Monday, June 14, 2010

Counteracting High Speed Traders

On the Planet Money show, there's been discussion about the practice of High Speed Trading. This is where traders use computers and high-speed connections to the stock market to analyze trade data and put in trades making penny or sub-penny profits on transaction trends by responding faster than other players.

So, for example, if someone is trying to make a buy of stocks, and they can't get them in one lot, their first partial buy might trigger an algorithm in a computer. Then the computer might use it's high speed trading connection to buy up available lots of the stock that it anticipates will soon go up by a small tick, reselling to a slower moving buyer trying to close out the complete order with a slower connection.

Institutional investors, such as those managing your pension mutual funds, are understandably wary of the practice because they're frequently the ones whose transactions become marginally more expensive due to high-speed trading algorithms. So how might they neutralize the effects of high-speed traders?

I see an opening where a larger traders could help to neutralize or even marginally improve transaction costs due high-speed traders via counter trades. In aircraft control theory, there is a phenomenon called pilot induced oscillation (PIO). This is where a pilot tries to damp out an oscillation, but because they're responding with the right response, but out of phase, the situation ends up inducing larger oscillations in the path of the aircraft. Usually, aircraft designers (and pilots) are looking to avoid PIO, but a counter trade would be trying for the opposite by inducing high speed trading responses.

The basic idea would be to issue a number of counter trades to trigger the high speed trading algorithms, then use the window of movement in price that the high-speed algorithm creates to run your intended overall transaction. For example, if you were selling, make a few buys first. Let the high speed algos try to drive the price up by buying up all the shares at that local price level, then you would issue your sale at a higher transaction price. If the high speed trading algorithms stay agressive, then you can continue to open windows for your intended transactions. Alternately if the high-speed algorithms are dialed down to become less aggressive then your marginal losses from the actions are drastically reduced. Either way, counter trading would be one way to bound the high-speed trading algorithms.

Update: in the same vein, here's an article in the Atlantic about how odd trading patterns have been identified in trading data, presumeably from high frequency trading bots.