Algorithmic Trading Effect on the markets?

[Richard Polkowski]

If algorithmic trading [robots] is increasingly dominating the market, [some say up to 80% of trades in some markets] and they tend to use momentum strategies that might trade 200-300 times a day on data faster than it appears on a screen what will be the effect of that trend in automation on the future character of the markets?

what do people think of momentum as a strategy?

[gadinaz]

I'm more of a trend trader, so my question is: if "the trend is your friend ... " what's the equivalent in momentum trading?

[Richard Polkowski]

i'm no expert on momentum which is why i'm asking. From the research i've done it looks like the bet is if a body is in motion it will continue in that direction with a certain acceleration for a certain time. There must be a graph somewhere that shows where on the curve one should get out ie the probability of further profit diminishes. Momentum is frame dependent.

so one pattern would be identifying ranges and then going with the breakouts not staying with any trends but just taking profit where the probability of further profit starts to diminish. Entries and exits would be based on statistical probabilities.

Momentum is part of Mechanics and goes back to the laws of motion. Newton, Galileo and all that. So by knowing momentum one is using the laws of physics as a basis for trading?

[Richard Polkowski]

Further to my research into mathematical finance its clear they regard most technical analysis as having little if any mathematical truth and see most indicator derived systems as barely better than 'belief systems'. Indeed one of the topics on a course called Advanced Modelling in Various Markets at Oxford University is called ' Technical indicators: using Black-Scholes models to take on the chartists.' :)


In a recent lecture series at Gresham College titled Topics in the History of Financial Mathematics which starts off with how 13th century monks dealing commodities like sheep and wool became so rich through mathematics to the present day we learn in part 2 of the course an interesting example from Shakespeare on risk

''William Shakespeare, in the Merchant of Venice, cunningly introduced the idea of actually having temporal diversification in your asset structure, when Antonio, in a conversation with his friends, told his friends he wasn't spending sleepless nights worrying over his commodity investments, and he says: "My ventures are not in one bottom trusted, nor to one place, nor is my whole estate upon the fortune of this present year, therefore my merchandise makes me not sad." Hidden in there is this idea of thinking about having a balance between the near future and the rather more distant future in terms of the return on investments.''

In the same article we learn about an asset allocation strategy from the 4th Century by Rabbi Isaac bar Aha who wrote what you should do with your wealth, you should hold a third in land, a third in merchandise, and a third, as he put it, "at hand", which means in cash. They also bring in the Chinese with the saying ' "He who will not economise will have to agonise,".

So the mathematicians are looking at optimisation and rebalancing the portfolio according to a time frame. They split capital between classes and so have a basket knowing that profit is basically an unknown. Which is a different way of thinking from indicator technical analysis.

The series of talks is the best i have found so far for explaining without too much maths the history of ideas used by mathematicians to view markets and risk.

part 2 of the talk is here

http://www.gresham.ac.uk/event.asp?PageId=45&EventId=770

in part three automated trading is dealt with specifically in the 2nd lecture where in 2008 automated trading is said to be 60% + of volume. To quote

...So automated trading has become a big deal, and behind most of these systems stand more or less sophisticated trading algorithms. Some of them are more or less straightforward, some of them are less straightforward, but they do have a major impact on finance, on how stock prices behave, and on how markets behave obviously.....

He goes on to talk about the use of genetic programming where one can create trading rules. He says

...This is one example, which definitely is not a historic example, because it's current work of a PhD student of mine, but this is a good indication that this is what the industry is currently using and actually has been using for quite some time, but it's also a good example that what the finance industry actually does is not always quite visible.....One of the major investment and broker companies,.... they offer one quantitative position per year worldwide, and it was my PhD student who got the job because he's working on these sort of topics, but he had to sign that he's not talking about his work with them, and he was not allowed to use any of his results, any of his data he worked on during the summer, because they wanted to have the exclusive rights. So this is what, at the moment, makes it difficult to pinpoint what are the issues in computational finance, because we know what we do in academia, but we do not quite know what the industry actually does. We have a rough idea, but now we know neural networks, hot issue, genetic programming, hot issue.

part 4 of the talks by a physicist who ran a trading firm ends with

..I think mathematics is going to continue to play an ever-increasing role in markets...I think we'll be able to go to a deeper level. We'll have laws, eventually, that will be more like physics. I think that we are going to be in a situation where the control of markets and the participation in markets will be increasingly non-human, simply because machines can process more information and process it faster,...

it seems the reason ordinary traders can make money is because the market is still inefficient and automated trading will make the markets more efficient which kind of fits with the stories some traders talk about how 25 years ago anyone could make money before electronic trading came in?

any way that probably answers my own question and i thought i would put it up for completion's sake.