Debunking Six Myths of HFT
Tue, 29 Jun 2010 17:34:00 GMT
Interview with Manoj Narang, Tradeworx
In the latest in our series of High Frequency Trading interviews, we have an in-depth conversation with Manoj Narang, Founder and CEO of Tradeworx, Inc. (www.tradeworx.com), a leading financial technology and trading firm whose mission is to democratize the role of advanced technology in the financial markets. Through its subsidiary Thesys LLC (www.thesystech.com), the firm offers a world-class trading infrastructure to investors with high-performance trading needs. Tradeworx also operates a successful and growing quantitative hedge fund business (which currently manages over $500M in assets), as well as an in-house proprietary trading business focused on high frequency trading strategies. Overall, the strategies generate nearly 100 million shares per day of volume in the US Equity market.
Tradeworx has been profiled extensively in the print media, including Reuters, The New York Times, and MIT’s Technology Review magazine. In addition, Mr. Narang has appeared on CNBC and PBS’s Nightly Business Report in order to discuss the role of HFT in today’s equity market.
Mr. Narang has held a variety of technology, research, and quantitative trading positions at several major Wall Street firms. He graduated from MIT in 1991, where he studied Mathematics and Computer Science.
High Frequency Trading and Tradeworx
High Frequency Trading Review: High Frequency Trading can mean many things to many people. What’s your definition?
Manoj Narang: The “frequency” in the term “high-frequency trading” refers to the rate of turnover of a trader’s portfolio. Thus, a very basic definition of a high-frequency trading strategy (HFT) is a strategy which starts and ends each trading day flat — this implies a turnover rate of strictly less than one day. Of course, most HFTs have turnover rates much shorter than one day, but one day is still the least arbitrary dividing line for definitional purposes because it distinguishes between intra-day and multi-day strategies, which are fundamentally different from each other.
While there is little controversy about the definition itself, the immediate consequences of the definition are far-reaching, and have the potential to dispel many misconceptions about HFT if people bother to think though the ramifications with even a modicum of clarity.
For instance, the constraint of high turnover implies that positions in individual stocks held by HFTs can not be very large. The higher the turnover (frequency) of the strategy, the less time the strategy has to accumulate positions. A large money manager or hedge fund who turns over infrequently can build up a massive position because they can accumulate shares over the course of days, weeks, or months. However, an HFT that liquidates its portfolio every ten minutes has, on average, only five minutes to buy and five minutes to sell the same shares.
Because HFTs perforce maintain small position sizes, they do not require significant capital to operate their strategies. In general, the firms operating the strategies often have enough capital on their own without having to raise additional capital from outside investors. Thus, HFTs tend to be proprietary traders rather than hedge funds, meaning they are closed off to outside investors because capital requirements are so low. Generally, a few million dollars in capital is sufficient to generate tens of millions of shares of volume. It is important to note that high volume is generated from high turnover (i.e. continually re-using the same capital base), not from taking large positions, which is a capital-intensive activity.
Another immediate consequence is that HFTs simply can not impact a stock’s price over the course of a day. In fact, the higher the turnover (frequency) of the strategy, the less of an impact on a stock’s price it can have. Traders impact stock prices by accumulating or liquidating shares. A trader who is only buying (selling) shares will cause the price to go up (down), in proportion to how much size they do. However, in the case of HFT, if my purchase of X shares impacted the stock’s price by Y%, then when the HFT unwinds (liquidates) those X shares, the impact on the stock’s price is -Y%. The net impact over the timeframe of 100% turnover is thus precisely ZERO.
Detractors who claim that HFT causes volatility or price impact (for example, Joe Saluzzi of Themis who has repeatedly claimed on television that HFTs are responsible for driving stock prices higher since March 2009) are either ignorant or deliberately deceptive. A trader who starts and ends each day with no positions can not materially impact the price of stocks – the positive impact of their buy trades is exactly canceled by the negative impact of their sell trades. You’d have to engage in some serious contortions of logic to argue otherwise.
HFTR: You’re quoted as saying that the way HFTs make their money is by identifying extremely small and extremely transitory trading opportunities. Without giving away any of your “secret sauce”, can you explain at a high level where these opportunities come from and how they are identified?
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