[steve8918]

Absolutely terrible blog post. Saying algorithmic trading isn't HFT is like saying a bird isn't an ostrich.

HFT is a subset of algorithmic trading. It's as simple as that. Not all algorithmic trading is HFT. But all HFT is algorithmic trading.

Algorithmic trading is any type of trading done based on an algorithm, and not based on "traditional investing principles". For example, "buy when the 10-day moving average crosses over the 20-day MA, and sell when the 10-day it crosses below 20-day". One of the most famous types of this is Richard Dennis and the Turtle Traders, where a successful commodities trader took a bunch of ordinary people and tried to turn them into traders using this method.

I'm also an algorithmic trader. Not a wildly successful algorithmic trader yet, but I'm still learning and growing, and I love it more than any programming venture I've ever been involved with. And I haven't taken a catastrophic loss yet, so that's good. I trade on 3 separate markets using different algorithms, and for the most part it is fully automated. I'll hold futures contracts anywhere from 1 seconds to 20 mins.

HFT is several orders of magnitude more intense. For the most part, they are types of arbitrage, where they can arbitrage a few cents worth of difference in stock prices between different markets, and make a few pennies per 1000 shares. Or they will arbitrage between the price of an ETF or futures contract and the underlying basket of stocks that it represents. These are the ones that need colocation and trade on the millisecond. The more nefarious ones are the ones that game the system, by "quote stuffing", by frontrunning large orders by institutions, or by creating volatility through momentum-trading.

Is there a downside to algorithmic trading? Sure. Algorithmic trading is what has turned the stock market from a predictive market of future earnings, into essentially a casino, where the predictive nature of the markets is completely dead. Instead, it's about thousands of computers running random number generators and picking up nickels every 10 ms. This is why I believe there will be market crashes every 7-10 years, and long term investing is dead.

But unfortunately, this is the reality of the system that we live in, and we have to adapt or die. Or you can just buy bonds and get a stable 3-5% return every year, which is nothing to shake a stick at.

[flourpower]

What evidence do you have that the stock prices have recently become less predictive of future earnings? Was the market performing its predictive duty in, for instance, September of 1929?

[steve8918]

Previously the vast majority of investors were buy and hold, where they believed in companies and that their earnings would increase. Of course, there were always traders like Jesse Livermore that traded off of order flow, but those were the minority. Most were like Warren Buffett where buying and holding was for the best.

Now the majority of trades are done by algorithms with no biases at all towards the earnings growth of a company, be it HFT, or statistical arbitrage, or through other quantitative models.

HFT accounts for 75% of daily volume, and by definition, HFT does not take into consideration things like future earnings growth, etc. For the most part, they simply find arbitrage opportunities and profit from them.

So stocks being bought and sold are not done based on the earnings potential of a company. Case in point, Citigroup before the reverse split was trading hundreds of millions of shares per day, not because so many people believed in the company, but because it was dominated by rebate traders, HFT, day traders, etc. I believe companies like Fannie Mae and Freddie Mac were trading millions of shares before they went pink slip, even though it was known that they were defunct.

[flourpower]

You're talking about volume, not price. Increased volume should, if a market is performing "properly", accompany new information. If there's new information, there's a reason to trade. The examples you cited seem like evidence of the stock market's predictive value - for instance, increased volume in Citi stock was a piece of evidence that something about the security was expected to change.

Moreover, it's not true to say that stat-arb guys don't care about future earnings growth - they just use statistical methods to project it. To use a simplified example, a stat-arb guy might automatically buy shares in some small-cap automotive supplier if Ford rapidly increases in price. If the increase in Ford stock represents positive fundamental information about the auto industry, they've applied that information to the price of the supplier faster than a human would have and they'd make a profit. If, on the other hand, it represents concern about some scandal involving the Ford CEO, they've contributed to the noise and lost money.

[steve8918]

I probably wasn't clear with my original statement. I said the stock market used to be a "predictive market of future earnings". What I meant more precisely was that the stock market used to be a market where people would make prediction about future earnings about companies. If you thought a company was doing well, you would buy and hold it, a la Warren Buffett. Some people traded order flow and other things, but the vast majority traded it as if it was a proxy for future earnings growth.

Over the years, that has changed. Once the internet hit and day traders became more common, it became more and more about buying stocks that will go up and selling stocks that will go down. I think people forget that even during the 90s, commissions for buying and selling stock were in the hundreds of dollars, not $8.95 like today. It was expensive for retail investors to buy and sell stock.

The time period for holding stocks has decreased sharply since then, where a few years ago rebate traders would buy and sell stock to just get the rebate from the exchanges, and now to where HFT eat the lunch of those same manual rebate traders.

The vast majority of trading done on the markets today is not done based on the quality of the company or the quality of the earnings, but based on how the stock will trade. Sure, there's still institutional trading, and I'm sure plenty of quant models make use of things like earnings growth, etc. And yes, things like news and fundamentals do cause prices to go up and down. But the vast majority of daily trading, 75% of volume, is done by trading entities that don't care about fundamentals, and only care about miniscule movements in the stock price. This is why I use volume as evidence, because it demonstrates that most trading done isn't done because of the predictive nature of the stock market for future earnings, but because of the extremely short term predictive nature of the stock price itself.

That's why I said that it's less about predicting future earnings grow and more about making nickels every 10 ms. C trading 500MM shares a day is like people rolling dice every millisecond in the alley way and exchanging money upon every roll. The other example that I was searching for but couldn't recall was when GM went bankrupt and the stock was still trading over $1. This was purely trading activity even though the "future earnings" of the stock was 0.

It's become a casino where probability theory dominate and less about "I drink Coke so I should buy KO".

BTW, I'm not saying this is good or bad. I just believe this is how the markets are. The same thing happened when daytraders entered the markets during the dotcom boom. I do believe gaming the system, trying to "break" the markets with quote stuffing, etc, is wrong, but fundamentally I believe that the nature of the markets have changed, and anyone who wants to get involved in it should understand the nature of the change. Anyone who thinks that they should keep their money in mutual funds and let the mutual fund companies sip 2-5% every year for doing worse than the markets, and then also exposing yourself to market crashes every 7-10 years, I believe, are fools.

[yummyfajitas]

I said the stock market used to be a "predictive market of future earnings". What I meant more precisely was that the stock market used to be a market where people would make prediction about future earnings about companies.

These two statements are not even discussing the same thing.

One statement discusses the practical computational power of a system. The other statement discusses the motivations of a majority of the people participating in that system.

[justincormack]

Historically there have been people trading off various schemes other than fundamental value forever, whether they be the public rushing into the bubble before the 1929 crash, or the chart-trading technical traders who have been around since at least the 1980s. And dont forget the people manipulating and cornering the market. None of this is new...

[eru]

If nobody were investing long term any longer, wouldn't there be less money in the system, and thus it would be relatively cheap to buy and hold?

[steve8918]

Not sure exactly what you're asking, but the fact is that trading has been drying up. Since 2007, volume has plummeted, and August I believe was one of the worst, if not the worst, month for people withdrawing from mutual funds. Less and less retail are staying in the markets because of the volatility.

So I don't know if it will get cheaper to buy and hold. It will definitely get more volatile.

[eru]

If the increased volatility is driving people out of the market, people who don't mind the volatility should profit, shouldn't they?

[ovi256]

Exactly, until their counterparts are all gone and they're left moving hot potatoes among themselves.

[eru]

Why? Warren Buffet doesn't need a counterpart after he buys a stock.