Wednesday, April 2, 2014

Books: (Flash Boys) Is It Rigged? and Should You Care?

The latest book by Michael Lewis had a perfect launch. It was covered all across the media (see here, here and even here). And apparently at least one HF farm has delayed their IPO allegedly because of this.

I have not read the book ( just got it, no matter how good or bad the underlying argument is, am sure it will be a great read. He is a fantastic story teller). But here is my first take on this.

HF trading broadly can be classified as below based on their style. Not all of them have similar impact on the market, nor they impact everyone similarly

Making the Market - this type of trading is basically played on volumes. This involves making the market (the intelligent part is how to stand on bid and offer better than others without running in to large inventory as a result of getting hit on them) and also on top handling large amount of trades by buying and selling names multiple of time (that's what market makers do) and earn the volume rebates from the exchanges. Overall good for the market. Do anyone get hurt. Well, if anyone, it is the competition.

Statistical Arbitrage - this is basically finding out tiny misalignment of prices (typical pair trading or correlation trading) or even trading patterns (technical trading - PDF). I would say nothing much unethical about it. Now this can be overall good or bad for the market. Stat-arb can bring stability if prices veer off from equilibrium by abring away the spread. It may also cause destabilization if everyone follows some technical trend. By definition, any kind of mean reversion strategy ought to bring stability and any kind of momentum strategy has the potential to be destabilizing. Overall, no bad intention here, just good-natured profit seeking.

Trading the Book - this is the most interesting part. I guess, based on the write ups and responses, this is what the book mostly about. Now this kind can be quite interesting. It basically aims to figure out what is going on with the flows and try to take advantage of it. At the simplest, it can be trading mean reversion after a large move in a stock. At the other end of spectrum, can be anything like front running or other predatory trading. Overall, mixed. As good as as the intention of the human behind the bots.

And these are the passive trading methods - generally taking the signals from the market and acting upon them. It can also be active, by generating signals and expecting the market to act in a certain way and then profit from it (those exploratory trading and momentum ignition  - here is a good paper on it, PDF)

And apart from getting privileged access to data, this is one place where this entire HFT stuff can cross the boundary of what is ethical.

Now the question is who gets hurt. After all

Chances are, if you are just a small guy, you are NOT the one

As a retail investors, your trades or orders are so small compared to the market that it is improbable to cause a HFT bot to stand up and listen to you. Nor it is possible for your trading pattern to respond to a momentum ignition of a malicious algo. If you want the maths behind this, it will be something like this (PDF). It is the big guys who can get really fried. And perhaps they do. I have not read the book, but no wonder David Einhorn is interested in IEX.

And if not unethical, then any conspiracy theorist worth his salt might suggest fight against the HFT is the latest Wall Street plot. When the big guys lose out to a smart little guy with superior codes, they will fight back. There are claims and counter claims and all sorts of theories.

To cut a long story short, it is a fight among the biggies. Stand back and watch. Don't forget the pop corn. As Josh Brown summed up so aptly, market was never fair anyways

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