
Algorithmic trading -- the positive side - gabaix
http://physicsoffinance.blogspot.com/2011/08/algorithmic-trading-positive-side.html
======
gabaix
"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."

~~~
joe_the_user
Ah,

But is it real liquidity or the illusion of liquidity?

Liquidity is, more or less, money ready to be invested.

The question of whether sophisticated strategies really provide this is
complex, like the strategies themselves. If you want background, I think Doug
Noland's Credit Bubble Bulletin has done a good job of addressing these
questions over the years.

At the same time, I think we can see simple things. The big question isn't
day-to-day-liquidity but liquidity-when-you-need it. By that measure, when we
look at recent and older wild-swings in the market and especially the "flash
crash", it seems fairly evident that the spectrum of "sophisticated
strategies" don't provide liquidity-when-you-need-it and that is increasingly
a problem.

~~~
joshu
No. Liquidity is the measure of the ease with which it is easy to trade a
given item. That is to say, shares of IBM are pretty liquid, treasury bonds
are very liquid, and dollars are extremely liquid. But your car is not
particularly liquid.

The rest of your analysis is nonsense.

~~~
joe_the_user
Liquidness - has easily a thing can be liquidated, how easily it can be turned
into cash. _Liquidity_ \- cash waiting to buy the thing and liquidate it. A
"liquid market", though, is normally a market with lots of liquidity rather a
market which can be easily sold.

The existence of money to be invested is what makes a stock markets liquid...

Money to be invested is the necessary ingredient of a "liquid market". And a
liquid market is a complex thing to measure. A market can easily seem liquid
if lots of shares trade. But if it's the same shares over and over again on a
day-to-day basis and if any time a large block appears, the price goes way
down, then the market has an illusion of liquidity rather than real liquidity.

~~~
joshu
[http://www.investopedia.com/terms/l/liquidity.asp#axzz1UscLt...](http://www.investopedia.com/terms/l/liquidity.asp#axzz1UscLt1Wj)

------
jessedhillon
For further reading, here is a survey of different professors and
practitioners in the field, and their take on questions related to the market
impact of HFT. It's a very thorough discussion:
<http://www.conatum.com/presscites/HFTMMI.pdf>

------
georgieporgie
My understanding of liquidity in the stock market is that it refers to being
able to quickly sell stock, and minimally affect the price of said stock by
the sale.

I see the value of the former, having an asset you can't sell means its value
is rather pointless, but I'm not sure I seed the point of the latter. Isn't
money made in the stock market by price volatility? Doesn't algorithmic
trading simply smooth out price fluctuations to the point that individual
traders receive nothing, while HFT houses skim immense numbers of tiny
slivers?

It seems to me that we're moving toward the future that some people want: that
we only invest in companies which we believe have real growth or dividend
payout potential over the long term. Meanwhile, money will continue to be made
by "gambling" on price fluctuations, but only by high frequency traders.

I can't help thinking that liquidity has diminishing returns, and I definitely
think that claims of HFT value are heavily undermined by their tendency to
drop out of the market during crashes.

If I'm wrong in these views, I would love to be enlightened.

~~~
yummyfajitas
_Doesn't algorithmic trading simply smooth out price fluctuations to the point
that individual traders receive nothing, while HFT houses skim immense numbers
of tiny slivers?_

Yes. Good speculation smooths out price fluctuations to the point that bad
speculators receive nothing, while good speculators receive all the alpha.
This is true not only of HFT, but of any good strategy.

 _...claims of HFT value are heavily undermined by their tendency to drop out
of the market during crashes._

If you don't want HFT and other speculators to drop out of the market during
crashes, don't break trades after the fact.

During a crash, most HFT's should make money hand over fist. But if the market
centers break trades, HFT's are in danger of stabilizing the market and being
heavily penalized for it.

I.e., if an HFT pushes accenture up from $0.05 to $1.00 and sells at $35,
following which accenture eventually goes up to $40, they run the risk of
having their $1.00 buy trade broken. Then they are stuck with a short sale at
$35, while the price of accenture went up to $40.

~~~
copper
> I.e., if an HFT pushes accenture up from $0.05 to $1.00 and sells at $35,
> following which accenture eventually goes up to $40, they run the risk of
> having their $1.00 buy trade broken. Then they are stuck with a short sale
> at $35, while the price of accenture went up to $40.

Shouldn't both trades be broken, though? Breaking just one sounds like the
kind of behaviour that would be a strong disincentive to trade at all in the
first place.

~~~
yummyfajitas
_Shouldn't both trades be broken, though?_

Under current market rules, no. Besides, this would quickly become a
combinatorial disaster. Think of your counterparty who bought at $35 and sold
at $36 - now one leg of his trade gets broken, and he has a short position. Or
maybe we break both of his trades? Where does the chain end?

And of course, this still hurts people doing stat arb. If you want to go long
accenture, short IBM, and your accenture trade is broken, you find yourself
with an unhedged IBM short.

 _Breaking just one sounds like the kind of behaviour that would be a strong
disincentive to trade at all in the first place._

This is why HFT's pull out of the market under circumstances where broken
trades become likely. Most of the HFT's that stayed in the market during the
flash crash made huge money - volatility rocks.

~~~
copper
Thanks, thats interesting. It seems unfair to use the HFT to create stability,
and then penalize it for that. I suppose that can't be fixed easily, though.

