Brownian Motion – A Deeper Problem With High-Frequency Trading, Algortihmic Trading, and Their Ilk.

Micheal Lewis’s new book has done us a favor by finally dragging the high-frequency trading (HFT) phenomenon into the spotlight.  It has always seemed fairly obvious that any trading strategy that depends on being a few milliseconds faster than others is clearly predatory.*

One can argue that ALL trading is inherently predatory, so what’s the problem here?  But that doesn’t sound so good on TV.   So HFT’s defenders fall back on lame arguments about how they provide increased liquidity blah blah blah.  This is total bullshit of course.  That isn’t liquidity. It is “forestalling” – literally to “buy before it gets to the [market] stall.”  Forestalling was banned way back in the middle ages and there’s no reason it should be allowed today.

Old English – foresteall ‘an ambush’ (see fore- and stall). As a verb the earliest sense (Middle English) was ‘intercept and buy up (goods) before they reach the market, so as to raise the price’ (formerly an offense).
 

But I see something more disturbing about HFT and various other computer-driven strategies.  You have more an more market actors who explicitly, consciously, ignore any consideration of “value” – ie. the stream of future earnings that underpin a stock certificate’s actual worth.  

Like most market perversions, this only becomes a problem with scale.  A few robot-actors aren’t a problem.  Nor are particular individual robot-actor strategies.  The problem is when the collective whole starts to crowd out the humans that do (theoretically) consider “value” – if only fleetingly before searching for that next greater fool).

  • Consider the quaint old days when a stock was actually bought or sold on the basis of its dividend.  As in “I am buying shares of Union Pacific because they promise to pay out ten cents a year for every dollar.”  Said while wearing a bowler hat twirling a ferocious mustache.  This goes back to the very idea of “equity” – the profits left over after you have paid off suppliers, workers, and debt interest.
  • Later on, of course, we expanded that conception of “value” to capital gains, retained earnings, and intangibles.  From there, it was a hop, skip and a jump to valuation based on the more modern, scientific “NGF” model (Next Greater Fool).  Basically a stock was worth what someone else was willing to pay you for it.

It is hard to see how a market increasingly dominated by robot-actors doesn’t stray further and further away from the (hypothetical) real value of a stock.  Which is the (perhaps equally quaint) reason for a market’s very existence.  It’s raison d’etre, one might say… (ed: sorry – I couldn’t resist).

Instead, we get a market that is truly a “random walk.”  Driven more by internal correlations and contradictions.  Straying further from the real-world prospects of the companies purportedly represented there.  The system grows increasingly disconnected from the real world and increasingly driven by its own internal Brownian motion (great animation here btw – http://en.wikipedia.org/wiki/Brownian_motion).  And that is not a good thing.

*  The predatory nature of HFT was/is clear to anyone who has watched their own personal “buy” or “sell” order (for a tiny number of shares) make the quoted price skitter away as some HFT shop tries to gouge you for a few pennies.  And then revert right back to what it was quoted at before you actually tried to transact at that price.  I’ve learned to always specify a limit price.  “At market” orders are just asking to be taken for a ride.

 

 
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