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New trading strategies

 on Saturday, November 26, 2016  

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The marriage of electronic trading mechanisms with computer technology has had far-ranging impacts on trading strategies and tools. Algorithmic trading delegates trading decisions to computer programs. High-frequency trading is a special class of algorithmic trading in which computer programs initiate orders in tiny fractions of a second, far faster than any human could process the information driving the trade. Much of the market liquidity that once was provided by brokers making a market in a security has been displaced by these high-frequency traders. But when high-frequency traders abandon the market, as in the so-called flash crash of 2010, liquidity can likewise evaporate in a flash. Dark pools are trading venues that preserve anonymity but also affect market liquidity.

Algorithmic Trading
Algorithmic trading is the use of computer programs to make trading decisions. Well  more than half of all equity volume in the U.S. is believed to be initiated by computer algorithms. Many of these trades exploit very small discrepancies in security prices and entail numerous and rapid cross-market price comparisons that are well suited to computer analysis. These strategies would not have been feasible before decimalization of the minimum tick size. Some algorithmic trades attempt to exploit very short-term trends (as short as a few seconds) as new information about a firm becomes reflected in its stock price. Others use versions of pairs trading in which normal price relations between pairs (or larger groups) of stocks seem temporarily disrupted and offer small profit opportunities as they move back into alignment. Still others attempt to exploit discrepancies between stock prices and prices of stock-index futures contracts.
 

Some algorithmic trading involves activities akin to traditional market making. The traders seek to profit from the bid–ask spread by buying a stock at the bid price and rapidly selling it at the ask price before the price can change. While this mimics the role of a market maker who provides liquidity to other traders in the stock, these algorithmic traders are not registered market makers and so do not have an affirmative obligation to maintain both bid and ask quotes. If they abandon a market during a period of turbulence, the shock to market liquidity can be disruptive. This seems to have been a problem during the flash crash of May 6, 2010, when the stock market encountered extreme volatility, with the Dow Jones average falling by 1,000 points before recovering around  600 points in intraday trading. The nearby box discusses this amazing and troubling episode.

High-Frequency Trading
It is easy to see that many algorithmic trading strategies require extremely rapid trade initiation
and execution. High-frequency trading is a subset of algorithmic trading that relies on computer programs to make extremely rapid decisions. High-frequency traders compete fortrades that offer very small profits. But if those opportunities are numerous enough, they can accumulate to big money. We pointed out that one high-frequency strategy entails a sort of market making, attempting to profit from the bid–ask spread. Another relies on cross-market arbitrage, in which eventiny price discrepancies across markets allow the firm to buy a security at one price and simultaneously sell it at a slightly higher price. The competitive advantage in these strategies lies with the firms that are quickest to identify and execute these profit opportunities. There is atremendous premium on being the first to “hit” a bid or ask price.

Dark Pools
Many large traders seek anonymity. They fear that if others see them executing a buy or a sell program, their intentions will become public and prices will move against them. Very large trades (called blocks, usually defined as a trade of more than 10,000 shares) have traditionally been brought to “block houses,” brokerage firms specializing in matching block buyers and sellers. Part of the expertise of block brokers is in identifying traders who might be interested in a large purchase or sale if given an offer. These brokers discreetly arrange large trades out of the public eye, and so avoid moving prices against their clients. Block trading today has been displaced to a great extent by dark pools, trading systems in which participants can buy or sell large blocks of securities without showing their hand. Not only are buyers and sellers in dark pools hidden from the public, but even trades may not be reported, or if they are reported, they may be lumped with other trades to obscure information about particular participants.

Bond Trading
In 2006, the NYSE obtained regulatory approval to expand its bond trading system to include the debt issues of any NYSE-listed firm. In the past, each bond needed to be registered before listing; such a requirement was too onerous to justify listing most bonds. In conjunction with  these new listings, the NYSE has expanded its electronic bond-trading platform, which is now called NYSE Bonds, and is the largest centralized bond market of any U.S. exchange. Nevertheless, the vast majority of bond trading occurs in the OTC market among bond dealers, even for bonds that are actually listed on the NYSE. This market is a network of bond dealers such as Merrill Lynch (now part of Bank of America), Salomon Smith Barney (a division of Citigroup), and Goldman Sachs that is linked by a computer quotation system. However, because these dealers do not carry extensive inventories of the wide range of bonds that have been issued to the public, they cannot necessarily offer to sell bonds from their inventory to clients or even buy bonds for their own inventory. They may instead work to locate an investor who wishes to take the opposite side of a trade. In practice, however, the corporate bond market often is quite “thin,” in that there may be few investors interested in trading a bond at any particular time. As a result, the bond market is subject to a type of liquidity risk, for it can be difficult to sell one’s holdings quickly if the need arises.
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New trading strategies 4.5 5 eco Saturday, November 26, 2016 The marriage of electronic trading mechanisms with computer technology has had far-ranging impacts on trading strategies and tools. Algorit...


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