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Is High Frequency Trading Really So Bad?

In his New York Times op-ed today, quantitative finance guru Paul Wilmott tries to connect the dots between the cause of the 1987 crash and and the perils of high frequency trading:

It has been said that the October 1987 stock market crash was caused in part by something called dynamic portfolio insurance, another approach based on algorithms. Dynamic portfolio insurance is a way of protecting your portfolio of shares so that if the market falls you can limit your losses to an amount you stipulate in advance. As the market falls, you sell some shares. By the time the market falls by a certain amount, you will have closed all your positions so that you can lose no more money.

It’s a nice idea, and to do it properly requires some knowledge of option theory as developed by the economists Fischer Black of Goldman Sachs, Myron S. Scholes of Stanford and Robert C. Merton of Harvard. You type into some formula the current stock price, and this tells you how many shares to hold. The market falls and you type the new price into the formula, which tells you how many to sell.

By 1987, however, the problem was the sheer number of people following the strategy and the market share that they collectively controlled. If a fall in the market leads to people selling according to some formula, and if there are enough of these people following the same algorithm, then it will lead to a further fall in the market, and a further wave of selling, and so on — until the Standard & Poor’s 500 index loses over 20 percent of its value in single day: Oct. 19, Black Monday. Dynamic portfolio insurance caused the very thing it was designed to protect against.

But Wilmott's logic here is sorely off. He basically says portfolio insurance was an alogrithm that failed. High frequency trading uses algorithms, therefore it must be dangerous.

That's like arguing: The first attempt at powered flight failed. Airplanes are a type of powered flight, therefore they are suicidally dangerous. Portfolio insurance was one type of trading strategy that had a disastrous outcome. And if portfolio insurance were just being invented today, high frequency trading would be the mechanism used to execute it. But there are plenty of other strategies that also rely on the mechanism of high frequency trading but have nothing to do with portfolio insurance.

In his nice interview with Felix Salmon yesterday, Jon Stokes points out that many people are conflating high frequency trading with flash orders, which is just one of these strategies, albeit the one highlighted in the Charles Duhigg Times piece that setoff the current HFT firestorm.

Yeah, and like the NYT article there is a slight conflation of flash orders with HFT. I don’t even mention flash orders in my article… I thought they were the least interesting aspect of HFT, at least to me as a computer guy. But clearly the idea of anyone getting market info ahead of anyone else touches nerves (at least among those who are getting the info second… the folks who are getting it first love it).

And I fully support banning flash orders--the idea that someone can pay a little extra to get a look at a trade before it's executed seems fundamentally unjust. On the other hand, there are ways to use high frequency trading that seem perfectly legit. For example, suppose an institutional investor has a buy order and is willing to pay a certain range to acquire the stock he/she wants. An alogrithmic trader looking to sell the stock to the investor can send out different price points starting from a high number and work its way down until it hits the top of the investor's range. The algorithm then goes out and finds the stock for a couple of cents less and turns around and sells it to the investor, pocketing the difference.

Though some disagree, I don't see the problem with this. The algo is acting like the middle-men we're all quite familiar with. It seems to me that it's now up to institutional investors to be as inventive as the sell-side algos and figure out a way not to get gamed. If the algo can find the stock for a couple of cents less, so can the investor.

--Zubin Jelveh