Tag Archives: finance

Fast Data: Information Advantages of High-Frequency Traders

The popularity of high-frequency trading (HFT) has boomed in the past decade as hedge funds and proprietary traders have made astounding sums of money exploiting network technology to execute trades a few milliseconds faster than their competitors. High-frequency trading is a form of high-speed arbitrage where traders capitalize on small discrepancies in the prices of financial products. Essentially, traders will search for situations in which two investors have different valuations of a stock. When they find such a situation, the HFT traders will buy the stock from the person who values the stock at a lower price, and simultaneously sell the stock to the investor with the higher valuation. For example: if the price of a stock is lower on the U.S. exchange than it is on the British exchange, the trader will simply buy the stock in the U.S. and sell in Britain, pocketing the difference. This strategy (Arbitrage) has been around for centuries, but high-frequency trading is steroid charged version that delivers unheard-of risk-adjusted returns for investors. Professional traders and finance specialists use a risk measurement called a “Sharpe ratio,” which is defined as the return of the portfolio minus the risk-free rate (such as the interest rate on U.S. treasury bonds) divided by the volatility (standard deviation) of the portfolio. To put things in perspective, typical real-life daily trading strategies generate Sharpe ratios in the 1-2 range, but well-designed HFT strategies typically produce double-digit Sharpe ratios, which means a trader can generate risk-adjusted returns that are high multiples of the typical trader’s returns.

While many have been fearing HFT because they worry about the volatility that it can potentially create, such as during the “flash-crash” of 2010 when the Dow Jones Industrial average plunged over 1000 points (around 9%) only to recover a few minutes later. Professor Kimball wrote in his quartz article about the perceived unfairness of HFT traders having the ability to exercise their trades faster than ordinary investors. Although many of those concerns are worrisome, as the Wall Street Journal reports, investors may have to worry about HFT traders getting another advantage: information.

Many HFT traders have now begun to capitalize on small time lags between press-releases of financial information on different websites. This direct access subscription to financial news and data gives HFT traders a split-second advantage over other investors. For example, on December 5th of last year Ulta Salon Cosmetics and Fragrance Inc. released its earnings statement that missed analyst’s forecasts. They released the information to the public over a number of sources, but each distributed the earnings at slightly different times. Traders that paid for an ultra-fast subscription to BusinessWire, a financial reporting company, received their information 242 milliseconds before Bloomberg news published the results and 464 seconds before Dow Jones published the results. This meant that anyone who paid for BusinessWire got a legal, split-second advantage in getting the information. As a result, at only 50 milliseconds after the initial press release, over $800,000 worth of Ulta’s stock was sold in a series of rapid-fire trades, even before investors using Bloomberg and Dow Jones received the same information.

This discrepancy between the time different investors receive information brings up important questions about the efficacy of current regulations of financial reporting. As Scott Paterson of the Wall Street Journal writes:

The Securities and Exchange Commission’s fair-disclosure rule, Regulation FD, requires that public companies issue material information about their businesses to the broader public at the same time it is disclosed to market professionals. The SEC passed the rule in 2000 amid concerns that companies were selectively revealing material information to Wall Street analysts and certain privileged investors. The rule, written before the era of high-speed trading, doesn’t address whether fractions of a second matter in terms of when information is distributed.

Essentially, this could end up being looked at in a similar way as a typical insider trading case, since these HFT traders are able to get their information before (even just by a few milliseconds) the public receives this information.

Despite the worries about the impact that HFT is having on the financial industry, I remain cautiously optimistic. First, with regards to the rate at which individuals can receive company information, this is hardly a new phenomenon. In a range of packages, Bloomberg has for years offered investors stock price information at different lags and different prices. If you want to get the freshest information at 1 second intervals, you have to pay a higher price, but those willing to use stale information at lagged 10 minute or 1 hour intervals can get it cheaply. This is simply a faster version of an old practice. Second, as the price of up-to-the-millisecond information increases due to increased HFT demand, these HFT traders are slowly eroding the profits they can earn (more expensive information = smaller profits), so there might be smaller advantages to using this information in the future. Furthermore, as more and more investors jump on the HFT game, it might become standard practice for all to be able to execute trades within a few milliseconds; in this case, there’s no advantage to driving a Ferrari if everyone on the street is driving a super-car. Finally, the problem with this technological arms race with HTF is that it’s bound by the laws of physics. What I mean is, there’s a physical barrier to increasing the speed of information transfer: the speed of light. Even if you had magical fiber optic cables that prevented any lag in the light signals traveling down the cable (light typically slows down in a medium compared to a vacuum. You can see this in the childhood optics experiment by putting a pencil in a glass of water and watching the refraction of the light “bend” the pencil. This occurs because light travels slower through water than in air), the fastest you could ever send that information is at the speed of light. Eventually, the technological limitations to how fast you can send information will plateau, everyone will be able to access the high speed networks (for a fee), and the advantage of HFT will be erased. Overall, my opinion is that HFT is simply a high-tech version of the arbitrage game that has been going on for centuries, and the fact that there’s a physical limitation on the rate at which you can transmit financial information will ultimately erase the advantage of these traders.


Dodd-Frank: No one wins

In the wake of the financial crisis, there was a big push to make investment banks and other financial institutions more transparent and liable for their mistakes.  Essentially Congress wanted to ensure that there would be no repeat of the “too big to fail” testimonies so Barney Frank and Chris Dodd drafted legislation to ensure that none of the uncertainty and risks that brought the housing market crashing down could resurface.  However, as more and more details and parts of the bill take effect, it looks like Dodd-Frank is neither accomplishing its goals, nor is it able to.

On one hand it seems that Dodd-Frank is not doing enough or does not have enough power to  However, there are suggestions that Dodd-Frank has some limitations in terms of scope.  Real Clear Markets aims to analyze a few instances such as the Fed’s decision to overrule the law with AIG.  Originally Dodd-Frank would not allow the Fed to blatantly bail AIG out the way that was originally done in 2008.  The only way they could receive money is if the Fed lends the money to them under broad-based programs; However, the Fed was still allowed to financially support AIG because they were technically not in bankruptcy nor were they approaching insolvency.  For all practical intents and purposes this shows a serious lack of understanding of the state of many financial institutions by Dodd-Frank.  It is certainly not the first instance where Congress has failed to understand the nature and scope of financial institutions, but considering how much Dodd-Frank aims to regulate financial institutions this is not a promising start.

Then there are suggestions that perhaps the regulations put in place are going too far, and they’re coming from Barney Frank himself.  The Wall Street Journal claims that a lot of the legislation itself is rather misleading and that the implications cannot be realized until we actually see it in action.  Of course the effects could have big implications for various classes of funds which were not the intended targets of the bill itself.  Money mutual funds, hedge funds, and other non-bank financial institutions can potentially fall under these new rules, I am not entirely sure about this, but it seems that the original design of the bill will not only reign in the primary culprits of the financial crisis but also institutions that may have had very minor roles in the original crisis.

Financial regulation will be a very touchy subject in the next year or two, but it is clear that no one is really prepared for Dodd-Frank and that kind of uncertainty will make markets very sensitive and drive up legal costs when they want to create new instruments.  It doesn’t appear that anyone will be satisfied.

Another Bubble?

2013 was a year of continual record breaking in the US financial markets. While being driven by the FED’s bond buying program known as quantitative easing, whereby the FED buys short term treasury bonds and mortgage backed debt in an effort to lower interest rates and spur investment. Statistics from Morningstar had the broad market up 28% with the main averages; the Dow Jones Industrial Avg up 25%, the NASDAQ Composite up 33%, and the S&P 500 up 28%.(http://news.morningstar.com/index/indexReturn.html). The Dow broke its psychological ceiling of 16,000 and the S&P is nearing the 2000 level. All in all it was a truly spectacular year in the equities business. With the major indices at these levels though and  the FED taking their foot off of the figurative gas pedal of Q.E. it leaves both investors and the members of the FOMC in an environment asking themselves about the fair value of the market and whether or not we are in “bubble” territory.

A stock market bubble can be interpreted in many different ways but for my general purpose here I will characterize it as any situation in which the run-up in asset prices that causes worry about a “bursting of the bubble” in which asset prices would fall extremely rapidly. Notice the words “causes worry” because those play a big roll in the life cycle of these bubbles. Jason Zweig writes an article about this in his column called the “Intelligent Investor” that appears in The Wall Street Journal this weekend. Jason highlights what is characterized as the earliest known stock market bubble that occurred in the Netherlands, Britain, France, etc in the early 1700’s. Stock prices soared to almost 10x their original prices and then just as quickly as the prices had gone up, they collapsed. The interesting thing about this “bubble” is the fact that one is hard pressed to find any irrationality; people were investing in the United States as well as the first instances of publicly traded securities that sought to MINIMIZE risk. (http://blogs.wsj.com/moneybeat/2014/01/10/when-does-a-bubble-spell-trouble/?mod=WSJBlog&mod=MarketsMain). “So the people who bought into those companies weren’t wrong. They just ended up paying too much to be right” — This idea seems to come up frequently when looking at other bubbles as well. It seems as if many of these stock market bubbles are indeed, self fulfilling prophecies.

Looking at the markets today, there are many different metrics that try and gauge whether or not the market is indeed overvalued. The general consensus seems to be that the market is somewhere between slightly undervalued to slightly overvalued depending on the metric, but all need to be backed up by the upcoming earnings season. One of the points of Zweig’s article, I believe, is to start to notice the disconnect that exists between a bubble and overvalued. There are many different opinions about how and why the US financial markets are where they are– lots of them are extremely critical of the FED’s bond buying program and claim that they are the only reason that the markets have been going up. But it is this skepticism that I think gives more credibility to the state of the markets right now. The rally has survived the issues brought by both Washington with the government shutdown as well as made it through the start of the FED taper. I think as long as this upcoming earnings season is strong and the “nay-sayers” stay loud, this bull market could be sustained at least through 2014.

That Moment When An Alumnus Gets Caught in a Historic Insider Trading Scandal

The University of Michigan has become accustomed to having its prominent alumni featured in the news, often for their achievements and awards in medical research. For this reason, it came as a shock to many students and faculty to find one of their beloved medical professors on the wrong end of the insider trading trial of an ex-SAC Capital trader that began last week in New York.

This story started in a rather innocuous fashion back in early 2008. Elan and Wyeth were pharmaceutical companies conducting clinical trials for a drug they called Bapineuzumab. Bapi (for short) was an antibody designed to tag and eliminate beta-amyloid deposits in the brain, which are small build-ups of protein that were believed to be one of the main causes of Alzheimer’s disease. Early studies suggested the drug could therefore offer therapeutic effects to Alzheimer’s patients.

In anticipation of the approval of their new wonder drug, Elan and Wyeth’s stock prices soared, drawing the attention of a trader named Mathew Martoma at the hedge fund SAC Capital. In search of information, Martoma soon reached out to Dr. Sidney Gilman, a professor of neurology at the University of Michigan. Dr. Gilman had been a world renowned researcher of Alzheimer’s disease, but few knew that he also supplemented his income advising wall-street traders. Martoma’s choice of Dr. Gilman was no coincidence, as he not only consulted for Elan pharmaceuticals, but also “served as the chair of the Safety Monitoring Committee for […] bapineuzumab.”

In July of 2008, Dr. Gilman presented to the public the highly disappointing results of the phase II clinical trials at a conference, but not before reportedly sending Martoma details of his presentation 12 days earlier. SAC subsequently dumped its $700 million of Elan and Wyeth stock just days before Elan tanked from a high of $34.90 leading up to the announcement, to a low of $9.93 almost immediately after.

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Martoma was later arrested in late 2012 on evidence of his involvement in the insider trading scandal, and SAC Capital has recently plead guilty to federal charges and paid a record $1.8 billion fine, in what is now the biggest case of insider trading in American history. Dr. Gilman was ordered to pay a fine of over $230,000 and was offered a plea bargain to testify against Martoma and SAC capital. Dr. Gilman has since resigned his position at the University of Michigan and records of his employment have been removed from university websites.

While it’s evident that those involved in this scandal will soon be taught an important lesson, is it possible that we too might derive some useful ideas from it? In his book “A Random Walk Down Wall Street,” Burton Malkiel describes the problem of random effects, such as finding defects in a prescription drug, that confound the fundamental analysis of securities. In the case of Elan, it was (nearly) impossible to predict the failure of Bapi in clinical trials. Under my understanding of the semi-strong Efficient Market Hypothesis (EMH), the market prices should almost immediately reflect the news of Bapi’s failure. Investors would all at once (assuming everyone was paying attention during the press-release) bid down the price of Elan’s stock, and since everyone got this information at the same time, no one could easily benefit from it.

(The use of high frequency trading may prove to be an exception. In this case, those with faster computers or network connections could execute their trades fractions of a second before everyone else who had heard the news could click “sell”. A holder of Elan’s stock, for example, could sell all of their holdings before the stock dipped, and buy back their stock at the bottom once the market reacted to the news, instantly making up the difference in profit while holding the same portfolio as before. Anyways, I digress).

In this case, I would go out on a limb and say that even those that got the insider information  would not benefit from it (assuming that most will eventually get caught). While SAC saved itself around $700 million dollars by dumping their stock early, by using non-public information and committing insider trading they wound up with a net loss of $1.1 billion dollars after their record fine. Although this doesn’t lend credibility to the strong version of EMH, which claims that prices reflect even hidden and “insider” information (SAC did initially profit from its trade), it does suggest that the risks that come with using insider information often surpass the benefits, making it an inconsistent strategy to achieve above-average returns.

In the end, it looks like justice might well be served. And although yet another famous alumnus is now featured boldly in the press, sadly this is one case where you won’t hear me say the words “Go Blue”.

Parents and their children don’t share economic values? I’m not so sure.

As far as economic values go, I have always assumed (as well as taken from personal experience) that children receive a fair amount of their parents’ knowledge and wisdom. Ever since I started working when I was about 15 or 16 years old, and even before that, I can remember my mom explaining to me that I needed to start saving my money. At least some percentage of each paycheck I received needed to be put into my savings account so that — even at such a young age — I could start to accumulate my money. Of course she told my brother, two years older than I am, the same thing. I would say that in general I have been a pretty good saver up to this point in my life. There are always things that I want to buy, and do buy, but I have taken my mom’s advice about saving to heart. Thus, it comes as somewhat of a surprise to me that parents and children apparently do not share financial principles. This is according to an article in the Journal of Economic Behavior & Organization by Marco Cipriani, Paola Giuliano, and Olivier Jeanne (http://www.anderson.ucla.edu/faculty/paola.giuliano/Giuliano_JEBO.pdf).

In an economic experiment run by Cipriani, Giuliano, and Jeanne, “The researchers found, in an experiment involving financial contributions to a group fund, that there was no statistical correlation between the actions of a child and a parent,” (http://blogs.wsj.com/economics/2014/01/06/parents-kids-dont-share-economic-values/). In this experiment the children were very young as they conducted it in an elementary school. However, there was another experiment discussed in the journal article where the “kids” in the experiment were age 23. In that particular experiment the researchers found that the “children’s trusting behavior,…, is strongly correlated to that of their parents,” (Cipriani, Giuliano, and Jeanne, 2013). The reason this is so interesting is that I have found that in my case as well as in that of my brother, both of us have started to act more like our parents in terms of economic and financial values as we’ve gotten older. It seems to me that elementary school children would not yet necessarily be at a point in their lives where they have fully received the economic values from their parents; let alone be at a point where they can even truly understand the game they are playing in the experiment. Also, does it even matter if a five year old shares his or her parents’ economic and financial values or not?

I believe that to say children and parents do not share economic or financial values, based on an experiment done with elementary school children, is not quite fair. Given the other experiment done with 23 year olds and the result that they achieved, the children need to be at least a little bit older in order to get a meaningful result. All in all, I’m curious to know what the results of a similar experiment would be if conducted with children of age 15, 16, 17, and so on.