Price Discovery Terrence Hendershott Jonathan Brogaard Ryan Riordan Technology has been good for markets Is every use of technology good How do we think about evaluate HFT What are costsbenefits of those closest to the market ID: 268813
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High-Frequency Trading and
Price Discovery
Terrence Hendershott
(
Jonathan Brogaard
Ryan Riordan)Slide2
Technology has been good for markets
Is every use of technology good?How do we think about (evaluate) HFT?What are costs/benefits of those closest to the market?Analysis of Nasdaq HFT data in terms of price discoveryStatistical model of HFT and “information” and “noise” in pricesChallenges in interpreting these resultsCross-correlations between HFT and price changesExplore what types of information HFT has (not in paper yet):Macro news announcements Market-level (as opposed to individual stocks) resultsLimit order book imbalances
Overview
High-Frequency Trading and Price Discovery
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The old trading floor, NYSE 1873Slide4
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More recent trading floor High-Frequency Trading and Price DiscoverySlide5
Securities Market
Algorithmic & High-Frequency Traders/SystemsAlgorithmic and High-Frequency TradingAlgo Trade Definition: “The use of computer algorithms to manage the trading process.‘‘(Hendershott et al. 2011); HFT similar, but for short holding periods5Current trading floor
High-Frequency Trading and Price DiscoverySlide6
Is the evolution good?
Some News Articles“...the stock market is more prone than ever to large intraday moves with little or no fundamental catalyst.”“locusts … feeding off the equity market.”“High-frequency traders generated about $21 billion in profits last year.”“...use rapid-fire computers to essentially force slower investors to give up profits, then disappear before anyone knows what happened. ”“...rule changes are need to control risks...”
“…development have had negative effects…”
“HFT firms are accused of flooding markets with orders that are cancelled…, leading to volatility”
Ultra fast trading needs curbs – global regulators
July 7, 2011 - London
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It's hard to imagine a better illustration (of social uselessness) than high-frequency trading. The stock market is supposed to allocate capital to its most productive uses, for example by helping companies with good ideas raise money. But it's hard to see how traders who place their orders one-thirtieth of a second faster than anyone else do anything to improve that social function.
Paul
Krugman
August 2, 2009
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New York TimesSlide7
Longer perspective on technological changes affecting liquidity
Technological advances have made the markets better: Evidence from trends and specific events/introduction High-Frequency Trading and Price Discovery7Slide8
Liquidity (Trading Costs/Spreads) on NYSE
8Decline is from lower averse selection (less information in trading) -- Hendershott et al. 2011How well can we measure liquidity as trade size -> 0? Transitory impact of large orders? High-Frequency Trading and Price DiscoverySlide9
Algorithmic Trading on NYSE
9Hendershott et al. 2011 High-Frequency Trading and Price DiscoverySlide10
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High-Frequency Trading and Price DiscoveryCorrelation is not causality: we need a “natural experiment”: AutoquoteSlide11
Algo Trading is a superset of HFT
What is HFT?HFT is always AT – but AT is not always HFTTypical properties of HFT:High-speed tradingSophisticated computer programsUse of co-location services and data feedsShort time frames for establishing and liquidating positions, high trading volume and intensity(SEC, 34-61358, Concept Release on Equity Market Structure)HFT is a mixture of the use of technology and trading strategies (do they differ?)What is new is direct access, increased electronic information sources, and more computing
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High-Frequency Trading and Price DiscoverySlide12
Anything new here?
Short-lived strategies with tight risk managementBased on public information, technology, and sophisticated toolsIs the focus the technology, strategies, or interaction?HFT Strategies (SEC)Passive Market MakingArbitrageStructural
Directional
Strategies
Make money at the bid-ask spread and liquidity rebates
Cross asset and cross market arbitrage
Statistical arbitrage
Latency Arbitrage
Flash orders
News Trading
Liquidity Detection (order anticipation)
Momentum trading and ignition
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High-Frequency Trading and Price DiscoverySlide13
HFT and Price Discovery (beyond liquidity)
13Sept. 19th, 2002Sept. 6th, 200810:58 Sept. 8th, 2008United Airlines files for Ch. 11 to cut costs - BloombergSept. 8th, 2008United Airlines Share Price
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Price Discovery: Efficient Price & Noise
Explicitly model observed prices each minute as efficient price (martingale) and noise (pricing error)Observed price is martingale (efficient price) plus noise:Trading makes cov(s,w) <> 0 Standard market microstructure approach: Innovations in martingale are related to innovations in trading:Transitory component also relates to trading:Identification from Cov(m,u)=0 (Hasbrouck (1993) and others)
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Price Discovery: Interpretation
k trading’s (order flow) relation to efficient price+ informed about change in efficient price- adversely selected on efficient pricey trading’s (order flow) relation to noise+ direction of trading correlates with more noise Transitory price impact, risk mgt., manipulation, order anticipation- trading against noise, making prices more efficientStatistical arbitrage via identifying transitory effectsDecompose overall HFT order flow into Liquidity Demand and SupplyExamine highest volatility days (stability?)
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120 stocks: small, medium, large cap
Identifies 26 independent HFT firmsVia unique “port” which firms useDoes not identify large integrated firms, e.g., GoldmanAll data is aggregate across all HFT firmsIs this a representative sample? If not, why not?HFT firms worried about regulatory responseData is available via NDA with NasdaqNasdaq had 20-40% market shareHFT is 42% of volume in large stock, 12% in small stocksMarket/limit order volume similar in large, less limit in smallNasdaq HFT Data
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Overall HFT trade to make prices more efficient
Results remain (and are stronger) on high-volatility daysMarket order trading is responsible for this+ correlation with efficient price, - with pricing error/noiseConsistent with forecasting both parts of returnsLimit order trading coefficients have opposite signs- correlation with efficient price, + with pricing error/noiseEfficient price: standard adverse selection of liquidity providersNoise: risk mgt., adverse selection, manipulation, order anticipation?Do these passive trades make money?Yes, earn the spread and liquidity rebatesOverall HFT profitability per $ is low: ~$0.03/$10,000 tradedNasdaq HFT (SSM) Price Discovery Results High-Frequency Trading and Price Discovery17Slide18
Is HFT being informed good or bad?
HFT liquidity demand imposes adverse selectionBut, also trade against noise in pricesIt is possible to do one without the other?How important is this information? How long-lived?Would it get into price anyway?HFT liquidity supply looks a lot like market making (good)How could we measure excess intermediation (bad)?Next, cross-correlations for individual stocks and market-wide and macro news announcementsInterpretation of Statistical Model High-Frequency Trading and Price Discovery18Slide19
HFT Demand positively predict stock returns for a few seconds
HFT Supply negatively predict stock returns for a few secondsDemand effect dominates overall
Individual Stocks:
HFT and Future Stock Returns (1sec periods)
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Aligning return and HFT times is challenge (
Nasdaq BBO for subset)HFT Supply is adversely selected; HFT Demand is transmitting infoOverall Supply dominates; how to think about this HFT Demand?Regressions show HFT Demand is not associated with noise
Event Study: Macro Announcements
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Similar to Negative announcements
Predominantly HFT is providing liquidity at most stressful time209 Announcements in: Construction Spending, Consumer Confidence, Existing Home Sales, Factory Orders, ISM Manufacturing, ISM Services, Leading Indicators, Wholesale Inventories
Event Study: Macro Announcements
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HFT Demand positively predict market-wide returns for a few seconds
HFT Supply negatively predict market-wide returns for a few secondsSupply effect dominates overall (also true in a market-level SSM)Past market returns predict HFT similarly (E-mini predicts HFT Demand)HFT has a longer lasting role in market-wide price discovery
Market-wide:
HFT and Future Stock Returns (1sec periods)
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Limit
order book imbalance LOBI (Size at offer minus Size at bid)LOBI predicts future returns (-), HFT Demand (-), HFT Supply (+)Not much in the small stocksAnother source of HFT Information High-Frequency Trading and Price Discovery23Slide24
Other sources of “Public
” information in past prices, orders?In other assets (market-wide, announcement results)Large stock leading small stocksHFT Demand predicts returnsHow to think about short-lived nature of (public) information?Foucault, Hombert, and Rosu (2012) Reducing the transitory part is goodTrading on (soon to be) public information is notHow do we know what information will get into price without HFT?Sources of HFT Information High-Frequency Trading and Price Discovery
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Technology has improved markets
Algorithms: prices more efficient and markets more liquidHFT is technology applied to certain strategiesMake prices more efficient; true on high-volatility days alsoWhat are the benefits of getting info into prices in seconds?Does this improve financing and investment decisions?Should traders closest to the market mechanism be informed?Focus attention on HFT liquidity demanding strategies?Are long-term investors losing out (zero sum trading)?If so, will HFT become competitive and offer technology services to long-term investors?Will market structures evolve to support LFT (without HFT)?What is the optimal configuration of intermediation sector?Free entry or regulated monopoly/oligopoly?Specific regulations on liquidity supply and demand?
Conclusions/Thoughts
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