Randomization and Optimization on Electronic Stock Exchanges
A trading strategy revealed in two new patents illustrates the high speed game of cat and mouse played by automated traders.
It is difficult to overstate the extent
to which modern stock traders have become, in essence, cyborgs. Since the dawn
of electronic stock exchanges in the early 1990s, the speed at which trades
occur has allowed traders to exploit ever tinier movements in the price of a
stock. In the 1980s, for a broker not on the trading floor,
“immediately” meant a half hour. Nowadays, trades happen in
microseconds.
Automated trading systems are ubiquitous.
Automated traders have their own industry publication and – this is how you know
you’ve arrived – industry-specific editorial cartoons. A patent
published on an automated trading system just a few weeks ago by Trading Technologies
International, based in Chicago exemplifies how these automated systems work.
“System and method for prioritized automated trading
in an electronic trading environment” describes a software algorithm
that decides the order in which to put through a list of trades when more than
one of those trades would normally be triggered after a single condition is satisfied–say,
that the price of a stock drops to a pre-determined level. The patent describes
what might be considered a fairly basic function of all automated trading
software, which is relieving the burden of prioritizing a batch of trades that
were previously queued up and are waiting for the right conditions before
they’re sent to the exchange.
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Prioritizing trades is inherently a
deterministic process, unless you’re trading on a so-called “dark
pool” where trades are invisible the details of your trades are available
more or less instantaneously to everyone watching the market. If you are moving
a sufficient volume of shares and another trader can predict what your
automated system is going to do next, they could swoop in and take advantage of
whatever directionality you’re providing in the up or down movement of a stock.
Hence a second approach, published in a
patent also issued to Trading Technologies International just a few months
earlier. “System and method for randomizing
orders in an electronic trading environment” allows a trading strategy
that is seemingly at odds with deterministic prioritization of trades. This
patent describes a process that seeks to make your trades indistinguishable
from the background noise of other trades so that no one can predict what
you’ll do next, or where the price of a stock might move as a result. If it
works as advertised, there is the possibility that no one would even know you
are trading that stock.
These technologies could be seen as a
great leveler. Traders employed by financial institutions and large funds are
increasingly trading stock in dark pools to avoid disclosing to the world the
large trades they are making. Using software algorithms like the ones described
above, even everyday traders buying and selling on public exchanges like NASDAQ
and the NYSE have similar power to both optimize and disguise their trades.
On the other hand, automated trading
algorithms also represent a further step away from trading on a human time-scale.
If day traders exploiting the tiniest movements in stock prices are something
worth worrying about, what about software algorithms whose behavior in chaotic
markets is ultimately unpredictable?