Algorithmic trading -- the positive side
physicsoffinance.blogspot.com
physicsoffinance.blogspot.com
While we do control for share price levels and volatility in our empirical work, it remains an open question whether algorithmic trading and algorithmic liquidity supply are equally beneficial in more turbulent or declining markets.
A nominal transaction tax would eliminate most of the ultra-high frequency stuff and could be put to better use. Volumes would drop and spreads would widen, but it wouldn't really matter up to some reasonable amount.
Buyers pay the offer, sellers the ask. If you want to save the spread you can leave a resting order and wait for someone to take you out but you have no guarantee of a fill (or at least a timely one).
Individual traders who are value-oriented or technical traders, as well as mutual funds etc, gain money on "buy low, sell high". Of course mutual funds and the like do so on a very long term basis. In any case, they pay the spread. So if the spread is narrower then they make more money in average.
Example: if the Apple's quote is 95/105 (buy/sell) today and 105/115 tomorrow, an invidual trader buying and selling would just break even (buy at 105 and sell at 105) even though Apple's notional fair value has risen. But if there are more market makers, the quotes would be 99/101 and 109/111. Then our individual trader would make 109 - 99 = 10 in the same market conditions.
You're right that a wider spread wouldn't matter much to an individual trader, but that's mainly because their main cost is trading fees (paid to the broker) anyway. For mutual funds, though, a 1 basis-point change in the spread means a lot of money.
Let's say on average it was $0.01 per dollar. As soon as someone entered the market with some microstructure expertise and strategy, everyone but the microstructure guy starts making (say) $0.005 half the time and losing $0.006 the other half.
Reducing some of the randomness and providing more consistency is certainly worth something; you can imagine an example where it was +/- $0.50 per dollar reduced to +$.005, - $.006, but note (assuming the same dollar volume) that the HFT guy would still be making the same amount of money as in the previous example, where he was providing much less value. I.e. the cost that HFT commands isn't strongly tied to the value it provides. This is without even delving into the latency-arbitrage arms race cluster fuck.
No it wouldn't. Unless you make some really odd assumptions (like the traders are monkeys), you could still have tons of limit orders and NO executions. That's what happens to iliquid stocks.
But is it real liquidity or the illusion of liquidity?
Liquidity is, more or less, money ready to be invested.
The question of whether sophisticated strategies really provide this is complex, like the strategies themselves. If you want background, I think Doug Noland's Credit Bubble Bulletin has done a good job of addressing these questions over the years.
At the same time, I think we can see simple things. The big question isn't day-to-day-liquidity but liquidity-when-you-need it. By that measure, when we look at recent and older wild-swings in the market and especially the "flash crash", it seems fairly evident that the spectrum of "sophisticated strategies" don't provide liquidity-when-you-need-it and that is increasingly a problem.
The rest of your analysis is nonsense.
The existence of money to be invested is what makes a stock markets liquid...
Money to be invested is the necessary ingredient of a "liquid market". And a liquid market is a complex thing to measure. A market can easily seem liquid if lots of shares trade. But if it's the same shares over and over again on a day-to-day basis and if any time a large block appears, the price goes way down, then the market has an illusion of liquidity rather than real liquidity.
I see the value of the former, having an asset you can't sell means its value is rather pointless, but I'm not sure I seed the point of the latter. Isn't money made in the stock market by price volatility? Doesn't algorithmic trading simply smooth out price fluctuations to the point that individual traders receive nothing, while HFT houses skim immense numbers of tiny slivers?
It seems to me that we're moving toward the future that some people want: that we only invest in companies which we believe have real growth or dividend payout potential over the long term. Meanwhile, money will continue to be made by "gambling" on price fluctuations, but only by high frequency traders.
I can't help thinking that liquidity has diminishing returns, and I definitely think that claims of HFT value are heavily undermined by their tendency to drop out of the market during crashes.
If I'm wrong in these views, I would love to be enlightened.
Not completely. There are still dividends. (Or being able to live in a house, or rent it out, if we are talking about real estate assets.)
Yes. Good speculation smooths out price fluctuations to the point that bad speculators receive nothing, while good speculators receive all the alpha. This is true not only of HFT, but of any good strategy.
...claims of HFT value are heavily undermined by their tendency to drop out of the market during crashes.
If you don't want HFT and other speculators to drop out of the market during crashes, don't break trades after the fact.
During a crash, most HFT's should make money hand over fist. But if the market centers break trades, HFT's are in danger of stabilizing the market and being heavily penalized for it.
I.e., if an HFT pushes accenture up from $0.05 to $1.00 and sells at $35, following which accenture eventually goes up to $40, they run the risk of having their $1.00 buy trade broken. Then they are stuck with a short sale at $35, while the price of accenture went up to $40.
Shouldn't both trades be broken, though? Breaking just one sounds like the kind of behaviour that would be a strong disincentive to trade at all in the first place.
Under current market rules, no. Besides, this would quickly become a combinatorial disaster. Think of your counterparty who bought at $35 and sold at $36 - now one leg of his trade gets broken, and he has a short position. Or maybe we break both of his trades? Where does the chain end?
And of course, this still hurts people doing stat arb. If you want to go long accenture, short IBM, and your accenture trade is broken, you find yourself with an unhedged IBM short.
Breaking just one sounds like the kind of behaviour that would be a strong disincentive to trade at all in the first place.
This is why HFT's pull out of the market under circumstances where broken trades become likely. Most of the HFT's that stayed in the market during the flash crash made huge money - volatility rocks.
This generally affects sales involving large quantities. Say you want to sell 10000 of IBM. The current order book at the exchange looks like:
165.55 - 10
165.54 - 20
165.53 - 200
165.52 - 500
165.51 - 100
Market Order: As soon as you place your order, you are going to sweep the order book above. End of those 5 transactions, the market has moved to 165.51 while you've only liquidated 830 of your 10000! Worse, people are noticing a lot of sell activity so the folks who wanted to buy start placing bids at lower & lower prices. By the time you liquidate all your 10000 stocks, the average price you end up getting would be 165 or 164 or lower! You've moved the market by virtue of your sale & made less money as a result.
Limit Order: If you place a limit order for SELL 10000@165.55, then you sell the first 10 to the current highest bid. After that, everyone knows there's a seller looking to offload 10000 units. So they lower their bids. You are worse off!
By now, I hope it is clear why you should care about not moving the market by your sale. The way to solve this problem is to sell in small chunks periodically in ways that does not signal to the market what your actual quantity is. As you can imagine, computers are pretty good at doing this kind of grunt work. Hence Algorithmic trading :-) Specific examples would be VWAP, TWAP, etc. Just Google for them.
PS: this has nothing to do with HFT algos.