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Electronic copy available at: http://ssrn.com/abstract=1977561
Trading Rules Over Fundamentals:A Stock Price Formula for High Frequency Trading,Bubbles and Crashes
Godfrey Cadogan
∗
Working PaperComments welcomeJanuary 2, 2012
∗
Corresponding address: Information Technology in Finance, Institute for Innovation and TechnologyManagement, Ted Rogers School of Management, Ryerson University, 575 Bay, Toronto, ON M5G 2C5;e-mail:godfrey.cadogan@ryerson.ca. I thank Oliver Martin for his comments on an earlier draft of thepaper which improved its readability. Research support from the Institute for Innovation and TechnologyManagement is gratefully acknowledged. All errors which may remain are my own.
Electronic copy available at: http://ssrn.com/abstract=1977561
Abstract
In this paper we present a simple closed form stock price formula, which captures empirical reg-ularities of high frequency trading (HFT), based on two factors: (1) exposure to hedge factor; and(2) hedge factor volatility. Thus, the parsimonious formula is not based on fundamental valuation.For instance, it allows us to use exposure to and volatility of E-mini contracts to predict movementsin an underlying index. For application, we first show that for given exposure to hedge factor, andsuitable specification of hedge factor volatility, HFT stock price has a closed form double expo-nential representation. There, in periods of uncertainty, if volatility is above historic average, arelatively small short selling trade strategy is magnified exponentially, and the stock price plum-mets when strategies are phased locked. Second, we demonstrate how asymmetric response tonews is incorporated in the stock price by and through an endogenous EGARCH type volatilityprocess; and find that intraday returns have a U-shaped pattern inherited from HFT strategies.Third, we show that the stock price is bounded from below (crash), i.e. flight to quality, but notfrom above (bubble), i.e. confidence, when phased locked trade strategies violate prerequisites of van der Corput’s Lemma. Thus, extant regulatory proposals to control price dynamics of selectstocks, i.e., ”limit up/limit down” bands over 5-minute rolling windows, may mitigate but not stopfuture market crashes or price bubbles from manifesting in underlying indexes that exhibit HFTstock price dynamics.
Keywords:
high frequency trading, hedge factor volatility, price reversal, market crash, price bub-bles, fundamental valuation, van der Corput’s Lemma
JEL Classification Codes:
C02, G11, G12, G13
Electronic copy available at: http://ssrn.com/abstract=1977561
Contents
4.1 The impact of stochastic volatility on HFT stock prices. . . . . . 114.2 Implications for intraday return patterns and volatility. . . . . . . 134.3 van der Corput’s lemma and phase locked stock price. . . . . . . 15
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