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Man vs. Machine: Trading Smarter

 

“Nobody can catch all the fluctuations.”
– Jesse Livermore

TT partners with universities around the world through our University Program. We provide our software, free of charge, to dozens of schools to help them prepare students for careers in the global derivatives industry. 

webb
Professor Robert Webb

Our collaboration with the University of Virginia has been particularly beneficial. Professor Robert Webb has utilized our software in classes at both Virginia’s McIntire School of Commerce and the Darden Graduate School of Business. Students get experience in electronic trading as well as an understanding of automated trading through TT’s software. 


In this guest post, Professor Webb and Alexander Webb share their thoughts on the recent benefits and challenges that high-frequency trading brings to today’s markets. 

It has been said that today’s high-speed financial markets can change in the blink of an eye. That is wrong. A blink of an eye is too slow. In a market increasingly dominated by high-frequency trading (HFT), prices can change sharply in a millisecond, but it takes between 100 and 200 milliseconds for a human eye to blink.

Simply stated, you are literally missing trading opportunities in the blink of an eye.

With speed like this, can humans even hope to make money in a market dominated by high-frequency traders? Yes—but it entails trading smarter.

The Growth of High-Frequency Trading

HFT is growing because it is immensely profitable. A 2012 study by Baron, Brogaard and Kirilenko reports that HFT firms made $29 million in profits from the e-mini S&P 500 stock index futures market during August 2010 alone.1 And they did so bearing little risk. The average Sharpe ratio was a phenomenal 9.2. To be sure, the HFT firms earned a small amount per contract traded—on average $1.11—but given that they traded thousands of contracts each day, the small profit per contract grew quickly.2

HFT firms are not all the same. They vary from firms that are passive liquidity-providers to firms that are aggressive liquidity-takers. There are HFT firms that target human traders and firms that target other high-frequency traders. The Baron, Brogaard and Kirilenko study reports that the most aggressive HFT firms—which were largely liquidity takers—made the most money.

Milliseconds matter in the fast-paced world of HFT. This has led many HFT firms to co-locate their computer servers near the exchange servers in order to reduce exchange latency, i.e., the time it takes for an exchange to report information to participants.

How much is a millisecond worth? A 2012 study by Frino, Mollica and Webb found the introduction of co-location in the futures markets on the Australian Securities Exchange (ASX) in February 2012 resulted in a two-millisecond advantage to the HFT firms co-locating their servers near the ASX computer.3 Given that HFT firms are paying a minimum of A$10,000 per month for this privilege (and usually more), they must believe it is money well spent.

But the rise of HFT isn’t the only negative news for humans. The study suggests that the introduction of co-location on the ASX futures markets has increased liquidity with no apparent adverse effect on volatility. This increased liquidity would result in an annual savings of A$12 million in the cost of trading the four principal ASX financial futures contracts. These are estimates for the societal savings from the increased liquidity that HFT firms provide.

Trading Obsolescence

The reality is that while HFT may result in increased liquidity, it also presents many obstacles to the human trader. Strategies that were profitable before HFT are now obsolete.

Among those strategies with questionable profitability today are:

  1. Arbitrage: Markets move so quickly that the opportunity to arbitrage between them is difficult if not impossible for those who do not utilize HFT.
  2. Market making: HFT imposes excessive risks on those traders who provide two-sided markets in that the market maker cannot react to a change in the order flow as quickly as the high-frequency trader.
  3. Getting the “edge” in the market (i.e., buying on the bid or selling at the offer): With the exception of illiquid markets where the bid/ask spread is wide, the only situation where a trader can participate on the bid or the offer is when that market is turning.
  4. Event trading: Competing against HFT in terms of speed of response to scheduled economic reports and conventional news is impossible since HFT systems can process the information and react to it quicker.

Human traders need to trade strategically to avoid the dangers HFT presents.

Trading Opportunities

Is there hope for human traders? HFT systems may be fast, but they don’t always get it right. Sometimes, it seems that the market does not always know which direction it ultimately should move. Take, for example, the reaction of EuroFX futures to the monthly employment situation report on February 3, 2012. The euro initially rose in reaction to the January 2012 employment report and then fell. The same was true of gold. Moreover, this was not a one-off event, but similar examples occurred at other times. The key takeaway is that you may have more time than you think to react.

Humans are likely to be best at reacting to freak situations and unexpected market shocks. Not all algorithmic traders are high-frequency, but all high-frequency traders use algorithms. When the winds of change hit the market, humans are still more adaptable, flexible and able to change with the times. While algorithms can be reprogrammed, they can’t be reprogrammed fast enough to take advantage of a contemporaneous shock.

Algorithms are often unable to discern real news from fake news. For example, a tweet from a fake Muddy Waters Twitter account led to a 25 percent selloff in shares of Audience Inc. Reuters quoted Hammerstone Group founder, Jamie Lissette, as saying, “It’s good to some degree, because it makes people realize that we can’t just have a computer doing something like that just based on ‘Muddy’ and a symbol.”4

Trading Smarter

What are the weaknesses of high-frequency traders? Basically, many of them have gone after the easy money—market making—although with an eye toward minimizing losses. They are constrained by their algorithms. You need to think differently.

You need to get your hands dirty by observing the market’s reaction to various news events and spotting oddities. Other things equal, you are probably better off with a reason or hypothesis why prices should behave in a certain fashion than not. Your hypothesis also needs to be tested. It has never been easier for non-programmers to test relationships or develop simple trading systems. For instance, Trading Technologies offers ADL™, a visual programming platform that allows non-programmers to easily create algorithms by dragging building blocks onto a design canvas and connecting them to create executable strategies. The blocks convert to pre-tested code, and the desired features are all pre-programmed for you. Software like this is one way to develop and test potential trading strategies.

 

TT’s ADL™ visual programming platform allows traders and programmers alike to
develop, test and
deploy automated trading programs without writing a single line of code.

QIM co-founder and “hedge fund wizard” Jaffray Woodriff,  in his interview with Jack Schwager in Hedge Fund Wizards, argued that traders should “look where others don’t.”5 This is excellent advice. Equally important is the need to test potential ideas in a rigorous fashion in order to avoid introducing biases into the analysis.

Some HFT algorithms attempt to identify human orders from other HFT orders. Trading smarter also means not succumbing to some of the decision pitfalls to which humans are prone, like submitting orders for an even number of contracts or trading when volume is lower during the day (i.e., outside the open and close), etc. Easley, Lopez de Prado and O’Hara [2012] suggest some ways that human traders can avoid being victimized by HFT.6

Perhaps the most important thing to remember is that you get to choose when to trade, and you should only trade when you have an advantage. Whether you’re trading intraday or long-term, you should only pull the trigger when you are confident the odds are in your favor.

About the Authors

Robert I. Webb is a Paul Tudor Jones II research professor at the University of Virginia. His industry experience includes positions at the World Bank, the Chicago Mercantile Exchange, the Office of Management and Budget and the CFTC. He earned his PhD in finance from the University of Chicago. He edits The Journal of Futures Markets and has authored numerous books including his most recent book on high-frequency trading he co-authored with his son Alexander, Shock Markets: Trading Lessons for Volatile Times.

 

Alexander Webb is a writer. His interests include finance, emerging markets, politics, business, technology and international travel. Living in Asia for half a decade, Alex earned a baccalaureate degree in international business and global management from The University of Hong Kong. He has studied at the Chinese University of Hong Kong, Beijing Language and Culture University and at Shanghai Jiao Tong University. He also studied in Japan at Ritsumeikan Asia Pacific University.1 Baron, Brogaard and Kirilenko, “The Trading Profits of High Frequency Traders,” Working Paper, University of Washington, August 2012.
2 Baron, Brogaard and Kirilenko [2012] report that the small profit per contract “equates to $46,039 per day for each HFT in the August 2010 E-mini S&P 500 contract alone.”
3 Frino, Mollica and R.I. Webb, “The Impact of Co-Location of Securities Exchanges’ and Traders’ Computer Servers on Market Liquidity,” Working Paper, University of Sydney, November 2012.
4 Reuters, “A Tweet from Someone Posing as Short Seller Carson Block Sent a Stock Tumbling 25% Today,” BusinessInsider.com, January 30, 2013.
5 Schwager, J., Hedge Fund Wizards, New Jersey: Hoboken, John Wiley & Sons, 2012.
6 Easley, Lopez de Prado and O’Hara, “The Volume Clock: Insights into the High Frequency Paradigm,” March 30, 2012. The Journal of Portfolio Management, Fall 2012, Johnson School Research Paper Series No. 9-2012.

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Visual Programming: Cooking the Spaghetti

As further indication that Chicago is becoming increasingly recognized as a legitimate hub for tech talent in the U.S., the GOTO international software conference came to Chicago for the first time this week. The conference included speakers from many top names in the industry discussing the latest advancements in the software development community. Trading Technologies was proud to be a sponsor of the inaugural GOTO Chicago conference, and I was thrilled to have the opportunity to give a talk on visual programming languages (VPLs), and how TT has managed to utilize this technology in the algorithmic trading community with our ADL™ (Algo Design Lab).
Using visual programming, TT’s ADL allows traders and programmers alike to rapidly
 design, test and deploy automated trading programs without writing a single line of code.

Applying visual programming to professional industries has proven difficult; the fundamental tenets of VPLs (approachability and ease-of-use) tend to belie the goal of providing a usable platform for getting “real work” done. As educational tools for children or first-time programmers, VPLs often shine, but applying them to very specific domains (like low-latency trade development) often ends in frustration and something that looks more like spaghetti than anything else.

As I discussed in my GOTO talk, the way in which ADL has overcome these challenges—and a good model to follow when applying a VPL to any domain—is by adhering to three important characteristics:

  1. Domain specificity
    The fundamental building blocks in ADL are modeled with the automated trader in mind, utilizing concepts and vocabulary that come naturally to participants in this industry, without exposing complexity that is unnecessary to the business needs. If not domain specific, general-purpose VPLs tend to be cumbersome when trying to build something of business value.
  2. Hiding the “dirty stuff”
    As most any algorithmic trading developer will admit, managing tasks like “in-flight orders” and exchange-specific nuances add complexity to any automated strategy. What makes matters worse is that these complexities don’t offer the opportunity to differentiate your strategy from others. In other words, there is no value to be gained by solving these problems, so why spend time worrying about them? ADL aims to hide these “dirty” details to let you focus on what matters most: designing your trade quickly and safely.
  3. Mitigating the “Deutsch Limit” 
    Any development framework is only as good as its ability to provide unlimited flexibility without sacrificing maintainability; the larger and more complex your strategy becomes, the more you rely on your development environment to help you navigate your code. This should be no different for a visual development environment, and ADL strives to give you a rich set of tools that helps you manage even the most complex algos. With the proper tools in place, the Deutsch Limit is no longer a factor when it comes to managing visual complexity.

I wrapped up my talk at GOTO Chicago by explaining that I never intended to build a visual programming language. However, after realizing our industry lacked the tools which could provide a safe, robust environment for developing low-latency trading strategies, and which could empower every trader—regardless of technical know-how—to compete in the world of automated trading, ADL was the inevitable result.


A special thanks to the GOTO team for putting together such a fantastic few days of programming discourse.

Mexico, The Emerging Latin American Powerhouse

For the past few years, coverage of Mexico in the U.S. media has largely been dominated by stories of violence stemming from the country’s drug cartels. Lately though, the media have increasingly been turning their attention to the story of Mexico’s booming economy, and new president Enrique Peña Nieto’s bold moves to radically reshape it. This robust growth in Mexico looks set to continue for some time, which has led the Financial Times to label Mexico as the “Aztec Tiger.”1

MexDer, the nation’s only futures exchange, has been taking steps to ensure that it grows apace with the nation’s economy by making substantial upgrades to its matching engine, while continuing to make it easier for foreign investors to access the market. As a result of these changes, as of yesterday, April 14, north-to-south routing to MexDer via CME Group’s Globex® platform is available on TT. You can read the details in the news release that we published today.

The Aztec Tiger 

A perfect storm of positive influences is coming together to make Mexico one of the world’s emerging economic powerhouses. Mexico has a young and growing population, low levels of government debt and low inflation. The country is developing into a leading exporter due in part to widespread implementation of new manufacturing processes, but also due to the fact that Mexico has free trade pacts with 44 countries—more than any other nation on earth.

These forces have combined to make Mexico’s economy one of the few bright spots in a global economy still working off the hangover resulting from the credit bubble. Mexico’s economy grew at around four percent in 2012, quadruple the growth rate of Latin America’s largest economy, Brazil.2 The Mexican peso hit a 19-month high against the U.S. dollar in March, and has outpaced 16 other major world currencies over the last month.3

With its growth track record and favorable conditions for growth to continue, a Nomura Equity Research report in July 2012 predicted that Mexico would overtake Brazil to become the largest Latin American economy within the next decade.4 In addition, Standard & Poor’s and Fitch have indicated that in the near future, they are likely to upgrade Mexico’s debt, which is already investment grade.5

A Pact for Mexico, An Open Door for Growth 

Much of the optimism for Mexico’s future can be traced back to its new president, Enrique Peña Nieto. He hails from the Institutional Revolutionary Party (PRI), which ruled Mexico uninterrupted for 71 years and was identified with corruption and inefficient bureaucracy. That being said, President Nieto is quickly making himself known as a risk taker, willing to take on fights in which none of his predecessors seemed willing to engage.

Within two days of his swearing-in last December, Nieto’s PRI signed a “Pact for Mexico”6 with the opposition National Action Party (PAN). This pact outlines 95 proposals to modernize and liberalize Mexico’s economy. Nieto began by taking on the richest man in the world, Carlos Slim, by announcing plans to foster competition in the telecommunication and television industries, which are currently dominated by monopolies. Later this year, Nieto is expected to propose his most significant change, opening up Mexico’s energy market and allowing the state-run oil concern Pemex to work with the world’s largest oil companies. It’s expected that these reforms, once enacted, will increase Mexico’s GDP growth from four percent to six percent a year.7

Making MoNeT 

In parallel, MexDer and the Mexican government have done quite a bit to attract foreign investors, and to make it easy for them to access the market. Perhaps one of the most significant changes has been the development of the MoNeT matching engine, which went live on Bolsa Mexicana de Valores (BMV), the equities segment, last fall.

The MoNeT matching engine was designed to attract high-frequency traders, mainly from the U.S. and Europe. It boasts internal latencies of 90 microseconds, which is faster than the 110 microseconds of NASDAQ or 125 microseconds at the London Stock Exchange.8 BMV volumes have increased 30 percent to 40 percent since the launch of the new matching engine.9

For international traders and investors, accessing MexDer is straightforward. The north-to-south routing available via CME Globex allows any TT customer with an existing CME infrastructure to route orders to MexDer’s matching engine. MexDer is also accessible now in TT’s MultiBroker environment, which is currently available in beta. Additional information regarding how CME users can access MexDer is posted on the CME website.

There are a number of other reasons why doing business in Mexico is easier than most other Latin American countries. Unlike Brazil, there is no withholding tax of any kind on foreign investment. The Mexican peso is a freely traded and easily convertible currency, and MexDer’s clearing house, Asigna, accepts U.S. dollar-denominated collateral.

La Oportunidad Está En Todas Partes 

Owing to the fact that the U.S. does $1.5 billion per day in trade with Mexico,10 the Mexican markets are, predictably, highly correlated with America’s. North-to-south customers trading MexDer via Globex have access to a number of financial futures that allow for arbitrage opportunities against their American counterparts.

MexDer lists the IPC index of the BMV, which in general tracks closely to the S&P 500. The full Mexican yield curve is available on MexDer, from one-month bills to 30-year bonds, and it converges with the U.S. yield curve. Finally, MexDer lists a Mexican peso/U.S. dollar FX future, one of the 20 biggest FX futures contracts in the world by volume, which sets up arbitrage opportunities with the CME’s equally liquid peso/U.S. dollar future. In a recent MarketsWiki interview, MexDer CEO Jorge Alegria indicated that going forward, the exchange would likely look to list commodity futures linked to similar contracts listed on CME Group. 

The ascent of the Aztec Tiger is no sure thing. There is always the danger of President Nieto’s PRI party losing its appetite for reform and returning to its old ways. There’s the chance that the hiccups in the U.S. economic recovery may impact Mexico, given that 30 percent of the Mexican economy is tied to U.S. exports. There may even be signs that Mexico’s economy is stalling already, which led the central bank to reduce interest rates for the first time since March 2009. Either way, TT users now have the ability to participate in one of today’s most interesting markets.

Thomson, Adam. “Mexico: Aztec tiger.” Financial Times. January 30, 2013.
Rathbone, John-Paul. “Mexico’s reform plan lifts hopes for greater prosperity.” Financial Times. March 20, 2013
Kwan Yuk, Pan. “Mexican peso hits 19 month high”. Financial Times. March 14, 2013. 
“Mexico could pass Brazil as top LatAm economy in 10 years-Nomura.” Reuters. August 8, 2012.
Bases, Daniel. “S&P revises Mexico sovereign credit outlook to positive.” March 12, 2013 
“With a little help from my friends.” The Economist. December 8, 2012.
Thomson, Adam. “Mexico: next stop, a rating upgrade?” Financial Times. March 12, 2013.
Thomson, Adam. “Homegrown software fuels Mexican exchange’s efficiency.” Financial Times. October 3, 2012.
Kledaris, George. “Down Mexico way.” Advanced Trading. February 26, 2013.
10 Friedman, Thomas. “How Mexico got back in the game.” New York Times. February 23, 2013.

The History of Automated Trading at TT

Ever wonder what Autospreader® used to look like before today? Find out in this slideshow on the history of automated trading at TT. This slideshow revisits key historical events in the evolution of AutospreaderAutotrader™ and ADL™, which comprise TT’s suite of front-end automated trading applications. You will also find a sneak preview of concepts that are being explored for future releases.

What’s next? Stay tuned to Trade Talk and our website. There’s much more to follow.