What people don't seem to get about HFTs is that retail investors cannot and should not attempt to compete with them or trade actively at all - HFT or prop trading is a big no-no for the unsophisticated.
Historically buying into an index fund during a crisis is a perfectly reasonable way to achieve relatively easy alpha above the mutual fund/bond rates (~12% per year).
This type of investing (aka diversified value) is completely separate from HFT. As far as many retail investors should be concerned HFTs can duke it all out between themselves as much as they want - it really doesn't matter and is irrelevant to your long term investment decision.
Indeed HFTs provide the benefit that during times of crisis they provide plenty of buy side liquidity for you to get in at a lower spread and a lower spot price relatively easily.
Are you saying that HFTs have no impact on Alice and Bob regardless of how prudent they are about investing? In addition to ETFs Alice and Bob also have market exposure through a company 401k. Are the 401k managers and ETF managers immune to the effects of the HFTs?
On the page[1] first documenting this algo NANEX says the following:
"We believe that this algo will continue to grow and if left unchecked, could very well contribute to the next flash crash because it removes precious network capacity and provides zero economic value such as price discovery."
It has no effect on Alice and Bob if they don't sell. It is favourable to them if they buy.
The stock price is just the opinion of 0.2% of people at any one time - and hence means essentially nothing to an investor. Does the spot price opinion/first impression of a person matter - or does the long term attributes of their character matter? Just because there are more opinions - being given at a faster rate - doesn't mean that a) they're right or b) they should be acted upon as fact and c) that they shouldn't be exploited for those of a more stable nature.
For example: I bought a huge amount of TSLA stock when it fell 12% in one day a week or so ago for no particular reason. I subsequently realised a 6% gain. I'm happy - thank you HFTs and short term traders - your vol makes my alpha.
No, he's arguing that events like flash crashes don't destroy wealth at all. If the market returns to its original equilibrium after a week or so, then its as if the crash never happened at all.
Just keep in mind, in the stock market, you haven't made or lost money until you close out your position.
There's as much wealth created when the price rises again as there is destroyed when the price first erroneously falls, all other things equal. What's really being described is turning a profit on prices that are, for whatever reason, set too low and return to previous levels soon after.
Indeed. No one should be pitied for losing money in the stock market. If you know what you're doing, you'll know that there's risk involved; if you don't know what you're doing, you shouldn't be picking stocks in the first place.
People who lose out by being on the selling-too-low side of arbitrage have nothing to complain about. If you had a stop-loss order, you cede your position to the possibility of being sold too low. Moral being that like you said, if you're investing in something that might warrant a stop-loss order, you should be sophisticated enough to use something better instead.
>> If you're investing for long term - you shouldn't be investing in things that require stop losses.
Except that in the long term good companies sometimes go bad quite suddenly. Frequently, the harbinger (e.g. CFO suddenly quits) will erase a lot of wealth quite rapidly. Stops are a good way to not have your portfolio blow up while not also having to obsessively follow the news.
As an individual investor, you're not going to beat the automated algorithms on breaking news anyway. Trading individual stocks is a fool's game. Buy and hold index funds.
Just to be clear, I wouldn't counsel racing algorithms (this should be obvious). But you want to be able to exit somewhat rapidly in case of catastrophe at a portfolio company. A stop can turn a big loss into a smaller loss.
>> Buy and hold index funds.
To each his own, but this strategy has been pretty easy to beat over the last 20 years (even easier over the last 10), for those willing to study companies at all.
>Indeed HFTs provide the benefit that during times of crisis they provide plenty of sell side liquidity...
Any proof to that claim? Liquidity evaporated during the flash crash. The SLPs have no obligation to provide liquidity and can simply pull the plug when the market is in crisis. [1][2]
Buy side liquidity means quick access to sellers at little cost and on favourable terms to you. This was always the case - HFTs just make it faster and easier.
So if you are a buyer in a crisis - you get a better deal with HFTs quickly matching supply/demand of large stock orders. If you are a seller - you're screwed either way - HFT or not (see history).
Buying in the dips might give you a median positive return (95% of the time you'll come out ahead) - but your expected return can easily still be negative due to what happens the other 5% of the time.
If you're following a very simple strategy based on past returns that seems to make money all the time, you should wonder what the rest of the market is afraid of that you can't see.
If you bought in at 200 after the market had plummeted from 380 down to 200, you'd probably be thinking your strategy is working pretty well - especially once it rallied back to 290 or so. But after that point you'd be waitinga LONG TIME to get your money back. It wasn't until 20 years later - the 1950's!! - that the DJIA finally sustained a level above 240 (and not before falling to 40 - good luck staying solvent through that!!).
And this is only because the US economy did eventually recover (thanks to World War II). Argentina's stock market never did recover. There's no such thing as "time diversification". In the long run, the variance of your annualized return increases: http://www.norstad.org/finance/risk-and-time.html
This is why the DJIA fell to 6500 in Oct 2009. If you bought then, you are probably feeling pretty smug now - but it's simply that the rest of the market was afraid of Great Depression II and you may not have even realised that it was a possibility.
To say that you can obtain a positive expected return by following any strategy that is solely based on what the price has done recently is just as "naive" as a retail investor who thinks they can beat HFT algorithms.
As the SEC says: "Past returns are never an indicator of future performance"
1: I've been long TSLA since the IPO - I simply bought more stock with cash on hand. I'm not just median riding - although that is a relatively effective strategy for high earning companies/growth.
2: Risk is risk - TANSTAAFL. Great Depression risk is there just as there is nuclear war risk. I take it because I can. I try and make sure I pay the right rates though.
3: DJIA is not the entire market - it's a highly constrained subset.
4: Following past strategies does have positive value - it's what investing (and everything thing you know) is all about.
You live and die by induction.
Thinking that you are high on your black swan horse by stating otherwise is pointless.
Decisions need to be made and money needs to be correctly invested under uncertainty. Taleb guys bore me.
During a liquidity crisis - aka any crisis - buyers don't get front run - sellers do. There is a reason for this - front running only occurs when you want something (liquidity) without having to pay for it first.
For example: You want to off load a metric ton of stock in a company - you tell your broker - he puts out a VWAP sell call to an algorithm - HFTs realise - they short sell to anticipate your liquidity premium (aka you want to sell NOW and you are willing to pay for it).
If you didn't want to get out so bad - you cannot be front run - because you wouldn't demand a liquidity premium.
Buy side liquidity means quick access to sellers at little cost and on favourable terms to you. This was always the case - HFTs just make it faster and easier.
Maybe there is a terminology glitch. Buy side and Sell side mean something else, generally. Buy side is commonly referred to people holding asset on book, and sell side are capital raisers or intermdiaries.
If I'm buy side, I want liquidity -- period. HFT does not provide liquidity, it provides decreased "viscosity". As you note, (observed) liquidity evaporates under high Vol. Which, if it were true liquidity, or if markets participants met the threshold assumpyions of EMH, would not be the case.
If you're trying to differentiate two sides to a trade on an exchange, that's usually referred to as Bid/Ask. Again, observed lack of liquidity on one side or the other (or: massive spreads), signify commonly held assumptions about the markets are askew.
If we throw away EMH behavioural assumpyions, and we throw away liquidity, what we are left with is the following:
(1) Opportunistic market participants;and
(2) Ultra-low transaction viscosity.
These are a shitty combination, from the perspective of public policy. The lack of viscosity actually increases the returns to increasingly obscure and opaque methods of market maniplation.
Prop trading (proprietary trading) just means a firm is using their own money as opposed to trading on a customer's behalf. So the retail investor is by definition almost always engaging in the practice.
I agree completely ... let the HFTs eek out a few pennies per trade (or even fractions of cents). But I also wanted to see how much bandwidth my 4G phone could really use. Sorry for the perturbations I might have caused and I promise I'm only doing what's good for man-kind. Now if I could just get my phone to make a decent call!
I don't know what you mean. HFTs don't do what's good for mankind - they do what's good for themselves. Just like everyone else. No one does what's good for mankind - they do what's best for themselves.
We allow those who don't harm others to continue doing what benefits them - until such a time as it is shown to be harmful - then we stop it. HFTs have not been shown to be harmful.
It's more nuanced than that. There are things like patents and copyrights. When it suits them, big C capitalists demand longer trading terms, then turn around and say the opposite when it comes to HFT (shorter trading terms). (They also do this with their accredited investor requirements).
HFT harms society because it cuts off the number of investors that can do active trading. It's net effect is the same as regulations the keep out entrepreneurs from innovating in things like health care and drones and car manufacturing.
Concentrating trading in a few hands is the problem we had - too big to fail. HFT will lead to barriers to new entrants (because of increasing startup costs).
>Concentrating trading in a few hands is the problem we had - too big to fail
No. You're confusing things. High frequency trading had nothing to do with financial bailouts. To my knowledge, no high frequency trading shop has ever been bailed out or deemed too big to fail.
>HFT will lead to barriers to new entrants (because of increasing startup costs).
Please explain this, how does HFT increase startup costs?
I'm not sure who you think benefits the most out of high frequency trading, but it's not huge banks like Goldman Sachs. My understanding is that the best high frequency shops are relatively small. They're made up of a mix of programmer and quants, not traditional investment bankers.
I'm not confusing anything. Yes the previous crash wasn't HFT but current trends will lead to the already rich (the banks) being the HFT's because the land surrounding the exchange is limited and costs will increase (HFT is about land and computer resources, and high speed networks - new models don't factor in as much). It won't be programmers calling the shots, they'll be employed by the banks. Already, the average geek is outgunned (overall competitiveness has decreased).
How do you figure the average geek is outgunned? There are multitudes of small HFT shops staffed mainly by geeks in Manhattan doing pretty well. HFT tends not to be profitable enough for banks to bother with, especially if you have to pay most of your profits to the programmers behind it so they don't leave and do it themselves.
Yeah because retail investors should do more with their money - not.
There's a reason these industries are hard and should be hard - these are serious industries with serious consequences. Health care - screw it up and you kill someone. Drones - screw it up and you kill someone. Cars - screw it up and you kill someone. Finance - screw it up and you lose the retirement savings of your investors.
These are not games to be played by unsophisticated people or green entrepreneurs. This does not mean that the extant incumbents are any good - it merely means that new players does not automatically confer innovation goodness (see natural monopolies/booms).
The argument you're making is in favor of my argument of regulating HFT (I want a limit to daily or weekly trade, others want more taxation).
As to regulation on healthcare/drones/cars etc. things aren't perfect, that's all I'm saying. I think things are too restrictive right now, I'm not arguing for abolition of all regulations.
edit: Yes, retail investors should be trading more. That's the idea behind the recent rise in crowdfunding. Innovation happens a lot faster in small c capitalism than in big C capitalism.
Crowdfunding will be the core of the next tech bubble peaking ~2016-2018 - run on afterburner with the success of product pre-purchase launches (irrelevant to investment), the aggressive lobbying of VCs, the credulity/unsophistication of most investors and the passing of the JOBS act combined with the cycling of alpha searching global credit saturating the niche industry known as Silicon Valley.
But I'll gladly take part and take people's money while the times are good.
I don't particularly care either way - I make money no matter what the market.
Historically buying into an index fund during a crisis is a perfectly reasonable way to achieve relatively easy alpha above the mutual fund/bond rates (~12% per year).
This type of investing (aka diversified value) is completely separate from HFT. As far as many retail investors should be concerned HFTs can duke it all out between themselves as much as they want - it really doesn't matter and is irrelevant to your long term investment decision.
Indeed HFTs provide the benefit that during times of crisis they provide plenty of buy side liquidity for you to get in at a lower spread and a lower spot price relatively easily.