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Guest Post: The HFT-Induced Extinction Of Retail Investors

Tyler Durden's picture




 

Via The World Complex blog,

Invasive behaviour and extinction in the retail market

 
The term "invasive species" has been used to describe new types of plants or animals that have been introduced to a new area, whereupon they change the local biosystem.

The sudden appearance of new lifeforms in an environment can cause rapid losses in some of the species present prior to this appearance. Biosystems are dynamic systems with considerable stability, and often the arrival of new species simply cause a slight change in the dynamics of the system, which continues on with only small cosmetic changes.

On occasion, however, the new players cause overwhelm the stabilizing factors in the system, which undergoes dramatic changes, eventually stabilizing in a new configuration that is highly detrimental to many of the original players in the system.

Which brings me to today's invasive species.

Although high-frequency trading has been around for nearly a decade, it didn't hit public consciousness until the "flash crash" of May 2010. In the past two years, the incidence of HFT flash crashes has expanded (see archive here) to the point where they are causing significant pain to the retail investors.

 

Much has been written about the impact of HFT, and a broad survey of the literature is so contradictory that I have to feel that some authors are not writing honestly. For every article about manipulation and increased volatility and reduced liquidity, there are academic papers like this one claiming that HFT "improves liquidity and enhances the informativeness of quotes".

Many of the characteristics of successful invasive species are shared by HFT algorithms:

1) fast growth;
2) rapid reproduction;
3) the ability to alter form (mutate) to suit current conditions;
4) tolerance of a wide range of conditions (except perhaps transparency); and
5) ability to live off a wide variety of food types. As a bonus, living in contact with humans also helps invasive species.
What in the market is going extinct? The retail investor.

How so? It comes about through the erosion in their margins brought about by HFT. In the presence of HFT, the unsophisticated investor pays a higher price on the buy and receives a lower price on the sell than would be the case otherwise. The professional traders manage to maintain their margins--the losses of the unsophisticated are the profits of the algos.

As our markets have come to resemble casinos, investment is increasingly like gambling. For a typical gambler in a casino, where winning is determined by chance, is eventually ruined. Gambler's ruin is inevitable in a fair game--but comes faster now that the bias is negative because algos are skimming a little off each one of our gambler's bets.

 

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Sun, 01/06/2013 - 14:55 | 3127329 LetThemEatRand
LetThemEatRand's picture

The entire financial industry, which once was a source of capital for investment and industry, is now nothing more than a scheme to skim off the top.  Except "skim" is really a bit understated.

Sun, 01/06/2013 - 15:02 | 3127347 kliguy38
kliguy38's picture

No its worse than that.....this is analogous to stripping the scraps off the carcass AFTER the pride kill.....once the hyenas finish with the HFT scraps they will turn on each other once again as hunger needs to be satisfied. We are in the "end game" of a massive supercycle and a true feeding frenzy is about to ensue.....just don't get in the middle of the hyenas

Sun, 01/06/2013 - 15:11 | 3127368 idea_hamster
idea_hamster's picture

I agree with much of this post, except that it's important to point out one additional element:  HFT algorithms seem to rely on a (self-)regulatory structure that shields them from much of the catastrophic risk inherent in the business model.

Specifically, the nature of HFT trading is that if (read: when) the algorithm goes divergent (i.e., gets caught in a loop sending the target price to zero or infinity) the effect will materialize faster than human judgement can intercede. 

But when that happens, the exchanges do NOT enforce those trades -- they bust them.  Why?  It's never been clear to me just what the exchanges' rationale is for allowing HFT trades to be undone just because they took place "too far" from the day's trading range. 

The result is that the HFT operators enjoy a significant safety net that is a function of an arbitrary, opaque and after-the-fact process controlled by industry insiders.  If the exchanges simply enforced the trades as entered by market participants, the HFT scourge would burn itself out as exchange members learned that the risk of piping algo trades through their seats is just not worth the aggravation.

I believe this element bears striking semblance to the Price-Anderson law capping nuclear plant liability -- without the liability cap, neither HFT  nor civil nuclear power would survive.  At least with civil nuclear, however, there was a contemplative political process (whether or not we agree with the outcome) that society should bear the risks of contamination in exchange for some combination of weapon development and domestic energy production.  With HFT, this decision is being made on an ad hoc basis by industry insiders.

Sun, 01/06/2013 - 15:18 | 3127384 Karlus
Karlus's picture

I was kinda disappointed that when HFT Gone Wild happened with the flash crash that the retail investors that snapped up stocks at the end got their trades cancelled. You cannot have it both ways and call a mulligan when all the AIs decide to sell.

I dont mind going up against a machine, even a very fast machine because I trade over longer periods of time and am a fundamental trader.

But the system is corrupt after all....right?

Sun, 01/06/2013 - 15:26 | 3127403 Jesus Christ
Jesus Christ's picture

HFT is the spawn of fiat money systems, and a natural progression on the road to the NWO.

Sun, 01/06/2013 - 19:30 | 3128014 boogerbently
boogerbently's picture

"the unsophisticated investor pays a higher price on the buy and receives a lower price on the sell than would be the case otherwise. "

I disagree with the use of HFT....BUT, I never get a higher buy price or lower sell price than I stipulate.

I HAVE gotten higher sells and lower buys. I NEVER use stops.

 

Sun, 01/06/2013 - 19:56 | 3128110 Pengo Devaluation
Pengo Devaluation's picture

Funny that, because "a higher buy price than would be the case otherwise", does not mean the same as "a higher buy price than I stpulate".

Mon, 01/07/2013 - 09:27 | 3129150 Element
Element's picture

Hey Jesus! You've been gone a while dude! Good to see you're back.

Look, you must get a lot of these little requests, but could you please conjure up a new curtain or something, seeing you rent the last one asunder, so to spake? (cool trick btw)

Matthew 27:50-52

51 And, behold, the veil of the temple was rent in twain from the top to the bottom; and the earth did quake, and the rocks rent;

52 And the FED was opened and revealed; and we did peaketh behind the veil and sawest a beared-one, squirting green ink on the sacred metal plates of lasciviousness and want. And yea, we did desire his comeliness and fake tan. 

 

Mon, 01/07/2013 - 09:48 | 3129178 tabasco71
tabasco71's picture

I agree with your sentiment.

To invent something that preys on the unsophisticated trader and steals their margin is a resonable strategy and was probably one of the pro's in the business case at the outset.

However, to be able to reattach your electronic head after it got served to you is not playing on a level field.

From what I understand of IT, it will always be possible for a flash scenario to occur, no matter how sphisticated the programing gets. 

So, if HFT owners are not willing to trade profitably more often but with the downside possibility that they could wipe out, then they should not be allowed to use the technology.

Even I am against this double standard, and I work in finance!!

I am comforted by the fact that Arnie eventually won out agains the new improved terminator, despite all the odds...!!

Sun, 01/06/2013 - 15:22 | 3127392 Ghordius
Ghordius's picture

And those ad-hoc decisions make the system even more corrupt

Sun, 01/06/2013 - 16:01 | 3127505 overbet
overbet's picture

idea hamster, that is the best comment I have ever read on this website. You absolutely nailed it.

Sun, 01/06/2013 - 19:25 | 3127998 Jack Burton
Jack Burton's picture

Yes I agree, "idea hamster" has produced one of the best and most informative posts to end up in the ZH comments. Brilliant work, please post again when you can contribute that type of insight.

Sun, 01/06/2013 - 16:35 | 3127593 Keegan11
Keegan11's picture

Smartly put hamster

Sun, 01/06/2013 - 16:42 | 3127610 RockyRacoon
RockyRacoon's picture

Hey, idea_hamster, mixing talk of nuclear annihilation with HFT is pretty risky.  Don't give 'em any ideas.

Sun, 01/06/2013 - 19:34 | 3128026 boogerbently
boogerbently's picture

If it wasn't for HFT, we wouldn't have no trade at all. (Bad Luck/Cream)

Sun, 01/06/2013 - 15:22 | 3127393 DoChenRollingBearing
DoChenRollingBearing's picture

@ LTER, + 1

I typically disagree with your positions, but you nail this.

Whether it is here at the Hedge, among my own family & friends, wherever, hardly ANYONE I run into is in the market anyone, at least actively.  What I have in the market has just been sitting there a long time.  What am I going to do when my Treasuries (old 5 - 15 Year Notes) expire?  I really don't know.  I have gold (etc.), but where can I/we get some income?

Sun, 01/06/2013 - 15:37 | 3127434 B-rock
B-rock's picture

HFT is awesome for nimble day-traders (or minute-traders)....

Sun, 01/06/2013 - 19:35 | 3128031 boogerbently
boogerbently's picture

True statement.

But I believe "nimble" should be on the list of overused words NOT to be used in 2013.

Sun, 01/06/2013 - 15:48 | 3127469 El Oregonian
Sun, 01/06/2013 - 15:50 | 3127475 FL_Conservative
FL_Conservative's picture

He ain't heavy.  He's my algo.

Sun, 01/06/2013 - 16:11 | 3127530 secret_sam
secret_sam's picture

    The entire financial industry, which once was a source of capital

Almost--it was never the "source" of the capital, though.  It was just a transmission mechanism for the capital.

Sun, 01/06/2013 - 19:14 | 3127969 ball-and-chain
ball-and-chain's picture

The entire global market is dominated by fraud.

You'd be crazy to invest without insider information.

Best to keep the money under the mattress.

http://www.angrysinner.blogspot.kr/2013/01/saturday_7.html

Sun, 01/06/2013 - 19:38 | 3128042 boogerbently
boogerbently's picture

The journalistic Napoleon Dynamite.

Sun, 01/06/2013 - 14:56 | 3127330 espirit
espirit's picture

6) Self-Awareness.

Sun, 01/06/2013 - 15:01 | 3127341 espirit
espirit's picture

All your trades belong to us.

Sun, 01/06/2013 - 15:02 | 3127342 toady
toady's picture

I thought the retail investor was extinct.

I'm always surprised when I see an ameritrade or whatever commercial. Don't be surprised when you hear these etrade whatevers are going broke.

You're crazy if you think you can calculate faster than the slowest computer.

Sun, 01/06/2013 - 15:08 | 3127360 Everyman
Everyman's picture

Etrade, Schwab, and all the other "retail investment con artist" are the ones that need to really step up to the plate and eliminate the HFT advantage.  How many billions is the retail trader broker loosing a year?  Trillions?  I think that is good enough to hire a hit man, or to take the HFT cell tower networks.  It's theirs to keep and defend.  But all to many just go with the quick short term solution.

Etrade and the rest SHOULD be bring class action suit on SEC for not enforcing the trading rules and assesing fines on the "pennies" skimmed billions of times, all of whic aer fines of TENS OF THOUSANDS OF DOLLARS PER VIOLATION PER DAY!!!  There is some "revenue" to pay off some debt!  hey should also be class action suing the HFT trader houses, adn they know who they are and what they do.

It is damage to the system, and damage to business, and damages to retail investors.

Where are the lawyers on this one?

Sun, 01/06/2013 - 15:19 | 3127380 Quinvarius
Quinvarius's picture

You guys assume these HFT clowns make money.  We wouldn't cancelling all their trades every time they sell a $100 stock at 1 penny if they were.  Knight Capital is a prime example of what happens when you don't get a bailout.  I am sure they all claim they are doing fantastic. I am also sure HFT is just the latest snake oil loser "100% winning" trading technique Wal Street is trying to peddle.  The only thing HFT is good for is taking a loss to run someone's stops.

Sun, 01/06/2013 - 16:01 | 3127506 max2205
max2205's picture

I expect a lot of money when the class action against etrade isdone.  Etrade is frontrunning the algos too further toast you.  

 

I usually put in a long trade then max short them.  It works both ways

Sun, 01/06/2013 - 19:20 | 3127981 Freddie
Freddie's picture

Isn't Ken Griffin of Citadel the largest eTrade shareholder since they blew up selling mortages back 2006-2008?  The same Ken Griffin who just spent $80 million on two oceanfront lots in Palm Beach?

Sun, 01/06/2013 - 19:55 | 3128108 espirit
espirit's picture

Yes, and his lobster bisque is slightly on the salty side.

Sun, 01/06/2013 - 15:03 | 3127349 Everyman
Everyman's picture

7)  The ability to change the enviroment or ecological niche to promote and select the invasive specie and to deselect and disadvantage the original specie.

Sun, 01/06/2013 - 15:12 | 3127371 Seasmoke
Seasmoke's picture

same problem with horse racing pools......but the tracks are too scared/desperate to do anything about it

Sun, 01/06/2013 - 15:13 | 3127373 Racer
Racer's picture

I think casinos are much better than the current 'market'. The cancelling of orders and rapid market moves way beyond that of human reaction mean a human is fleeced at every opportunity by the HFTs

Sun, 01/06/2013 - 15:13 | 3127375 babylon15
babylon15's picture

HFT hurts mutual funds more than retail investors.  Retail investors actually have a decent shot.

Sun, 01/06/2013 - 16:10 | 3127495 buzzsaw99
buzzsaw99's picture

I actually agree with this comment in a way. Hedge funds front running first of the month buying mutual funds hurt pension funds in the extreme. As a retail investor I can take care of myself but I don't play chess against a computer (day trade) I hold positions for six months to a year. If they skim a penny coming and going it is no sweat off my ballz. Day traders are the ones getting killed.

Sun, 01/06/2013 - 16:17 | 3127541 Winston of Oceania
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Except when they flash-trash a stock you might have a position in, good luck getting out in a nanosecond.

Sun, 01/06/2013 - 16:25 | 3127567 buzzsaw99
buzzsaw99's picture

anyone even dabbling in equities must steel themselves against the possibility of loss. stocks are so thinly traded lately that any number of players could flash crash the entire "market". damn you w&r!

Sun, 01/06/2013 - 15:44 | 3127460 max2205
max2205's picture

If you'not on the one minute chart, they will eat you alive

 

Fuckers

Sun, 01/06/2013 - 16:03 | 3127511 Joebloinvestor
Joebloinvestor's picture

Since when did it become a priority that a trade has to be completed in a microsecond?

The only way to counter high speed trading is to slow the response down (confirmation?) or have every trade enter a "delay que".

As it has been shown, these guys are working together using the speed of the system against itself.

Sun, 01/06/2013 - 16:14 | 3127532 secret_sam
secret_sam's picture

    Since when did it become a priority that a trade has to be completed in a microsecond?

The lower interest rates become, the more important the short-term gain becomes.

Sun, 01/06/2013 - 16:55 | 3127636 Joebloinvestor
Joebloinvestor's picture

The interest rates are changing every second though.

Sun, 01/06/2013 - 17:12 | 3127674 secret_sam
secret_sam's picture

So what?  Every price changes every second. Technically, there's no such thing as a "market price," anyway.  It's always a projection or an estimate.

You asked when it became important to be able to trade on micro-second intervals.

Answer: when it became impossible to assess risk/return potential over longer periods because of functionally negative interest rates.

Sun, 01/06/2013 - 16:15 | 3127535 Winston of Oceania
Winston of Oceania's picture

Fuck them and their markets and their economy. Decouple from it and it can't hurt you much. Fewer choices at first but lets face it going "FORWARD" means far fewer choices in the long run regardless. Onward comrades...

Sun, 01/06/2013 - 21:07 | 3128286 HardAssets
HardAssets's picture

COMPUTER at NORAD (North American Air Defense Command) bunker:  ". . . . the only winning move, . . is not to play the game."

from the movie War Games (1983)

Sun, 01/06/2013 - 16:17 | 3127542 JohnGaltsChild
JohnGaltsChild's picture

....and if you don't know who the sucker at the card table is.......

Sun, 01/06/2013 - 17:58 | 3127772 CharliePrince
CharliePrince's picture

havent traded a stock in many many years... hope the machines have a good time

while im  gone

Sun, 01/06/2013 - 18:21 | 3127811 AgAu_man
AgAu_man's picture

Tyler, Reading this article and its similarity to my posting of yesterday (http://www.zerohedge.com/news/2013-01-05/future-world-growth-or-ipad-vs-...), regarding the Invasive Species vs. Indigenous Species model,  I am glad that the model had a bigger impact than the Up/Down Arrows to my posting suggest.  Cheers.

Sun, 01/06/2013 - 20:54 | 3127852 SlowMoney
SlowMoney's picture

The stock market is dying on it's feet. 

The reason that the retail investor is leaving ..because the market is rigged.

Not only from HFT but from front running crony greedy cheaters.

Those with inside information that take money from those without inside information.

How about the Goldman's of this world who have inside information from the primary dealers to front run any thing the Fed does...(David Stockman estimates that the front runners pocketed about 50B on the QE 3 announcement).

No different than a roulette dealer with a pedal on the floor.

Sun, 01/06/2013 - 18:55 | 3127923 Disenchanted
Disenchanted's picture

 

Maybe I've missed it, but what's the prevailing opinion on just who is it that owns/controls/programs the majority of these HFT algos? Is it primarily hedge funds, investment banks???

Sun, 01/06/2013 - 19:35 | 3128032 chump666
chump666's picture

It's an evil IT setup, managed by ex-traditional traders (banks, hedge funds, old school open out cry). It's not that sophisticated, there probably is a general algorithm that is then patched and re-patched to be more competitive.  At the same time becoming more and more unstable, as HFTs trading accesses dark pool liquidity.  But there is no holding of liquidity, or assets - just scalping, also there is a bubble of HFT firms, too many all trying to scalp the market.  The simple way of looking at it, is that the algo's trade sec for sec on the moving averages, trading with the VWAP.  They have become predicable, the problem is the market (visible) liquidity providers are still human e.g longs (hedge funds, mutual funds, banks, a lot of suckers etc).  HFTs will 100% crash this market, only when the liquidity providers (human) panic, you would have seen this on the flash crash (futures) a week of so back. 

Overall, the fact that IT nerds have rushed into the HFT market is scary, I mean you just have to look at the sh*t that is coming out of India and China, more so India.  Crappy software programming, poorly set up hardware, buggy, unstable and disposable.  Which is now the HFT market.  So, some sh*t IT company goes bankrupt, software is junk they disappear.  A HFT meltdown, could strip billions off assets.  Effect everything.

 

Sun, 01/06/2013 - 19:54 | 3128103 Disenchanted
Disenchanted's picture

Thanks for the reply...you said:

 

the problem is the market (visible) liquidity providers are still human e.g longs (hedge funds, mutual funds, banks, a lot of suckers etc).

 

I'm assuming pension funds would be in that group as well?

 

Sun, 01/06/2013 - 20:12 | 3128156 chump666
chump666's picture

Yes

A big crash will get the SEC frisky this time.

Mon, 01/07/2013 - 00:26 | 3128672 Cthonic
Cthonic's picture

Chicago Trading Company - Eric Chern
Citadel - Kenneth Griffin
Getco - Stephen Schuler, Daniel Tierey
Jump Trading - Bill DiSomma, Paul Gurinas
Quantlab Financial - Ed Bosarge
Sun Trading - Jeff Wigley
Renaissance Technologies - James Simons
RGM Advisors - Robbie Robinette
Timber Hill - Thomas Peterffy
Tower Research Capital - Mark Gorton
Tradebot Systems - Dave Cummings
Tradeworx - Manoj Narang
Virtu Financial - Vincent Viola

http://www.nytimes.com/2012/10/15/business/with-profits-dropping-high-sp...

http://www.cnbc.com/id/39038892/Man_Vs_Machine_Seven_Major_Players_in_Hi...

 

 

Mon, 01/07/2013 - 00:36 | 3128734 chump666
chump666's picture

Great post.

"Douglas Cifu is the president of Virtu Financial, a big player in the industry. “There was this mythology that you could get 90 computers, some Harvard Ph.D.’s and you would turn on your machines and make money,” he said. “It’s just not the case.” from NYtimes

 

Sun, 01/06/2013 - 19:27 | 3128002 BuyMeAPony
BuyMeAPony's picture

The financial markets have always been a giant skimming machine. Click traders have been screwing retail over for years... everyone is just pissy that the easy money has left the table.

Sun, 01/06/2013 - 19:27 | 3128003 fourchan
fourchan's picture

hft=asian carp

Sun, 01/06/2013 - 19:31 | 3128019 Miss Expectations
Miss Expectations's picture

This one just reached western North Carolina...bad news for walnut lovers:

What Is Thousand Cankers Black Walnut Disease?

Originally found to be killing trees in Colorado as early as 2003, this is a newly recognized disease (2008) of primarily Black walnut (Juglans nigra) and caused by a fungus, Geosmithia morbida, that is vectored into the tree by the walnut twig beetle (Pityophthorous juglandis). Thousand Cankers disease has produced widespread death of black walnuts in many western states during the past decade. Other species of walnut such as Arizona walnut, English walnut, and California walnut have all shown varying degrees of susceptibility to this fungus.

http://thousandcankerdisease.com/

 

 

Sun, 01/06/2013 - 20:49 | 3128240 secret_sam
secret_sam's picture

Sweet.  May be a good time to go long walnuts, eh?  Imminent extinction is profit-city, baybee!

Mon, 01/07/2013 - 04:19 | 3128938 dvsteenk
dvsteenk's picture

Anyone else having trouble accessing nanex.net? http://www.nanex.net/aqck/2715.HTML?

Surely seems like a weird coincidence that this occurs right after having posted some thorny questions in the discussion thread under Nanex' previous analysis on HFT manipulation (dear-sec-hft-cheating-its-most-obvious-regards-everyone-else)...

Mon, 01/07/2013 - 07:10 | 3129021 dvsteenk
dvsteenk's picture

spam about walnuts in a thread about HFT... whatever

And what's up with the ZH forums? They're full of spam off-topic subjects... e.g.

http://www.zerohedge.com/forums/zero-hedge-forums/derivatives-and-greeks-forum

http://www.zerohedge.com/forums/zero-hedge-forums/quantitative-trading-forum

Do NOT follow this link or you will be banned from the site!