The Knightmare (KCG)
Ludwig Chincarini on Knight and High Frequency Trading.
I remember when I built my own brokerage firm with a bunch of people, including Rich Hagen, co-founder of TradeKing. For the time, we had developed a novel way of trading, which needed market makers to understand and facilitate some of our new ways of trading. We found two great places to make our trades. One of them was Knight Securities (KCG). We used them to trade most of our NYSE stocks. The other was Madoff Securities. We used them to trade our OTC or Nasdaq stocks. Both were excellent firms for these purposes. Yes, you heard me correctly. Believe it or not, Madoff had created a legitimate securities firm, as opposed to his illegitimate hedge fund business.
It's been 10 years since then and Madoff Securities is gone and its founder in jail. Just last week, a computer glitch at Knight almost caused the firm to go bankrupt. What are ordinary investors to do? The purpose of a market maker is not to run a hedge fund on the side, not to take bets on Greece a la MF Global, and not to lose $440 million in one day. Market makers are there so that whenever you or I have a buy or sell order, there is a central platform that is so immersed in the market that they can buy or sell from us instantaneously with the intention to transfer the security to someone else relatively quickly. There is always risk in these activities, but market makers aim to keep this risk small.
Ivan Lendl said of tennis recently "The speed of the game has changed." The speed of trading has changed dramatically in 20 years due to the advances in technology. We used to have humans in pits having to work fast but fast meant processing information in seconds not milliseconds. High frequency traders (aka HFTs) represent about 73% of market trading (see my book The Crisis of Crowding). Some of them run complex algorithms to manipulate market prices, but this is still a source of debate. The movement in security prices intraday has become more subject to mini crashes over the last few years, most likely due to the technology driven speed of information and execution. The latest wreck though was initiated by an error in Knight's software program that led to a feedback effect as other electronic systems traded in reaction to the errors at Knight. Building software to do efficient trading isn't easy, but that's their job. How could they screw that up? I remember when we built our online brokerage firm, we spent countless hours thinking about whether any of our algorithms for trading could be gamed...and then we tested the software internally. That's just what Knight did. According to my friend and trading market expert, Eric Hunsader, Knight released the new version of their software with the test algorithm still attached. The test algorithm went out and instead of making mock trades was making live trades in the market resulting in large positions for the firm, some of which lost them lots of money. For other software companies, a mistake like this would not be so bad, but in the financial markets, this means real trades with real dollars.
So as a trader, what should you have done on the day of the Knightmare? On the day of the glitches, August 1, 2012 Knight's stock (KCG) stock dropped by 32%, the next day it dropped by another 63%, for a two-day drop of 75% to a share price of $2.58. It dropped so low, that KCG was trading well below book value by about 40%. When I saw this I paused and thought, "Should I buy Knight?" First, Knight relies on short-term financing. Thus, if the crowd runs for the exits, Knight is finished. The break-up value was estimated by analysts at $340 million or $3.79 per share. Thus, in some senses, it looked like a risk worth taking to buy Knight on Friday morning. It opened at around $3.16. Thus, small investors could have bought and made a Friday return of about 28%. But that's said and done. Should you buy Knight now? The risk is higher now and it all depends if the market regains their confidence in Knight. Over the weekend, Knight had a capital injection from a group of investors of $400 million in exchange for 267 million shares. If one ignores any impacts from the events, like loss of trust, lawsuits, etc, Knight's diluted value would be $2.48 per share. If you decide to invest money in Knight, proceed cautiously and start small. Above all, be sure that any investment is in line with your risk tolerance. Risk-averse investors may decide to stay out of this until further notice.
The saddest part of the news is that the efficiency of fast paced computer trading is crashing at regular intervals. It's all part of the new crash normal, and it's not clear that the SEC or anyone else knows what to do. Maybe things weren't so bad when we had tall, strong men elbowing each other in the pits.
Ludwig B. Chincarini
TradeKing All-Star Commentator
Author of The Crisis of Crowding
www.ludwigbc.com
Twitter @chincarinil
Online trading has inherent risk due to system response and access times that may vary due to market conditions, system performance, and other factors. An investor should understand these and additional risks before trading.
TradeKing selects and defines as All-Stars certain independent market commentators who are recognized industry personalities and experienced traders. TradeKing All-Stars provide timely market commentary via the TradeKing All-Star blog at http://community.tradeking.com/members/tk-all-star/blogs. Each All-Star commentator's bio, related qualifications and disclosure as to their relationship with TradeKing can be found on the All-Star blog roster, available at http://community.tradeking.com/members/tk-all-star/details. The selection of All-Stars commentators is solely based on the quality and style of the content provided. TradeKing does not measure, endorse, or monitor the performance or correctness of any statement or recommendation made by independent All-Stars commentators on TradeKing.com. Supporting documentation for any claims made in this post will be supplied upon request by the author of the post, who is solely responsible for the views expressed here. Send a private message to All-Stars using the link below the profile image.
All investments involve risk, losses may exceed the principal invested, and the past performance of a security, industry, sector, market, or financial product does not guarantee future results or returns. TradeKing provides self-directed investors with discount brokerage services, and does not make recommendations or offer investment, financial, legal or tax advice. You alone are responsible for evaluating the merits and risks associated with the use of TradeKing's systems, services or products. If you have additional questions regarding your taxes, please visit IRS.gov or consult a tax professional. TradeKing is unable to provide any tax advice.
© 2012 TradeKing Group, Inc. Securities offered through TradeKing, LLC. All rights reserved. Member FINRA and SIPC
I remember when I built my own brokerage firm with a bunch of people, including Rich Hagen, co-founder of TradeKing. For the time, we had developed a novel way of trading, which needed market makers to understand and facilitate some of our new ways of trading. We found two great places to make our trades. One of them was Knight Securities (KCG). We used them to trade most of our NYSE stocks. The other was Madoff Securities. We used them to trade our OTC or Nasdaq stocks. Both were excellent firms for these purposes. Yes, you heard me correctly. Believe it or not, Madoff had created a legitimate securities firm, as opposed to his illegitimate hedge fund business.
It's been 10 years since then and Madoff Securities is gone and its founder in jail. Just last week, a computer glitch at Knight almost caused the firm to go bankrupt. What are ordinary investors to do? The purpose of a market maker is not to run a hedge fund on the side, not to take bets on Greece a la MF Global, and not to lose $440 million in one day. Market makers are there so that whenever you or I have a buy or sell order, there is a central platform that is so immersed in the market that they can buy or sell from us instantaneously with the intention to transfer the security to someone else relatively quickly. There is always risk in these activities, but market makers aim to keep this risk small.
Ivan Lendl said of tennis recently "The speed of the game has changed." The speed of trading has changed dramatically in 20 years due to the advances in technology. We used to have humans in pits having to work fast but fast meant processing information in seconds not milliseconds. High frequency traders (aka HFTs) represent about 73% of market trading (see my book The Crisis of Crowding). Some of them run complex algorithms to manipulate market prices, but this is still a source of debate. The movement in security prices intraday has become more subject to mini crashes over the last few years, most likely due to the technology driven speed of information and execution. The latest wreck though was initiated by an error in Knight's software program that led to a feedback effect as other electronic systems traded in reaction to the errors at Knight. Building software to do efficient trading isn't easy, but that's their job. How could they screw that up? I remember when we built our online brokerage firm, we spent countless hours thinking about whether any of our algorithms for trading could be gamed...and then we tested the software internally. That's just what Knight did. According to my friend and trading market expert, Eric Hunsader, Knight released the new version of their software with the test algorithm still attached. The test algorithm went out and instead of making mock trades was making live trades in the market resulting in large positions for the firm, some of which lost them lots of money. For other software companies, a mistake like this would not be so bad, but in the financial markets, this means real trades with real dollars.
So as a trader, what should you have done on the day of the Knightmare? On the day of the glitches, August 1, 2012 Knight's stock (KCG) stock dropped by 32%, the next day it dropped by another 63%, for a two-day drop of 75% to a share price of $2.58. It dropped so low, that KCG was trading well below book value by about 40%. When I saw this I paused and thought, "Should I buy Knight?" First, Knight relies on short-term financing. Thus, if the crowd runs for the exits, Knight is finished. The break-up value was estimated by analysts at $340 million or $3.79 per share. Thus, in some senses, it looked like a risk worth taking to buy Knight on Friday morning. It opened at around $3.16. Thus, small investors could have bought and made a Friday return of about 28%. But that's said and done. Should you buy Knight now? The risk is higher now and it all depends if the market regains their confidence in Knight. Over the weekend, Knight had a capital injection from a group of investors of $400 million in exchange for 267 million shares. If one ignores any impacts from the events, like loss of trust, lawsuits, etc, Knight's diluted value would be $2.48 per share. If you decide to invest money in Knight, proceed cautiously and start small. Above all, be sure that any investment is in line with your risk tolerance. Risk-averse investors may decide to stay out of this until further notice.
The saddest part of the news is that the efficiency of fast paced computer trading is crashing at regular intervals. It's all part of the new crash normal, and it's not clear that the SEC or anyone else knows what to do. Maybe things weren't so bad when we had tall, strong men elbowing each other in the pits.
Ludwig B. Chincarini
TradeKing All-Star Commentator
Author of The Crisis of Crowding
www.ludwigbc.com
Twitter @chincarinil
Online trading has inherent risk due to system response and access times that may vary due to market conditions, system performance, and other factors. An investor should understand these and additional risks before trading.
TradeKing selects and defines as All-Stars certain independent market commentators who are recognized industry personalities and experienced traders. TradeKing All-Stars provide timely market commentary via the TradeKing All-Star blog at http://community.tradeking.com/members/tk-all-star/blogs. Each All-Star commentator's bio, related qualifications and disclosure as to their relationship with TradeKing can be found on the All-Star blog roster, available at http://community.tradeking.com/members/tk-all-star/details. The selection of All-Stars commentators is solely based on the quality and style of the content provided. TradeKing does not measure, endorse, or monitor the performance or correctness of any statement or recommendation made by independent All-Stars commentators on TradeKing.com. Supporting documentation for any claims made in this post will be supplied upon request by the author of the post, who is solely responsible for the views expressed here. Send a private message to All-Stars using the link below the profile image.
All investments involve risk, losses may exceed the principal invested, and the past performance of a security, industry, sector, market, or financial product does not guarantee future results or returns. TradeKing provides self-directed investors with discount brokerage services, and does not make recommendations or offer investment, financial, legal or tax advice. You alone are responsible for evaluating the merits and risks associated with the use of TradeKing's systems, services or products. If you have additional questions regarding your taxes, please visit IRS.gov or consult a tax professional. TradeKing is unable to provide any tax advice.
© 2012 TradeKing Group, Inc. Securities offered through TradeKing, LLC. All rights reserved. Member FINRA and SIPC
Comments
Follow commentsspshapiro posted August 08, 2012 (08:51PM)
In addition to elsewhere, there has been a fair amount of ink spilt over on the Forum concerning HFT. At first it caused me much concern, as it did to others, but the more I thought about it, the less it bothered me. To the extent that the practice is a cover up or excuse for wrongdoing, I have no problem with the perpetrators getting all that they deserve, but for the most part I don’t see how this type of trading effects me, except at some extreme moments. As I see it, except for the opening half hour last Wednesday, and maybe the day of ‘the crash’, HFT trades rarely move the market price of issues I hold by any amount that I would consider interesting enough to make me want to trade.
An offer at whatever price, that only is good for a portion of a second, is totally meaningless to me. I can’t response in the requisite amount of time. Although I would not compare myself to a market maker (MM), but they too can’t respond that quickly, if the response requires human thought to intervene. Now I do recognize that the MM could use a computer programmed with an algorithm to respond to the offer, but is that a necessary part of his responsibility? Yes, I know that they make their money in part through the amount of trades that they handle, so there is a financial reason for wanting to handle these trades, but I don’t see where a MM should be required to respond to an offer that is there for less time than it would take for a sentient being to absorb the offer and respond. It seems to me quite possible to institute a rule that an offer must be maintained for X seconds, before a MM is required to respond to it. Some MM’s might wish to use a computer to beat others to the punch, but let those who wish to live by the supercomputer, also be capable of being gored by same.
Now as to using algorithms to generate a methodology for trading, there is an inherent flaw which I don’t think is fully realized. I don’t deny that they might offer some good trading opportunities, but there will always be a possible limiting case that will cause any algorithm to ‘blow up’. It is basically a corollary to Godel’s Proof, that there will always be some true statements of the system that will be unprovable by the rules of that system, and so some set of conditions could be constructed to cause the algorithm to go astray. I strongly suspect that this is what happened in both the Knightmare and the Flash Crash. Having a human being (without a financial interest in the trade) standing there who could intervene and say this is not what we want to see in ‘our’ market, could go a long way to correcting the situation.
I am not saying that when ‘things get out of hand’ that someone should always intervene, only when it is perceived as market moving ‘out of the blue.’ Sometimes the market makes an outsized move, but it can thought to be due to conscious decision (be it wrongheaded or not.) People have the right to make a market call, but they have no right to manipulate the market.You must Log In to post to this blog.
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