The Perils of Algorithmic Trading

By on May 28, 2011

How to Make Money in Microseconds: News about algorithmic trading is old hat, and we all know about the “flash crash” that happened last year.  But this article has a couple interesting points worth knowing about.

First, algorithms “fight” with one another.  One trader’s algorithm does something, and another algorithm detects that, then moves to counter it.  All of this happens in the span of a couple of hundred milliseconds.  (In this excerpt , “VWAP” is a certain type of trade.)

Far more controversial are algorithms that effectively prey on other algorithms. Some algorithms, for example, can detect the electronic signature of a big VWAP, a process called ‘algo-sniffing’. This can earn its owner substantial sums: if the VWAP is programmed to buy a particular corporation’s shares, the algo-sniffing program will buy those shares faster than the VWAP, then sell them to it at a profit. Algo-sniffing often makes users of VWAPs and other execution algorithms furious: they condemn it as unfair, and there is a growing business in adding ‘anti-gaming’ features to execution algorithms to make it harder to detect and exploit them.

Second, the amount of time it takes to execute trades is becoming ridiculously minute, to the point where making money or not is butting up against the limits of physics – even the actual speed of light.  (In this excerpt, Mahwah is the city in New Jersey where the New York Stock Exchange has its data center.)

Consider:

Imagine, for example, that your office is in Chicago, the second largest financial centre in the US, and you want to trade on the New York Stock Exchange. You are around 800 miles away from the matching engines in Mahwah, and sending a message that distance, using the fastest fibre-optic route between Chicago and New Jersey that I know of, takes around 16 milliseconds. That’s a huge delay: you might as well be on the moon.

Technical improvements in the amplifiers needed to boost signal strength and in other aspects of fibre-optic transmission will reduce the delay somewhat, as would straightening the route (fibre-optic cables still tend to follow railway lines because it’s easy to negotiate rights of way there, but railways don’t usually run in straight lines for long distances, instead going via centres of population). Ultimately, however, the speed of light is an insuperable barrier. If Einstein is right, no message is ever going to get from Chicago to Mahwah in less than four milliseconds.

The entire article is a fascinating read.

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Comments

  1. Once something like algorithmic trading became wide spread enough it was only a matter of time before others started using that to their advantage. Classic arms race.

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