Frank Thoughts: The Commodization of the Stock Market
Frank Boland
September 06, 2011

“Oh, my!  MRK (Merck Drug) is trading like soybeans!” screamed the shocked trader.  It was the spring of 1982 and stock futures and program trading had just been introduced to the equities market.  Prior to then futures, which existed for hedging purposes, were only in commodity markets.  Computer-driven Program Trading– the simultaneous purchase of a basket of stocks-  would then link stock futures in Chicago to equities in New York.  However, the margin requirement (the amount of capital one had to put down on a contract) in futures was dramatically lower than margin requirements in equities.  Thus smaller amounts of money in Chicago could control much larger pools of equities in New York.  This could, and did, produce instant volatility in the stock market.  In effect, the trader’s scream was justified.  Stocks could, for a moment in time, trade up or down dramatically, just like soybeans.  Today, in an average week, Program Trading is roughly 30% of N.Y.S.E. volume; a large enough amount of money to impact daily trading momentarily.                  

Program Trading was the first step in the quantitative evolution of stock trading.  In 1998 the S.E.C. authorized electronic exchanges to compete with established exchanges such as the New York Stock Exchange.  This was a seminal event in the development of quantitative High-Frequency-Trading.  The intent was to open markets and lower transaction costs for individual investors.  And it did just that.  Decimal trading spreads replaced old 1/8 spreads as trading executions became finalized in pennies. 

Moreover, competition did intensify.  There are now more than 12 electronic exchanges.  As recently as five years ago the N.Y.S.E. handled over 70% of the volume.  Now its share is just 36%.  While the New York Stock Exchange continues to maintain a trading floor, it is overwhelmingly electronic. The end result is that High-Frequency-Trading represents some 60% of daily trading volume across all exchanges.  Whether it is liked or not computer trading, as in all computer uses, is a permanent part of our lives.  On any given day quantitative trading now represents 90% of total market volume.

But quantitative trading is dramatically different than investing!  High-Frequency-Traders make a living by being the first to react to events.  The macro picture is everything to them.  One new strategy is to use powerful computers to speed-read news reports.  Then other machines interpret and trade on it. Trades are executed round trip (buy and sell) at 98 microseconds; that’s a speed equal to 98 millions of a second.  This activity can, and often does, cause near total correlation in the stock market.  All stocks can go up  or down on a big macro news day.  This is largely what we have been experiencing this August.

Market correlation can make it difficult for managers to outperform the market in the short term.  But as the time line elongates out to three, six, nine and twelve months correlation diminishes.  Stocks trade like soybeans for just brief moments in time.  Good managers have over 10+ years of outperformance to prove it; this represents the entire time line of High-Frequency-Trading!                                   

-Francis Patrick Boland

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