Inevitable Information Percolation in High-Frequency Trading and Reactions in Volatility by Michael V. Blumeyer
I recently read an article in MIT Sloan Magazine (summer
2013) on volatility trends in a study with high-frequency traders. The article discussed the difference in
behavior in the financial markets with a study in how volatility increased as
traders reacted to bad news while in contrast with the analogy of relating
trading with how pedestrians would react while walking across London’s
Millennium Bridge. The purpose of my
blog is to reveal to my followers more on the fundamentals of the escalation of
volatility and to point out the flaw in stating the argument on the desire to
test the market without high-frequency trading.
Discussed in the MIT Sloan article, in June of 2000, a crowd
of pedestrians who were crossing London’s Millennium Bridge felt the bridge
begin to sway to one side. In a panic,
the crowd immediately rushed to the other side, which only created the problem
of causing the bridge to swing to the other side, building even more momentum
for pedestrians to constantly maneuver left and right to balance the swaying bridge.
The main point of the article was that after testing the
reaction of trading firms that had no direct news of how much selling the other
trading firms were executing, synchronized selling was inevitable. In other words, whether or not trading firms
had insider information as to what other firms were doing or not, the trading
firms would mostly respond in a similar way, causing volatility to continue to inevitably increase in the markets.
My response to this article is that the study to measure whether
one trading firm has direct information to another trading firm, is somewhat of
an act of futility. The assumption to test
traders who are not easily open to information doesn’t mean that information
may percolate from one source to another.
Dr. Daniel Andrei, a finance professor who teaches at the University
City of Los Angeles, discusses the relationship between information percolation
with increases in volatility. The main
point of Dr. Andrei’s article, titled “Information Percolation Driving
Volatility,” solidifies two main facts in behavioral finance: (1) information
will always find a way to percolate and (2) the level of imperativeness that
the information is received causes volatility to react faster. In essence, strong form information that can’t
possibly affect the securities that are passed through trading floors through
word-of-mouth, forums, etc. have relatively a minimal effect on volatility. In contrast, imperative and critical news
that could immediately cause traders
to lose enormous amounts of profits in their positions, very quickly cause
traders to shift their positions to either sell or to reverse their futures
positions, causing tremendous spikes in volatility.
Another point that I will make here is the unstated premise and false assumption in the article that in nature, high-frequency trading can possibly not exist. That assumption
that “one day there will be no skews in the markets” or “if only traders would
not react so impulsively to good/bad news” is wishful thinking. To support my premise, let’s relate these
statements with nature. In the book “The
Selfish Gene” by Richard Dawkins, he discusses something described as the
Evolutionary Stable Strategy (ESS). I will support my reason with a book that discusses behavior and evolution, since behavioral finance is evidently related to emotions and thus, human nature and evolution. Basically, the point made by Dawkins describing this strategy is that there
will almost always be ratios of
certain species that are in relationship with one another. Dawkins goes so far as to relate the ratio of
hawks and doves, stating that if the hawks and dove ESS ratio was 5:5, the
hawks would dominate the dove population, shifting the ratio to 8:2. Then, however, hawks in multiple areas would
only get hungry and would have to fight other hawks for food. This would cause a reversal shift in the ESS
ratio, causing the hawk population to decrease, while dove would seize the
opportunity to populate. Over time, the
ESS would stabilize, but similar to volatility, it would have quick spikes,
followed by a delayed and slower decrease over time. The point here is that there always will be some high-frequency
trading, but the magnitude of high-frequency trading is what will change over
time, depending on the magnitude of imperativeness of information percolation that is leaked
out throughout the trading floors and the current state that the financial
markets is already in.
In conclusion, the study was accomplished by MIT Sloan
magazine did indeed prove that the financial markets moved in synchronization over
a short-period of time, but carried the false assumptions. In the financial markets, (1) high-frequency trading will always exist (if one day this
trading decreases, the ESS will cause high-frequency traders to take on quick
profits, which will cause this type of trading to increase) and (2) information
percolation is still present, whether
or not trading firms have access to direct trades of other firms.
References:
Andrei, Daniel, 2013, "Information Percolation Driving Volatility" Social Science Research Network pp. 1-11
Pan, Wei, Pentland; Ale Sandy; Chen, Ren; Ernsbo-Mattingly, Lisa; Summer 2013, "Can High-Frequency Trading Drive the Stock Market Off a Cliff?" MIT Sloan Magazine
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