Look Out Below: The Quants Control The Markets and May Cause Another Crash in Stock - TheNewTopical.com - current events, politics, culture, ethics, economics discussion forum

FredFredson · #1 (**permalink**) 07-09-10, 02:42 PM

Robert Lenzner
The Bottom Line

Aug. 26 2010 - 9:35 am | 1,477 views | 0 recommendations | 2 comments

Look Out Below: The Quants Control The Markets and May Cause Another Crash in Stock Prices
By ROBERT LENZNER

Look Out Below: The Quants Control The Markets and May Cause Another Crash in Stock Prices - Robert Lenzner - The Bottom Line - Forbes

“WATCH OUT FOR THE QUANTS,” a column I wrote in February, 2008, warned that computer driven buy and sell orders were dangerously fragmenting the marketplace for stocks. Dan Mathisson, Credit Suisse head of advanced execution services, told me then; “More and more of the world’s trading is done by spraying dark orders across multiple destinations by using deliberately complicated patterns and algorithmic models that can’t be discovered or duplicated. No one knows who’s doing what to whom anymore.”

The market went into a death spiral over a 20 minute period in the early afternoon due to massive sell orders by professional traders that were a multiple at times hundreds or thousands of orders for each transaction executed. Some of the computers trying to deal with the massive data at peak times at least 3 million messages per second overwhelmed the available liquidity and caused several high frequency trading firms to shut down completely.

That’s 180 million messages every minute when the market is open. Or 900 million messages communicated to computers in the 5 minute period when the market had its most sickening collapse. Larry Tabb, founder of TABB Group, the expert research firm on quant activity, explains that “the machines had to sift through all this data to get the trades executed, and they just couldn’t keep up. The data was overwhelming, because it ranged from orders in stocks to options on stocks, indexes, and most problematic, the EWTFS that dealt in these stocks. This is the reason the drop in ETF prices was so sickening.”

Chaos ensued because no one could make sense of sellers trying to sell 100 shares by offering 1000 or 10,000. In the face of this avalanche of selling orders many “systems shut down automatically,” says “Drowning in Data,” a report by BMO Capital Markets in Montreal warns that this primitive method of trading stocks “has placed a growing stress on market systems that makes a crash more likely.”

No wonder that many old line investment advisers with billions of other peoples money under management believe that the ability to properly evaluate buy and sell decisions for clients has been smashed by the volatile movement of stock prices caused by computer driven trading strategies. How do you invest for the long run in the era when massive intraday buying and selling dominates the marketplace? Is quant dominance making the markets more dysfunctional?

Today, the quants, High Frequency Traders (HFTs) like Getco, Allston, Citadel and RGM, quant hedge funds like D.E Shaw and Renaissance, as well as the high tech trading desks at Credit Suisse, Goldman Sachs and others also dominate trading in options, futures, sovereign debt (US Treasuries) No doubt computer driven mathematical formulas will soon rule credit default swaps and other complicated derivative instruments.

Wall Street will never be the same. High Frequency Traders alone are responsible for 56% of stock trading volume according to Larry Tabb, founder of TABB Group, widely considered the research authority on computer trading. Tabb describes the quant role as a war of the robots, HFT robots against hedge fund robots. Sen. Edward Kaufman, Dem., Delaware, who is asking the SEC for major reforms, calls it a “micro arms race.” It is no longer the activity of Fidelity, T. Rowe Price or J.P Morgan that dominate the intraday market action. It is the HFTs buying and selling, buying and selling‹and trying to get flat‹ie no long positions by the markets close.

Regulation and oversight of the war of the robots has failed to keep pace with their suddenly vastly more dominant role.

Some HFTs have achieved an unequal technological superiority by paying exchanges to place their servers in a location close to the market to achieve price discovery earlier than competitors. Some exchanges practice “pay for play” by offering rebates on orders for competitive advantage.

Today more than 50 trading venues and 200 brokers can execute buy and sell orders internally without other parties knowing the details. In fact, there are 40 so-called “dark pools the largest being owned by Goldman Sachs and Credit Suisse that close off their bids and offerings to the HFTs so that these operators can’t detect price action on some 10% of all trading.

As Wall Street waits for the SEC to act, Sen. Edward Kaufman wrote SEC Chairman Mary Shapiro on August 5, warning that “several areas of current market structure lead me to be concerned about the performance of the markets for investors and companies seeking to raise capital. The proliferation of exchanges and other market centers has increased fragmentation., the substantial rise in volume executed internally by broker-dealers or in dark pools, excessive messaging traffic, the dissemination of proprietary market data catering to high frequency traders, and order-routing inducements all may be combining in ways that cast doubts on the depth of liquidity, stability, transparency and fairness of our equity markets.” Kaufman will not be in the Senate to fight for reform as he has only 90 days left in the Senate.

The Bottom Line will continue to cover this crucial market development over he next several days and weeks.

FredFredson · #2 (**permalink**) 07-09-10, 02:45 PM

Computer Trading Dominates All Financial Markets -- "Investment" Obsolete

By The Curmudgeon

http://www.fiendbear.com/Curmudgeon5.html

High-frequency-trading (HFT), quote stuffing, derivatives and the "carry-trade" are now dominating global stock (and other financial) markets. The big trading firms don't even remember the old boring ways of buying and selling stocks. In fact, the revered specialist system on the NY Stock Exchange is gone- replaced by computers trading with one another. It has been said that 60- 70% of NYSE volume comes from HFT. And you wonder why even short term trends don't persist?

HFT Explained: HFT computers apparently use algorithms to fade the short term reaction of professional traders. When the news is bad and the market is down, the HFT computers kick in and buy at the same time, squeezing the shorts who had sold earlier. One computer can enter 10,000-20,000 orders in one second. It overwhelms those who are on the other side of the trades.

Illustration of HFT based on fast keyword search: News feeds, such as Dow Jones, Bloomberg and Reuters are input directly into HFT computers. The algorithms recognize keywords, such as "big upside earnings surprise for xyz" or "xyz misses estimate by 3 cents per share." That triggers the computer program to place up to 10,000 individual orders in 1 second. Multiply that by a number of different computers from different HFT firms, and you can see the potentially huge influx of orders, literally in a few milliseconds.

A specific HFT example: On Aug. 4, Priceline announced earnings that were much better than expected. The stock soared over $50 per share in a matter of seconds. Obviously, human beings wouldn't want to pay $50 per share more only 1 second after an earnings announcement. And they can't place the orders that quickly. But computers trading with other computers can do it.

There are other algorithms used by HFT firms- all of them proprietary. If you look at the websites for financial jobs, you will see many ads for computer programmers and mathematicians to work in HFT operations.

"Quote stuffing" is a newer method of the HFTs. Here is a report from a trader:

"...a war between HFT ‘bots’ and their firms. It is bot vs. bot as HFT computers battle each other for short-term profits. The newest technique, and one that may have caused the May Flash Crash, is called quote stuffing."

Quote stuffing first came to light in a report by Nanex, one of the leading market trading analytics firms, in a report about the Flash Crash. In this report, Nanex presented irrefutable evidence of quote stuffing by HFT algorithms in tens of stocks in which thousands of canceled quotes would reappear each second with regularity right around the time of the May "Flash Crash." It is ILLEGAL to indicate a quote without a trade intent, but according to Nanex, it was happening at an alarming rate.

Worse, Nanex concluded that this type of quote stuffing is in fact manipulative and can end up "pushing bid/offer range up to 10% HIGHER without even one trade ever having occurred." This is blatant upside market manipulation, and to make matters worse, the SEC has looked the other way (even though reports blame quote stuffing for the Flash Crash in May).

The exchanges and regulators won't officially address the potentially illegal situation in order to avoid scaring investors away, and they don't want the exchanges to lose this lucrative business. Here is a new article that highlights the dangers:

Another Suspect in the Flash Crash: 'Quote Stuffing' - DailyFinance

Implications and Conclusions:

Has anyone noticed that all the market rallies, however sharp, are on very low volume? And that the volume on the NYSE far exceeds that of the NASDAQ- the reverse of the last 12 years? That is because the public and conventional institutions are either out of the market or sitting on their hands. It's also likely that computers trading with other computers get better execution (tighter bid-ask spreads) on the NYSE vs. NASDAQ and that individual NYSE stocks have larger share floats and trading volumes.

The computers are dominating trading, without human intervention. And the algorithms used or so short term in nature, that they blow out the quants who have intermediate term trading models.

HFT and other computerized trading is why all the fundamentals--discussed endlessly by the financial media are now irrelevant. Take technical trading systems based on trend following (price/volume), support/resistance, breakouts/breakdowns, moving averages, stochastics, etc don't count anymore either. Each time the S & P 500 has a good rally it is smashed down and each time it breaks down it rallies back to the last resistance (in this case 1100 - the last rally failure) and sometimes exceeds it by one or two percent. But that doesn't change the direction of the market, which is back and forth with a downward bias.

But the worst part of all this computerized trading is that the SEC and other government regulators are turning a blind eye to it. They seem to be oblivious to HFT, quote stuffing (see Thurs Sept 2 WSJ lead article+), and other front running computerized schemes. They refuse to investigate on the terms that all these HFTs are providing needed liquidity to the market, and there has been no formal request by the exchanges to investigate this matter. This may now change as reports are swirling that Quote Stuffing caused the May Flash Crash.

+The WSJ reported, "The Securities and Exchange Commission has begun looking into whether the practice is putting some investors at a disadvantage by distorting stock prices, according to people familiar with the matter. The SEC is looking at what role, if any, quote stuffing played in the May 6 "flash crash," when the Dow Jones Industrial Average collapsed 700 points in minutes, the people say."

SEC Probes Role of Canceled Trades in Flash Crash - WSJ.com

In the meantime, here is a message for all those long and short term traders: Caveat emptor!

The Curmudgeon

Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

FredFredson · #3 (**permalink**) 07-09-10, 02:53 PM

The Long Term Does Not Exist
THE GREATEST STOCK MARKET MANIA OF ALL TIME -
DATED SEPTEMBER 4, 2010
A SPECIAL REPORT BY ALAN M. NEWMAN, EDITOR
CROSSCURRENTS
This feature is now published on roughly a quarterly basis.
Our next update will likely be published in late December 2010. This is our 68th report on the consequences of the mania since we first published this website on January 15, 1999.
Over the last year, we have complained repeatedly of the problems securing accurate data for Dollar Trading Volume (DTV). There are now so many "exchanges" that collating data has become nearly impossible and additionally, there is every reason to believe that sufficient black box trading off the exchanges muddles the picture significantly. Simply put, there may now be no way to accurately quantify transactional volume.
Nevertheless, we are committed to presenting the best view we can for this report, what amounts to a best guess. What we see is staggering and utterly depressing.
In the last report, our charts assumed - according to the common wisdom - that the New York Stock Exchange accounted for roughly 25% of all transactional volume. For the basis of this report, we are increasing the denominatorto 30%, since there is no real hard evidence for either percentage.
Determining DTV for the New York Stock Exchange is not particularly difficult and below is a link to view the most recent data. From January 1st through July, DTV on the NYSE totaled $11 trillion and at this pace, DTV would total about $18.86 trillion over the course of the year. This is a considerable increase from our last report.
[CLICK FOR NYSE TRADING]
As we did last time, we sought confirmation and found same from the BATs exchange. While we only examined a brief history as our sample due to time constraints, we believe the sample is reasonable and infers a decent grasp of the overall picture. Transaction volume has slowed significantly in August, typical of the summer "doldrums" and is expected to pick up again into the autumn. However, even in this slow month, total notional volume (DTV) averaged $200 billion per day.
[CLICK FOR BATS TRADING]
Thus, our estimate places total DTV at a pace approaching $63 trillion for the year. Bear in mind if we used a denominator of 25% for NYSE trading versus our 30% assumption, it would place our DTV estimate at over $75 trillion and would necessitate extending our charts further. Given GDP of $14.6 trillion, DTV is more than 4.3 times GDP, the highest ever (by a wide margin). Using the 25% denominator, DTV would be more than 5 times GDP.
Amazingly, the 2000 lunacy and the 2007 bubble echo have been eclipsed.
Another record breaking year is in progress.

Below, Dollar Trading Volume is measured in relative terms versus total stock market capitalization rather than GDP.
Although in the 2000 tech lunacy, DTV fell slightly shy of the manic top in 1929, DTV has since exploded. Over the last four years, beginning with the bubble echo in 2007, the ratio of trading to market cap has simply gone what can only be described as bonkers and is now more than ten times the average ratio from 1926 through 1999!
To repeat from our previous report; "the two most significant distinctions in this chart stem from our line marked "MANIA!" After the first occasion, stocks took 26 years to recover. Since the second occasion, a decade has elapsed and prices are still lower.
Each tall bar has resulted in disaster for investors.
We expect the same now.

Below, we have not shown Speculative Fervor all that often but clearly, the phenomenal increase in trading this year deserves another perspective. While far shy of the lunacy of 2000, the current echo clearly measures closely with that of 2007 and will likely play out in somewhat similar fashion.
As transactional volume increases,
"fair price" as determined by traditional valuation methods decreases.
As transactional volume increases,
investors have less sway,
traders have more sway.
In the current environment,
"fair price" is no longer a major consideration.
From the August 23rd issue of Crosscurrents:
"The stock market you used to know and love has totally disappeared and has been replaced by an arena in which the long term not only doesn’t count, it does not exist."

roadkill · #4 (**permalink**) 08-09-10, 02:03 PM

That segment of the market is under the control of idiot savants. They have turned it into a gambling forum. Since other online gambling venues are illegal in the US, where do you think the outside chancers will go?

Yes, you can make money for a long time by arbitraging the markets with millisecond responses. But that is not what serious investors like Berkshire Hathaway or CalPERS do. If you found out that your superannuation fund was doing something like the OP stuff, you would be well advised to pull out your money and put it somewhere wiser.

Gilles de Rais · #5 (**permalink**) 08-09-10, 02:55 PM

"Yes, you can make money for a long time by arbitraging the markets with millisecond responses..." : Why not forever?

TBH, I don't like HFT much either. But, while it definitely increases (very) short term volatility and look to screw other participants over, I think sentences like "HFT and other computerized trading is why all the fundamentals--discussed endlessly by the financial media are now irrelevant" are incorrect. If HFTs want to be flat by days-end, every day, by definition, they are not affecting the LT price of a given company...