High frequency bovine scatology

Charles Duhigg is a good journalist, whom I've quoted a couple times in the past year.

His latest article made quite a splash on trading desks and the journalists who follow us today. He reports:

Yet high-frequency specialists clearly have an edge over typical traders, let alone ordinary investors. The Securities and Exchange Commission says it is examining certain aspects of the strategy.

“This is where all the money is getting made,” said William H. Donaldson, former chairman and chief executive of the New York Stock Exchange and today an adviser to a big hedge fund. “If an individual investor doesn’t have the means to keep up, they’re at a huge disadvantage.”

For most of Wall Street’s history, stock trading was fairly straightforward: buyers and sellers gathered on exchange floors and dickered until they struck a deal. Then, in 1998, the Securities and Exchange Commission authorized electronic exchanges to compete with marketplaces like the New York Stock Exchange. The intent was to open markets to anyone with a desktop computer and a fresh idea.

But as new marketplaces have emerged, PCs have been unable to compete with Wall Street’s computers. Powerful algorithms — “algos,” in industry parlance — execute millions of orders a second and scan dozens of public and private marketplaces simultaneously. They can spot trends before other investors can blink, changing orders and strategies within milliseconds.

High-frequency traders often confound other investors by issuing and then canceling orders almost simultaneously. Loopholes in market rules give high-speed investors an early glance at how others are trading. And their computers can essentially bully slower investors into giving up profits — and then disappear before anyone even knows they were there.

High-frequency traders also benefit from competition among the various exchanges, which pay small fees that are often collected by the biggest and most active traders — typically a quarter of a cent per share to whoever arrives first. Those small payments, spread over millions of shares, help high-speed investors profit simply by trading enormous numbers of shares, even if they buy or sell at a modest loss.

I agree with everything that Duhigg has reported, but the reporting is one-sided. In order for a high frequency trader (HFT) to make money, someone has to take the other side of the trade, and the liquidity Taker pays a higher fee than the exchange pays the liquidity Provider. The exchange keeps the spread. (You may be familiar with this concept if you have a savings account with a bank, and a credit card or mortgage--the bank keeps the spread between the interest rate they pay you and the interest rate you pay them. If you hate that, maybe you should consider a career in banking.)

Ever play Texas Hold 'Em? If you are the Big Blind, you pay most of the ante, and in return you get to see if anyone wants to play with you--they need to give you information first. So it is with the liquidity provider: putting your limit order out there means you are showing a card first (the shares you are willing to buy or sell at a given price level), and you've taken the risk of getting picked off. You get paid for taking risk and providing liquidity, or at least, you should. Otherwise, there is probably a more productive career somewhere else for you.

Certainly, the grocer who takes the risk to provide food for you in your neighborhood should get paid for that service? Or are "experts" suggesting we go back to subsistence farming so we don't get ripped off by Big Food and Big Supply Chains? I thought reducing poverty was a good thing.

While there is an advantage for the players with the best technology, the playing field is more level than ever. Thirty years ago, a retail investor would have to pay a few hundred dollars to Merrill or other broker to execute a few hundred shares. Now we pay less than $20.

Ten years ago, your mutual fund manager would have to use Goldman or a competitor's block desk to move 100,000 shares of Proctor and Gamble. And they would have to trade an eighth wide, i.e. 12.5 cents per share. The financial intermediaries would take that spread, or more, if another customer was willing to trade through your manager's limit to take the other side of the trade.

No one pays those types of commissions any more. Tick sizes have shrunk over 90%, and as have costs to the retail investor.

The fact that Duhigg had to quote a dinosaur, Bill Donaldson, tells you something. I've spoken to the founder of DLJ and SEC chair on one of his lecture circuit gigs, and the guy is from a different age. His research driven business model was fantastic back in the 70s and 80s, but its a woolly mammoth now. His appointments since cashing out have been largely political; those who can't do teach, and those who can't teach must regulate ...

There are a lot of grizzled Wall Street veterans who pine for the days of tick sizes an eighth wide, and funneling trades to a single market maker on a trading floor. That's because a monopoly is great if you are on the right side of it.

Price discovery is improved with liquidity. There is more liquidity because of high frequency trading.

Right now, GE is quoting $11.97 x $11.98, half a million shares a side. I guess Donaldson and Duhigg are pining for the days when it would be quoting $11.875 x $12.000, and we retail investors would be paying Merrill $300 to sell 1,000 shares, in addition to giving up $95 extra in the day of eighths, in that we would be selling at $11.875 rather than $11.97.

As usual, the good ol' days aren't as good as they seem, once you realize you are giving up your clean running water for the outhouse.

NOTE: The flash orders that Duhigg refers to are a new feature. I'll have more to report on in the coming weeks as I find out more about them.

UPDATE: Eric Falkenstein weighs in a week later than this post, but, oh my, is it worth the wait!

Who let the dog out?

A big mystery seller of futures contracts during the market meltdown last week was not a hedge fund or a high frequency trader as many have suspected, but money manager Waddell & Reed Financial Inc, according to a document obtained by Reuters.

Waddell sold on May 6 a large order of e-mini contracts during a 20-minute span in which U.S. equity markets plunged, briefly wiping out nearly $1 trillion in market capital, the internal document from CME Group Inc said.

75,000 ESM0's worth of error comes out to $4 billion. I'd guess that anywhere from 20,000-100,000 contracts trade per hour from 915am - 415pm on most days. To try push 75k minis through a 20 minute window was never going to turn out very well.

There you have it folks. It was caused by an old school, low frequency, no technology, "Toto, we're still in Kansas" shop. Sure, Greece, California, British Petroleum et al. could have helped. And maybe even a couple of stupid trading algorithms. But not the high frequency guys.

I know, you're really, really sorry for ever suspecting otherwise.

UPDATE: CME concurs:

Some have questioned whether high-frequency traders (HFTs)
deploying so-called algorithmic trading methods
played a role in the May 6th incident. Certain HFTs
were active in both spot and futures markets during
this period as an ordinary course of business.
However, there is no visible support of the notion
that algorithmic trading models deployed in the
context of stock index futures traded on CME Group
exchanges caused the market fluctuations in
question.

Rather, we believe that automated trading
contributes to market efficiencies, generally bolsters
liquidity and thereby contributes to the price
discovery function served by futures markets. This
view is supported in the academic literature where
one study found that “the move to screen trading
strengthens the simultaneity of price discovery in
the cash and futures markets and lessens the
existence of a lead-lag relationship.” Another study
concluded that their “results are consistent with the
hypothesis that screen trading accelerates the price
discovery process.”

Further, we find no evidence in CME stock index
futures of any undue concentration of activity
amongst algorithmic or any other types of traders.

UPDATE: It turns out NYSE's measures to slow the crash actually exacerbated it:

As several stocks declined sharply under heavy selling pressure, the New York Stock Exchange, one of the largest pools, stopped or slowed trading in particular stocks.

As part of that process, the NYSE held on to "buy" orders, in the hopes that it could gather enough of them to meet the selling demand. "Sell" orders that came to the NYSE were rerouted to other exchanges, which were not required to slow trading. Those other exchanges were soon overflowing with sell orders and didn't have enough buy orders to meet them, leading to the rapid decline in prices.

Quotes of the day

The drug that saved my life is banned in Great Britain. ... Companies actually need to hide their new drugs from Europe, because the government doesn't want to pay for them.--Representative Billy Tauzin, on CNBC

There are three big problems with attempting to control health care costs by reducing so-called "obesity." First, it's a fake problem. Second, the solutions for the problem are non-existent, even assuming the problem existed. Third, focusing on making Americans thinner diverts resources from real public health issues.--Paul Campos

Gastric bypass is surgically induced bulimia. People starve for the first few months so of course their blood sugar levels go down. At five and ten year followup the average weight loss from these procedures is about 10% to 15% of body mass (it's actually less than that since lots of people drop out of the studies) which means most of these people end up still "morbidly obese." And they can never eat normally again.Why do you think you never see the actual stats for weight loss from stomach stapling? If they were good they'd be on billboards 50 feet high.--Paul Campos

... we don't know how to lose weight. Some of the things Paul Campos is saying about obesity are controversial, but this isn't. Every single study which has attempted to make overweight people get thin without very risky surgery has failed completely and utterly. Fewer than 1% of patients ever keep the weight off.--Megan McArdle

As capitalism struggles, the parasites who feed off its wealth creation are doing pretty well. The political class is growing. Home prices in Washington D.C. are rebounding three times faster than the national average - and job loss in DC has been less severe than in any other major city.--John Stossel

If Congress can tax plastic surgery, can it tax abortion?--Glenn Reynolds

What's the definition of 'speculation'? A price move that Congress doesn't like.--Eddy Elfenbein

Specialists would emphasize the risk they took in providing liquidity, yet on big gap days like October 19 1987 they did not step in and exacerbated the situation. The risk they took on providing orderly markets was a license to steal for decades, and they now scream 'unfair!' as their order flow evaporates.--Eric Falkenstein

I do not worry about high-frequency trading. Telegraphs and telephones also brought their own, earlier versions of high-frequency trading. As did stock index futures. There are second-best arguments relating to hockey helmets and the like but that is the case with most forms of progress and greater economic speed. You don't have to think that the current profits measure the current social value of high-frequency trading to argue that the overall trend should be allowed. The correct judgment of efficiency occurs at the system-wide level, not at the level of the individual trading strategy. The short-run story is that private profits exceed social returns but in the longer run the trading activity and liquidity brings increasing social returns and better communication of information.--Tyler Cowen

... when the banks did well, their employees were paid well. When the banks did poorly, their employees were paid well. And when the banks did very poorly, they were bailed out by taxpayers and their employees were still paid well. Bonuses and overall compensation did not vary significantly as profits diminished.--Andrew Cuomo

Microsoft needed Yahoo's search business for its longer-term strategic goal of competing with Google on the Internet. That should have allowed Yahoo to force a premium price. Instead, it squandered last year's approach. It is now hard to see a sale of the reshaped Yahoo for a good price, leaving the company to slog it out in the increasingly competitive display-advertising market. Small wonder Yahoo investors lost a boatload of money Wednesday, as shares crashed 12%.--Thorold Barker

The once proud warrior of the internet space laid down its sword, knelt at the feet of Microsoft and gutted itself today. There was no honor in this death, it was one brought by the shame of losing to Google and a lack of faith in one’s ability to compete in the space they created. To be clear, Yahoo didn’t need to do this deal, Microsoft did. Ultimately Yahoo will look back at this moment as the second–and perhaps fatal–mistake in their epic history. Search is the most important business of the 21st century and owning a commanding lead in second place is not insignificant. At one time Yahoo was the number one search engine and portal. However, they didn’t see the value in search and decided to syndicate that piece of their business to a small company called Google. For a couple of years we all experienced Google in Yahoo’s wrapper. Our only indication of who made this wonderful tool was a tiny “Powered by Google” logo on the top right of the page.--Jason Calcanis

High frequency profits capped at 4 basis points of trading volume

That's about $20 billion on an annual $50 trillion of trading.

The real figure is probably somewhere between $5-10 billion. While this suggests a nice revenue pie, assuming there are 1,000 high frequency traders (and I'd bet there are more), not everyone is making money after technology and support personnel costs.

It's basically in line with the television revenues spun off by the NFL, except there could be more jobs created by high frequency trading than from NFL television, plus the established fact that HFT provides liquidity to everyone else who has an interest in the stock market, which is pretty much everyone with a 401(k), a pension, or a job. We could even extend that to the jobless, who receive unemployment benefits courtesy of the employees and corporations that pay taxes.

Via Dennis Berman.

High frequency traders mitigated the flash crash

as opposed to the popular myth that they caused or exacerbated it.  Kara Scannell reports:

According to a joint report from the staffs of the Securities and Exchange Commission and Commodity Futures Trading Commission, the trader chose to use an algorithm to trade the E-mini futures contract, a contract that mimics trading in the S&P 500 stock index. The computer program executed the trade "extremely rapidly in just 20 minutes," according to the report.

The report found that the trades were initially absorbed by high-frequency traders and others in the market, but soon liquidity dried up for that contract and elsewhere.

The party that started the crash was Waddell & Reed, an old-school financial services shop with no high frequency trading.

The trader who worked the order tried to get the market to buy 35,000 SPX Emini futures contracts in 7 minutes. That would be $2 billion, folks.  There's no way to do that and avoid market trauma.  $2 billion is more than the entire market capitalization of several companies in the S&P 500, such as Eastman Kodak and the New York Times.  The market is not set up to exchange equivalent ownership of these companies in a few minutes.

About 2 million of these contracts trade daily (based on the last 20 days of volume). The trading session starts at 430pm and ends at 415pm. The largest single lot size exchanged today was 1,114 contracts at 10:03, followed by 1,069 exchanged at 12:17.

The report implies that certain changes to the market structure would have reduced the effects, and certainly, enforcing a trading break without exception would be one of those measures that would have resulted in less harm done, but really, if someone is going to make this type of trading error, then it's going to be a problem.

UPDATE:  Stephen Grocer has a nice summary.  The total sell order was 75,000 contracts.

Eek! High Frequency Trading is coming!

Rick Brookstaber says, the sky is not falling:

For algorithmic trading, the issue is simple. Some investors have determined to buy and others have determined to sell. They have reached these determinations however they have done it in the past; it doesn’t have anything to do with the advent of millisecond trading. Now they happen to decide to execute these trades over time as a function of the bid-offer spread, the volume of trading, the level of prices – that is, based on the same sorts of things that they would have without computers. And they can monitor what is going on with their trades over the course of the day. So this is not a tightly coupled process. A call to their broker, and the trading stops. Just like if the broker had someone doing it on the phone.

For high frequency trading, the issues are not as simple. It is possible to construct a scenario for high frequency trading where a strategy is widely shared which has a reinforcing feedback and which pushes forward without anyone intervening. But I can construct such scenarios even without the need for millisecond trading. Not just construct such scenarios – I have seen them, and so have you, in any number of bubbles and crashes.

Quotes of the day

Apple couldn’t have killed Flash if HTML 5 hadn’t recently been adopted by major browsers. HTML 5 offers alternatives to most of the key features of Flash. And no one controls it the way Adobe controls Flash. Since no software company wants to build its products on a standard it doesn’t control, every company other than Adobe has a natural incentive to adopt HTML 5 over Flash.  This brings to mind Jonathan Zittrain’s book The Future of the Internet and How to Stop It. Zittrain warned that the success of the proprietary iPhone threatened to undermine the decentralized, bottom-up structure of the Internet. The Flash story is a useful counterexample to Zittrain’s thesis. On the one hand, iOS is a proprietary standard controlled by Apple, so its ascendancy looks like a threat to open standards. Yet the rise of the iPad was a major factor in the decline of another proprietary standard, Flash.  ... for at least two decades, it has looked like proprietary technologies were on the verge of taking over the software industry. Yet open standards have grown more and more dominant. This hasn’t been a lucky fluke, it’s a matter of basic economics. Proprietary software is central planning. And in the long run, central planning doesn’t work as well as bottom-up organization.--Timothy B. Lee

Trading is about being self-aware to obtain profits in excess of losses. Gambling is about the emotional payoff. ... When a trader lacks emotional intelligence and has no inner voice to listen to, he is more of a philanthropist than a trader. He’s giving money away, so it doesn’t matter who is on the other side of the trade ... [rogue traders] didn’t deliberately trade a Martingale system, but this is what their emotions led them to do, whether they knew it or not. That’s how vicious a cycle it is if you don’t learn to take small losses and flush your ego. Traders don’t think it can happen to them, and then all of a sudden they’re emotionally invested in the outcome of a trade. A trader must detach emotionally from the outcome of any particular trade.--Joshua Brown

You [men] don’t have to take the pill, wear a patch, insert messy rings or go through the hassle of making an appointment with your doctor to change and refill your prescription for said pills, patches, rings and paraphernalia. As for the potential short and long-term health consequences such as nausea, decreased libido, blood clotting, cancer, and infertility? On us. Cervix with a smile. If I didn’t know better, I would say that it’s like men invented birth control. But, of course, that’s just the woman in me talking crazy.--Clare Halpine

... if your blogger was good at forecasting market movements, he would be running a hedge fund, not enduring the daily sardine-like commute on the Piccadilly line. It is that the nature of financial journalism is in assembling evidence from published sources, analysts, fund managers that other people know as well. By the time the evidence of a trend is convincing enough for an article, the trend may well be over.--Buttonwood

[Jamie] Dimon, a lifelong Democrat who was rumored to be on Obama’s short list for treasury secretary before he settled on Tim Geithner, met privately with Romney on Tuesday morning before a fund-raiser at Brasserie 8¹/2 hosted by Highbridge Capital, a JPMorgan-owned hedge fund. Dimon, who was spotted “in a discreet one-on-one” discussion with Romney, cannot publicly endorse a candidate because he sits on the board of the Federal Reserve Bank of New York. But he donated to Democratic candidates in 2008 and privately supported Obama. ... Political insiders are buzzing that a defection would signal further Wall Street hostility toward Obama, who famously called them “fat cat” bankers in 2009. Dimon responded, “I don’t think the president of the United States should paint everyone with the same brush.” One insider said, “There is not a person on Wall Street, with the exception of the genetic Democrats, who would get anywhere near supporting Obama. The hostility to the administration is huge. Dimon will continue to look bipartisan, then work behind the scenes to get a Republican elected.” There were few big Wall Street names openly linked to Obama’s fund-raisers in New York. And we’re told ticket sales for Obama’s Friday event with Warren Buffett have been slower than expected, with staffers calling and e-mailing supporters to shift tickets at up to $35,800.--Page 6

High-frequency traders—often seen as the destabilizing villains of the currency markets—may in fact be helping it to run smoothly, a study by the Bank for International Settlements suggested Tuesday. Many traditional market players blame secretive high-speed traders for "predatory" or "unfair" practices, bemoaning the superfast computers they use to pick out trade signals and exploit banks' often slower machines. Some banks have even toyed with the idea of setting up closed trading systems, where they can trade with one another and avoid these accounts. But in a report based on research by officials at 14 central banks, the BIS said high-frequency traders help to make trading cheaper for everyone by squashing so-called spreads—the gap between where banks buy and sell currencies. High-frequency traders also support liquidity, and don't tend to flee the market in tough times any more often than banks.--EVA SZALAY And JACOB BUNGE

A good corporate board should be characterized by constant tension, with non-executive directors respectfully questioning the decisions of management. This can make board meetings very uncomfortable, especially for young people. Chelsea’s background makes her very well suited to dealing with this situation. So stop your hating, kids.--John Carney

Sometimes, frankly, it seems the Jets organization is afraid of Namath.--Mike Freeman

Photo links here and here.

How to survive: adapt

If you can't beat 'em, join 'em:

Hoping to harness the tech savvy of the high-frequency traders who have eaten away at its business, the New York Stock Exchange is bringing one of the biggest computer-driven firms onto its iconic floor.

Beginning Monday, Chicago-based Getco LLC will become a "designated market maker," the role once occupied by the specialists who used to fill the floor of the exchange, stepping in to buy or sell shares to keep trading orderly.

The arrival of Getco, a pioneer in computer-driven high-speed trading, marks the first time the exchange has embraced such a technologically sophisticated player in the role. The move gives something of a high-tech stamp of approval on the NYSE's modernization effort.

A roundup of high frequency trading posts over the past year.

High frequency trading quotes of the day

People should expect and be willing to pay a price for the liquidity that they get. No one should expect that a provider of liquidity is just going to stand there while you bulldoze them into submission.--Manoj Narang

If you were on Wall Street in the 1990s ... you would need to take guys out to dinner and build relationships, otherwise you couldn't get at the order flow. And now, if you're good ... there's no barrier to entry. That is a really incredible improvement to the Wall Street environment. That's how we want markets to work.--Cameron Smith

A misunderstood dynamic of high-frequency trading is that it thrives off volatility, thereby reducing it. The clear winners in the revolution are small investors, who have seen their trading costs fall remarkably and markets price shares far more efficiently.--Herbert Lash and Jonathan Spicer

Once you're successful, once you have a system that's making money, you become very secretive because it's very easy for one of your guys to leave and replicate it. What are the exact ingredients and proportions of Coca-Cola? Is there something wrong going on at Coca-Cola? That's the point. It's replication, ease of replication. The barriers to entry, to competing, are not too high.--Robert Olman

Here are some of my musings on HFT, from July and October.

Quotes of the day

Should you really take financial advice from someone foolish enough to write for a living? Run the numbers. If a typical author earns, say, $3 per book sold and the book sells 20,000 copies, then that's $60,000 in gross income -- before costs. But that may be for a year's work. We're talking maybe $30 an hour.--Brett Arends

There is risk, definitely, but quant funds like us take it all. If a quant meltdown happens, it won't affect the retail investor. All [high-frequency] funds have a profit-and-loss line like this [unusually negative in August 2007, when they all had to sell off in order to meet their margin calls]. And here's the second quant meltdown, in January of '08. It's tiny. You can hardly see it. That's because funds running quantitative strategies are mostly market neutral. When we take a position, we're always balanced somewhere else, and when we unwind, it doesn't affect the market either. We don't take from the retail guy. We make the market more efficient. Things are better for the retail investor because of high-frequency trading. We don't make volatility happen. We reduce it, but it is how we make our money. We create order. When the markets are disorderly, we make a lot of money, but we are doing it by restoring the markets to order.--Manoj Narang

Today, chess programs have become so good that even grandmasters sometimes struggle to understand the logic behind some of their moves. In chess magazines, one often sees comments from top players such as “My silicon friend says I should have moved my King instead of my Queen, but I still think I played the best ‘human’ move.” It gets worse. Many commercially available computer programs can be set to mimic the styles of top grandmasters to an extent that is almost uncanny. Indeed, chess programs now come very close to passing the late British mathematician Alan Turing’s ultimate test of artificial intelligence: can a human conversing with the machine tell it is not human? I sure can’t. Ironically, as computer-aided cheating increasingly pervades chess tournaments (with accusations reaching the highest levels), the main detection device requires using another computer. Only a machine can consistently tell what another computer would do in a given position. Perhaps if Turing were alive today, he would define artificial intelligence as the inability of a computer to tell whether another machine is human!--Kenneth Rogoff

More than any other variable in education—more than schools or curriculum—teachers matter. ... Parents have always worried about where to send their children to school; but the school, statistically speaking, does not matter as much as which adult stands in front of their children. Teacher quality tends to vary more within schools—even supposedly good schools—than among schools. But we have never identified excellent teachers in any reliable, objective way. Instead, we tend to ascribe their gifts to some mystical quality that we can recognize and revere—but not replicate. The great teacher serves as a hero but never, ironically, as a lesson. ... Things that you might think would help a new teacher achieve success in a poor school—like prior experience working in a low-income neighborhood—don’t seem to matter. Other things that may sound trifling—like a teacher’s extracurricular accomplishments in college—tend to predict greatness. ... [Steven Farr] and his colleagues surveyed Teach for America teachers at least four times a year to find out what they were doing and what kinds of training had helped them the most. Right away, certain patterns emerged. First, great teachers tended to set big goals for their students. ... Superstar teachers had four other tendencies in common: they avidly recruited students and their families into the process; they maintained focus, ensuring that everything they did contributed to student learning; they planned exhaustively and purposefully—for the next day or the year ahead—by working backward from the desired outcome; and they worked relentlessly, refusing to surrender to the combined menaces of poverty, bureaucracy, and budgetary shortfalls.

... Poverty matters enormously. But teachers all over the country are moving poor kids forward anyway, even as the class next door stagnates. ... What did predict success, interestingly, was a history of perseverance—not just an attitude, but a track record. In the interview process, Teach for America now asks applicants to talk about overcoming challenges in their lives—and ranks their perseverance based on their answers. ... Gritty people, the theory goes, work harder and stay committed to their goals longer. (Grit also predicts retention of cadets at West Point, [Angela Lee] Duckworth has found.) But another trait seemed to matter even more. Teachers who scored high in “life satisfaction”—reporting that they were very content with their lives—were 43 percent more likely to perform well in the classroom than their less satisfied colleagues. These teachers “may be more adept at engaging their pupils, and their zest and enthusiasm may spread to their students,” the study suggested. In general, though, Teach for America’s staffers have discovered that past performance—especially the kind you can measure—is the best predictor of future performance. Recruits who have achieved big, measurable goals in college tend to do so as teachers.--Amanda Ripley

And when it comes to textbooks, what happens in Texas rarely stays in Texas. The reasons for this are economic: Texas is the nation’s second-largest textbook market and one of the few biggies where the state picks what books schools can buy rather than leaving it up to the whims of local districts, which means publishers that get their books approved can count on millions of dollars in sales. As a result, the Lone Star State has outsized influence over the reading material used in classrooms nationwide, since publishers craft their standard textbooks based on the specs of the biggest buyers. As one senior industry executive told me, “Publishers will do whatever it takes to get on the Texas list.” Until recently, Texas’s influence was balanced to some degree by the more-liberal pull of California, the nation’s largest textbook market. But its economy is in such shambles that California has put off buying new books until at least 2014. This means that [Don] McLeroy and his ultraconservative crew have unparalleled power to shape the textbooks that children around the country read for years to come.--Mariah Blake

Yes, high frequency traders are trying to take a profit

But specialists and human market makers (not computers) used to take a much bigger profit, on a per trade basis. Instead of working with spreads a penny or two wide, for pretty much all of the last century, spreads were twelve-and-a-half and twenty-five cents.

That's a lot of dough that the specialists were able to pocket. It could be argued that high frequency traders are saving you more than 10 cents a share, if they are the ones providing you with liquidity as you trade, as they probably are, accounting for more than half the volume traded. If a retail investor traded 100 shares per week for forty years--between her brokerage and IRA accounts, 401(k) allocations, mutual funds, insurance claims, and pension funds--that's a savings of over $20,000. For 100 million retail investors, that's $2 trillion dollars of savings.

Let's not go backwards here. Here is the 60 Minutes piece that just ran over the weekend.

Quotes of the day

The economy sucks up people who know [math and science], and the pay and the respect of working for Google or Microsoft, ... or Goldman Sachs (Heaven help them, ... uhhh, just kidding) is a heck of a lot more than there is to teaching in a high school.--Jim Simons

I consider high frequency trading to be natural, and definitely socially useful. What's happened is, that as the markets have become more electronic, and computers have been applied for generating prices and accepting trades, the markets have grown tremendously more liquid. The bid-ask spread has come down. The fellas of old that used be specialists on the floor were supposed to be the market and they were full of baloney, and they would create wide spreads and at the first sign of trouble they would disappear. ... There was a glitch, I think they called it the 'Flash Crash' ... and for 8 minutes or so, some parts of the market took a dive. It came right back. ... In 1987, when the stock market crashed it went down 25% in half a day and didn't recover for 6 months, 'cause there was nobody there on the other side. ... Yes, I consider high speed trading socially useful, and those people who argue against it are wrong.--Jim Simons

[Jim] Clark was particularly irked by the disclosures surrounding Abacus. He had met with Paulson & Co. founder John Paulson in August, 2006 and been impressed by the hedge fund manager’s plans to bet against the subprime-mortgage market. His Goldman brokers talked him out of investing with Paulson, describing him as a bit player, Clark says.--Richard Teitelbaum

Sentiments on how the country is doing break down along partisan lines. Among Democrats, 14 percent said the country is doing very well, while another 51 percent said it is doing fairly well. Thirty-five percent of Democrats said the country is doing badly. Just one percent of Republicans surveyed said the country is doing very well and 24 percent said it is doing fairly well, while 76 percent said it is doing pretty badly or very badly. Independents’ views are middling, with 41 percent saying the country is doing well, while 49 percent said it is doing badly.--Jennifer Epstein

Do we think the administration has even considered that the problem [the slowing pace of new drugs coming out of the pharmaceutical industry] might be the huge costs imposed on new drug development by the FDA?--Jeffrey Miron

As states struggle with enormous deficits and exploding pension costs, some analysts are urging Congress to enact a law enabling states to declare bankruptcy the way municipalities can under Chapter 9 of the federal bankruptcy code. This is a bad idea. A state bankruptcy provision could create more problems than it solves. Bankruptcy proponents understandably worry that states such as California and Illinois are so deep in the hole they may end up petitioning Congress for federal relief. To forestall this possibility, the argument goes, even the threat of bankruptcy would give governors and legislators a powerful new weapon for forcing concessions from recalcitrant public employee unions. Yet state officials committed to cutting costs already have options for putting the squeeze on their unions.--E.J. McMahon

Here we go again with the political grandstanding around the idiotic "debt ceiling" -- idiotic because it's defined in a fixed number of dollars instead of a percentage of GDP.--Steven Conover

The experimental study reported here employed one of the most compelling visual cues of female sexual attractiveness (low waist-to-hip ratio) to test the influence of news anchor sexualization on audience evaluations of her as a professional and their memory for the news that she presents. Male participants saw the sexualized version of the anchor as less suited for war and political reporting. They also encoded less news information presented by the sexualized than her unsexualized version. Conclusions were drawn in line with evolutionary psychology expectations of men’s cognitive susceptibility to visual sex cues.--Maria Elizabeth Grabe and Lelia Samson

Is it better to test sexual compatibility as early as possible or show sexual restraint so that other areas of the relationship can develop? In this study, we explore this question with a sample of 2035 married individuals by examining how soon they became sexually involved as a couple and how this timing is related to their current sexual quality, relationship communication, and relationship satisfaction and perceived stability. Both structural equation and group comparison analyses demonstrated that sexual restraint was associated with better relationship outcomes, even when controlling for education, the number of sexual partners, religiosity, and relationship length.--Dean Busby, Jason Carroll & Brian Willoughby

Quotes of the day

The high-frequency traders are like the beautiful women. If their biggest “threat” is to stay home, we are not worse off for their existence. If we fear their flaky departures enough, we may prefer to trade in other markets or at other time horizons, namely very long.--Tyler Cowen

Said a Harvard professor of econ,
"That Google's got something unique on:
They have cash by the score,
Yet still borrow more;
This is something I've puzzled all week on."

Said an expert in cross-border taxes,
"I should hope the professor relaxes;
As Google keeps cash
In an overseas stash,
'Til taxation here wanes and not waxes."--Dr. Goose

The three largest U.S. metropolitan areas, New York, Los Angeles, and Chicago, contain 13 percent of the population and generate 18 percent of GDP. This (crudely) suggests that densification could increase GDP considerably.--Reihan Salam

If normal growth theory is right, it takes a lot of work just to keep a rich economy rich. Just replacing the old, depreciating physical capital is an enormous task that only a highly productive economy can accomplish. The more capital you have, the more capital you have to replace every year. If you fall behind in replacing the fast-decaying capital, you quickly become less productive. The fact that the US has been able to keep its relative ranking is evidence that it has stayed highly productive over the decades. Solow’s growth model captures this fact—and it’s why a one-time massive gift of capital can’t make a poor country rich. It’s a gift that keeps on wearing out.--Garrett Jones

I just pre-ordered Ezra F. Vogel, Deng Xiaoping and the Transformation of  China, which looks to be an important book.--Tyler Cowen

Our exchange rate is just a price — the price of the dollar in terms of other currencies. It is not controlled by anyone. And a high price for the dollar, which is what we mean by a strong dollar, is not always desirable. Some countries, like China, essentially fix the price of their currency. But since the early 1970s, the United States has let the dollar’s value move in response to changes in the supply and demand of dollars in the foreign exchange market. The Treasury no more determines the price of the dollar than the Department of Energy determines the price of gasoline. Both departments have a small reserve that they can use to combat market instability, but neither has the resources or the mandate to hold the relevant price away from its market equilibrium value for very long.  In practice, all that “the exchange rate is the purview of the Treasury” means is that no official other the Treasury secretary is supposed to talk about it (and even he isn’t supposed to say very much). That strikes me as a shame. Perhaps if government officials could talk about the exchange rate forthrightly, there would be more understanding of the issues and more rational policy discussions.--Christina Romer

In addition to his wide-ranging influence within the academic and policy spheres of economics, Harvard Economics Professor Martin S. Feldstein ’61 has perhaps had his greatest impact in the classroom. While sitting in a meeting about Social Security reform in the West Wing of the White House in 1999, Harvard Kennedy School Professor Jeffrey B. Liebman—once a Ph.D. student of Feldstein’s—realized he shared something with the others at the meeting. “[I noticed] that three of the four economists in the room—Larry Summers, Doug Elmendorf, and myself—had been Marty’s students,” he said. “The fourth economist had studied at MIT under someone who himself had been a student of Marty’s.” Feldstein, a professor at Harvard since 1967, has taught every level of economics, from introductory to upper-level graduate courses—training some of the world’s foremost economists in the process and spurring the Wall Street Journal to term him perhaps the “most influential economist of his generation.”--Benjamin M. Scuderi

Washington relies too much on off-the-cuff comments and tweets to drive policy debates. Serious policy addresses like these three provide depth that is essential to the national dialogue. I also wish we had more frequent serious policy speeches on the House and Senate floors. Today I will begin to respond to the Geithner speech, which is the most effective presentation of the Administration’s fiscal policy argument I have seen. It’s a long speech with a lot that deserves analysis and response. Since the partisan policy battle is already fairly heated, and since I haven’t written in a while, I’ll start today with a reach-across-the-aisle post. ... Secretary Geithner is reflecting the conclusions of the Social Security and Medicare Trustees, issued last Friday, and he is saying something different from the Washington Consensus, which focuses only on health care cost growth. In fact demographics is a bigger deficit driver over the next 10-20 years than health care. Kudos to the Secretary for emphasizing both. He also correctly identifies the two subcomponents of an aging population: more Baby Boomers becoming retirees and longer lifespans. The first of these is big but temporary (one generation), the second is gradual and permanent. ... Secretary Geithner is right that the ultimate forcing action will be when investors lose confidence in American fiscal policy and take their funds elsewhere. He is right that, if this happens, it can happen suddenly and without warning. He is right that this would be extremely painful and costly to stop. And he is right that it is unpredictable. We may not know the market-imposed deadline until it has already passed.--Keith Hennessey

So much for rational ideas in public debate.--Peter Suderman

The fact that I would want to be able to involve the police if my daughter became a streetwalker, but not if she became a Hari Krishna, tells me something important about what kind of legal regime I should support.--Ross Douthat

(A map of slave ownership by county)

You have now shown under the most adverse circumstances that the great mass of the people of Western Virginia are true and loyal to that benificent [sic] government under which we and our fathers have lived so long. ... The General Government cannot close its ears to the demand you have made for assistance. I have ordered troops to cross the Ohio river. They come as your friends and brothers, as enemies only to the armed rebels who are preying upon you. Your homes, your families, and your property are safe under our protection. All your rights shall be religiously respected, notwithstanding all that has been said by the traitors to induce you to believe that our advent among you will be signalized by interference with your slaves. ... I call upon you to fly to arms and support the general government, sever the connection that binds you to traitors, proclaim to the world that the faith and loyalty so long boasted by the Old Dominion are still preserved in Western Virginia, and that you remain true to the stars and stripes.--General George McClellan, May 26, 1861

In terms of basketball talent, I’ve been covering pro basketball for more than 40 years, and I’ve never seen a guy Rodman’s size play like he did and shut down opponents who were half a foot taller and 100 pounds heavier. When he played for the Bulls from 1996 to 1998, I remember 7-1, 335-pound Shaquille O’Neal trying to back Rodman into the paint to posterize him with a dunk. But Rodman would body up, using his leverage and pelvis to impede Shaq’s progress.--Lacy Banks

He has six of the 17 best seasons in history for offensive-rebounding percentage, and six of the 12 best for defensive-rebounding percentage. And unlike most top rebounders, one skill didn’t impede the other. Most players who are great on the defensive glass aren’t as good at corralling offensive rebounds, perhaps because they are behind their teammates in getting down the floor.--Carl Bialik

Wait, what? Dennis Rodman is a Christian? Not yet, but wait for it. This one is going to happen and when it does, we’re going to lock in a phenomenally colorful rebounder.--Jon Acuff

Photo link here.

Quotes of the day

It’s funny to me that honesty turns one into a dissident in global development.--Jessica Mack

One of the most unfortunate (and surprising) side-effects of the triumph of computer-generated animation was the death of the female protagonist in children’s movies. Think of all the female protagonists in Disney musicals. There are quite a number, almost as many as there are males—Cinderella, Belle, Ariel, Pocahontas, Mulan… the list goes on. Now think of female protagonists in Pixar movies. There aren’t any. Not a single one.--Stefan

I don’t look at [high frequency algorithmic trading] it as in any way evil … I don’t think the guy who’s trying to hide the supply-demand imbalance [by using an execution algorithm] is any better a human being than the person trying to discover the true supply-demand. I don’t know why … someone who runs an algo-sniffing strategy is bad … he’s trying to discover the guy who has a million shares [to sell] and the price then should readjust to the fact that there’s a million shares to buy.--unnamed New York broker

Whatever view one takes on its ethics, algo-sniffing is indisputably legal. More dubious in that respect is a set of strategies that seek deliberately to fool other algorithms. ... Systems that are both tightly coupled and highly complex, Perrow argues in Normal Accidents (1984), are inherently dangerous. Crudely put, high complexity in a system means that if something goes wrong it takes time to work out what has happened and to act appropriately. Tight coupling means that one doesn’t have that time. Moreover, he suggests, a tightly coupled system needs centralised management, but a highly complex system can’t be managed effectively in a centralized way because we simply don’t understand it well enough; therefore its organization must be decentralized.--Donald MacKenzie

In San Francisco, one of the toughest places in the country to find a place to live, more than 31,000 housing units — one of every 12 — now sit vacant, according to recently released census data. ... Invoking the Ellis Act would also mean that any new tenant to the unit, should Murphy decline the chance to return, would also be entitled to Murphy's old rent amount for many years to come. So the Koniuks would likely opt to just leave it vacant. Increasingly, small-time landlords ... are just giving up. ... Perversely, that is hurting the city’s renters as well, as a large percentage of the city’s housing stock is allowed to just sit vacant, driving up rents that newcomers pay for market-rate housing.--Elizabeth Lesly Stevens

[Mayor Bloomberg's] strategy adds up to one thing: twisting himself in knots to acknowledge the city's untenable fiscal situation while avoiding a head-on fight with labor. But sometimes peace -- and cognitive dissonance -- is unaffordable.--Nicole Gelinas

My gripe is with the Universe. If I were running the Universe, there’d be some level of accomplishment that confers immunity from death, deterioration and obscurity. I’m not sure exactly where I’d set that bar, but I’m sure Dan Quillen would have cleared it.--Steve Landsburg

The more dogmatic and determined the leader, the less likely it is that they’ll face any opposition. Leaders who quash dissent are virtually certain to be able to make any decision they feel like virtually unopposed. ... The danger of the fundamental attribution effect when applied to CEOs or securities analysts or investment gurus or the apparent internet insider with the hot tip is that they’re as mentally hamstrung as we are. If we have to lose money on the markets we can at least do it through our own errors, rather than at second hand.--timarr

... [F.A.] Hayek’s skepticism about government was NOT based on his certainty, as [Francis] Fukuyama would have it, but on his awareness of his ignorance. (and everyone else’s) We public intellectuals who are communicating ideas of Hayek to a broader public are NOT fond of ideas that highlight our own ignorance, so one prediction that can be made with a higher degree of certainty than usual is that Hayek will continue to be misunderstood.--William Easterly

World population grew by almost 300% during the twentieth century; over the same time period, world per capita incomes grew by about 400%.--Gary Becker

Photo link here.

The British Open, in full swing

For those of you who haven't checked out the British Open, I recommend it highly. I understand that some like a 3-hour span of high-frequency high-liquidity in-game trading. Golf is slower paced. But there is a lot of liquidity, with the market maker showing 300 per side, and it rare to spot him withdrawing bids and offers.

And as with all the majors (the others being the Masters, the US Open, and the PGA Championship), it's FOUR whole days of fun.

Given the huge interest in the World Cup last month, I'm thinking that you get 4 big tourneys a year with a distinct international cross section (instead of just one every 3 years), plus plenty of smaller ones to trade every season. And you'll have something to chat about with future interviewers and doctors down the road.

Finally, the women's equivalent looks a little softer than the WNBA.

UPDATE: The top 3 contracts, what are you waiting for?











I'm long all 3, getting crushed on FIELD.

Scott Paterson sounds the alarm on high frequency trading

He reports:

The ability to estimate price moves ahead of the national best bid and offer price, which is consolidated electronically from exchanges, can give traders an advantage of about 100 to 200 milliseconds over investors who use standard market tools, according to a November 2009 report on such trading activities by Jefferies & Co.

An advanced look at exchange data and order flow can provide firms "the ability to forecast future prices" and "make adjustments to their orders in the market or send new orders which are based on this information," the report found.

Some investors are searching for ways to protect themselves. Rich Gates, co-founder of TFS Capital LLC, started becoming concerned about latency arbitrage in early 2009 after a Wall Street bank pitched the trade to his firm.

In hundreds of tests, TFS has found that some of its trades were getting picked off by firms exploiting the time-delay wrinkle. That was costing the firm money.

I agree that the markets are not perfectly efficient. Those with material information first mover advantages will take profit out of the market. Those of you who subscribe to Darwin's natural selection will recognize a similar inequality between a tall, handsome, intelligent, athletic, musical and funny chap getting more dates than his short/dull/clumsy/unskilled/boring counterpart. Even if the latter's genes might be stronger in the autoimmune and nurturing departments.

Market efficiencies are a heck of a lot better than half a generation ago, when instead of 2 cents, it was more than 10 times that amount.

Let's not make perfect the enemy of the much-improved.

Usually, I have stronger visceral reactions to things I read, not so much videos

Today was different: here is Felix Salmon being interviewed by Aaron Ross Sorkin.

Here is my incredulous comment:

I think that Felix is going to make stocks less accessible to the general public by eliminating high frequency trading. Decimalization, electronic trading, and now HFT have provided incredible liquidity. A stock trade now costs $2 (in 2011 dollars) not $200 (in 1971 dollars). And this is because of moving from eighths to decimals, and because of moving from specialists, $2 brokers, and block desks.

Which crash was worse and took longer to recover from? 1987 or the Flash Crash? HFT is estimated to take $2 billion in profits out of the market, but I wouldn't be surprised $20 billion has been returned to retail investors by financial disintermediation, if it is on the order of the reduction in commissions retail investors pay. [Note: I should have also commented "not to mention crossing a spread of 1 or 2 pennies instead of 12.5 to 25 cents"].

And if regulation makes public corporations more expensive to run, of course there will be fewer, larger corporations because of economies to scale.

Of course publics will be taken private and left that way, if listing and reporting requirements are significantly less of a burden. This is just natural incentives. Regulation ain't free, as much as anyone wants to wave it away. Before the Internet, I used to have to go to the DMV and stand in long queues. If I could have avoided that with a cheaper alternative (like I have now), I would have chosen the process today. That is the choice I see companies making.

The market capitalization of the NYSE in 1950 was about $100 billion. Now it's about $15 trillion. So yes, the number of listed stocks has halved from 8,000 to 4,000. So instead of holding 50 stocks in a portfolio, hold 25! What is the right number of listings? I'm not sure how much difference there would be between 5- and 10,000.

Salmon and Sorkin are great writers, but this was a puff piece.

Eric Falkenstein makes a great case on high frequency trading

here, making similar points that I did last week. But he also articulates something that I only mentioned in subsequent comments on other sites, namely that the 'front running' of 'flash orders' pales in moral comparison to the shenanigans of the 'good ol' days':

An algorithm chasing micropennies does not instigate trends the way portfolio insurance did in the 1987 crash, because in that case long-only funds were looking at their total long position, selling into declines (emulating a put option). The current algorithms generally look at relative value trades between sectors or issues, momentary order imbalances, a very different beast. Trade imbalances have always and will continue to move prices, but that isn't the computers fault. If there's continually 10x as many sell orders as buy orders, the result is going to be lower prices no matter what market is created. When buys and sells are coming in with equal size, price stability will be restored. To suggest the computers could exaggerate a movement is hysterical fear mongering in this context, because while anything is possible, it's a baseless hypothetical. Maybe we should regulate financial textbook writers as they popularize models that create things like CDO's that were so prominent in our latest financial crisis? Perhaps he is diverting our attention from his crime of the century?

Top posts of 2010

3. High frequency profits capped at 4 basis points of trading volume

2. Intrade now predicting that the Democrats will seat less than 51 senators

1. Tom Brady's fantasy draft value just plummeted

Trader of the 20th Century?

James Simons:

Mr. Simons made his reputation on his signature fund, called Medallion, which has posted average returns of about 45% a year, after fees, since its inception in 1988. Since 1995, it has had only one money-losing quarter, slipping 0.5% in the first quarter of 1999, according to documents reviewed by The Wall Street Journal. Medallion's returns have outpaced those of Warren Buffett, whose Berkshire Hathaway Inc. has gained roughly 20% a year since Mr. Buffett took over in 1965.
...

In the 1980s, Mr. Simons, who shuns the public eye, was among the first to develop a form of trading that used mathematical models and computers to predict markets. In the process, he blazed a trail followed by a slew of hedge funds that rely on quantitative strategies—so-called quants—such as D.E. Shaw Group, AQR Capital Management and Citadel Investment Group.

Nearly all of the Medallion fund's trading is automated, involving little to no human interference. Computers are programmed to buy and sell assets of all kinds, attempting to predict whether they will rise or fall based on historical patterns.

I'm proud to say that I've only had one losing quarter in the last 4 years (Jul-Sep 2008) of my primary trading strategy. But I'm nowhere near 45% per year in average returns.

Then again, Medallion's returns have been easing in recent years. My theory is that other high-frequency players are now eating part of the same lunch that Simons was able to eat by himself a decade or two ago.