HFT Is NOT Responsible for Market Volatility You Are!
Wed, 14 Sep 2011 03:58:00 GMT
This is a Guest post by Manoj Narang, Founder and CEO of Tradeworx Inc
In recent months, a plethora of articles have remarked on elevated levels of market volatility, while simultaneously pointing out that computers generate an ever-growing share of the market’s volume. The implication, or in some cases, outright accusation, is that the latter is the cause of the former. While the recent front-page New York Times article on this topic refrains from outright casuistry, it does follow the typical pattern of using coincidence to suggest causality. Not only is this sub-par journalism, but it is bad statistics — particularly when the numbers themselves can easily be used to draw relevant causal inferences.
The article correctly notes that there has been an increasing incidence, in recent times, of days exhibiting unusually high volatility (measured as days when the close-to-close return, or alternatively, the high-low trading range are large in magnitude). However, in sharp contravention to what is now the conventional wisdom, the very same data used by the article’s authors also reveals that computerized trading (in particular, high-frequency trading), bears absolutely none of the culpability for this.
This is easily seen by comparing the data from 2000-2006 to the data from 2007 onward. The year 2007 is of interest here because it was the year that the modern market structure was adopted, due to a mandate of the Securities and Exchange Commission known as Regulation NMS. In many important respects, the adoption of Reg NMS represents a kind of unofficial birth date of what is now known as high-frequency trading.
Sure enough, a cursory examination of the data reveals that from 2000-2006, the S&P 500 moved an average of 0.83% from one day to the next, whereas the market has been much more volatile since then, to the tune of 1.06% per day. But is computerized trading somehow to blame for this, or is the more obvious explanation — uncertainty brought about the global financial crisis — the correct one? Stated differently, who is to blame for volatility — investors or traders?
The data offers a fairly compelling and straightforward way to answer this question, because part of the volatility of the market occurs when the market is closed; i.e. when there is no trading (especially of the high-frequency variety). From 2000-2006, the S&P 500 moved an average of 0.37% per day when the market was closed (that is, between the close of one day and the open of the next), whereas from 2007 onward, it moved 0.61% per day during this period, a 65% increase.
Logically, it is impossible to blame high-frequency traders for this 65% rise in close-to-open volatility, because there is no trading when the market is closed. This volatility reflects one thing and one thing only — markets react to news, and since 2007, there has been an abundance of news which has caused investors to panic.
This 65% increase in volatility is particularly revealing when it is juxtaposed against the comparable difference when the markets are open. From 2000-2006, the S&P 500 moved an average of 0.76% between the open and close of the same day, compared with 0.85% since 2007. In other words, volatility during trading hours has increased only 12% during the exact same period when volatility during non-market hours has increased 65%, less than a fifth of what would be expected.
Using this direct apples-to-apples comparison, it is impossible to escape the conclusion that markets are now significantly less volatile during trading hours than they would otherwise be in the absence of computerized trading. To a rational and unbiased observer, this ought to make perfect sense. Volatility is caused by panic behavior. Computers don’t panic, humans do. Virtually every academic study on the topic has concluded that the effect, if any, of high-frequency on market volatility is to lower it. This is hardly surprising — high-frequency traders are known to go home every day with no positions, which requires them to buy and sell in exactly equal amounts every day (and in most cases, intraday as well). To argue that such an approach can have a material effect on stock prices requires some serious contortions of logic.
High-frequency trading may make for a convenient scapegoat for policy-makers wishing to deflect focus away from their poor decision-making, or for money managers seeking to explain away their perennially abysmal performance, but the facts argue otherwise. It is time for these groups to take a look in the mirror, and for the public and the press corps to hold them to account. The herd mentality exhibited by investors who continually inflate one asset bubble after another (the latest example being gold), and the economic policies which incentivize them to do so, are the root causes of what ails our markets.
Manoj Narang, CEO
Re "convenient scapegoat", people using this practice self-identify themselves as blame-shifting excuse mongers. While waiting for the press and public to hold them to account, there will be ample time to identify their non-optimal biases and work out trades against them.
The opportunity is to find which best represent large clusters of their intellectual fellow travelers, because such clustering, of unquestioned common delusions, reveals market inefficiences ripe for plucking. They will stay ripe for as long as it takes for them to catch on, or achieve insolvency, whichever comes first.
bryan stallard 1949 days ago,(2011/11/28)