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When the Market's Momentum Shifts, So Too Will the Robot Traders' Mission


Last week proved more than ever that the rally in stocks is a function of robots jamming prices higher in a self-reinforcing reflexive trend.

Tuesday morning I was chatting it up on IM with Minyanville's Michael Sedacca about how the day's events were unfolding. We had just received successive weaker than expected manufacturing reports from China, Germany, and the US yet stocks maintained their bias to the upside.

09:21:07 Michael Sedacca: today will be an interesting day
09:38:29 Vincent Foster: this is pretty remarkable
09:47:27 Michael Sedacca: right at the 61.8% retrace of the whole move
09:49:37 Vincent Foster: not sure numbers matter at this point
09:49:42 Vincent Foster: its all momo
09:49:50 Vincent Foster: hal 9000 is in charge

Momo is short for momentum. Hal 9000 is the computer aboard the spaceship in 2001: A Space Odyssey which is a metaphor for the high frequency trading (HFT) algorithms that have come to dominate activity in our financial markets.

Through lunch the market was grinding sideways after the initial morning ramp and then out of nowhere just after 1:00 p.m. EDT the AP headline hit twitter:

13:09:46 Michael Sedacca: U SEE THIS!?!? Two Explosions in the White House and Barack Obama is injured

ES Tick 042313

A few minutes later as markets quickly recovered and we had time to assess the validity of the tweet, it was evident what had happened.
13:21:24 Vincent Foster: like i said hal 9000 is in charge

I don't know what was scarier; that a fake tweet could crash the market or the realization that the market was fake to begin with.
15:15:50 Vincent Foster: it was pretty quick
15:16:01 Vincent Foster: surprised that much ES volume traded
15:16:24 Vincent Foster: must be a lot of trailing stops
15:21:22 Vincent Foster: just freaky how fast the order book can disappear

For those who are passive investors, the order book is the list of buy/sell orders up and down the price structure of the market. In the old days (just a few years ago) when "specialists" at the NYSE and "locals" at the CME were in charge, the order book was relatively stable and you would never have seen this type of sudden air pocket in price. Of course you might see large price movements intraday, and once in a cycle markets will crash, but not because quotes instantly vanished. Today with high frequency trading dominating the order book, quotes are placed and removed in milliseconds. As we learned on Tuesday and during the flash crash of 2010, price can move just as fast.

No one has done more work to expose the systemic risk of HFT than Nanex. In a recent response to a Harvard-based report by Adam Scott-Joseph that aims to shed some light on the motivation behind HFT "exploratory" algorithms trading the S&P (INDEXSP:.INX) e-mini futures contract (ES), Nanex concludes:
The top HFTs probe the market by sending in small aggressive orders and then gauging market reaction: a practice that allows them to get a private glimpse of the "true" supply and demand at the expense of everyone else. Once the market direction is ascertained, these HFT aggressively remove liquidity, causing an immediate market move. Since the eMini is heavily arbitraged by SPY (which in turn is arbitraged by its many components and options), these sudden moves in the eMini will set off waves of overwhelming message traffic as traders and algos react and reprice thousands of instruments in milliseconds.

A lot of media discussion about HFT focuses on three benefits: they provide liquidity, narrow spreads, and lower trading costs. This Harvard paper exposes some disturbing truths: the top HFT engage in a predatory market manipulation strategy that removes liquidity 59.2% of the time (by volume), causes undue intraday volatility (which amounts to a tax on investors), warps the true picture of supply and demand, and raises trading costs for everyone processing market data.

On January 28 in The Great Rotation? The Market Is a Bit More Complicated Than That I quoted volatility guru Chris Cole of Artemis Capital Management who provides a methodical framework for how to invest in today's market that is impervious to traditional models.

The following is taken from Cole's Volatility of an Impossible Object:

The perfectly efficient market is by nature random. When the market has too much influence over the economic reality it was designed to mimic, the flow of information becomes increasingly less efficient with powerful consequences. Information becomes trapped in a self-reflexive cycle whereby the market is a mirror unto itself. Lack of randomness ironically leads to chaos. I believe this is what George Soros refers to as "reflexivity." The impossible object is a visual example of reflexivity.

As Cole implies, reflexivity is a feedback mechanism whereby market prices begin to influence the fundamentals they portend to reflect in a positively reinforcing the trend. The robots dominating trading activity operate under the laws of reflexivity. They don't know value or fundamentals; they only know price and momentum, buying more when price goes up and selling more when price goes down. With equities trading at all-time highs in the face of massively deteriorating economic data, it's pretty obvious reflexivity is driving price.
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