Who made the investment decisions for HFTs: people or computers?

2:45 pm May 6, 2010, with the Dow Jones down more than 300 points for the day, the equity market began to fall rapidly, dropping more than 600 points in 5 minutes for an almost 1000 point loss on the day by 2:47 pm. Twenty minutes later, by 3:07 pm, the market had regained most of the 600 point drop.


This May 6, 2010 Flash Crash or The Flash Crash was the second largest point swing with almost 1010 points in Dow Jones Industrial Average history. It was also the biggest one-day point decline with 998.5 points.

CNBC Coverage of the Dow 1000 Point Plunge - "Machine Error"

What made this happened? Why did the financial markets experience such huge fluctuation in just twenty minutes? After five months of investigation, the U.S. Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) issued a joint report (FINDINGS REGARDING THE MARKET EVENTS OF MAY 6, 2010). The report attributed the decline to Sell Algorithm and HFTs. The trades of E-Mini S&P 500 from Sell Algorithm dropped the market 3% in the first four minutes, and then followed by the huge trade of HFTs. Most of trades were triggered by the computer, who detected the arbitrage opportunities or stop loss requirements, then launched tremendous orders in just several minutes.

So what is HFTs? Why do they have such huge effect on the financial markets? HFT, High-frequency trading, is to use complex technological tools to trade securities like stocks or options. Generally speaking, HFTs employed computerized algorithms to analyze incoming market data and traded in large quantities within very short period. The purpose of their trade is to trade them immediately, but not to hold the position. They gain profits by accumulating very small money from every trade. At the end of a trading day, they generally hold no net position. 

                                                                        
                                                                                                What is high frequency trading?


Since HFTs are very sensitive to the processing speed of markets and of their own access to the market, they highly rely on the information and communication technology. They compete with each other on a basis of speed. HFTs use the best technology to communicate information and the fastest computers to process market information. "It's become a technological arms race, and what separates winners and losers is how fast they can move," said Joseph M. Mecane of NYSE Euronext, which operates the New York Stock Exchange(Stock Traders Find Speed Pays, in Milliseconds).  Also please listen the interview audio from Charles Duhigg on HFTs.

High-Frequency Trading:- Corporate super computers cornering share markets

With advancement of information and communication technolgoy, HFTs are experiencing rapid development. In 2009, they accounted for 60 percent of the daily U.S. stock market volume of 9.8 billion shares and about 40 percent of futures and foreign-exchange trading (Trading Pennies Into $7 Billion Drives High-Frequency’s Cowboys).

At the end of day, through high frequency trading people may win a lot of money, however, they may also lose tons of money. But why do people make or lose money? It is by people themselves, or by computers. Is it competition between people, or race between machines? Who made the investment decision? In the future digital marketplaces, people need to think about the relation between people and machines.

The engine of hedge fund - information and communication technology

On April 19, 2012 I led a team of ten first-year Global MBA students from The Johns Hopkins Carey Business School to visit Campbell and Company, one of famous hedge fund based in Baltimore. Founded in 1972, Campbell & Company is a pioneer in absolute return investment management, specializing in systematic managed futures and equity market-neutral strategies. Mike, director of trading, Jon and Grace, research manager gave us a wonderful presentation on how they do research and trade. There is lots of insightful information.



A hedge fund is an investment fund or asset fund that can undertake a wider range of investment and trading activities than other funds. Due to risk exposure, hedge fund is only open to some particular types of investors specified by regulators. Typically most of them are institutions and higher net worth individuals.

Hedge fund introduction

"We have tree trading teams", Mike told us, "North America team, Europe team and Asia team. They work for different hours. Now we can reach any major market in any place at any time, providing 24 hours a day and five days a week." How can Campbell and Company do that? Obviously the answer is ICT, information and communication technology. With the information technology, most of orders that Campbell & Company want to trade can be done through the internet connection to exchanges. Roughly one decade ago, traders at Campbell & Company needed to call the broker at the Chicago Mercantile Exchange. And then they had to wait for the deal to get done, maybe one hour later. Now all the order will be traded within thousandth second.


"We have a lot of models," the research manager Jon was very confident about the research levels at Campbell & Company, "With the help of the computer, we can quickly simulate trade with any model." If someone comes out any idea, it can be quickly turned to models. Then computer can run these models with huge historical data. With these kinds of simulations, models can be easily tested and verified. Without the computer, we can't image how this huge work can be done manually. Many hedge funds always bought the latest the most powerful computer or even mainframe to do models simulation. Once these models turned out to have very good positive results, they will be put the real market to make money. However, it needs the accurate execution by the computer. Only the computer can instantly calculate the data to verify if the conditions are met. In some sense, it is the computer not the people help hedge fund make money.

Hedge Fund Modelling and Analysis

                                                             

 Recently hedge funds are becoming more and more depending on information and communication technology. Who has fastest information gathering, fastest data communication and fastest data processing, and then he has most chance to win the money.  According to the Prime Finance 2011 IT Survey released by Citi, Hedge funds will spend approximately $2.09 billion on information technology (IT) in 2011.

Buy stocks from Mount Everest within one second?

Chen was the first generation of investors to buy stocks in China. In the early years of 1990s, China opened its first stock exchange in Shanghai. At that time, people in this developing country was curious about this new product. Chen was one of few people, who spent all his money to buy the stocks. In order to do that, Chen must travel long distance to the Shanghai from his hometown and visit the office of securities broker firms. He filled the order form and then turned it in with the required cash. After that, the broker would call the officials at the Shanghai Stock Exchange. More than three hours later, Chen can know whether or not his order had been traded. If not, he could get the refund. Chen has saved all this early order forms.


Several years passed, and Chen earned millions of money from the stock market. With the advancement of information technology, lots of securities broker firms developed their order and trade information system. Also, Chen owned his personal computer, a Dell brand PC. He installed a simple application in his PC. Then, he can submit his order at home. He went through the finance news from the Internet website as he drank coffee. When he read about good news about listed companies, he submitted his order to buy these stocks in a few seconds and got confirmed within one second. He was happy because he could do that at home.

Now, Chen is a fan of Apple. He even bought an iPhone from Hong Kong when iPhone was not available in mainland China. He installed an app in his iPhone. No matter he is waiting an airplane or he is drinking with his friends, he can check the stock market and even submit his order to buy or sell stocks. Just several click on his iPhone, a transaction with up to millions dollars can be finished. Chen is able to travel around the country. At the same time, he can buy or sell any stock, no matter where he is. Chen really enjoys the convenience of information technology.

In the past couples of decades, the information and communication technology has totally changed the way that people reach the stock market.

The time of trade transaction has been substantially reduced. It may take more than two hours to match the buy and sell orders twenty year ago. But now the same transaction can be committed with a thousandth of a second. According to one article published at Computerworld, NYSE shrinks time measurement to nanoseconds, which means a transaction can be finished within just several billionth of a second.

The place where people order transaction has no limitation. People need travel to special offices to submit their order to buy or sell stocks before they can access Internet at home. When they have personal computer and access to Internet, these things became very easy. Now with the wireless communication technology, people can access to the stock market at almost any place around the world. Even at the highest mount, you can access the Internet and place your orders to buy Starbucks stocks.

Mount Everest now 'wired' for Internet, ready for Starbucks

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