Market Microstructure Theory - Traditional Framework Econophysical Market Microstructure Theory Recent Research Works Relate

Trends in Algorithmic Trading

ChongSeok Hyun1 ordeeq@ajou.ac.kr
1 Ajou

University, South Korea

Prepared for the Algorithmic Trading Forum, 2012

Market Microstructure Theory - Traditional Framework Econophysical Market Microstructure Theory Recent Research Works Relate

Outline

Market Microstructure Theory - Traditional Framework Econophysical Market Microstructure Theory Introduction Large Price Change and Long-memory of Order Flow Market Impact Recent Research Works Related to Algorithmic Trading

Market Microstructure Theory - Traditional Framework Econophysical Market Microstructure Theory Recent Research Works Relate

Standard References

S. Grossman (1989): The Informational Role of Prices. M. OHara (1995): Market Microstructure Theory. J. Hasbrouck (2007): Empirical Market Microstructure. R. Lyons (2001): The Microstructure Approach to Foreign Exchange Rates. L. Harris (2002): Trading and Exchanges: Market Microstructure for Practitioners. R. Tsay (2005): Analysis of Financial Time Series. K. Eom (2011, ARFR): Market Microstructure in the Koeran Financial Markets: A Survey.

Market Microstructure Theory - Traditional Framework Econophysical Market Microstructure Theory Recent Research Works Relate

The Denition and the Earlier History Denition (OHara): Market microstructure is the study of the process and outcomes of exchanging assets under explicit trading rules. Demsets (1968)
Originally focuses on the nature of transaction costs. His analysis of how the supply and demand aected market prics set the stage for the formal study of market microstructure.

Grossman
A series of equilibrium analysis with information asymmetries. How prices are aected by traders information, and how this, in return, aects the information traders can infer from market prices. A fundamental insight: Along with clearing markets, prices algo aggregate information. Noise trader: introduce by Grossman (1976, JF).

Market Microstructure Theory - Traditional Framework Econophysical Market Microstructure Theory Recent Research Works Relate

Information, Trade, and Eciency

Market eciency
Market eciency should be the core postulate for nance theory: Ross (2004). A market is informationally ecient if current price is always the best predictor of future prices (martingale), i.e. prices are unpredictable. A market is allocationally ecient if it is Pareto optimal. A market might be informationally ecient yet allocationally inecient: Stiglitz (1981, JF) Prices are unpredictable but prices are not set properly. The impossibility of informationally ecient markets: Grossman and Stiglitz (1980, AER).

Market Microstructure Theory - Traditional Framework Econophysical Market Microstructure Theory Recent Research Works Relate

Information, Trade, and Eciency (Cont.)

Trading and information

Informational eciency means that information must be properly incorporated into prices. Unanticipated news for the change of the fundamental value of an asset market participants work out how this changes the price of the asset, and trade. Question: is the fundamental value of an asset?: Black (1986, JF). No-trade Theorem (Milgrom and Stokey (1982, JET)): assumed rationality and same information In reality, rationality or same information??.

Market Microstructure Theory - Traditional Framework Econophysical Market Microstructure Theory Recent Research Works Relate

Three Theoretical Approaches

Inventory models: Garman (1976, JFE), Stoll (1978, JF), and Ho and Stoll (1981, JFE).
The uncertainties in order ow can result in inventory problems for market makers (the specialist) How a market maker determine the appropriate compensation to oset the cost he/she faces in providing the intermediary services. The market makers cost (due to uncertainty) is a function of the inventory amount. He/She can adjust bid and ask price to maximize the expected utility of the terminal wealth.

Market Microstructure Theory - Traditional Framework Econophysical Market Microstructure Theory Recent Research Works Relate

Three Theoretical Approaches (Cont.)

Information-based models
Bagehot (1971, FAJ): market gains vs trading gains (information cost). Copeland and Galai (1983, JF): the rst attempt to model information costs using option pricing theory. Glosten and Milgrom (1985, JFE)
A sequential trading model on how market makers set bid and ask spreads (ignoring the inventory risks: risk neutral market maker) Informed traders prot from trading if prices are not at full-information levels. An uninformed market maker (quickly) adjust prices to reect the revealed information from the trading by the informed Bayesian updating!!!.

Market Microstructure Theory - Traditional Framework Econophysical Market Microstructure Theory Recent Research Works Relate

Three Theoretical Approaches (Cont.) Strategic Model I (Kyle (1985, EMCA))

An (risk-neutral) informed trader submit orders(x) strategically to maximize his expected prot. The market maker aggregates the orders and clears all trades at a single price without making any prot. There are noise traders who don not act strategically but rather submit orders () randomly. The market maker can only observed the aggregated order ow not a specic order ow from the informed traders nor the one from noise traders. Linear price impact: p(x + ) = p0 + (x + ), where is the coecient of the order volume on the price interpreted as reciprocal of market depths.

Market Microstructure Theory - Traditional Framework Econophysical Market Microstructure Theory Recent Research Works Relate

Three Theoretical Approaches (Cont.)

Strategic Model II (Admati and Peiderer (1988, RFS))

Two types of uninformed traders - discretionary traders and nondiscretionary traders Nondiscretionary liquidity traders are similar to noise traders in Kyle (1985) Discretionary liquidity traders trade an exogenously given amount, but they have some discretion with respect to the timing of their trades. They must satisfy their liquidity demand before the end of the trading day, but may choose the trading time. This model can explain the U-shape pattern of trading volumes reported by Harris (1986, JFE) or Jain and Joh (1988, JFQA)

Market Microstructure Theory - Traditional Framework Econophysical Market Microstructure Theory Recent Research Works Relate

Other Theortical Issues

Insiders hedging problem: Back (1992, RFS) Back and Baruch (2004, EMCA): the equivalence between the Kyles model and the Milgrom and Glostens model ...

Market Microstructure Theory - Traditional Framework Econophysical Market Microstructure Theory Recent Research Works Relate

Econometric and Empirical Issues

Microstructural noise: bid-ask bounce (Roll (1984, JF)), Engle (2000, EMCA) Random trading times: Engle and Russell (1998, EMCA), Engle (2000, EMCA) Information contents: Hasbrouck (1991, RFS; 1991, JF) Asyncronous trading events: Epps (JASA, 1979), Andersen et al. (2003, EMCA), Bollerslev et al. (2003, JEmF), Fleming et al. (2003, JFE). Biais, Hillion, Spatt (1995, JF): double auction market

Market Microstructure Theory - Traditional Framework Econophysical Market Microstructure Theory Recent Research Works Relate Introduction

Econophical Viewpoint

Econophysics ??? Econophysics is similar in spirit to behavioral econmics in that it postulates simple plausible rules of agent behavior, and explores their implications, However, it diers by puting less emphasis on the psychological microfoundations, and more on the result of the interactions among agents. Gabaix et al. (2006, QJE) Econophysical market microstructure theory is well summarized in Bouchaud, Farmer, and Lillo (2009), How market slowly digest changes in supply and demand.

Market Microstructure Theory - Traditional Framework Econophysical Market Microstructure Theory Recent Research Works Relate Introduction

Econophical vs. Traditional

Prices often respond slowly to new information

Changes in supply and demand constitute a long memory process: Slowly decaying autocorrelation (Bouchaud et al. (2004, QF), Lillo and Farmer (2004, SNDE)) Order splitting (by large traders): Barclay and Warner (1993, JFE), Gabaix et al. (2006, QJE)

Traditional theory has emphasized information and de-emphasized supply and demand.
Orders contain a variable amount information about the hidden background of supply and demand.

Informed vs. uninformed

The informed are skillful (or rational)?: Odean (1999, AER) Can any valuable information be measured and operated immediately?

Market Microstructure Theory - Traditional Framework Econophysical Market Microstructure Theory Recent Research Works Relate Introduction

Liquidity and Equilibrium

Empirical ndings
Even highly liquid markets are in fact not that liquid. Empirically observe market impact is a concave function of trading volume contrary to Kyles linear model.

Trading game and equilibrium

Both informed and uninformed traders want to have their trading done as quickly as possible, but both try not to show their hands and reveal their intensions. The notion of equilibrium prices can only make sense over a long time scale High frequency prices are necessarily soiled by a signicant amount of noise

Market Microstructure Theory - Traditional Framework Econophysical Market Microstructure Theory Recent Research Works Relate Introduction

Time Scales and Market Ecology

Low frequency vs high frequency

Number of large jumps in high frequency price returns is much higher in the absence of any identied news. Low frequency, large volume investment decisions imply high frequency, small volume trades. Market-making is usually a high-frequency trading strategy taking out a prot from the bid-ask spead: Glosten-Milgrom (1985, JFE).

Classifying market participants (w.r.t. trading frequency)

Speculator/liquidity hunter Market-maker/liquidity provider

Market Microstructure Theory - Traditional Framework Econophysical Market Microstructure Theory Recent Research Works Relate Introduction

The Roll of High Frequency Trading (HFT)

Eciency
HFT compound information into prices so that it may increase the eciency of the market Information process cascade from fundamental information on slow time scales to technical information on fast time scales

Volatility smoothing
Average volatility is remarkably constant on a wide range of dierent time scale: refer also to Epps eect (Large (2012)). Information cascading results in white noise on all scales.

HFT may contribute in decreasing the market stability

The Flash Crash (Kirilenko et al. (2010)).

Market Microstructure Theory - Traditional Framework Econophysical Market Microstructure Theory Recent Research Works Relate Large Price Change and Long-memory of Order Flow

Long-memory of Order Flow

Empirical evidence
Order ow is a highly autocorrelated long-memory process: Bouchaud et al. (2004, QF), Lillo and Farmer (2004, NDE) contrary to Lo (1991, EMCA).

Mathematical models
Fractional Brownian noise (Mandelbrot and van Ness (1968, SIREV)), ARFIMA process (Granger and Joyeux (1980, JTSA)).

A highly autocorrelated order ow may generate a fat-tailed behavior or bubbles

Market Microstructure Theory - Traditional Framework Econophysical Market Microstructure Theory Recent Research Works Relate Market Impact

Market Impact

Non-linear market impact

Many empirical ndings showing concave market impact functions

Market Microstructure Theory - Traditional Framework Econophysical Market Microstructure Theory Recent Research Works Relate

New Topics in Market Microstructure Conference 2012 in Paris

Empicical research on large uctuations (Lillo et al.) The Flash crash: theoretical modeling (Menkveld), predictability (Kyle) Many research on the Hawkes process Price discovery and HFT (Hendershott) The protability of HFT (Brogaard) An econometric analysis on Epps eect (Large) Mean eld game theoretic approach to model limit order dynamics (Lions et al.)

Market Microstructure Theory - Traditional Framework Econophysical Market Microstructure Theory Recent Research Works Relate

New Topics (Cont.)

Hedging with HFT (Almgren) Bilateral order book modelling (Gould) News and HFT (Rocu) The value of order book (Skouras) Reinforced learning (Nevmyvaya)

Market Microstructure Theory - Traditional Framework Econophysical Market Microstructure Theory Recent Research Works Relate

Thank You !!!