
Quants and the crash - Maven911
http://wired.com/business/2012/08/ff_wallstreet_trading/
======
ozataman
What a boring, presumptuous article ridden with hyperbole. I'm getting tired
of these popular magazines picking up a cool-sounding subject, a recent mishap
and selling the whole thing as if it will completely obliterate the old ways.
Oh and add a few awesome words (algorithms, speed of light, 3 feet of fiber,
quantum mechanics,...) that they hope will make the reader think he's in the
23rd century. Half of the article is basically repeated fancy sentences like
"Faster and faster turn the wheels of finance, increasing the risk that they
will spin out of control"...

Let's be serious. Value-based investment is not going away and high frequency
trading is just one more avenue through which a decent number of companies,
and so people, will take advantage of an opportunity and do well.

Who is supposed to be the target audience of Wired these days?

~~~
light3
Further, many articles describing financial failures of a similar flavour will
blame the "Quants", whereas in reality they have little power and merely
provide the means to execute an idea. With nobody willing/able to regulate
against such practices, they will continue to remain a valid avenue for value
generation.

------
dbecker
In the hand-wringing over Knight's mistake, the media seems to be missing the
massive benefit to many other traders. Specifically, Knight kept buying
certain stocks even as they were driving up prices of these stocks. Everyone
who sold these stocks to Knight got the benefit of selling it for a higher
price.

So, Knight didn't destroy wealth. It just made an unintended gift to people
willing to sell them overpriced stock.

~~~
rayiner
The flip side of this coin is that when Knight "makes money" it isn't creating
wealth either.

~~~
Variance
That's not true, because the idea that Knight's mispurchases were zero-sum
isn't correct either.

All business enterprises, including stock trading, only operate when their
returns can exceed the discount rate of the market [1]. This means that
overall, the returns of all players in the stock market will tend to exceed
4-5% on average, and on a time-averaged basis. As a result, the S&P 500 has
tended to yield an average return of 5% over the last decades [2]; it was
higher before that when markets were younger.

What this means is that the stock market isn't zero-sum, but via the EMH, adds
value to the economy. The first question you'll probably ask is, but _how_?
The answer is that returns are made by making prices for assets, in this case
stocks and other securities, more accurate. When the market has accurate
prices it functions more smoothly [3], and this smoothness is attributed to
stock investors, who make a profit from doing it.

This means that the market is benefited when prices are made more accurate--
that is, when companies make profitable stock purchasing decisions. It's
harmed when companies make unprofitable decisions. While other companies will
buy Knight's errant stocks, their profits will ideally be less than Knight's
loss, due to frictional costs. Goldman is just making a marginal profit on
these purchases; Knight is taking a $440 million loss. Goldman isn't going to
make $440 million on reselling Knight stock. This difference means that the
transactions should ideally be a net loss to the market overall, because they
were purchased in error and the time integral in the deviations caused in the
affected stock prices is the factor by which the broader economy is harmed.

But yes, when the market functions correctly, it creates wealth by making
prices accurate (price discovery [4]). When it functions incorrectly, a la
Knight capital, prices are distorted and wealth (in this case the value of
correct prices) is eliminated.

[1]<http://en.wikipedia.org/wiki/Capital_asset_pricing_model>

[2][http://en.wikipedia.org/wiki/S%26P_500#Total_annual_returns_...](http://en.wikipedia.org/wiki/S%26P_500#Total_annual_returns_.28b.29)

[3][http://www.investopedia.com/articles/basics/09/the-
function-...](http://www.investopedia.com/articles/basics/09/the-function-of-
speculators.asp#axzz22gEQ6BrT)

[4]<http://news.ycombinator.com/item?id=4226738>

------
SeanDav
This whole process could easily be sorted by simply requiring that every quote
is good for at least 1 second and that quotes are only updated every second,
on the second timed from a basket of atomic clocks.

The chances of this actually happening - yes you guessed it - zero. Too many
stakeholders making too much money on the status-quo.

~~~
prodigal_erik
I'd make it five minutes. If HFTs want to claim adding liquidity as legitimate
value they're offering to the market, let them add it in a way that human
decision-makers thinking about fundamentals can benefit from, rather than just
gaming the way the market clears and scalping imminent trades. It's not as if
the true value of a company can change faster than that.

~~~
simonh
You bet your bottom dollar it can. Have you ever seen activity on the CME when
the non farm payroll numbers are published? Five minutes might as well be all
week.

~~~
prodigal_erik
That's just the market converging on current reality, which changed gradually
over the course of weeks. A company can't change its fundamentals (the goods
and services it offers) continually in fractions of a second, so any such
price fluctuations are noise rather than signal, and we shouldn't be using a
system which amplifies and reacts to that.

~~~
simonh
A company can't change it's fundamentals, no, but the market it operates in
can change in seconds. A major disaster, announcement of a government policy,
or new economic information can become available that instantly changes the
fate of a company, or even a whole industry. You really want to make laws that
stop people acting on information? Good luck with that.

------
at-fates-hands
Nothing new here - the problems with computer aided stock trading go back two
decades:

This was from an article in the NY Times back in 1989:

[http://www.nytimes.com/1989/11/09/business/market-place-
asse...](http://www.nytimes.com/1989/11/09/business/market-place-asset-
allocation-s-effect-on-volatility.html?src=pm)

"Money managers engaged in the version of program trading known as tactical
asset allocation, which involves using computer models to signal when to shift
assets among stocks, bonds and cash equivalents like Treasury bills, concede
their trades may be disruptive. But they disagree with Mr. Phelan that the
technique is as potentially destructive as portfolio insurance."

~~~
alpine
I suppose what _is_ new is the speed of execution.

------
yummyfajitas
The title is a bit misleading. What crash does it discuss?

~~~
activepeanut
I think the title refers to the Knight Capital Group incident which is
referred-to in the Editor's note:

    
    
      One of the most interesting things about the catastrophe
      at Knight Capital Group—the trading firm that lost $440
      million this week—is the speed of the collapse.

~~~
yummyfajitas
I didn't realize the market crashed as a result of the Knight Capital
incident. Hmm, let me go look at a stock chart:

<http://www.google.com/finance?q=INDEXSP%3A.INX>

I see a few 10-20 point losses at various times in the past month, but nothing
that looks like a crash.

~~~
rhizome
Yeah, "the" crash means Knight's fail.

~~~
samstave
The headline made me think is was the 2008 crash - caused by the same
issues...

------
dbuxton
What I'm confused by is the way this article talks about lower-latency
intercity links as valuable for HFT activities. Surely if you're an NY fund
you just buy servers in Chicago or wherever. Can anyone explain why these low
latency links could be valuable? (Over and above general infrastructure?)

~~~
sseveran
Because futures and options are traded in Chicago and equities are traded in
NYC (well north jersey) there are opportunities to trade equities and their
derivative counterparts. For instance SPY (S&P 500 ETF) in NYC and ES (S&P 500
futures contract) can be traded against each other as they move. However the
guy who gets their first will get most or all of the profit. So you need
servers on both sides and the lowest latency possible links between them. For
instance a microwave network is being built which shaves a couple of
milliseconds off the existing special fiber cable that traders have been
using.

------
ldayley
Why don't you let the "quants" speak for themselves outside of pop-science
news articles, they've built their own HN clone: <http://quant.ly>

------
wisty
Surely, unrealistic assumptions about rationality were the biggest factors
leading to the crash - the Fed ignored all the hazards because it would be
"irrational" for anyone to make a mistake.

Quants are mostly not big believers in rationality. They use it sometimes
("all other things being equal, the market is probably about right"), but if
they didn't think people were making mistakes they would be trying to make
money off those mistakes.

------
Tycho
Seems like a lot of the R&D that HFT funds are interested in could have great
side-effects for society. Nutrino messaging through the centre of the Earth;
fleets of drone relays over the Atlantic; super fast internet infrastructure;
research into trends of vast historical datasets; cross country wireless
networks...

------
vampirechicken
I'm loathe to listen to the advice to invest in the market for the long term
when the HFTs (who are making lots of money) have driven the average hold time
down to under 30 seconds.

It make me feel like I'm being encouraged to put by money in the market so
ensure that there's money for the HFTs to steal.

~~~
tedunangst
If you buy and hold, the hft leeches won't have much opportunity to steal your
money...

~~~
vampirechicken
if they manipulate the market downwards my investment. is worth less. I'd buy
a stock long term for dividends. But since dividends are apparently rare these
days (something about the evil of double taxing), we're forced to invest in
the hopes that somebody will believe it's worth more later. What used to give
stocks some worth was they value of the dividend, that you'd reinvest, to
compound over the long term.

Without dividends, I think you should just invest in currencies. It's just as
volatile, and you don't have to lie to people about the nature of the
marketplace.

~~~
tedunangst
The obvious solution is to take a short position so then you profit when the
market is manipulated downward.

------
rbanffy
That's why they fail: they are running their programs on batteries instead of
servers.

[http://www.wired.com/images_blogs/business/2012/08/ragingBul...](http://www.wired.com/images_blogs/business/2012/08/ragingBull_servers1.jpg)

------
shasta
Can someone explain why trades are done continuously in real time? Wouldn't it
make more sense to have a turn-based exchange with a turn of one minute or an
hour?

~~~
ramchip
What do you do if 10 people try to buy a stock at a certain price when there
is only one on sale?

~~~
shasta
Lots of possibilities, but the simplest way to modify our existing sysyem is
probably to process requests in random order within a turn.

------
alpine
I think the market makers (who are often just skimmers) and Investment Banks
have cooked their goose. How many 'muppets' have now left the market _never_
to return because of all the outrageous revelations, scams and bad news?

