Formula May Pave Way to Stopping Flash Crashes By Justin Grant (mailto:jgrant@techweb.com) March 07, 2011 URL: (http://advancedtrading.com/infrastructure/229300493) Marcos Lopez de Prado, head of high-frequency futures trading at Tudor Investments, explains why a metric he developed with Cornell University professors Maureen O'Hara and David Easley (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1695041) may hold the key to stopping a repeat of the market events of May 6, 2010. In an interview with Advanced Trading, Lopez de Prado sheds light on how Volume Synchronized Probability of Informed Trading, or VPIN, can enable high frequency market makers to continue supplying liquidity in times of stress, stopping sudden market plunges in their tracks. How can VPIN keep high-frequency market makers supplying liquidity despite toxic order flow? Marcos Lopez de Prado: This model identifies when order flow toxicity is negatively impacting the performance of market makers, either because volume is imbalanced, there is an increase in the rate of trading, or a combination of both. If this information could be made available in the form of a contract, market makers could hedge against losses they would incur if toxicity keeps increasing. So you could see it in a similar way that the VIX -- the Chicago Board Options Exchange Volatility Index -- is used to hedge against increases in volatility. VPIN could be used to hedge against increases in order flow toxicity. What makes order flow toxic to market makers? Lopez de Prado: An order flow is considered toxic when market makers provide liquidity at their own expense. Market makers are constantly in the market providing bids and offers, or providing a trading range around the bid and offer. But if toxicity increases, they start to accumulate inventory on a particular side and this inventory begins to lose money. In many cases they shut the portfolio down and call it a day or they have to widen the spread they're providing liquidity at. So order flow becomes toxic when it selects market makers adversely. Why is it important for high-frequency market makers to be able to detect order toxicity? Lopez de Prado: Because of what happened during the Flash Crash. On May 6, the order flow was the most toxic it's been in recent history. That day illustrates what happens to market makers when they operate under extreme toxicity. In this case they were selected to buy stocks and it became very hard for them to turn their portfolios around to sell. And the market kept going down. They accumulated losses. At some point they had to shut down their portfolios and vanish from the market. The crash occurred because there was no liquidity to support their loss-taking. The little liquidity that existed was drained by market makers who were leaving the market they were supposed to make. So once they note high toxicity, what can be done to keep the market makers involved? How can they do this within the context of VPIN? Lopez de Prado: There are many ways this model can be used. One way would be for regulators to design their circuit breakers based on VPIN instead of price changes. Because by the time the price has dropped 10 or 20 percent, it's already too late. The damage is already done. What they could do is to design circuit breakers in terms of toxicity which is a good predictor of illiquidity-induced volatility and that's one of the conclusions that we reached. Secondly, this model could be the basis for a futures contract that market makers could buy and sell in order to hedge against rises in toxicity. So that enables them to protect themselves and they can continue supplying liquidity in times of stress like during the Flash Crash? Lopez de Prado: Market makers do not have any way to hedge against the probability of adverse selection. They are always providing bids and offers, which exposes them to adverse selection. That people only trade with them if they have information could generate persistent losses for the market makers. Some days they could lose many times what they could make in a good day. What a contract on VPIN could do is provide a hedge against those extremely negative days. How necessary is such a contract in an environment where mini flash crashes seem to be occurring regularly? Lopez de Prado: Flash crashes are happening all the time. It's just that they don't reach the magnitude of May 6. But sudden drops of one or two percent are becoming more common and they are very damaging for market makers. High frequency market makers in particular run with very limited capital. They're not like the traditional market maker that would operate with large capital and little leverage and they could just withstand a position for several days. Once they face a loss of one or two percent, they have to liquidate and protect their firm. In these circumstances we're seeing many more mini flash crashes. Editor's Note: A more complete version of this interview will appear in the March digital issue of Advanced Trading.
red bout this a while ago fancy way of saying, if they cant offload to a sucker within 5 milliseconds, its toxic
Ya the study was done last summer I believe and they shopped their idea around. This is the first time I've seen it published in a Trade Journal... Kind of a polite way that the Hedge Fund Industry can pretend its got everyone's best interests in mind I guess.
What a joke! So the criminal front running insider trading HFT nerd wants an 'index' to protect his dumb azzzz from losses?? Didn't you know that 'flash crashes' are named such because they are down to flash orders which are done exclusively by HFT nerds. You caused it, now you want someone to protect your azz? This is unbelieveable, listen here and listen good NO ONE WANTS YOUR SO CALLED VOLUME. 99% of your HFT volume is NEVER traded, it's just order stuffing to slow down systems of mere mortals. Furthermore, all normal traders hope that you do go bust and never come back in the market again. What next? Peadofiles demanding an index that calculates the percentage chance that a child will tell the cops? When, and not if, there is another flash crash I can't wait to see your coward computers turn yourselves off and run to the bathroom with a brown stain on your pant, because that all HFT's are, frontrunning cowards that now, despite all the illegal help they get, want even more help to protect their dumb azzes from losses.
+1 no special "crash committee" needed.. 5 years old can figure this out...all they have to do is take a look at intraday charts of low/medium volume stocks to see the difference..
Y'all will be crying a different tune when spreads widen as soon as HFTers leave the markets. Despite some disruptive practices, HFT has and does tighten spreads and increase liquidity. The issue is that the liquidity disappears in times of market stress, like May 6th. Several jurisdictions have proposed imposing market making obligations on HFTers and one way to incentivize HFTers to trade in stressed markets, thereby provide y'all with narrower spreads, is by creating an instrument used for hedging against toxicity...
You don't trade do you. I trade the EMini SP and the spread will not change without your HFT's. I traded during the flash crash, I didn't stop, your HFT's did, did I ask for a 'index' to cover my losses? Nope. I didn't require a blow up banana from the exchange either as I was only trying to make money for myself, period. This BS about providing liquidity has got to stop. Your orders are fake and miles away from market, they are not genuine, hence why you turned off your nerdboxes when the going gets tuff and the good traders make money. You have no idea where the market is going, hence your need for an 'index', because your whole trading strategy is based on screwing over and insider trading REAL VOLUME. I know a few big volume traders, they dont ask for no special treatment because they are providing liquidity. If you wanna gamble on futures, place an order to make money...period. Let me show you clearly how 'real' your volume is. Your volume is so real the way you exit a 300 lot in the e-mini is by doing 300 1 lot orders. Who the hell does that??? Why not just clip 300. Well, the reason you do that is so that you can fulfill the exchanges messaging policy, since you had placed 300,000 fake ungeniune orders whilst your position was open. Anyone here want that sort of BS 'volume'?
The funny thing is on reading that article- Does the Author suppose that by being 2 hours early to leaving the party is going to have any effect on when and under what circumstances the whole Market ("so called liquidity providers") decide to leave the party? It might get him out with the Tudors, but if everyone has the same tool and an agreed upon indexing technique, all it means is that people are now aware of a problem of serious magnitude 2 hours earlier.... and the inevitability of the event itself doesn't change at all. My point - There is no real risk control when you are symbolically exchanging your liquidity measurements. This article comes by way of Advanced Trading Magazine, of which in its entirety is solely a Marketing tool for HFT and HFT wannabe consulting types who think they can resurrect their place in the Market for another business cycle via the HFT strategies they are all pimping. Remember, didn't the credit crisis rid the Market of 100s of thousands of peripheral players (traders and technologists who were no longer needed due to the new Market efficiencies)? The whole article is really just a closet invitation for intervention in the Markets by way of the fed. Thats my conclusion.