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Physicists successfully predict stock exchange plunge

They were actually early by 2-3 weeks – not bad.  But their precise date prediction in fact misled me in a big way!


Paper here for 3-page pdf and here.



WITH 20/20 hindsight, financial crashes seem inevitable, yet we never see them coming. Now a team of physicists and financiers have bucked the trend by successfully predicting a steep fall in the Shanghai Stock Exchange.

Their model, which employs concepts from the physics of complex atomic systems, was developed by Didier Sornette of the Financial Crisis Observatory in Zurich, Switzerland, and Wei-Xing Zhou of the East China University of Science and Technology in Shanghai. The idea is that if a plot of the logarithm of the market’s value over time deviates upwards from a straight line, it’s a clear warning that people are investing simply because the market is rising rather than paying heed to the intrinsic worth of companies. By projecting the trend, the team can predict when growth will become unsustainable and the market will crash.

Sornette, Zhou and colleagues applied their model to the Shanghai Composite Index, which tracks the combined worth of all companies listed on the Shanghai Stock Exchange, the world’s second largest. Early this year, the index gained 50 per cent in just four months. In July, the team predicted that the index would start to fall sharply by 10 August (www.arxiv.org/abs/0907.1827). The index duly began to slide on 4 August, falling almost 20 per cent in the subsequent two weeks.

Anyone hoping to exploit the model for profit should think twice. “If enough investors take action based on our predictions, the evolution of prices will probably be affected,” says Zhou.

August 29, 2009 Posted by | Event Risk | Leave a comment

WSJ: Meet Getco, High-Frequency Trade King

One of the biggest players in the hot area of high-frequency trading is one of the least known.

Getco LLC, a private company with fewer than 250 employees, often accounts for 10% to 20% of the daily trading volume of many U.S. stocks, the company has said, including highly traded names such as General Electric Co., Oracle Corp. and Google Inc.

Since its founding a decade ago, the firm has risen to become one of the five biggest traders measured by volume in stocks and other instruments that trade electronically on exchanges, such as Treasury bonds and currency futures, according to firm executives, who spoke with the Journal this week, and other people in the industry.

“They are probably the biggest market maker in the U.S. stock market,” said Justin Schack, a vice president at Rosenblatt Securities Inc. who closely tracks high-frequency trading. A market maker is a firm that always stands ready to buy or sell a stock.

High-frequency trading, in which traders use powerful computers and algorithms to trade at lightning-fast speeds, has grabbed attention after it produced stellar results during the financial crisis and amid estimates that it now accounts for more than half of U.S. daily stock trading.

Critics say high-frequency traders can trade ahead of less fleet-footed investors and squeeze pennies out of their pockets. Defenders say high-frequency shops help markets operate more efficiently by constantly stepping in to trade securities when investors wish to buy and sell. That, in turn, makes trading cheaper for individual investors.

The Securities and Exchange Commission has increased its scrutiny of high-frequency trading, even as exchanges rush to attract the high volumes the trading firms bring. In turn, Getco has increased its contact with the SEC and others as it seeks to influence policy decisions on matters such as rules governing options markets.

Getco’s founders, former floor traders in Chicago’s futures and options pits, say a lot of confusion surrounds the industry they helped pioneer.

“Electronic markets have been the best-performing parts of the financial markets” in the past few years, said Dan Tierney, a co-founder of the company with Stephen Schuler, in a rare interview. By contrast, many securities and derivatives traded over the counter, such as credit default swaps, malfunctioned amid the credit crisis, with devastating consequences.

Mr. Tierney, a 39-year-old who favors jeans, T-shirts and tennis shoes for work, points to volatile stock markets in late 2008 as a way high-frequency trading helps grease the market’s wheels. As investors scrambled to sell stocks, high-frequency outfits such as Getco stepped in to buy.

One day last October, Getco juggled about two billion shares, representing more than 10% of the volume in U.S. equities, according to a person familiar with the firm.

Without high-frequency traders, Mr. Tierney says, the market’s losses could have been much steeper. The Dow Jones Industrial Average plunged 14.1% that month.

All this has been profitable for Getco, which earned about $400 million in 2008, trading mostly with its own money, people familiar with its finances say. Getco, which stands for Global Electronic Trading Co., declines to comment on its profit.

In 2007, private-equity firm General Atlantic LLC invested about $300 million, a deal that then valued Getco around $1.5 billion.

At Getco, traders stare at enormous high-definition screens stacked to the ceiling that display trades in virtually every financial instrument traded electronically on exchanges. Large white boards, thick with scribbled formulas and intricate diagrams, line the walls of its expansive trading hub on the second floor of the office tower that houses the Chicago Board of Trade.

Unlike traditional Wall Street firms, the company holds relatively few securities by the time markets close for the day. Nor does it use much leverage, or borrowed money, to amplify the effects of its trades.

Since it constantly buys and sells, it can move in and out of hundreds of millions of dollars’ worth of securities every day with a relatively small amount of capital. It favors shares that are the most heavily traded.

During the trading day, it can lose money if it accumulates large positions and the market suddenly moves against it, a risk it works to minimize by trading quickly in and out of markets, as well as through hedging strategies.

For example, if Microsoft shares are trading in range of $24.09 and $24.12, an investor may place an order to sell Microsoft for no less than $24.10. On the other side of that trade could be Getco with an order to buy at $24.10. Getco likely also will have an offer to sell Microsoft for $24.11.

If the trade works, Getco will make money on that tiny spread. Sometimes they don’t; the challenge then is to get out as quickly as possible. In this case, if it accumulates a large amount of Microsoft stock at $24.10, however, it will stop buying and offer to buy and sell at lower prices.

Getco depends on the success of its proprietary complex algorithms to help it make money on the transactions more often than not. It also can pick up tiny rebates that some exchanges offer to firms willing to take the other side of trading orders. The company focuses on hiring top computer programmers and technicians, as well as traders.

Messrs. Tierney and Schuler founded Getco over a handshake in a small office at the Chicago Mercantile Exchange on a Friday afternoon in October 1999.

The previous year, Mr. Schuler, now 47, had been trading futures contracts linked to the Standard & Poor’s 500-stock index. His wife was pregnant, and he was considering his future. As he watched electronic trading capture more volume, he concluded floor trading was becoming outmoded.

“I was feeling threatened,” he says.

He started learning more about how electronic markets work. In 1999, he met Mr. Tierney, a floor trader at the Chicago Board Options Exchange, who also had been researching electronic trading.

Later that year, the two set up shop in a small office in the CME and started trading S&P futures contracts electronically. They installed floor-to-ceiling computers that at times became so hot they pushed the temperature in the room to 100 degrees.

Their goal was to create an all-electronic market-making business. By 2001, Getco employed about 20 people and had branched into exchange-traded funds.

Around that time, stock exchanges switched to decimalization, pricing stocks in dollars and cents rather than dollars and fractions, a change that narrowed spreads and boosted the importance of swift trading to capture gains.

In 2003, Getco started trading fixed-income securities such as Treasurys; it expanded into currency markets and, more recently, commodities.

The boom in ETFs in recent years has also boosted high-frequency trading, as moves in and out of the funds can mean hundreds of trades in the underlying stocks. More recently, exchanges have been ramping up their technology platforms, making high-frequency trading easier and more profitable.

Today, Getco operates in electronic exchanges around the world. It has offices in New York and London and has about a dozen employees in Singapore, where it expects to expand soon.

A priority now is trading more on options exchanges. The company says regulations currently in place restrict the ability of options investors to get the best price. If options markets are more open to high-frequency traders, that will make the market more competitive, increase volumes and give investors better deals, it says.

Write to Scott Patterson at scott.patterson@wsj.com

August 28, 2009 Posted by | Hi Freq Trading (HFT) | 1 Comment