Wild swings in the stock market have become slightly less mysterious. An economist and an astrophysicist from UCSC argue that the volatility of financial markets can best be understood when chronological time is taken out of trading altogether. The researchers, Eric Aldrich (Economics), Gregory Laughlin (Astronomy and Astrophysics), and undergraduate Indra Heckenbach (Physics), show that when time corresponds to the arrival of new trades, instead of ticks of the clock, volatile phases in the financial market become more transparent.
High Frequency Trading
Price movements in the stock market, especially its erratic fluctuations between the highs and lows, have long fascinated economists and pundits alike. The release of Flash Boys, the newest book by Michael Lewis, author of Liar’s Poker (1988), Moneyball (2003) and The Blind Side (2008), caused a media chatter during its release in April, 2014. It is making news again as critics catalog their annual “best ofs” and Lewis’ work is gracing many top 10 business book lists for the year. His topic, high-frequency trading, is also the subject of the new pieces of research recently published by UC Santa Cruz’s Center for Analytical Finance (CAFIN), the cutting edge research hub that engages with critical issues in the financial markets.
CAFIN’s latest working papers The Random Walk of High Frequency Trading and Insights into High Frequency Trading From the Virtu Initial Public Offering address high-frequency trading in the US financial markets. High frequency trading is the rapid-fire trading practice done through computers. Assets such as stocks and futures contracts are bought and sold electronically, with securities held for fractions of a second. Trades and market movements occur much faster than humans can react.. As the paper about the Virtu IPO points out, “the finite speed of light is a consideration.”
Cutting Edge Research
The UCSC trio’s research provides fresh insights into how and why stock prices rise and fall. They study the stock market in an unusual way: rather than measuring price changes over fixed units of chronological time, they focus on how prices fluctuate over periods of time in which a fixed numbers of trades occurs.
“In current markets, trades arrive at very fast rates, but they can be erratically spaced in time.” Aldrich says. “When morning trade starts for a stock like Apple (AAPL), 100 trades might arrive in the first 10-millisecond period while only 5 arrive in the second 10-millisecond period. Our concept is to compute returns as the difference in prices for every Nth trade rather than every Nth millisecond,” he adds.
The researchers new “trade time” approach allows for a compelling analysis. The UCSC researchers find that most erratic trends in markets can be attributed to trading rates being ramping up and down in a complicated - but nonetheless understandable - manner. As Aldrich says, “understanding the fundamental relationship between trade rates and volatility can have important implications for exchange architecture as well as policy design.”
The research also shows how pre-scheduled news announcements, including those made by the Federal Reserve, seed genuine and non-random price swings into markets. Interestingly, the authors also point out that location of financial exchanges can have an impact on trading. They find that the physical distance between the Chicago and New York areas acts as a natural threshold, even when signals are traveling at the speed of light. As a result, traders have to carefully monitor market activities separated by mere milliseconds of communication time.
Ultimately, the authors demonstrate that volatile times in the market seem less erratic if the focus of analysis changes from the traditional view of clock time. The report points to a fundamental misunderstanding in the public perception of high frequency trades: it is not the speed that these types of transactions are made that is the problem, but rather the details of the microstructure in which it operates.
The Random Walk of High Frequency Trading can be read in full here and for more information please visit found the CAFIN website.