
Insights into High Frequency Trading from the Virtu IPO [pdf] - chollida1
https://online.wsj.com/public/resources/documents/VirtuOverview.pdf
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smallnamespace
Note that the key assumption for why losses are unlikely is that they make
many independent trades that are each likely to be profitable.

But in real markets, outside events can suddenly make many trades all fail at
the same time. This is the same reason AAA tranches of CDOs got those high
ratings -- you only lose money if many obligations fail at once, but that is
extremely unlikely if you think they have low correlation with each another,
which was historically the case.

But in a market crash, all correlations will tend towards 1.

~~~
SEJeff
Not exactly, a firm like Virtu makes money due to volume and volatility. If
the market goes up, they make money, if it goes down, they make money. They
don't make money when they break things, or when the volume (and volatility)
is low.

Source: Worked at Madison Tyler / Virtu for over 4 years, but left before
their IPO.

~~~
ravibala1
Not sure I understand why we can assume that its all trades are entirely
"independent" here.

Agree with you that HFT performance is not correlated with market direction.
But given the volume of trades it would imply that many of the trades are
occurring on a smaller pool of equity instruments. I'd think that given
liquidity constraints and competition that there's a sweet spot in terms of
number of stocks that a given strategy is actually efficient on.

So not entirely sure why we consider every trade to be iid - rapid shocks
(flash crash), equity specific news etc would affect a number of trades at
once changing the 51% probability?

Also does anyone know if the profitability numbers include payments to be a
market-maker?

~~~
tcbawo
Market makers typically have a requirement to be in the market a certain
(high) percentage of the time. In return, they get rebates (which can be a
significant source of revenue) and protections from the exchange against
overfilling. This can help them for certain shock events.

Most likely, though, their profitability % is tuned by edge and risk
parameters. They can adjust size, widen out, or tighten up the spread to tune
trade frequency and profitability. They are finding a sweet spot between # of
trades and profitability.

------
chollida1
When HFT firm Virtu went public they announced they had one loosing day in 6
years.

A physics professor explained how this was possible by using the law of large
numbers and some basic assumptions.

~~~
arcanus
I was offered a job at virtu, and met people who discussed this in the
interview. They had backtested the model but apparently it had a slight bug.
After fixing it they claimed to have made much more than the loses.

------
ealloc
Summary:

\-- Their trades are profitable f = 51% of the time, and they do N = 3 million
trades per day.

\-- Their net profitability per day is thus (well approximated by) a normal
random variable with a mean of f and a standard deviation of sqrt(f(1-f)/N),
or 3e-4

\-- The probability of this value being less than 50% is well approximated by
norm.cdf(0.5, 0.51, sqrt(f(1-f)/3e6)) which gives 2.4e-263

In other words they only expect one loss per 10^263 days, which is much larger
than the age of the universe. They are actually doing much worse than expected
because they lost on one day.

~~~
pg314
So something is obviously wrong with their model.

~~~
phdp
Most likely fat tails. A normal distribution is probably not a valid
assumption

------
the_cat_kittles
to me this is a perfect example of how incredibly indifferent capitalism can
be to creating value. no one is bad here, per se, but its useless as far as i
can tell, and someone gets very very rich. nothing wrong with capitalism of
course, but i feel the need to keep harping of the fact that it doesn't
necessarily imply anything about value or desert.

edit: every time i make a comment along these lines, its interesting to see...
it seems like HN is split about 50/50 on this. is it that this point is trite?
or that you disagree?

~~~
aaronchall
Trading firms create value by providing liquidity.

If they can buy low and sell high, they will be buying when there are
relatively fewer other buyers, and sell when there are relatively few other
sellers.

This activity creates value for other people who want to trade in those
circumstances.

If no value was created, there would be no value to capture.

And the prima facie evidence that they are creating value is that they are
capturing value from willing market participants.

This is fundamental economics.

~~~
hsitz
> Trading firms create value by providing liquidity.

Obviously true when they're added to market with little to no liquidity.

But hard to see as true when you're adding them to market that is already
extremely liquid. At least, it's a statement that needs some empirical
justification in that case, to show that the value from marginal liquidity
being added (which is tiny) offsets the waste of the incredible amount of
human effort used to create it.

~~~
tptacek
Just substitute "cost of trading" with "liquidity".

It's true that at this point, now that market making is pretty much all
automated, there isn't much more cost to squeeze out of this component of the
market. But be careful not to imply that liquidity is binary: the more
liquidity you have, the less it costs to buy or sell something.

~~~
hsitz
I'm not implying that liquidity is binary. I'm implying that it does not scale
linearly, but rather exponentially towards an asymptote. That is, you can add
as much as you want, the total amount approaches a limit.

Said a different way, with your "trading costs" substitution: If x amount of
human effort is required to reduce trading costs from, say, 5% of a
transaction to 0.001%, perhaps (let's assume) that's justified. But is it then
wise for a society to encourage expenditure of 10x more effort just to reduce
costs to 0.0001%? (This analogy doesn't really hold, because cost of trading
could be 0 and there could still be 0 liquidity, just no other parties
interested in buying or selling, but it still seems to point at a real issue
when restricted to talking about liquidity.)

~~~
consz
I think an interesting point you might consider -- let's suppose there is such
a thing as "too much" liquidity, and as a corollary, there's a "perfect"
amount of liquidity. What do you think happens when more liquidity than the
perfect amount is introduced?

I think a lot of arguments which support the idea of HFT being too much
liquidity seem to take, as a premise, that the extra liquidity costs consumers
-- namely, non-HFT participants in the market trading against the HFTs, the
"buyers" of liquidity. Does it? If you have too much liquidity, doesn't that
just mean that the buyers don't buy any of it? They saw as much liquidity as
they needed, completed their trades, and went home. It seems like the actual
cost of too much liquidity is HFT firms which send orders that don't get
traded against, so they have no benefit (to the HFT), but still have a cost
(the firm has to run, after all). Yes, there's some cost to society here, in
the same way that there's a cost any time someone takes on a speculatively
profitable business that turns out not to be.

I'm sure there are some strong arguments you could make that HFTs are
unnecessary, but the argument of "too much" liquidity always felt shaky to me
(in part, because it's one of those arguments that relies on playing fast and
loose with nebulous terms).

~~~
ultraluminous
But he didn't argue we have "too much" liquidity. The argument is that we have
"enough" liquidity and are now expending a huge volume of capital on a
literally imperceptible increase in liquidity.

~~~
consz
My point is that I don't think it's a huge volume of capital. The extra wasted
capital here is the cost of running an HFT firm while you test your strategy
(aka. see if your liquidity is valuable or not) -- if it's not profitable,
it's not a huge loss (HFT firms, in the grand scheme of things, are relatively
small) and the firm shuts down; if it's profitable, then clearly they're
trading against non-HFTs that value their liquidity, so what's the issue here?

------
infecto
I generally like HFT. I do not like front running or information advantages
that have happened in the past.

Spreads these days are the lowest in history. What many people fail to realize
is that before electronic market makers (I almost want to eliminate the name
HFT), people sat in between these trades. It was slow, inefficient and they
took a larger spread on the trade.

~~~
metaphorm
this seems contradictory to me. HFT is basically predicated on front-running
information advantages. It wouldn't be profitable otherwise.

maybe you can explain in more detail?

~~~
tptacek
HFT is in basically no sense predicated on front-running. Front-running is an
agency problem: it occurs, for instance, when you're trading on behalf of
someone else, and before you execute their orders, you submit your own orders
that benefit you at the expense of your client.

The whole premise of the market is that people have informational advantages.
They don't work without it. The point is that they aggregate the information
of all the participants. You can call that, or anything else, "front-running",
but that's a meaningless definition.

~~~
metaphorm
let me be more specific since I think you're misinterpreting me because I
wasn't specific enough.

hedge-funds that execute a strategy based entirely on leveraging HFT as a
means to take advantage of information arbitrage (such as they kind that a
fund taking trade orders from its clients would have) are predicated on having
that information advantage "front-running".

HFT in different contexts is just machine execution of trade orders and isn't
what I was asking about.

~~~
tptacek
That's not how a hedge fund works. Hedge funds trade on behalf of other
people, but their clients have equity stakes in the fund itself; they're not
asking the hedge fund to trade _their own positions in things_. Hedge fund
customers don't inject tradable information.

The canonical example of a front-runner is a broker trading on behalf of (say)
a pension fund. The pension fund wants to offload (say) all its shares in
CSCO, and pays a broker to do that. That trade is complicated and will move
the market. The broker front-runs by first trading CSCO for its own accounts,
at the expense of its clients.

An "HFT-enabled" broker could front-run its own clients, but (a) they don't
need HFT to do that; they have (relatively speaking) all the time in the world
to act on the confidential information that their client is offloading a large
block of CSCO, and (b) _they 're the ones complaining about HFT and setting up
new exchanges to combat it_.

------
kordless
Electronic arbitrage. Interesting, scalable with compute, and highly risky, if
you aren't careful or fast enough.

------
Kenji
I don't know why HFT exists at all. I would just pass a law that forces a bit
of random latency/noice in the market data, in the order of seconds (in a
similar way as GPS has artificial inaccuracy). Normal people are not gonna
notice and all this HFT garbage is completely eliminated. Win win.

~~~
Glyptodon
I agree that it's likely not particularly useful for the market to care about
things in millisecond resolution.

~~~
sidlls
That's a very clever comment, but I think you should include something
indicating why for those who don't know how HFT works.

~~~
ForHackernews
If nothing else, it means that firms that can afford to collocate their
servers in the cage next to the exchange's servers have an advantage over
those that can't.

It seems like something like the roundtrip time for a packet from NYC to Tokyo
would be a fair "speed limit" for exchanges, and ensure that all firms,
globally, are on an even footing.

~~~
MichaelGG
I think you'll find, when you try to get down into it, there's no easy way to
enforce a speed limit. It's a naturally arising behaviour. You could try
making a market that crosses orders every X seconds, but then you move the
speed to the edge of those periods.

If you wanna slow down HFT, then kill the stupid restriction that stocks be
priced in pennies. With 8 digits of resolution, HFTs would then be forced to
compete on price.

~~~
ForHackernews
That's an interesting idea. Is that rule just a holdover from the days of
manual accounting?

~~~
consz
From my own conversations with exchanges -- I think this is just the exchange
appealing to layman investors. The exchange wants to appear liquid, and they
like to do this by having a lot of shares on the best bid or offer. If you
reduce the tick sizes, you'll definitely see fewer shares on the inside bid or
offer (even though you'll see _more_ shares on the inside x% for any x, aka.
you'll see more liquidity), but the layman investor (e.g. mom and pop, retail
traders, people like brad katsuyama, etc.) will suddenly think you're _less_
liquid because the best price now has fewer shares.

That's, at least, the strongest argument I've heard for why tick sizes aren't
reduced more rapidly.

