Algorithmic Trading is the Modern Gus Gorman

In Superman 3 Gus Gorman (Richard Pryor) is a computer genius fed-up with the government taxing so much of his pay (don’t get me started).  Frustrated, he hacks his company’s payroll system to collect all the rounded off half-cents.  His boss, rather than fire him, sees this as an opportunity to reap massive rewards from the financial system and rule the world.  Well, thanks to Superman, it didn’t work out too well for them.  (Watch the video here. It’s worth a chuckle and tell today’s story.)

Superman, we know is fiction.  High-frequency trading to capture itty-bitty gains is real, and legal, and is creating billionaires at our expense.

Today’s But if Not is the story of how hedge funds, with superfast computers and algorithms have, essentially, figured out how to capture the half-cents.

From a recent Wire magazine post, Algorithms Take Control of Wall Street

algorithmic trading has overtaken the industry. . .  computer code is now responsible for most of the activity on Wall Street. (By some estimates, computer-aided high-frequency trading now accounts for about 70 percent of total trade volume.) Increasingly, the market’s ups and downs are determined not by traders competing to see who has the best information or sharpest business mind but by algorithms feverishly scanning for faint signals of potential profit.

With these algorithms and superfast computers traders can, at their most benign, react to market moving information faster than others, and, more manipulatively, peek at and take advantage of orders and  subtly manipulate prices. 

While not precise, it’s the modern equivalent of catching the half-pennies.  The truth is it’s much more complex than that.  Some traders use algorithms to read news stories and trade ahead of emerging sentiment.  Others use them to arbitrage prices across different markets, which may only exist for seconds.  While others still are simply trying to hide very large trades.

But where do the billions that they make come from?  Oversimplifying for the sake of clarity, it’s getting into a position before the market reacts to news – such that they capture significant portions of the market gains that come from real innovation.  It’s a suckers bet for the lay investor to try to beat the professionals.

But to what effect really?  Why should we the general public care what these guys do?

On September 27 Progress Energy stock collapsed 90 percent in less than a minute.  Had the Harris Nuclear plant melted down?  No.  Many different automated trading algorithms had found a trading opportunity and, in a feedback loop reacting to each other,  spun out of control.  But that’s just one stock and one isolated incident. 

 How about the whole stock market?  In May the Dow plunged nearly 10% in five minutes in reaction to a single trade.  This trade was no ordinary “buy 100 shares of GE for $50.”  It was a $4.1 billion dollar futures trade, designed to be executed in many micro-trades, the purpose of which was to make it invisible to the market.  The problem began when other algorithms found the trade and began making their own trades in reaction.  From the report analyzing the flash crash

Still lacking sufficient demand from fundamental buyers or cross-market arbitrageurs, HFTs began to quickly buy and then resell contracts to each other

Let’s slow down for a minute to make sure that we adequately digest that little nugget.  “Lacking sufficient demand from fundamental buyers” can be read as real investors, with real knowledge of the real value of the asset class were satisfied with the market price.  Lacking buyers, the algorithms began trading with each other, until the artificial volume spike triggered a “real” market reaction.  From the NY Times piece on the flash crash

Startlingly, as the computers of the high-frequency traders traded contracts back and forth, a “hot potato” effect was created, the report said, as contracts changed hands 27,000 times in 14 seconds, but with eventually only 200 actually being bought or sold.

The selling pressure was then transferred from the futures markets to the stock market by arbitrageurs who started to buy the cheap futures contracts but sell cash shares on markets like the New York Stock Exchange.

What happened is that the hedge funds, in their quest to shave the half pennies, had accidentally triggered a crash and exposed themselves.  The risk they pose is not a flash crash these are the sound of the cookie jar hitting the floor as the thief slips out the door.  The risk is the loss of wealth and confidence from the thievery.

There are those that say the traders are important.  I, for one, have long wondered what the value is of what they are doing.  Perhaps they add liquidity.  But in so doing they are transferring the gains from true economic trade and innovation from society to themselves.  They are Gus Gorman.  Where is Superman?

For more on algorithmic trading and high frequency trading take a look at these articles.

This entry was posted in Benefits from Trade, Economics, Trading and tagged , , , , , , . Bookmark the permalink.

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