Wednesday, August 10, 2011

Algorithmic trading -- the positive side

In researching a forthcoming article, I happened upon this recent empirical study in the Journal of Finance looking at some of the benefits of algorithmic trading. I've written before about natural instabilities inherent to high-frequency trading, and I think we still know very little about the hazards presented by dynamical time-bombs linked to positive feed backs in the ecology of algorithmic traders. Still, it's important not to neglect some of the benefits algorithms and computer trading do bring; this study highlights them quite well.

This paper asks the question: "Overall, does AT (algorithmic trading) have salutary effects on market quality, and should it be encouraged?" The authors claim to give "the first empirical analysis of this question." The ultimate message coming out is that "algorithmic trading improves liquidity and enhances the informativeness of quotes." In what follows I've given a few highlights -- some points being obvious, others less obvious:
From a starting point near zero in the mid-1990’s, AT (algorithmic trading) is thought to be responsible for as much as 73% of trading volume in the U.S in 2009.
That's no longer news, of course. By now, mid-2011, I expect that percentage has risen to closer to 80%.

Generally, when I think of automated trading, I think of two activities: market makers (such as GETCO) and statistical arbitrage high-frequency traders, of which there are many (several hundred) firms. But this article rightly emphasizes that automated trading now runs through the markets at every level:

There are many different algorithms, used by many different types of market participants. Some hedge funds and broker-dealers supply liquidity using algorithms, competing with designated market-makers and other liquidity suppliers. For assets that trade on multiple venues, liquidity demanders often use smart order routers to determine where to send an order (e.g., Foucault and Menkveld (2008)). Statistical arbitrage funds use computers to quickly process large amounts of information contained in the order flow and price moves in various securities, trading at high frequency based on patterns in the data. Last but not least, algorithms are used by institutional investors to trade large quantities of stock gradually over time.
One very important point the authors make is that it is not at all obvious that algorithmic trading should improve market liquidity. Many people seem to think this is obvious, but there are many routes by which algorithms can influence market behaviour, and they work in different directions:
... it is not at all obvious a priori that AT and liquidity should be positively related. If algorithms are cheaper and/or better at supplying liquidity, then AT may result in more competition in liquidity provision, thereby lowering the cost of immediacy. However, the effects could go the other way if algorithms are used mainly to demand liquidity. Limit order submitters grant a trading option to others, and if algorithms make liquidity demanders better able to identify and pick off an in-the-money trading option, then the cost of providing the trading option increases, and spreads must widen to compensate. In fact, AT could actually lead to an unproductive arms race, where liquidity suppliers and liquidity demanders both invest in better algorithms to try to take advantage of the other side, with measured liquidity the unintended victim.
This is the kind of thing most participants in algorithmic trading do not emphasize when raving about the obvious benefits it brings to markets.

However, the most important part of the paper comes in an effort to track the rise of algorithmic trading (over roughly a five year period, 2001-2006) and to compare this to changes in liquidity. This isn't quite as easy as it might seem because algorithmic trading is just trading and not obviously distinct in market records from other trading:
We cannot directly observe whether a particular order is generated by a computer algorithm. For cost and speed reasons, most algorithms do not rely on human intermediaries but instead generate orders that are sent electronically to a trading venue. Thus, we use the rate of electronic message traffic as a proxy for the amount of algorithmic trading taking place.
 The figure below shows this data, recorded for stocks with differing market capitalization (sorted into quintiles, Q1 being the largest fifth). Clearly, the amount of electronic traffic in the trading system has increased by a factor of at least five over a period of five years:


The paper then compares this to data on the effective bid-ask spread for this same set of stocks, again organized by quintile, over the same period. The resulting figure indeed shows a more or less steady decrease in the spread, a measure of improving liquidity:


So, there is a clear correlation. The next question, of course, is whether this correlation reflects a causal process or not. I won't get into details but what perhaps sets this study apart from others (see, for example, any number of reports by the Tabb Group, which monitors high-frequency markets) is an effort to get at this causal link. The authors do this by studying a particular historical event that increased the amount of algorithmic trading in some stocks but not others.The results suggest that there is a causal link.

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. 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. Like Nasdaq market makers refusing to answer their phones during the 1987 stock market crash, algorithmic liquidity suppliers may simply turn off their machines when markets spike downward.

This resonates with a general theme across all finance and economics. When markets are behaving "normally", they seem to be more or less efficient and stable. When they go haywire, all the standard theories and accepted truths go out the window. Unfortunately, "haywire" isn't as unusual as many theorists would like it to be.

** UPDATE **

Someone left an interesting comment on this post, which for some reason hasn't shown up below. I had an email from Puzzler183 saying:

"I am an electronic market maker -- a high frequency trader. I ask you: why should I have to catch the falling knife? If I see that it isn't not a profitable time to run my business, why should I be forced to, while no one else is?

You wouldn't force a factory owner to run their plant when they couldn't sell the end product for a profit. Why am I asked to do the same?

During normal times, bid-ask spreads are smaller than ever. This is directly a product of automation improving the efficiency of trading."

This is a good point and I want to clarify that I don't think the solution is to force anyone to take positions they don't want to take. No one should be forced to "catch the falling knife." My point is simply that in talking about market efficiency, we shouldn't ignore the non-normal times. An automobile engine which uses half the fuel of any other when working normally wouldn't be considered efficient if it exploded every few hours. Judgments of the efficiency of the markets ought to include consideration of the non-normal times as well as the normal.

An important issue is to explore if there is a trade-off between efficiency in "normal times" as reflected in low spreads, and episodes of explosive volatility (the mini flash crashes which seem ever more frequent). Avoiding the latter (if we want to) may demand throwing some sand into the gears of the market (with trading speed limits or similar measures).

But I certainly agree with Puzzler183: no one should be forced to take on individual risks against their wishes.

56 comments:

  1. Great article about (not catching the falling knife). Over a longer period, with all the market maker & AT activity, it's hard for individual lone investors like myself to make money.

    However, it runs against the purpose of stocks in the first place as a way for individuals to own pieces of corporations and take part in their rewards. Without review of the company itself, core strengths, weaknesses, opportunities, and threats, the benefits of going short are hedged by folks like me :)

    Glad to take one for the team, anytime.

    ReplyDelete
  2. Computers can be gamedOctober 5, 2011 at 10:22 AM

    I have a strong background in econometrics and pure mathematics, including some familiarity with what are know as Impossibility Theorems. Goedel's is one of the best known of this lot as an example.

    Apparently there is a great deal of money to be made in market-making. I however see no way to use algorithmic trading for consistently good investing decisions (long-term). it is very similar to the job of economic forecasting, which is quite difficult to do accurately very far out and breaks down completely when historical data sets diverge from current conditions. You will note that quant funds tend to break down when tail events occur. Look at the performance of quant index-plus funds versus human-input index-plus funds during periods in which market conditions are ahistoric.

    Then one might say, well, stop the algorithm when the times are ahistoric. Which raises the question, how do you know with a large enough set of variables what is ahistoric and what is not.

    My strong suspicion is that there is an impossibility theorem at work here. Whether some combination of human input and algorithmic investing might be superior to one based just on human input is an interesting question. (Investing, not trading.) My guess is that computers can help identify from a large number of securities a small number worth "looking at," to improve the efficiency and scope of an investor.

    To use an apt analogy - one may be able to use a computer-driven algorithm to provide a person with a list of ten people they may want to meet to date, but only by meeting can the person possibly decide which, if any, might be a possible mate, or which would be the best mate. It is for similar reasons that psychologists will not do therapy over the phone (too little data, not articulable or quantifiable). This notion that computers could do such tasks very efficiently strikes me as akin to Whitehead's hope of systemizing mathematics, which Goedel showed to be in effect impossible.

    ReplyDelete
    Replies
    1. Remind us about Goedel's Theorem. It's the one about completeness and consistency not being possible in the same algebra, is that right?

      Delete
  3. the problem with algorithms is that they are created by humans.

    it would be possible that if company A knew of the algorithm of company B, company A would know of company B knowledge even before company B, but as described above - this might not even be possible unless the 2 algorithms actually meet :) p.s. I'm not a robot

    ReplyDelete
  4. Algorithmic Trading the positive side is a nice article.The main advantages of Algorithmic Trading include, the speed of Order Entry in to the market, controling or minimizing human emotions and enforcing discipline in your trading, the ability to back test, the ability to obtain consistency and diversify your trading.

    ReplyDelete
  5. A new crop of algorithmic trading platforms tries to turn amateurs into math-driven mini-hedge funds. algorithmictradingportfolio.com Admin

    ReplyDelete
  6. I think that computers can help identify from a large number of securities a small number worth "looking at," to improve the efficiency and scope of an investor.
    best way to trade stocks

    ReplyDelete
  7. Its always good to learn tips like you share for blog posting. As I just started posting comments for blog and facing problem of lots of rejections. I think your suggestion would be helpful for me. I will let you know if its work for me too. Travel Tips and Guide

    ReplyDelete
  8. After reading this article qualitative research analysis becomes so easy to understand. It also add some valuable things.

    ReplyDelete
  9. Top automated trading strategies
    robo advisor canada
    The robo advisor Canada is gaining importance among the investors around the globe.

    ReplyDelete
  10. Its a great pleasure reading your post.Its full of information I am looking for and I love to post a comment that "The content of your post is awesome" Great work custom designed shirts

    ReplyDelete
  11. I will probably be coming back to your weblog for more soon what to text your ex girlfriend to get her back.mtn data plans

    ReplyDelete
  12. it’s horribly exciting to be able to examine on the market habit observe this kind of exhibit write-up. I just now desire to many thanks to your exceptional accomplish.mortgage brokers london

    ReplyDelete
  13. Thank you very much has been sharing the information very helpfull mortgage broker barrie

    ReplyDelete
  14. Glorious info in your weblog, thanks for taking the time to share with us. Superb perception you have got on this, it is good to discover a web site that particulars a lot details about completely different artists.rebate for you

    ReplyDelete
  15. The New York Musical Theatre Festival highlights the best and brightest upcoming stars of musical theatreERP Users email list

    ReplyDelete
  16. Hey! I have read all your Blog this So Nice and Awesome service you have provided, I learn many new things from here and want implement my website. If you are also Know for Algorithmic Trading Courserelated to this then visit my website.

    ReplyDelete
  17. Thanks for this great post. Download nova launcher app from: nova launcher prime features apk

    ReplyDelete
  18. Great information, really loved to read this blog post. Find latest version of clone hero from this site: clone hero mac

    ReplyDelete
  19. There is no doubt this will get you amp’d up for a good weightroom workout. This is the 2nd edition of Brian Eno’s art software project.Resin Drives Diy Kit

    ReplyDelete
  20. One of our efforts to continue the struggle of the heroes who have fallen is to improve the nation's science and can through a site like this by sharing the Science beneficial form of news.Tenerife

    ReplyDelete
  21. I am really enjoying reading your well written articles. It looks like you spend a lot of effort and time on your blog. I have bookmarked it and I am looking forward to reading new articles. Keep up the good work.bed bug extermination

    ReplyDelete
  22. Thank you so much for sharing this valuable information with us. Kalakutir Pvt Ltd provides the top quality Food Truck Branding and Indoor & Outdoor Advertising.
    Indoor & Outdoor Advertising

    ReplyDelete
  23. Thanks for this valuable information. Visit Protrek Adventure for the best Everest Base Camp Trek(EBC) and Annapurna Base Camp Trek(ABC) at the best price.
    Everest Base Camp Trek

    ReplyDelete
  24. I have read your articles many times and I am always inspired by your tips and knowledge. Thank you for sharing.
    Share market tips

    ReplyDelete
  25. Get the best Aluminum caps & Closures Machinery and Aluminum Foil Converting Machine Suppliers in Delhi in top quality at sarswati enterprises.
    Aluminum Foil Converting Machine Suppliers in Delhi

    ReplyDelete
  26. Intelligent Algorithmic Trading Systems

    Indias Most Building Winning Mechnical Auto Trading Robot for NSE, BSE & MCX. For More Details. Call - +919738956761

    to get more - https://mytrendsoftware.com/

    ReplyDelete
  27. Intelligent Algorithmic Trading Systems

    Indias Most Building Winning Mechnical Auto Trading Robot for NSE, BSE & MCX. For More Details. Call - +919738956761

    to get more - https://mytrendsoftware.com/

    ReplyDelete
  28. Effective trading strategies

    Indias Most Building Winning Mechnical Auto Trading Robot for NSE, BSE & MCX. For More Details. Call - +919738956761

    to get more - https://mytrendsoftware.com/

    ReplyDelete
  29. Effective trading strategies

    Indias Most Building Winning Mechnical Auto Trading Robot for NSE, BSE & MCX. For More Details. Call - +919738956761

    to get more - https://mytrendsoftware.com/

    ReplyDelete
  30. Really nice, keep it up for more valuable information. Visit Veramed for Sensitive Skin Body Moisturizer Online and Pearl Glow Ayurvedic Skin Care Products at affordable price.
    Buy Pearl Glow Herbal Skin Care Products

    ReplyDelete
  31. You can open a Savings account in Dubai in Mashreq bank UAE. That is the oldest and top private bank in UAE.

    ReplyDelete
  32. Excellent!! This One Blog Is Awesome, thanks for sharing this impotent Information Please share me about Golden Triangle India Tour

    ReplyDelete
  33. Really Interesting Blog, keep it up for more updates like this valuable blog. Digitaginfo provides the best SEO Services in Delhi, Noida, and Gurgaon. Here you will get professional Digital Marketing Services by the Experts.
    SEO Services in Delhi

    ReplyDelete
  34. Superb, thank you so much for sharing such amazing information. Visit Bidz365 for List of Items on Gem Portal and MSME Registration Services in Delhi.
    List of Items on Gem Portal

    ReplyDelete
  35. Nice Blog. As a leading Job Recruitment in Delhi, Rosiroti provides one of the best Job Vacancies for Freshers in India.
    Job Vacancies for Freshers

    ReplyDelete
  36. Trucks &Trailers for rent in Sharjah . Get comfortable trucks, trailers for cheap rent. Flatbed trailer available for rent. We are providing Transportation services with (40ft) long Trailer in Sharjah. Trailer Leasing & Rental Service's In Sharjah UAE.

    ReplyDelete
  37. This comment has been removed by the author.

    ReplyDelete
  38. Thanks for sharing this post on algorithmic trading positive side. Homeowner management service

    ReplyDelete
  39. Thank you so much sharing such an amazing blog. It’s really helpful for me. Visit for Karnataka Scholarship

    ReplyDelete
  40. Get one of the best Import Export data services by Importglobals for China, Pakistan, Ukraine, USA, and Turkey by the brilliant import-export experts of Importglobals.
    China Import Data
    Pakistan Import Data
    Ukraine Import Data
    USA Import Data
    Turkey Import Data

    ReplyDelete

  41. شركه عزل فوم بالدمام

    شركه عزل اسطح بالدمام

    شركه عزل فوم بالقطيف

    شركه عزل فوم بالاحساء

    شركه عزل فوم بالجبيل
    شركة تنظيف خزانات بجدة شركة تنظيف خزانات بجدة تقدم جميع الخدمات المتعلقة بالخزانات من تنظيف وغسيل وتعقيم إلى الإصلاح والصيانة والعزل. شركة تنظيف خزانات بجدة

    ReplyDelete
  42. I really happy found this website eventually. Really informative and inoperative, Thanks for the post and effort! Please keep sharing more such blog. 광양출장마사지
    나주출장마사지
    목포출장마사지
    순천출장마사지
    여수출장마사지
    익산출장마사지
    정읍출장마사지

    ReplyDelete
  43. I really happy found this website eventually. Really informative and inoperative, Thanks for the post and effort! Please keep sharing more such blog. 남원출장마사지
    군산출장마사지
    전주출장마사지
    김제출장마사지
    김해출장마사지
    밀양출장마사지
    사천출장마사지
    양산출장마사지

    ReplyDelete
  44. Es ist kein Geheimnis, dass die Scouts von Real Madrid den brasilianischen Markt in den letzten Jahren genau beobachtet haben, während sie nach den besten jungen Spielern des Weltfußballs suchen.
    Günstig Trikots Fußball Kinder
    Fussball Trikot Shop Online
    Fussballtrikot Fans Online

    ReplyDelete
  45. Fantastic blog! Continue to provide posts like this one, which is really interesting, and thank you for sharing this useful information.

    custom erp development

    ReplyDelete