31 July 2009

"High-frequency" stock trading

The term doesn't refer to the (now old-fashioned) "day trading," where traders would establish and liquidate positions several times per day. "High-frequency" now refers to computerized programs that buy and then sell within seconds... or milliseconds...
The collection of computer-automated, high-speed trading technologies and techniques that are typically lumped under the heading of "high-frequency trading" (HFT) have been around for a while, but HFT has recently become heavily identified with the banking giant Goldman Sachs, which dominates some aspects of it on the New York Stock Exchange...

Only about three percent of the trading volume on the NYSE is actually carried out by means of traditional "open outcry" trading, where flesh-and-blood humans gather to buy and sell securities. The other 97 percent of NYSE trades are executed via electronic communication networks (ECNs), which, over the past ten years, have rapidly replaced trading floors as the main global venue for buying and selling every asset, derivative, and contract...

The real issue is that when the average retail investor gets an E*Trade account and tries to play the stock market, she typically has no idea that she's going up against the market equivalent of IBM's chess grandmaster-thumping supercomputer, Deep Blue...

What the vast majority of these algos have in common is that they are not long-term, buy-and-hold "investors" in the classic sense. Rather, they focus on executing as many trades per second as possible and on turning a small profit (often pennies or fractions of a penny) on each trade...

At least two different groups, the TABB Group and FIXProtocol, estimate that high-frequency trading generated around $20 billion in profits for the financial sector last year. Goldman Sachs accounts for some 20 percent of global high-frequency trading activity, and the bank recently had a blow-out quarter in which its HFT-heavy trading operation racked up a record number of days where profits topped $100 million...

At the back of everyone's mind is the 1987 program trading crash, described by Richard Bookstaber in A Demon of our Own Design. In the run-up to October of 1987, all of the major market participants had been using essentially the same computer-automated algorithm to hedge their portfolio risk. On Black Monday (10/19/1987), all of the portfolio insurance programs started dumping assets in lock-step, in response to a particular set of inputs. This synchronized selling begat more synchronized selling, and by the time this giant, market-sized feedback loop was shut down by the closing bell, the Dow had lost almost 23 percent of its value in a single day.
I remember Black Monday. I was an active investor in 1987 and lost 10 months worth of profits over the course of three days. And through it all I slept like a baby*. The thought of what could happen nowadays, either triggered by normal human panic, a sudden catastrophe, or a deliberate hacking, scares the bejeezus out of me.

More details on how HFT works at the ars technica link. Via BoingBoing.

*(woke up every hour and cried)

1 comment:

  1. And then people try to tell us that how high the Dow goes has something to do with the economic soundness of the companies involved, rather than being strongly related to millisecond-long gambles by computer programs...

    ReplyDelete

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