Best of the Week
Most Popular
1. TESLA! Cathy Wood ARK Funds Bubble BURSTS! - 12th May 21
2.Stock Market Entering Early Summer Correction Trend Forecast - 10th May 21
3.GOLD GDX, HUI Stocks - Will Paradise Turn into a Dystopia? - 11th May 21
4.Crypto Bubble Bursts! Nicehash Suspends Coinbase Withdrawals, Bitcoin, Ethereum Bear Market Begins - 16th May 21
5.Crypto Bubble BURSTS! BTC, ETH, XRP CRASH! NiceHash Seizes Funds on Account Halting ALL Withdrawals! - 19th May 21
6.Cathy Wood Ark Invest Funds Bubble BURSTS! ARKK, ARKG, Tesla Entering Severe Bear Market - 13th May 21
7.Stock Market - Should You Be In Cash Right Now? - 17th May 21
8.Gold to Benefit from Mounting US Debt Pile - 14th May 21
9.Coronavius Covid-19 in Italy in August 2019! - 13th May 21
10.How to Invest in HIGH RISK Tech Stocks for 2021 and Beyond - Part 2 of 2 - 18th May 21
Last 7 days
UK Energy Firms Scamming Customers Out of Their Best Fixed Rate Gas Tariffs - 23rd Sep 21
Global Stock Markets Topped 60 Days Before the US Stocks Peaked - 23rd Sep 21
Should School Children be Jabbed with Pfizer Covid-19 Vaccine To Foster Herd Immunity? - UK - 23rd Sep 21
Stock Market FOMO Hits September Brick Wall - Evergrande China's Lehman's Moment - 22nd Sep 21
Trading Crude Oil ETFs in Foreign Currencies: What to Focus On - 22nd Sep 21
URGENT - Crypto-trader event - 'Bitcoin... back to $65,000?' - 22nd Sep 21
Stock Market Time to Buy the Dip? - 22nd Sep 21
US Dollar Bears Are Fresh Out of Honey Pots - 22nd Sep 21
MetaTrader 5 Features Every Trader Should Know - 22nd Sep 21
Evergrande China's Lehman's Moment, Tip of the Ice Berg in Financial Crisis 2.0 - 21st Sep 21
The Fed Is Playing The Biggest Game Of Chicken In History - 21st Sep 21
Focus on Stock Market Short-term Cycle - 21st Sep 21
Lands End Cornwall In VR360 - UK Holidays, Staycations - 21st Sep 21
Stock Market FOMO Hits September CRASH Brick Wall - Dow Trend Forecast 2021 Review - 20th Sep 21
Two Huge, Overlooked Drains on Global Silver Supplies - 20th Sep 21
Gold gets hammered but Copper fails to seize the moment - 20th Sep 21
New arms race and nuclear risks could spell End to the Asian Century - 20th Sep 21
Stock Market FOMO Hits September Brick Wall - Dow Trend Forecast 2021 Review - 19th Sep 21
Dow Forecasting Neural Nets, Crossing the Rubicon With Three High Risk Chinese Tech Stocks - 18th Sep 21
If Post-1971 Monetary System Is Bad, Why Isn’t Gold Higher? - 18th Sep 21
Stock Market Shaking Off the Taper Blues - 18th Sep 21
So... This Happened! One Crypto Goes From "Little-Known" -to- "Top 10" in 6 Weeks - 18th Sep 21
Why a Financial Markets "Panic" May Be Just Around the Corner - 18th Sep 21
An Update on the End of College… and a New Way to Profit - 16th Sep 21
What Kind of Support and Services Can Your Accountant Provide? Your Main Questions Answered - 16th Sep 21
Consistent performance makes waste a good place to buy stocks - 16th Sep 21
Dow Stock Market Trend Forecasting Neural Nets Pattern Recognition - 15th Sep 21
Eurozone Impact on Gold: The ECB and the Phantom Taper - 15th Sep 21
Fed To Taper into Weakening Economy - 15th Sep 21
Gold Miners: Last of the Summer Wine - 15th Sep 21
How does product development affect a company’s market value? - 15th Sep 21
Types of Investment Property to Become Familiar with - 15th Sep 21
Is This the "Kiss of Death" for the Stocks Bull Market? - 14th Sep 21
Where Are the Stock Market Fireworks? - 14th Sep 21
Play-To-Earn Cryptocurrency Games Gain More and Is Set to Expand - 14th Sep 21
The CashFX TAP Platform - Catering to Bull Investors and Bear Investors Alike - 14th Sep 21
Why every serious investor should be focused on blockchain technology - 13th Sep 21
SPX Base Projection Reached – End of the Line? - 13th Sep 21
There are diverse ways to finance the purchase of a car - 13th Sep 21
6 Tips For Wise Investment - 13th Sep 21 - Mark_Adan

Market Oracle FREE Newsletter

How to Protect your Wealth by Investing in AI Tech Stocks

Dangers of Seeking Fast Profit in High Speed Trading

Stock-Markets / Financial Crash Oct 22, 2010 - 01:22 PM GMT

By: Barry_Elias


Benoit Mandelbrot, world renowned mathematician from Harvard and Yale, passed away last week at the age of 85.

He coined the term “fractal” (a shape comprised of smaller similar shapes). He determined that derivative pricing in financial markets follows this self-similar characteristic, which leads to infinite variance (e.g., black swan, fat-tail events)

Mandelbrot used the Hurst exponent (H) to describe the relative tendency for a time series to strongly regress to the mean or cluster in a particular direction (e.g., index of dependence or "fractalization").

The Hurst exponent identifies the manifestations associated with high frequency trading (HFT). The range for the exponent is zero to 1: zero suggests 0 percent correlation, while 1 represents 100 percent correlation. Unbiased trading activity centers near the mean of 0.5.

Correlation indicates multiple events co-exist simultaneously (doesn't imply a causal relationship). The term “herd mentality” is a manifestation of this phenomenon, whereby demand is generated by previous demand, leading many participants to make a similar decision. The result is high volatility and a large H exponent (near 1).

Reginald Smith, of the Bouche-Franklin Institute, recently examined the high frequency time series from 2002 through 2009. Starting in 2005, when high frequency trading was most prominent, nearly all of the 14 most heavily traded stocks on the New York Stock Exchange (NYSE) demonstrated a significant increase in the Hurst exponent. He noted average trade size declined during this period, which increased the magnitude closer to 1.

This suggests a self-similar correlation and it is associated with high volatility. This phenomenon occurred on May 6, which is now termed the “flash crash.”

Ironically, this high volatility caused many high frequency traders to exit the market, thereby reducing the liquidity in the system. This further exacerbated volatility within a negative feedback loop.

The SEC recently published the fee schedule for high frequency traders to obtain early access to market orders via co-location (e.g., the traders’ computer servers remain in close proximity to those of the exchange).

These fees can approach seven figures annually. With this information, the high frequency trader can identify and capture the excess demand in the system to optimize revenue and profit.

For instance, the trader may receive a market order to sell 1 million shares of Company XYZ at $10 per share. The trading system may elect to purchase all the shares at this price. It then attempts to sell these shares at a higher amount to maximize profit. It places small sell orders to assess the strength of demand by measuring the time required to fill the small order. If the time required is small, it suggests there may be stronger demand. It then places another small sell order at a slightly higher price. It continues this process until all the shares are sold. This can take less than a second with the use of high speed algorithmic trading.

Typically, most of the orders placed by the trading system (estimated near 90 percent) are to assess the market demand and are subsequently canceled. This mechanism is termed “order stuffing.”

Recently, participants with a high frequency trading firm were prosecuted for this activity, and some were fined and banned from trading for a specified amount of time.

In addition, the algorithmic nature of the system lends itself to systematic dysfunction if there is human error during the initiation phase.

High frequency traders represent 2 percent of traders, conduct more than 50 percent of trading volume, and generate annual profit of nearly $20 billion. A further consolidation of trading activity will intensify the underlying dynamics of volatility and liquidity risk in times of crisis.

The retail and institutional investor has determined the market may not be functioning in a fair, effective and efficient manner.

Recently, “60 Minutes” on CBS reported that mutual funds recently withdrew nearly $70 billion from the market. In addition, volume on the exchange has decreased. Professionals indicate this low volume environment may last a year or more as financial deleveraging continues.

Since May 6, there have been more instances of the flash crash dynamic, and professionals are explicit in saying another serious market condition can happen unless the process is reformed.

In fact, one high profile investment professional appeared on CNBC just hours following the flash crash to strongly advocate for a more responsible system that preserves market integrity.

By Barry Elias

Barry Elias provides economic analysis to Dick Morris, a former political adviser to President Clinton.

He was cited and acknowledged in two recent best-sellers co-authored by Mr. Morris: “Catastrophe” and “2010: Take Back America - a Battle Plan.” Mr. Elias graduated Phi Beta Kappa from Binghamton University with a degree in economics.

He has consulted with various high-profile financial institutions in New York City.

© 2010 Copyright Barry Elias - All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

© 2005-2019 - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.

Post Comment

Only logged in users are allowed to post comments. Register/ Log in