algo trading risk 2
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Bernard S. DoneferDistinguished LecturerBaruch College, [email protected], Conatum Consulting LLC
2008 Bernard S. Donefer. All rights reserved.May not be reproduced by any means w ithout prior written consent.
mailto:[email protected]://www.conatum.com/mailto:[email protected]:[email protected]://www.conatum.com/mailto:[email protected] -
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Wall Streets computer scientists andlinguists keep trying to find quicker ways toreact to the news by creating ever-morecomplicated algorithms, the mathematicalformulas that execute stock tradesautomatically based on such criteria asheadlines and news stories. The idea is to buyor sell at a faster clip than the guy orcomputer at a rival trading desk.
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All this can go horribly wrong, as United Airlineslearned last week when a six-year-old storyabout the companys 2002 bankruptcy filinggained new life on the Internet, triggering a
cascade of stock sales. In a matter of about 12 minutes more than $1
billion in stock-market value evaporated.
Human error seems to have played only a minor
role. The financial damage was mostly the resultof the interplay between the algorithms thatsearch and compile information from the Weband the ones that Wall Street firms and hedgefunds use to make trades automatically.
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4New York Times Sept 14
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Witness another recent case that had thepotential to cause a stock market wipeout, butbenefited from serendipitous timing: after the
close of trading on Aug. 27, Bloomberg Newsinadvertently released an obituary of Steve Jobs,the chief executive of Apple who, despitefrequent rumors of ill health, was, and is, verymuch alive. The story was quickly retracted.
Remember its not just news, it could also beerroneous or late quotes, or any other algoparameter driving the trading strategy.
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The Japanese arm of Credit Suisse Group may getpunished by local regulators over problemsinvolving an automated trading system used by itsmajor clients, the Yomiuri Shimbun daily said onFriday
Japan's Securities and Exchange Commission(SESC) is considering asking the Financial ServicesAgency (FSA) to punish the company for a series ofproblems with an algorithmic stock trading system,which include mistakenly placing large share
orders, the paper said. Should the FSA find it necessary, it may order
Credit Suisse to improve its business managementand operations, the Yomiuri added, without givingdetails.
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An official at the SESC also declined to commentbut said that in general terms administrativepunishment could include suspension of businessor ordering a company to improve its operations.
The algorithmic trading system relies on computeralgorithms to decide when to trade stocks and inwhat amount, based on data such as pricemovements. Using these calculations, the systemthen places orders on its own.
Kajino said Credit Suisse began algorithmictrading in Japan in 2003 but declined to givefurther details except to say that this business wasgrowing.
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'When I use a word,' HumptyDumpty said, in a ratherscornful tone,' it means justwhat I choose it to mean,
neither more nor less.''The question is,' said Alice,'whether you canmake wordsmean so many differentthings.'
OK Humpty, what is electronictrading?
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An STP FIX connected trade to anelectronic market for execution An order directly from a buy side OMS
Retail or institutional
A high frequency trading strategyexecuted autonomously by computer
About which are we and the regulators
most concerned?
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The Liquidity Algo Trade Break up an institutional sized order and use an
automated strategy across multiple market placesand over time, to minimize market impact You know the asset, side and size to trade
High speed search for liquidity at a price The Alpha Seeking Algo Trade
Implement a strategy using historical models andreal time market data, find and exploit profitabletrading opportunities stat arb / pairs trading /news Do not know in advance the security or timing of the trade
Aka black box, quant, etc.
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Market Making Given a list of securities, stocks, options, etc.
and a source of order flow, adhere to theorder handling rules and trade at the spread Automate the expertise of a Series 55 licensed trader
under all market conditions
Most NASDAQ and ISE market makers arefully automated
The NYSE is offering ability to interface algocapabilities to floor specialists
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Buyside
SellSide
MarketPlace
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Buy Side Client Am I using the correct strategy?
Did I get the trade done at the benchmark cost?
Algo Vendor Sell Side Firm or ISV
Do I have the capacity, speed, reliability to meet myclients needs?
Does my Algo work as advertised?
Intraday client exposures
Market Places
Do I have the capacity, speed, reliability to meet my
clients needs?
Can an algo roil the market?
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The FAT finger Remember Mizuho
Market Data historical and real time Quality and speed (latency)
Network latency trading and data LAN and WAN
Pre-trade process TCA process assumptions Choosing the right strategy and
parameters
Executing the strategy Increased volatility, trending markets, news Basket correlations
Predators sensing your orders Trading battlebots earn est. $15-25B
annually
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The Algo The models logic and implementation
The historical data to create the model
The real time data controlling its execution
DMA and smart router infrastructure Connectivity, logic, latency
FIX message correctly representing the algostrategy
New order types and market specific orders
The markets trading system correctly interpretingand executing the order
Is FIX ADTL enough?
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Who is now responsible for Best Execution? The buy side trader with DMA and an assortment of
algo tools Whos job is it to ensure the algo strategies are
correctly understood?
What responsibilities are taken on by the sellside providing algos and infrastructure? Are the rules for disaster recovery, losses due to
technology related losses clearly understood by allparties?
How will internalized markets, (ATSs) and ECNsaddress risks from algos? Will a100 share retail quote move the NBBO and result
in millions of shares executed at that price?
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Most risk management systems provide a daily viewof client and firm positions Can they respond to high frequency trading? While flat EOD, can intraday positions exceed credit limits? Are clients violating short sale rules? Impact of high frequency trading on firm capital
requirements Can we stop a clients trading mid strategy??? Hedge funds using multiple prime brokers hide their
strategy and positions What risks are held by prime brokers in the event of a
hedge fund failure? Clearance, settlement, loans, etc.
With buy side firms creating their own algos, howdoes their broker handle Algos Gone Wild?
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Wasnt 1987 algos gone wild? Will Algo trading bethe next crashs portfolio insurance? Is momentum and alpha trading adding to systemic risk?
Slicing and dicing further decreasing bid/offer size
Reducing liquidity and furthering market fragmentation High speed trading increasing quote frequency,
flicker and adding noise to price discovery
Are retail orders being disadvantaged?
Brokers unable to control client trading Potential for market manipulation
it wasnt me, it was the algo!
Complex clearing and settlement
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Participant should develop and implementfail-safe mechanisms for the supervisionof proprietary algorithmic trading systemsthat are adequate to prevent the entry oforders and execution of trades that, basedon market conditions, are unreasonable.
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Source: http://docs.rs.ca/ArticleFile.asp?Instance=100&ID=0E566B16E2394630BFC53DC41CBFF288
http://docs.rs.ca/ArticleFile.asp?Instance=100&ID=0E566B16E2394630BFC53DC41CBFF288http://docs.rs.ca/ArticleFile.asp?Instance=100&ID=0E566B16E2394630BFC53DC41CBFF288 -
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More proprietary Algos More complex strategies More competition
More asset classes and cross assettrading More electronic market places More data
More speed More risk
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