
Algorithmic Trading is Not High Frequency Trading - jeffmiller
http://talkfast.org/2011/09/13/algorithmic-trading-is-not-high-frequency-trading
======
T_S_
Accurate article? Yes I think so. Hairsplitting? A bit. Any content about the
big picture? Afraid not.

Algo trading has been around longer than HFT. It was invented to protect the
information that that a big order was being executed. This avoided the risk of
front running by handing the order to humans or scaring liquidity providers by
executing it all at once.

HFT came about when computerized exchanges began to compete with each other
for business. Nowadays you go hunting for liquidity. Speed differentials are
more important.

I think the OP is likely to agree up until here.

Today HFT in its worst form amounts to high speed computerized rumor
mongering. You game the market by bluffing orders and trading faster than your
customers. The regulators will never catch on and try to fix it even thought
the remedies are many and simple. Moreover our attitudes about who owns
information make it very difficult for us to even consider these simple
solutions.

~~~
reverend_gonzo
There are a massive number of HFT shops. Most of these are prop-shops rather
than funds, as in they trade their own money and don't take investors. They
are physically unable to front run their customers because they simply don't
have customers.

I will give you that there are some big banks getting into HFT now, and that's
a different story, but a statement like "HFT in its worst form amounts to high
speed computerized rumor mongering." is wildly inaccurate and shows a complete
lack of understanding of the industry.

Furthermore, there is a massive difference between algo trading and HFT.
Technically speaking, yes, HFT falls under algo. However, HFT is about speed
and making very little profit many times throughout the day, usually by
providing liquidity.

Algos on the other hand, especially things like high end models aren't meant
for HFT because they take larger amounts of time to run (ie: backtesting).
These are used (for example) to determine misprices in the market that will
pay off heavily in the long term, or (as others have mentioned below) to
buy/sell a large quantity of shares in a way that it won't move the market in
the other direction, rather than make an immediate, albeit tiny, profit.

~~~
T_S_
I understand the industry quite well and from experience. BTW My only daggers
were aimed at HFT.

Let me be clear. Anybody that puts an order in not expecting to get executed
but to create favorable conditions for their next order is engaging in what I
call "high speed rumor mongering". There are lots of variations of this game.
Never happens? Always happens? You tell me.

But markets aren't chess. "Rumor-mongering" is a legal term I chose on
purpose. It is generally prohibited because it destroys liquidity in markets,
which hurts investors and issuers. The term is intentionally objectionable,
but not inaccurate. Just don't trouble the regulators to figure it out.

------
sspencer
For one who works with HFT systems, an extremely refreshing clarification.

Though I do get a chuckle out of the extremely bombastic stories ("MAN
OBSOLETE? COMPUTERS TAKING OVER!!!"), it's nice to see the record set
straight. Sadly this will get 1/10000th of the page views of the garbage
articles it dissects.

------
steve8918
Absolutely terrible blog post. Saying algorithmic trading isn't HFT is like
saying a bird isn't an ostrich.

HFT is a subset of algorithmic trading. It's as simple as that. Not all
algorithmic trading is HFT. But all HFT is algorithmic trading.

Algorithmic trading is any type of trading done based on an algorithm, and not
based on "traditional investing principles". For example, "buy when the 10-day
moving average crosses over the 20-day MA, and sell when the 10-day it crosses
below 20-day". One of the most famous types of this is Richard Dennis and the
Turtle Traders, where a successful commodities trader took a bunch of ordinary
people and tried to turn them into traders using this method.

I'm also an algorithmic trader. Not a wildly successful algorithmic trader
yet, but I'm still learning and growing, and I love it more than any
programming venture I've ever been involved with. And I haven't taken a
catastrophic loss yet, so that's good. I trade on 3 separate markets using
different algorithms, and for the most part it is fully automated. I'll hold
futures contracts anywhere from 1 seconds to 20 mins.

HFT is several orders of magnitude more intense. For the most part, they are
types of arbitrage, where they can arbitrage a few cents worth of difference
in stock prices between different markets, and make a few pennies per 1000
shares. Or they will arbitrage between the price of an ETF or futures contract
and the underlying basket of stocks that it represents. These are the ones
that need colocation and trade on the millisecond. The more nefarious ones are
the ones that game the system, by "quote stuffing", by frontrunning large
orders by institutions, or by creating volatility through momentum-trading.

Is there a downside to algorithmic trading? Sure. Algorithmic trading is what
has turned the stock market from a predictive market of future earnings, into
essentially a casino, where the predictive nature of the markets is completely
dead. Instead, it's about thousands of computers running random number
generators and picking up nickels every 10 ms. This is why I believe there
will be market crashes every 7-10 years, and long term investing is dead.

But unfortunately, this is the reality of the system that we live in, and we
have to adapt or die. Or you can just buy bonds and get a stable 3-5% return
every year, which is nothing to shake a stick at.

~~~
flourpower
What evidence do you have that the stock prices have recently become less
predictive of future earnings? Was the market performing its predictive duty
in, for instance, September of 1929?

~~~
steve8918
Previously the vast majority of investors were buy and hold, where they
believed in companies and that their earnings would increase. Of course, there
were always traders like Jesse Livermore that traded off of order flow, but
those were the minority. Most were like Warren Buffett where buying and
holding was for the best.

Now the majority of trades are done by algorithms with no biases at all
towards the earnings growth of a company, be it HFT, or statistical arbitrage,
or through other quantitative models.

HFT accounts for 75% of daily volume, and by definition, HFT does not take
into consideration things like future earnings growth, etc. For the most part,
they simply find arbitrage opportunities and profit from them.

So stocks being bought and sold are not done based on the earnings potential
of a company. Case in point, Citigroup before the reverse split was trading
hundreds of millions of shares per day, not because so many people believed in
the company, but because it was dominated by rebate traders, HFT, day traders,
etc. I believe companies like Fannie Mae and Freddie Mac were trading millions
of shares before they went pink slip, even though it was known that they were
defunct.

~~~
flourpower
You're talking about volume, not price. Increased volume should, if a market
is performing "properly", accompany new information. If there's new
information, there's a reason to trade. The examples you cited seem like
evidence of the stock market's predictive value - for instance, increased
volume in Citi stock was a piece of evidence that something about the security
was expected to change.

Moreover, it's not true to say that stat-arb guys don't care about future
earnings growth - they just use statistical methods to project it. To use a
simplified example, a stat-arb guy might automatically buy shares in some
small-cap automotive supplier if Ford rapidly increases in price. If the
increase in Ford stock represents positive fundamental information about the
auto industry, they've applied that information to the price of the supplier
faster than a human would have and they'd make a profit. If, on the other
hand, it represents concern about some scandal involving the Ford CEO, they've
contributed to the noise and lost money.

~~~
steve8918
I probably wasn't clear with my original statement. I said the stock market
used to be a "predictive market of future earnings". What I meant more
precisely was that the stock market used to be a market where people would
make prediction about future earnings about companies. If you thought a
company was doing well, you would buy and hold it, a la Warren Buffett. Some
people traded order flow and other things, but the vast majority traded it as
if it was a proxy for future earnings growth.

Over the years, that has changed. Once the internet hit and day traders became
more common, it became more and more about buying stocks that will go up and
selling stocks that will go down. I think people forget that even during the
90s, commissions for buying and selling stock were in the hundreds of dollars,
not $8.95 like today. It was expensive for retail investors to buy and sell
stock.

The time period for holding stocks has decreased sharply since then, where a
few years ago rebate traders would buy and sell stock to just get the rebate
from the exchanges, and now to where HFT eat the lunch of those same manual
rebate traders.

The vast majority of trading done on the markets today is not done based on
the quality of the company or the quality of the earnings, but based on how
the stock will trade. Sure, there's still institutional trading, and I'm sure
plenty of quant models make use of things like earnings growth, etc. And yes,
things like news and fundamentals do cause prices to go up and down. But the
_vast majority_ of daily trading, 75% of volume, is done by trading entities
that don't care about fundamentals, and only care about miniscule movements in
the stock price. This is why I use volume as evidence, because it demonstrates
that most trading done isn't done because of the predictive nature of the
stock market for future earnings, but because of the extremely short term
predictive nature of the stock price itself.

That's why I said that it's less about predicting future earnings grow and
more about making nickels every 10 ms. C trading 500MM shares a day is like
people rolling dice every millisecond in the alley way and exchanging money
upon every roll. The other example that I was searching for but couldn't
recall was when GM went bankrupt and the stock was still trading over $1. This
was purely trading activity even though the "future earnings" of the stock was
0.

It's become a casino where probability theory dominate and less about "I drink
Coke so I should buy KO".

BTW, I'm not saying this is good or bad. I just believe this is how the
markets are. The same thing happened when daytraders entered the markets
during the dotcom boom. I do believe gaming the system, trying to "break" the
markets with quote stuffing, etc, is wrong, but fundamentally I believe that
the nature of the markets have changed, and anyone who wants to get involved
in it should understand the nature of the change. Anyone who thinks that they
should keep their money in mutual funds and let the mutual fund companies sip
2-5% every year for doing worse than the markets, and then also exposing
yourself to market crashes every 7-10 years, I believe, are fools.

~~~
yummyfajitas
_I said the stock market used to be a "predictive market of future earnings".
What I meant more precisely was that the stock market used to be a market
where people would make prediction about future earnings about companies._

These two statements are not even discussing the same thing.

One statement discusses the practical computational power of a system. The
other statement discusses the motivations of a majority of the people
participating in that system.

------
eftpotrm
From the article and other sources I've seen before, it seems that algorithmic
trading is not necessarily high frequency, but that high frequency trading is
necessarily algorithmic.

In which case is this not a rather thin hair to split?

~~~
pemulis
Not really. HFT is a subset of algorithmic trading, where many small orders
are placed to take advantage of intraday (or intraminute, or even intrasecond)
shifts in the spread. A large strategic order executed through an algorithm is
a different creature altogether.

The big problem when you place a huge buy or sell order is that it shifts the
price in a direction you don't want it to go. For a large sell order, the
price goes down, as the market becomes skittish about the security. For a
large buy order, the price goes up, as the market becomes bullish and
arbitrageurs quickly buy up securities to resell to you. So, many traders use
algorithms to hide their trades. The purpose of these algorithms is to _avoid_
volatility, so they shouldn't be dangerous to the market, as long as they're
designed correctly.

(Although, to be fair, algorithms may automatically stop trading when the
market becomes too volatile, which contributes to flash crashes by reducing
liquidity.)

~~~
dholowiski
"so they shouldn't be dangerous to the market, as long as they're designed
correctly". Even if we accept the author's position, why would we also make
the assumption that this software is designed properly and bug free?

~~~
shabble
I guess it depends on the stakes, and how well the traders understand (the
risks of) software development to pay for the quality, testing, and
maintenance.

 _"This isn't just some human lives we're playing with, this is serious! It
could cost us billions!"_

------
paperwork
I always find it interesting how much vitriol there is against automated
trading, even among programmers. Too many people seem to believe that a small
number of, ultra resourceful, nefarious folks are using unfair means to "game
the system." The truth, as usual, is less interesting.

Doing this type of trading doesn't require millions of dollars and teams of
PhDs. You don't have to know the right people and you don't have to know any
secret handshakes.

Critics of high frequency trading are almost always misinformed. Some of the
most informed critiques I have read about this stuff are the following books:

"A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial
Innovation" by Bookstaber

"Traders, Guns and Money: Knowns and unknowns in the dazzling world of
derivatives" by Das

And Nasim Taleb's work.

\------- More to the point, the author is explaining something very basic
(which journalists don't seem to understand): -Algorithmic trading is NOT a
general term for all trading done with algorithms/computers. It refers to
telling a computer to EXECUTE a specific trade. In other words, when your
retirement fund decides to buy A LOT of AAPL, they naturally need to spread
that trade over the whole day (or even several days). In the old days, human
traders used to do it. Now it is mostly done by computer programs.

This is different from the kind of trading where a computer decides WHAT to
trade (NOT HOW to trade). This kind of trading involves so many different
strategies that it is silly to lump them together.

There seem to be other misconceptions: -The best and the brightest are working
in Finance, instead of doing things more beneficial to society.

A quant colleague of mine, who has a PhD in Physics from an Ivy League school
told me that he, and many of his friends, left academia because there were
simply no positions for them.

-75% of trading is now automated, it is just computers trading with each other.

I hope someone will correct me if I'm wrong but I have never figured out if
this 75% includes algo trading. If it does include algo trading (my guess is
that it does), then I'm surprised it is not 100%. That is like saying 95% of
TV channels are controlled by remote-control devices.

-People seem to think that wall-street traders make their money by "trading ahead" of mom & pop investors: your Dad buys 1000 shares of microsoft, a wily trader puts your dad's order on hold, buys it for himself, raises the price, sells his shares to your dad at a higher price...thereby making money off your dad.

Your broker is not allowed to 'trade-ahead' of you. At least in the places
where I have worked, this is taken very seriously. Interestingly, high
frequency traders (who are most frequently accused of this) don't actually
have access to customer order-flow. High frequency trading hedge funds don't
generally have any client orders. Places where the two co-exist are forced to
have seperation. Traders from one department cannot share information with the
other. As more and more client facing firms (sell-side) become automated, the
chance of them actually coding up such cheats is even dumber.

Flash trading is often given as an example of people, in cahoots with
exchanges, trading on others' order information. As far as I know, "flash"
functionality exists to help clients trade more effectively. Large traders are
VERY concerned about letting the whole market know that they are interested in
some stock. Some exchanges offered the following functionality: if you are
interested in buying a stock, you have the OPTION of giving other members of
the exchange a chance to trade with you. If no one takes you up on the offer,
then the order goes to the wider market.

I have to admit that a laywer friend told me that he opposes this
functionality at his firm. If someone _really_ needs to know more, I suppose I
could ask him to explain.

-High frequency traders trade so fast that mom & pop simply can't compete with them. Their computers/networks are just too fast and they can get closer to the exchanges than anyone else.

High frequency traders are not competing with mom & pop, they are competing
with market makers. If two people hear a news item, the one closer to the
exchange will naturally get the trade done faster (presumably at a better
price). The same is (generally) true of people on the East Coast vs rest of
the country (let's assume US financial system). The same is true of people who
can click their mouse faster. Besides, there is no moral reason your Mom
should be able to dump her Enron stock faster than Joe Trader.

etc., etc., etc. \-------------

I should add that I am actually not at all comfortable with the role finance
plays in world economy. I can't call myself a critic since being critical
requires more complete understanding.

I am specifically opposed to things like direct market access. This is where
any Joe Blow can use an API to setup his trading system. If he accidently
leaves an infinite loop in his code, he can cause real problem. I remember
sweating bullets (and almost trembling) when my boss asked me to flip the
switch on the trading system I wrote. In reality, there are at least some
protections built in to keep this from happening. However, I would like to see
more uniform, consistent and better advertised rules.

I am also against the ability to trade by borrwing money from brokers (margin
trading or leveraged trading). If an individual trader screws up, they wipe
themselves out. If they borrowed money, then the consequences of their bad
trades starts to seep out to others. If more than a handful of traders,
trading on margin, go belly up, the lender could be in trouble as well...you
can see how this could ripple across a system.

Closely related to allowing trading on margin is reliance on models. Say you
have calculated that two stocks always move together. You _and your lender_
are so sure of this correlation that they think of it as the truth. What if
your calculations or your assumptions were wrong? The consequences of this
mistake may not be linearly related to the risk you thought you took. Read
Nasim Taleb's work on this for more.

Finally, those who smell something fishy should broaden their concern beyond
just modern trading system or even complex derivatives. I can see no
principal, within the framework of free markets and individualism, which leads
to condemnation of ever more automated and faster trading, more complex
instruments and more dependence of finance. The best moral principal, I can
think of, which opposes the current state of affairs, is the one uttered by
Martin Sheen's character in the movie Wallstreet: "Create, instead of living
off the buying and selling of others."

Wallstreet 2 was a piece of shit.

~~~
LiveTheDream
> I am also against the ability to trade by borrwing money from brokers
> (margin trading or leveraged trading). If an individual trader screws up,
> they wipe themselves out. If they borrowed money, then the consequences of
> their bad trades starts to seep out to others. If more than a handful of
> traders, trading on margin, go belly up, the lender could be in trouble as
> well...you can see how this could ripple across a system.

In theory, shouldn't those giving the loans account for the risk and thus be
protected from wiping out themselves?

~~~
bd_at_rivenhill
This is exactly what happened during the stock market crash of 1929, and
regulations were put into place in the 1930s to prevent excessive margin
leverage that might result in liquidity problems at brokerages (and in the
banks that lend to them). These regulations have been in place since then and
probably mitigated the effects of the dot com crash in 2000. See
<http://en.wikipedia.org/wiki/Regulation_T> as a good starting point for
research.

Interestingly, I read somewhere that there were similar regulations regarding
residential mortgage loans that were repealed during the 1980s, does anybody
have a reference to this? I think that requiring a 20% equity/debt ration when
originating or refinancing a mortgage loan probably would have made the 2008
real-estate crash look a lot more like the dot com bust and would have saved a
lot of economic pain.

------
littlegiantcap
I'd argue that there's more good than bad about algorithmic trading. People
making decisions based on fear and adrenaline is much more dangerous than
setting a pre-determined course and sticking to a mathematical model. Besides,
it's not like they just set up these programs and forget about them. If
there's some sort of flaw in the algorithm the trader isn't just going to bang
his head into the wall while he loses millions; he's going to fix the
algorithm.

------
jackgavigan
Approx 99% of what is written about algo and high-freq trading is written by
people who don't have a clue, have never worked in a trading environment (let
alone actually traded) and think they're some kind of expert because they've
read an article or two. Just remeber that the next time you read an article
(or a comment about an article) on algo/high-freq trading.

------
icandoitbetter
This is wrong. Algorithmic trading can be fully automatic as well. It just
doesn't need to operate on short time windows as HFT does.

------
joshu
execution and portfolio construction are separate things.

you can do both algorithmically, or manually, or a mix.

------
seanos
For those that are interested:

Here is a video of an extremely interesting talk, entitled "Human Traders are
an Endangered Species!", by Dave Cliff who's involved with the Foresight
project:

[http://trading-gurus.com/human-traders-are-an-endangered-
spe...](http://trading-gurus.com/human-traders-are-an-endangered-species/)

and more information on the Foresight project itself:

[http://www.bis.gov.uk/foresight/our-work/projects/current-
pr...](http://www.bis.gov.uk/foresight/our-work/projects/current-
projects/computer-trading)

------
Game_Ender
Are there not hedge funds that attempt to use algorithms to spot longer term
(ie. days, weeks, months) market trends and then buy and sell on that
information? I think it's pretty crazy to say that humans will always make the
decisions, computer can process more information faster then any human can. At
some point computer programs will be able to make more accurate market
predictions then humans, and at that point the "robots" really will be in
control.

~~~
eru
Though we still haven't reached the level where programs write themselves.

------
flourpower
Isn't the claim that algorithmic trading will never replace human decision
making basically equivalent to the claim that humans will never construct
strong AI?

~~~
eru
Yes. But replacing (or augmenting) just most trading instead of all trading
requires less than strong AI.

------
joezydeco
In your opinion, Jeff, was the 2010 Flash Crash the work of HFT, or Algo
trading? Maybe both?

~~~
steve8918
The 2010 flash crash was caused by "blackhat" HFT traders trying to game the
system.

It was shown that one, some, or many HFTs were involved in "quote stuffing"
which is bidding for stock and then pulling the order, something like 100k
times per second. This gave the appearance of liquidity and demand, but it was
fake, because as soon as someone would bid for the stock, they would pull
their order. But another use of this was to essentially slow down the "ticker
tape" of the NYSE. What was happening was that the "ticker tape" that showed
the current bids and asks was slowing down, and by doing this, some HFTs could
make use of the latency arbitrage. Colocated HFTs got their quotes for the
best bids and asks directly from the exchanges, but other people were getting
their quotes from the NYSE, so they were behind. I believe they were something
like 30 seconds behind, so what would happen is that the HFTs had full reign
to take advantage of others being blinded like this.

Of course, the side effect of this was that they "broke" the markets. Because
of this latency, the NYSE suspended the markets temporarily, which then had
the unintended consequence of forcing all the bids and asks to flow into the
smaller exchanges, which didn't have the liquidity to handle the orders. There
were so many sell orders, that basically all the buy orders for some stocks
got taken out, causing the prices to plummet down to 1 cent or something like
that.

I'm expecting another flash crash to occur at some point, so whenever I see
heated market action, I place a bunch of trades around 25% below the current
stock price, which I believe is just above the limits that the exchanges would
use to roll back bad trades. (Un)fortunately, it hasn't happened yet, but I'm
sure at some point it will.

~~~
chollida1
> I place a bunch of trades around 25% below the current stock price

Funny, we sat around trying to figure out the right price and this is what we
came up with as well.

Too bad this doesn't show up in second level quotes, it would be a good
leading indicator of what funds in general thought the chance of a crash was
on any given day:)

~~~
steve8918
I place a limit order, which I guess you could see if the depth were deep
enough, but I could very well have programmed an algorithm to just monitor the
prices and do market orders instead, which you definitely wouldn't see. I'm
sure most traders do it that way.

The interesting thing is that on the day of the Flash Crash, if I'm not
mistaken the ES futures contract bounced exactly off the 200 day MA. So, one
thing that the flash crash revealed is a lot of algorithms programmed into the
markets that would normally never have been revealed. So if you want, keep a
floating order just above the 200 day and you might make a few dozen points in
a few mins, just like May 6, 2010!

~~~
chollida1
> but I could very well have programmed an algorithm to just monitor the
> prices and do market orders instead, which you definitely wouldn't see.

yes, but then you run the danger of your order not getting to the exchange in
time and buying at the very bottom after everyone else has been filled.

We nixed this idea as being too risky:(

------
czDev
by the way, the original article (now) opens with "Algorithmic trading,
including high frequency trading (HFT)" and not "Algorithmic trading, also
known as high frequency trading (HFT)"

------
known
Why HFT is opposing Tobin tax?

~~~
gaius
Perhaps a better question is why Tobin himself now opposes the Tobin tax?

------
drstrangevibes
I think the author is actually wrong on this algo trading is defined as
programs taking the decision, how fast this happens determines whether it is
high frequency. Computer aided execution is called smart order routing.....
just saying :)

