Algorithmic trading

[Storm]

Storm, I don't think the share holders of a company are analogous to the mortgage lender for a house buyer. The company does not get money from the share holders, the share holders own the company. If they sell out of the company, each owner has to find a buyer. I'm just saying that the remaining owners could in effect act as intermediary buyers. The remaining owners would take the risk of doing that and would want to do it so as to make the company attractive for new shareholders.

I believe it is analogous, because you don't own the title to your home, the bank (shareholders) does.  If the bank wants to sell your mortgage they can, and the buyer of that mortgage takes the risk.  It's just like equity in a company.  But, a bank can't force you to buy back your own mortgage.

[Storm]

Storm, market makers currently are using money they get from banks. If akratic screws up and his algos buy a load of stock they can't sell, ultimately it is the bank that loses the money. I'm not saying that the hypothetical "mutual market maker" should offer an attractive price. Currently market makers sell all of the stock they have by the end of the day at whatever price they can don't they. A "mutual market maker" would do the same. I think it is worth bearing in mind just how expensive an enterprise it is that would be cut out by this. It costs billions and billions of dollars. There are hundreds of thousands of very high cost people employed.

Doesn't the "bullion vault" gold storage company do its own market making?

You make it sounds like anybody can just go out and become a market maker, borrowing money from the bank to do so.  To be an official market maker, it really does require liquidity and reserves of your own.  It's not like the exchanges just say "let's pick Joe Bob to be our market maker because he's cheap and he runs it out of a trailer."  They are looking for well respected, established broker/dealers that are on the up and up, have good accounting practices and safeguards to protect their capital reserves.

But, what's great about the algos is that what if that appointed "official" market maker is charging too large of a spread?  The algos come in and start offering better spreads, because they know they can make a profit by helping everyone else to pay a little less.  This is competition and capitalism.  Everybody benefits.  Investors pay a smaller spread, and perhaps the official market maker has to tighten their spreads a bit to compete, but they probably should have done that in the first place.

I think there is a misperception that all algo traders are HFT or some type of pump and dump scam artists.  The market has gotten extremely efficient (due in no small part to all of the algo traders) and the side effect of an efficient market is that it punishes those who try to create inefficiences in extreme ways.  I'm sure there are all kinds of horror stories about traders that got too aggressive and tried to corner the market in something and ended up losing their shirt.  Efficient markets punish inefficiencies (by making them eat losses).

It's like evolution when you think about it - survival of the fittest.

[stone]

Storm, just as with a house, with a company, the creditors (eg bond holders) also have a senior claim over the owners. if a company goes bust, the creditors of the company come first before the share holders when the assets of the company are liquidated. The mortgage lender is like the creditors of the company and the person who took the mortgage out is like the share holders of the company. Typically to take a mortgage out you have to put down a deposit (we put down 5% on our house). Our house had an ownership stucture that was 5% equity, 95% debt. We then paid off the mortgage so that it became 100% equity. I think I'm right about this.

[stone]

Storm, "It's like evolution when you think about it - survival of the fittest."

My issue is that the "fitness" required to make money as a trader does not confer a proportionate cost/benefit to the market. They can go in and hoover up money when market conditions are as they expect and then stand aside when there is "crazyness they don't understand". I think the proportion of company earnings that get harvested by trading is in good part responsible for frightening off other people from the equity markets. The way things are going, all corporate earnings will be harvested by sophisticated traders and the arms race between them in terms of costs of computors, staff etc will consume much of global production. Evolution causes all kinds of wacky inefficiencies too. To my mind this is evolution of a peacocks tail.

[Storm]

Stone, I haven't seen any evidence that having lots of algos trying to create efficiencies hurts global production or anything like that.

Let's take a somewhat contrived example:

1.  I can drive to the market and buy a loaf of bread, but it costs me $2 in gas for a loaf of bread that is only worth $3.  Total cost $5.

2. My neighbor decides to start a business and buys a whole bunch of bread in the morning, then delivers it to my house for only the $3 cost plus a $0.50 delivery fee.

The neighbor has just created more market efficiency by saving all of us a separate trip to buy bread.  Doesn't he deserve some small compensation for that?

3. Another neighbor can do it for cheaper and only charges a $0.25 delivery fee.

Again, another efficiency was created and everyone benefits by paying a lower price than they would have.  They also produce less pollution and our overall carbon footprint as a society is lower because of this efficiency.

If market makers and algos were not allowed to do any business at all, we would most likely:

• Not have any stock exchanges, because nobody would be able to make a small profit for allowing trading to take place.
• Companies would have to print their own paper stock certificates, find investors manually, and distribute the paper stock certificates through snail mail to each investor.
• If you ever wanted to sell your shares, you'd have to just call around and ask random people "hey, do you want to buy 100 shares of AAPL for $385?"
• You'd pay a lot more for your shares than they were worth when you bought them.
• You'd get a lot less for your shares than they were worth when you sold them.
• Globally economies, companies, and employees would suffer because companies wouldn't have quick access to the capital needed to expand their business.

I'm trying to think of one way that society as a whole would benefit if we had "communal" exchanges or some type of non-profit scenario in place.  The only thing I can think of is that it would be a huge bureaucratic nightmare where paper shares would be traded with extremely high spreads with the government keeping all of the proceeds, or the proceeds from spreads would just feed the bureacracy.  It sounds horrific to me.

[Laker]

Storm,

Believe it or not, I am not targeting you. I have been a long time lurker here, but today started posting. The algo traders and HFT's have only been a factor in the last 10 years. Before that, somehow stock was stock and derivatives contracts were transacted every day for well over a hundred years. The notion that the everyone benefits from the HFT's is incorrect. They would like everyone to believe that they came and saved the world and provide a great service to everyone. It is simply not true.

[Storm]

Storm,

Believe it or not, I am not targeting you. I have been a long time lurker here, but today started posting. The algo traders and HFT's have only been a factor in the last 10 years. Before that, somehow stock was stock and derivatives contracts were transacted every day for well over a hundred years. The notion that the everyone benefits from the HFT's is incorrect. They would like everyone to believe that they came and saved the world and provide a great service to everyone. It is simply not true.

Laker, welcome to the forum.  I really don't think you're targeting me, and enjoy reading your insight.  I've been thinking about it in my head and trying to ponder whether it is a net benefit or net loss to the market, but it seems to me that if you can find a way to save everyone a few cents on their transaction, then maybe you are benefiting the market and not leeching.  I guess if you are doing it through quote stuffing and other nonsense then I think you should be removed from the market, but I honestly believe that the exchanges will cut those operators off anyway.

Imagine this - I run an exchange, and sell hosting/co-location to a bunch of different prop shops or algo traders.  Most of my customers play nice, but one guy uses 100x the network bandwidth and is making all my other customers transactions slower.  What am I going to do?  Let the other customers suffer and move their equipment out?  Or kick out the 1 guy causing all the problems.  I think the markets take care of these problems on their own.  It's in their best interest to do so.

The only thing I could see happening (possibly) is if a well connected prop shop bribed the exchange (in the form of paying higher fees or transaction costs) to let them do some quote stuffing, but then I think the extra fees they were charged would probably cut into their profits and make it not work out, financially for them.

Anyway, I enjoy reading your response.  I've been puzzling about this on my own, but I can't seem to see much wrong with it, other than the vast amount of computing resources spent on efficient capital allocation.  And, we spend vast amounts of computing resources on much more mundane things like streaming Netflix movies... who is to say that efficient allocation of capital is more important than Netflix? 

[akratic]

I'm sorry but I'm not going to be able to continue to field questions indefinitely, and at this point I think I would be mostly repeating myself anyway.

If you want to continue your education on algorithmic trading, this would be a good next step: Rise of the Machines: Algorithmic Trading in the Foreign Exchange Market

And here is a nice quote:

“Faced with the choice between changing one’s mind and proving that there is no need to do so, almost everyone gets busy on the proof.”? -John Kenneth Galbraith

PS: My firm invests its own money.  Why would a firm that makes tons of money every year need to borrow money from a bank or individual?  There is only a finite amount of inefficiency to capture, and over-trading your edge is just as sure a way to lose money as trading without an edge is.

[stone]

akratic, thanks again for your insight. It is impressive that your company uses no leverage (I presume you are also meaning that the securities you trade also are not leveraged). Goldman Sachs et al use 37:1 leverage don't they?
As you say, I need to educate myself more about this.

Storm, the analogies you gave involved efficiency gains in terms of getting more bread for less petroleum used. Trading "efficiency" is not reducing consumption of anything real such as petroleum. It is ironing out minor mispricings -if it is all working ideally. It is more analogous to making sure that two half pound loaves of bread cost as much as one one pound loaf. As Laker and me have been saying, stock markets have been around for several centuries. Those minor mispricings used to just result in a random distribution of profits amongst the market participants. Sometimes you did well when you bought or sold and sometimes the other guy did. Nothing was wasted, it was just a zero-sum redistribution as a consequence of the mispricings. What happens now is that the sophisticated traders are able to deploy superior computing power and financial mathematics to ensure that the redistribution is always to them and away from the other market participants.
The genuine waste is the arms race between traders to divide up a pie of fixed size. The size of the pie is the earnings of the listed companies traded. Trading does not influence the size of that pie, it just is a scrabble to get a piece of it. All those legions of traders and best of the best IT systems have to be paid for out of that pie.
I wasn't advocating not having stockmarkets, I was advocating calling a truce in the arms race between traders. Much like the fact that F1 motor racing has limits on number of replacement cars, engine size etc. I was wondering whether a stripped down to the bare bones, mutually run exchange might be a suitable structure for that. It would be a private sector set up. The difference is that the costs would be accountable to the stockholders. Currently the costs of the trading arms race are huge and you are paying for them.

[Storm]

Stone, we will have to agree to disagree.  As much as I want to carry on this conversation it seems like we disagree on the fundamental issue of whether or not algo trading is beneficial to the market as a whole.  Thanks for your replies and thoughts.

Akratic, thanks for your posts as well; this has been a great thread.

[stone]

Storm, agreed . I'll think about what you and akratic have said. I often need to mull things over a long time before the penny drops.

[Kel]

There are some interesting issues around high frequency or Fast Algorithimic trading - some of which is not fair to the rest of us - the below link is not opposed to high frequency or algorithmic trading just when there is an unfair advantage over others... I think the SEC has a rule making out for comment on the issue.

http://www.defendtrading.com/

Also here is another link that I started on the neoticker forum by posing the question of various firms deploying system related servers in close proximity of exchange servers to somehow capitalize on the sometimes microseconds advantage of getting info from the exchange servers quicker than others and somehow exploiting that edge:
http://forums.neoticker.com/showthread.php?t=61781

BlueCrest Capital - one such hedge fund that did/does? employ high freq trading techniques- has some pretty impressive track records...last I looked (2 years ago)

[Kel]

Storm - one area I am looking into are programs that generate systems for you by using genetic algorithms...currently futurestruth (which monitors systems without hindsight) has two such systems in their top ten S&P listing - they begin with TSL (at least they were listed that way at the time of this post)

http://www.futurestruth.com/top10spsystems.htm

Further I have found Micheal Byrant to be a fair and honest vendor who as written a code generator for trade station (called "adapt trade builder")....here is an nice article where he illustrates how one could use it.
http://www.breakoutfutures.com/Newslett ... er0911.htm

[gizmo_rat]

In a different context, an illustration of the risks of algorithmic trading.
Summary

• fubar Algorithm (I guess)
• accidental £23 million liability
• Hilarity ensues

http://www.guardian.co.uk/sport/2011/de ... la-vedette

I shudder to think what would happen in a stock market.
All in all algorithmic trading on your own behalf is hard earned money.

[MachineGhost]

Stone, don't lose sight of the fact that the stock market is all about the "ownership of the private means of production" aka Capitalism.  Its lets average, ordinary Joes like participate in those businesses.  That is truly revolutionary from a historical perspective.  It is clearly distinct from Communism where only the state is legally allowed to own the means of production.  Or some other shut-out system where only the rich can.

So naturally, there will be a lot of hanger ons, bottom feeders, "financial engineering" pests in the vampire economy coalescing around the stock market like the money-changers in the Temple of ??.  They are an inevitable consequence.

The much bigger issue is that of government spending.  With so much unproductive inflation being generated, it is a liquidity boom for capital markets, so more and more careers will go to this vampire economy and away from the "real" economy -- whatever the hell that really means.  Sometimes I think we are all too stuck on Marx's definition of physical labor being the only source of value instead of intellectual creativity.  Value is so subjective yet we like to be rooted to physicality for it.

MG

What Medium Tex said about the adverse consequence of people trading with borrowed money makes a lot of sense to me. To take a simplified example, if you were “trading”? on the results of flipping a coin, then it would be possible to have a strategy that won most of the time but gave back those winnings on the rare occasions when a catastrophic loss occurred: http://en.wikipedia.org/wiki/Martingale ... ng_system)
Ofcourse if you are using your own money and have to cover the downside as well as the upside then that would be pointless. BUT if you are a finance company and you get to keep any upside but simply file for bankruptcy and get jobs in a new company whenever the once in a blue moon event occurs, then it is something that you absolutely have to do in order to remain in the game with your competitors.
From what I can see, much financial activity is in essence just such a martingale betting strategy. Trading with stop loss limits or with algos that opt out when they detect “craziness they don’t understand”? acts to substitute a continuous mix of small wins and losses for a long sequence of predominating wins punctuated by huge losses when a close succession of stop outs happen to occur.
I suppose on a macro scale what happens is that leveraging up by banks entails interest that must be got from somewhere and so eventually has to be offset by debt forgiveness in the form of bankcruptcies.
As I say, I know absolutely nothing about this. I’m just struggling to get my head around it.