Understanding Quant Trading and how Mathematicians are Affecting the Markets

Over the years, computers have somewhat reduced the necessity of brokers. But until recently, dealers maintained their status as the rulers of the market world. However, with quant trading, broker status is being threatened, as well — and its effect on the market has earned a closer look. Mathematicians, who have long been key players in financial risk management, have now expanded the use of their skills to making money in addition to avoiding losing it.

The new role of mathematicians in the stock market includes tracking patterns in trading, predicting market movements with formulae and finally using algorithms that trade automatically according to triggers derived from that information. HFT, or High Frequency Trading, is a term becoming common and refers to these quantitative trading programs.

Quant trading can be fully automated or overseen by an individual. In addition, while some quant trading occurs in seconds, it can also take the traditional days, weeks or months. One of the most impressive characteristics of quant trading is its ability to switch strategies in less than a second.

In the United States, two private HFT companies, Getco and Tradebot, account for about 1/5 of all equity trading. With these two companies doing 15 to 20 percent of the market trades, the assumption is that HFT is extremely profitable.

A study done in the UK found many of the effects of quant trading to be positive, asserting that it improved liquidity and helped reduce costs without hurting overall efficiency of the market. However, the same study highlighted self-reinforcing feedback loops, a major concern of HFT. Self-reinforcing feedback loops are a concern because they occur when a small trigger leads to a large overall impact because of a chain of events that amplifies the original effect. As a significant example, the study cites the “Flash Crash” of May 2010 in which, within five minutes, the U.S. market fell by 700 points. However, when the systems were overridden, putting human beings in charge once more, it only took a half hour for the market to bounce back.

The key problem with HFT, according to some, is that mathematicians do not take into account the irrational human behavior that often accompanies trading; because they deal in absolutes, they cannot understand markets. Furthermore, mathematics cannot completely account for the complexities of supply and demand.

While it is the hope of some that HFT will reduce stock broker fraud, in can increase market volatility; investors should be aware of what it is and how it influences the market they are immersed in.