{"id":5335,"date":"2013-07-28T06:57:36","date_gmt":"2013-07-28T10:57:36","guid":{"rendered":"http:\/\/www.jasonapollovoss.local\/?p=5335"},"modified":"2018-09-21T02:04:04","modified_gmt":"2018-09-21T06:04:04","slug":"beware-the-alpha-sharks-high-frequency-trading-and-its-impact-on-markets","status":"publish","type":"post","link":"https:\/\/jasonapollovoss.com\/web\/2013\/07\/28\/beware-the-alpha-sharks-high-frequency-trading-and-its-impact-on-markets\/","title":{"rendered":"Beware the Alpha Sharks! High-Frequency Trading and Its Impact on Markets"},"content":{"rendered":"

Maureen O\u2019Hara<\/a>, professor of finance at Cornell University, and member of the Systemic Risk Council<\/a> has a warning to traditional investment managers, i.e., low frequency traders (LFT): High-frequency trading<\/a> (HFT) is now the norm, and it is not going away. Continuing to pretend that HFT has no effect on your investments and on your alpha is at best na\u00efve and at worst ignorant. Need proof?<\/span><\/p>\n

New Laws, Including Breaking the Speed of Light<\/strong><\/span><\/p>\n

Both the Chicago Mercantile Exchange and NASDAQ are building a new faster link between their data centers in Chicago and New Jersey to \u201cbeat\u201d the speed of light. Wait, I thought the speed of light was a universal maximum? It is, but you see by constructing two 60-foot towers the additional height travels a shorter distance than if the connection were at ground level due to the curvature of the earth. Doing this earns each transaction a faster execution time of\u00a0\u2014 wait for it\u00a0\u2014 4 milliseconds!<\/span><\/p>\n

Exchange attention is directly proportional to the amount of trades executed on their exchange. Tall towers will result in more orders and thus, more profits. So HFT is not going away, and this is why you have to understand it.<\/span><\/p>\n

Importantly, as O’Hara pointed out at the\u00a02013 Financial Analysts Seminar<\/a>, \u201cgetting HFT\u201d is not just about obsessing over speed, as the media so often does. No, she argues markets are forever different, yes, due to the speed of trading, but also the nature of market making, and even basic concepts like liquidity are dramatically different in an HFT world. \u00a0O’Hara emphatically states that this does not make markets worse, just different than before.<\/span><\/p>\n

One important advantage discussed infrequently is that HFT bases decisions on a large amount of information. This processing speed of Big Data is leading to the development of new fundamental information, and combined with the lightning-quick execution, you are at a permanent disadvantage. You might ask, \u201cHow weird could it be, really?\u201d<\/span><\/p>\n

Your Clock is Wrong<\/strong><\/span><\/p>\n

Since the dawn of time, humans have based their time measurements in chronology. That is, for people, time is a measurement system used to sequence events. But machines think in terms of cycles and are therefore event based, not time based. Machines complete a cycle at various rates depending on the amount of information involved in a particular instruction. So machines are volume based. Their world is measured in jobs done, not in the regular rhythms tapped out by time.<\/b><\/span><\/p>\n

As it happens, HFT relies on machines, and thus it relies on measuring time in terms of events. This volume-time is challenging for us humans. But for a “silicon,” it is the natural way to process information. Why is this important?<\/span><\/p>\n

If you use a volume clock as opposed to a time clock to measure returns\u00a0\u2014 say look at trades every 1,000 shares\u00a0\u2014 return distributions are much more well behaved. Goodbye fat tails. Goodbye the leptokurtic middle. Goodbye skew. Because HFT machines are looking at the world through a volume-clock lens, your actions are predictable; the distributions allow for extremely accurate predictions.<\/span><\/p>\n

Ever lose money because a savvy trader anticipated your actions? Thought so. Now imagine an army of machines all looking at the world through their lens and programmed to take advantage of your na\u00efvet\u00e9. In other words, machines can see your clumsy human trades from hundreds of milliseconds away. Goodbye alpha!<\/span><\/p>\n

Alpha Sharks<\/strong><\/span><\/p>\n

We are all swimming in silicon waters, whether we want to or not. Now there are \u201cpredatory algorithms\u201d or \u201calgos\u201d looking to feed. These algos are a special type of informed trader. Rather than possessing exogenous information yet to be incorporated in the market price, they know that their endogenous actions are likely to trigger microstructure mechanisms in either your trader or your algorithms, and all with a highly predictable and foreseeable outcome.<\/span><\/p>\n

Examples of these alpha sharks include:<\/span><\/p>\n