, in a matter of only 45 minutes, Knight Capital Group lost $440 million due to a computerized trading system malfunction.  Five days later, a consortium of four firms rescued Knight and diluted shareholders, with the company’s stock dropping from $10 to $3.  A victim of their own creation, the machines rule the trading world, and are getting even faster, leaving us wonder if humans still play a necessary role in trading.

Knight is a trading firm and one of the largest market makers in a number of stocks in the United States.  Its high-frequency trading system malfunctioned that morning, or was accidently tested before it was ready[i], as it simultaneously entered buy and sell orders in the same 148 stocks, sending prices fluctuating wildly.  According to reports[ii], trading volume on the New York Stock Exchange (NYSE) was six times more than average.

Through the 1970s, the most sophisticated mode of communication for the financial world remained the same for nearly 100 years.  The telegraphic ticker system gave prices of stocks and the telephone allowed the communication of orders until then.  Now, high speed servers send orders through fiber optic cables with speed as the main objective; one millisecond means the difference between profit or loss.

High frequency trading (HFT) programs make money in multiple ways , usually less than a penny per share at a time (as stock quotes are to the penny but real prices are up to six decimal places).  Sometimes the programs simply provide liquidity taking the other sides of trades and getting rebates from the exchanges.  In the more dubious ‘flash trades,’ programs ‘flash’ buy or sell orders to pinpoint the limit price orders of other participants and then quickly soak up orders until the limit is filled at the most profitable levels for the HFT program.[iii]  The brainpower for the trading comes from the mathematics and physics PhDs applying a variety of theorems from other scientific fields to financial data in a lighting fast manner.

Speed is the number one concern among these program traders.  The following charts from Nanex and Zero Hedge provide a great visual as to what it is like trying to compete with these machines.  The first image is a massive jump in price for this particular instrument.  The entire “spike” took only 275 milliseconds to complete. This image represents what a human sees during this spike.

HighFT1

The next picture shows what the High Frequency Trade algorithms sees during that same 275 milliseconds time frame during the “spike” from the image above.

HighFT2

Speed is everything in the competitive world of HFT programs.  Putting servers right within the walls of the stock exchanges helps with speed.  In addition, networks with the shortest distance between the two major trading hubs of Chicago and New York help facitiliate even faster trading.

FiberOpticCableLines

Source: Wired Magazine

The original cable took data 14.5 milliseconds per roundtrip, while a much shorter cable through Cleveland took this down to 13.1/roundtrip.  But due to physics and the refraction of signals, the faster way of sending the signals is through towers using microwaves, which the McKay Brothers just finished while Traderworx will finish its towers this winter.  This will take the roundtrip time for data to 9.0 milliseconds and 8.5 milliseconds, respectively.   More high speed cable is being laid across the Atlantic at a cost of $300 million, as cost is hardly an object when the HFT all but are guaranteed to make money trading, if the fastest data speed is on their side.

Unfortunately, problems invariably arise with such complex systems trading so much money so quickly.  With shares traded in decimals as opposed to eights and profit margins for brokers at razor thin levels, the human market maker is becoming extinct.   Many estimate that 70% of dollar trading is now HFT and supporters say the benefit of liquidity is worth it, but its shortcomings are evident.   Whether it is the flash crash when the Dow fell 1,000 points in May 2010 or the Facebook IPO debacle during its first day of trading, the periodical computerized mishaps are common place.  A solution is more human market makers, who have cognitive ability to recognize berserk trading while most systematic trading simply processes information and send out directions as ordered.

Regulators allowed this to happen and are considering the previous missteps.  The German DAX and NASDAQ exchanges are considering doing away with HFT while the SEC is looking into banning it, though we are far from it becoming rule.

Per one of our investment managers, “[Stock market] volatility is going to keep people away from what is the most promising investment opportunity because it is ‘uncomfortable’…  this is the result of regulatory overreach with no market makers now, which were replaced by short term trading, people anticipating price moves that fool real investors and take pennies from them [investors] which amount to millions every day.  It’s too bad.”

 

Important Disclosures
This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security/instrument, or to participate in any trading strategy. Any such offer would be made only after a prospective investor had completed its own independent investigation of the securities, instruments or transactions, and received all information it required to make its own investment decision, including, where applicable, a review of any offering circular or memorandum describing such security or instrument. That information would contain material information not contained herein and to which prospective participants are referred. This material is based on public information as of the specified date, and may be stale thereafter. We have no obligation to tell you when information herein may change. We make no representation or warranty with respect to the accuracy or completeness of this material. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein.

Estimates of future performance are based on assumptions that may not be realized. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates. Other events not taken into account may occur and may significantly affect the projections or estimates. Certain assumptions may have been made for modeling purposes only to simplify the presentation and/or calculation of any projections or estimates, and Aurum Wealth Management Group and/or Aurum Advisory Services does not represent that any such assumptions will reflect actual future events. Accordingly, there can be no assurance that estimated returns or projections will be realized or that actual returns or performance results will not materially differ from those estimated herein.  This material should not be viewed as advice or recommendations with respect to asset allocation, any particular investment, or any tax advice.  Persons should not use any information contained herein or linked presentations as a primary reason for investment or tax decisions.

[i] http://www.zerohedge.com/news/explaining-knightmare

[ii] http://dealbook.nytimes.com/2012/08/03/trading-program-ran-amok-with-no-off-switch/

[iii] http://www.wired.com/business/2012/08/ff_wallstreet_trading/all

 

 

 

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