Having read this white paper the general impression I get from the authors is that they are unhappy about automated market traders exploiting other poor algorithms.
In essence this is five pages dedicated to,"Entity A has better algorithms than we do, this should be illegal because we don't know how to compete."
If you can identify the bubble, you can make money. These guys have figured out how the game works now they need to exploit it, in the name of free market capitalism of course.
Well said. Though given the stupidity of their examples, I would not bet on these guys to write any winning trades any time soon. Better to cry foul and scam a few buy-siders into buying their snake oil.
To illustrate, let’s use an institutional algo order pegged to the NBBO with discretion to
pay up to $20.10. First, the predatory algo uses methods similar to the liquidity rebate
trader to spot this as an institutional algo order. Next, with a bid of $20.01, the predatory
algo goes on the attack. The institutional algo immediately goes to $20.01. Then, the
predatory algo goes $20.02, and the institutional algo follows. In similar fashion, the
predatory algo runs up the institutional algo to its $20.10 limit. At that point, the predatory
algo sells the stock short at $20.10 to the institutional algo, knowing it is highly likely that
the price of the stock will fall. When it does, the predatory algo covers.
When it's just a tiny percentage of the overall trades, it doesn't really matter.
As Goldman Sachs is now proving though, it can be wildly profitable. What happens if it eventually becomes the dominant form of trading? What does the stock market then represent? Surely not the value of a company, based on research and bets on the future. Doesn't it just become a high speed game where computers try to steal pennies from each other?
Ahem. Please don't attribute Goldman's success to trading. Goldman Sachs recent "success" is largely due to them adroitly navigating the political waters of the bailout, without which i suspect they would be in serious trouble.
As for machine trading or stat-arb, high freq, whatever...i don't think it is any better than a random walk. Risk was (is?) just being hidden somewhere and lied about.
No. You need to find enough of an arbitrage opportunity to overcome the friction. But once you found it, it's a risk-free profit. (You can't do too complex an atomic transaction on the financial markets; but most arbitrage deals take much less than a day --- even less than a few minutes, so your window of exposure is quite short.)
If you are trading based on research and conviction then this sort of predatory behavior should only minimal effect. I.e. if you think a company has good prospects for the future, then you probably expect the price of the stock to go up a significant percent. The sort of games described in the paper only alter the price by a small percent over a short period of time. Does it really matter if you buy the stock at 20.00 or 20.10 if you think the price is going to go up to 30.00?
For at least "conventional" blue-chip stocks, if the market fails to represent the present value of all future dividends, discounted back to the present, trading based on that metric should be a dominant strategy, since it is a method of extracting value from a stock without trading it.
If the stock is underpriced, sure. But shorting overpriced stocks comes with a cost - what if the market gets even more irrational over the next few years?
If you can identify the bubble, you can make money. These guys have figured out how the game works now they need to exploit it, in the name of free market capitalism of course.