Law & Disorder / Civilization & Discontents

The Sorcerer’s Apprentice, but with money: another look at HFT

A new series of visualizations from a market data feed firm paints a true …

"Why don't you know BATS [the third largest equity market in the world]?," Bernard Donefer, a finance professor and HFT expert at CUNY's Baruch College, asked me rhetorically. "Because there's nothing to look at. It's based in Kansas; the computers are in Jersey City." -- The Matrix, but with money: the world of high-speed trading

In the opening part of my first article on the bizarre and fascinating world of high-frequency trading, I went to some lengths to debunk the notion that "the stock market" looks anything like those still-popular press and movie images of gel-haired, frantic young traders screaming at each other across a large, open trading pit. Today's markets are essentially electronic networks, where humans and machines trade against each other via terminals and server racks.

But just because the markets are electronic doesn't mean you can't take a picture of them. Market analysis firm Nanex has produced some very compelling visualizations of the type of sub-second trading that goes on in our electronic exchanges. A number of the pictures are from BATS—a fully electronic exchange that consists of a bank of computers in Jersey City—but others cross multiple exchanges.

Nanex's visualizations page contains an ongoing catalog of the traces that stock-trading bots leave in the market, as they move individual symbols up and down in price thousands of times per second. The obvious, repetitive, algorithmically generated patterns produced will be familiar to any physicist or electrical engineer—the stock market is a now a networked collection of high-frequency oscillators and feedback loops of varying sizes, where computers cycle stock prices by the millisecond.

To get a sense of how this looks without clicking through to the Nanex page, take a look at the charts below for SHG, an NYSE-traded company company called the Shinhan Financial Group.

The Google Finance chart above shows the trading activity for July 14, 2010. Clearly, nothing unusual happened—it looks like a typical stock on a typical day.

But over the course of one second, at exactly 9:36:26 ET, a rapid-fire series of 760 quotes produced the following pattern:

Nanex calls this pattern "the Blue Bandsaw," and it's a small sample of a longer 11-second period in which 15,000 quotes were pushed through the exchange and the price oscillated in this cyclical pattern.

The pictures above may cause you to wonder if there's any meaningful relationship between the Google Finance chart and the Nanex chart. In other words, does the algorithm-generated activity that happens at the sub-second level affect the overall course of the stock on longer timeframes (a day, a month, a year), or are the two kinds of trading more or less independent?

Proponents of HFT argue that they are independent—that such millisecond fluctuations in a particular stock's price don't affect that same stock's price on a time scale that longer-term investors care about. Critics of HFT find it preposterous that such a fundamental change in the very structure of the markets has either a neutral or benign impact on long-term investors; in the wake of the May 6 "Flash Crash," those critics have gained some clout.

Informal conversations I've had with money managers and traders indicate that in the wake of the Flash Crash, even the insiders are scared of what the markets have become. Still, they have no choice but to keep trading—not only must they keep trading, but everyone is quietly stepping up their automated trading efforts to avoid getting eaten alive by their competitors' machines. It's a bit like The Sorcerer's Apprentice, except that there's no master magician who can step in and save us in the end.

Wherever you come down in the HFT debate, everyone with any money in the stock market would be well served to take a look at Nanex's pattern collection, so that they get the antiquated image of the trading pit out of their heads and get a real picture of the market that they've entrusted their assets to. Caveat emptor.

If you're interested in more details of the patterns and the backstory on how they were uncovered, Alexis Madrigal at The Atlantic has a great story up on them. Zero Hedge actually had this story a few days before Alexis, but their chart dump doesn't have nearly the amount of context.

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