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"August Sucks" MIT Quant Warns New Strategies "Are Creating Volatility"
"August Sucks," concludes MIT Quant guru Andrew Lo, reflecting on the systematic-trading strategy effects on markets, and it's not going to get better any time soon. As he explains to Bloomberg, "algorithmic trading is speeding up the reaction times of these participants, so that’s the choppiness of the market. Everybody can move to the left side of the boat and the right side of the boat now within minutes as opposed to hours or days." As we have noted many time, Lo explains how "crowded trades have got to the point of alpha becoming beta," warning that volatility-targeting strategies (such as Risk-Parity) are not only "exaggerating the moves," but he cautions omniously reminiscent of the August 2007 quant crash, "I think they are creating volatility of volatility."
Bloomberg interviews MIT Quant guru and Chairman of AlphaSimplex Group LLC, Andrew Lo...
Question: What does this volatility look like to you? Is this another quant meltdown?
Lo: I’m not sure I’d characterize it as just a quant meltdown. I think that makes it a little bit too cut and dried. Probably there are a number of different factors, including algorithmic trading, that plays into it. We have a number of different forces that are all coming to a head. And because of the automation of markets and the electronification of trading, we’re seeing much choppier markets than we otherwise would have five or 10 years ago. But it’s many forces operating at different time scales, all coming to a head.
Question: Is systematic trading exaggerating the moves?
Lo: I think it’s doing two things. One it can be exaggerating the moves if it lines up with what the market wants to do. So if the market is looking to sell because of an impending recession, then I think we’re going to see a lot of the algorithmic trading going in the same direction. And if the time horizon matches, you will see that kind of cascade effect. At the same time, I think algorithmic trading can play the opposite role. They can dampen some of the market swings if they’re going opposite to the general trend... The one thing that is true, though, is that algorithmic trading is speeding up the reaction times of these participants, so that’s the choppiness of the market. Everybody can move to the left side of the boat and the right side of the boat now within minutes as opposed to hours or days.
Question: When you talk about exaggerating the effect, is that mostly CTAs and momentum players or is it not that simple?
Lo: I think that over the course of the last few weeks, that’s actually a pretty decent bet: That there are trend followers that are unwinding because of some underperformance and concerns about the change in direction of the market. But, for example, what happened in August 2007 was equity market neutral strategies that unwound. So I think it really varies depending on the nature of the strategies that are getting hit and the money going into and out of those strategies, and how that’s affecting market dynamics.
Question: A lot of focus has fallen on risk parity strategies. The notion that, as volatility picked up, there was a lot of deleveraging going on, especially with futures and ETFs. Does that make sense to you from what we’ve seen?
Lo: Well, it certainly looks that way. Part of the challenge of risk parity is that it ignores anything about expected returns. The idea behind risk parity is not a bad one, which is to focus on risk and to manage your portfolio so as to try to stabilize that risk. But the problem with equalizing it across all asset classes or investments is that not all investments are created equal at all points in time. So there are certain strategies that end up doing worse than others during periods of times. And if you end up equalizing your volatility across those strategies, you might end up getting hit pretty hard as some of the equity risk parity strategies got hit over the course of the last few weeks.
Question: Is risk parity looking like a crowded trade?
Lo: I think there’s definitely a case in point of the idea of alpha becoming beta. The idea that once you start popularizing a particular investment approach, and it becomes so popular, that in and of itself creates these kinds of shock waves. So for example if the strategy itself underperforms, now we have a larger number of investors that are going to be unwinding that strategy and that will create a kind of cascade effect where the strategy will underperform even more as people start to take money out of the strategy. There are a number of examples. Risk parity, of course, is the most recent. But before that trend following, before that value investing, growth investing, earnings surprise, earnings momentum, any kind of a strategy can become a crowded trade. And when it does you have to just make sure that the risk premium associated with that trade is commensurate with the potential risks of getting hit with these unwinds.
Question: Are volatility targeting strategies part of the story? Have they become so popular that they’re exaggerating the moves?
Lo: Not only are they exaggerating the moves, but I think they are creating volatility of volatility. So it’s making the market quite a bit more complicated and the dynamics now are much more different and much more difficult to manage if you’re not aware of how these dynamics play out.
Question: What about when you get a big rebound? What do you suppose that is? Is that actually value-type of investors seeing the drops and coming in, or is it just another systematic trading function?
Lo: These rebounds are a confluence of a number of phenomena. One, you’re seeing that once selling pressure declines, investors will naturally become more optimistic and will come back into the market. That’s a common phenomenon. But I think that a rather newer phenomenon is the fact that these algorithms, because they operate at such high frequencies, when the price moves beyond a certain threshold, the algorithms will kick around and flip and go the other way. It’s happening at a rate that’s faster than it’s been anytime in the past because we haven’t had the technology to be able to do that.
And finally what we’re seeing is expectations shifting more rapidly because unlike five or 10 years ago we now have very big players in the financial markets, actively trying to move markets. In particular, I’m thinking about central banks and governments that are trying to manage economies by engaging in quantitative easing or other kinds of financial market transactions. When you have a small number of very big players that are going to be trying to move markets for political or long-term economic reasons, it becomes much, much harder to understand what’s happening. So people are all sort of trigger happy when small pieces of information hit the market, they tend to start moving money very quickly and in large size.
Question: Is that type government intervention something that algos can’t anticipate? Is that sort of an Achilles heel of algo strategies?
Lo: Absolutely. That event risk is something most algorithmic trading strategies really can’t manage yet. I say "yet" because in five or 10 years maybe natural language processing and artificial intelligence will have allowed them to read the news, interpret it and make judgments the way George Soros or Warren Buffett can. But I think we’re still a few years away from that
Question: Are a lot of momentum strategies able to turn on a dime that quickly? We’ll see this intraday drop of several hundred points, then it turns on a dime…
Lo: I think that it’s hard for momentum strategies to be able to move that quickly. In fact, some of the strategies that do move that quickly end up getting whipsawed. The real challenge in operating in these markets is that risk management would have you cut risk in the face of losses. The problem is that if you cut risk too quickly and by too much, you may end up missing out on the rebound, in which case you’ve locked in your losses and you might be getting back in the market exactly at the worst time. So you’re getting hit on both ends. What this atmosphere creates is a much more complicated challenge to risk managers to figure out what is the right frequency with which they need to cut risk and put it back. And I think everybody is trying to figure out what that optimal frequency is. But until we get a sense of who’s involved in the markets and driving these frequencies, it’s going to be anybody’s guess. And as a result a lot of people are going to be surprised over the next few weeks and months.
Question: Any other observations you have from the last couple of weeks that you think people might be interested in?
Lo: Yeah. August sucks.
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that would be volatility squared. Or cubed. Next generation algos, Volatility calculus.
Good luck finding fair value in anything.
this is good stuff.. and Lo is spot on....
CFTC Study Confirms Impact of Volatility Trading On $VIX Futures PricesI'LL agree with the headline.
Almost as bad as any February you care to name.
Measuring the change in change (2nd derivative) should be simple stuff for them. What is he whining about?
There should never be ANY HFT. It should be illegal unless everyone can do HFT. All participants should be on an equal footing for the so called markets to have credibility. Since that is not the case, the market is not credible.
You need two points to get a rate of change. You need 3 points to get the change in change. So there will be a delay. The US is on the order of 20 milliseconds across (speed of light). The world is anout 70 milliseconds. Add in delays and the fact that the real speed of the cables is about 2/3rds light speed and that says a trade needs a while to be completed. The farther away your counterparty the longer it takes.
If your counterparty is in your computer - very fast. Microseconds. Across town - a millisecond. Across the country tens of milliseconds. Across the world hundreds of milliseconds.
To keep track of a market you not only have to watch prices. You also have to account for delays. Tricky.
Prices are good, now. I've made a list, and I'm selling everything I can think of to get rid of.
From what I've seen of your posts , you should be George Costanza, Opposite Man.
Yes, except for the description of slow witted. According to court decrees handed down and signed by Supreme court Federal judges, I'm making 8.25% average guaranteed for the next 20 years.
How slow witted are you?
I would not use that term, it passes over the head of those intended to skewer.
The last few weeks are the first >10% correction since, what? 2011?
Algorithmic traders can do as they please. In a real market, their investment strategy would grow, become popular and then die as the market slowly devalued their strategy to worthlessness. But it's not a real market any more. The big players have no real fear of death. They botch it up too bad and they know the printing presses will be run non-stop and the taxpayer coffers emptied to bail them out once more.
What irks me is the longer term outcome of all this nonsense: investments in gaming the market seem to be the only place left in the US where there is absolutely no shortage of R&D and CapEx being expended. The real productive part of the economy? Flat on it's back since 2009 with no sign it's getting up any time soon.
Gaming? As in casinos?
Sorry Gaming as in Hedges.
Shows you where my head is at.
.Had to read it twice.
I must insist that the taxpayer coffers are empty for many years to come
There is no difference between the two.
And government coffers have been empty for almost 2 decades. Just that the casino keeps buying their markers.
As little as I know about the game, the dice will eventually show 'craps'.
Five words: BUY THE INTRADAY DEEP TOMORROW.
The machines will dump some stuff in the morning violently and buying it back all the way up (s&p/ndx)
Yes, real artificial intelligence is coming to the market, first serious tests in 3 years
From my experience on trading, the more machines in the market, the easier to make money in the market. Historical volatility is crap nowadays, intrinsec is the key. Regarding the machines modus operandis, they all share one point in common. After that cracked, the rest is easy, even with 100-200ms filled orders. But hey, dont tell this to "them"
See my http://www.zerohedge.com/news/2015-09-08/august-sucks-mit-quant-warns-ne... on delays.
I'm new to the market having only done this about a year. These last couple months I've really seen the light with the pumping of stocks by certain websites and the outright lies. Disgusting. I am confused though, It would seem that at my trading website once I make a buy or sale, I have to wait 3 working days for my funds to settle or I could end up with at "Free ride". Is this not the case with the HFT's also?
It would seem that I get fed up with the manipulation and now more than 2 seconds after I've made a decision to either buy or sale, the market or stock takes a turn. So if I bail or get in then I have to wait 3 days and watch it all reverse again while I "lose" out. It's getting old. I shorted the market with two Inverse 1x ETF's on Friday to watch this market sore on the hopes of the Fed not raising rates. Now that the market almost seems to flip the bird to it all and keep climbing on bad news, the Fed might just raise the rates.
"Now that the market almost seems to flip the bird to it all and keep climbing on bad news"
Algos. Figure out when they operate and trade when they do, sit it out when they don't. This is what our MIT quant is getting at - volatility of volatility. This is all these markets are now.
Good luck.
The best approach is to burrow a hole deep in the bios of the AlphaSimplex Group's(ASG) execution servers. Lay in wait once you do because they have OS layer sentries that sweeps every so often looking for you. So set your sniffer initially to detect the sweep and find it's pattern.
Once detected the pattern can be defeated. Next step is to activate the bios network stack and let me in. The work I do is highly proprietary and involves teaching the hard drives to ignore my partition and clone the execution actions using my account.
You get paid in BTC via my darkweb portal. If you do your work correctly, undetected.
ASG routes through GSET. In future coms with me hide your text by surrounding your private coms with the < and > tags. < Your secret message here>
Go forth and replicate.
August sucks when you're back to Germany for work while all your unemployed friends are enjoing sea and sun down south
"When you have a small number of very big players that are going to be trying to move markets for political or long-term economic reasons, it becomes much, much harder to understand what’s happening."
The Reston 6.
Make your bed and lay in it HFT trader's. Competing algorithms can send out a false positive transmission too your little buggers.
Let the games begin. You were asked to stop computer trading, you ignored. Expect the worse. Bet you want to ban HFT after you lose trading positions. Reap what you sow.
/hahahahaaa
Ha-ha what's the point of having markets ? The illusion of freedom I guess