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“Exploratory Trading” and Momentum Ignition

28

December, 2012

We have heard the term “momentum ignition” tossed around a lot lately.  A recent Credit Suisse report said that momentum ignition was an HFT strategy.  They defined momentum ignition as when “an instigator takes a pre-position; instigates other market participants to trade aggressively in response, causing a price move; then trades out.”

A new paper titled “Exploratory Trading”  written by Adam Clark-Joseph from Harvard University attempts to explain how high frequency traders use exploratory trading techniques (or momentum ignition) to make their profits.  The theory goes that HFT’s will probe with small aggressive orders that will often lose money so that they could find out more important market information that they could then take advantage of.  The study was done using actual CME data for the period of September 17, 2010 to November 1, 2010 (as opposed to other sponsored pro-HFT studies that have used the same old stale stock exchange provided data which does not even drill down to the user level).  During this period, over 41,000 accounts traded and HFT’s were less than 0.1% of these accounts but were responsible for 46.7% of the trading volume and earned an average of $1.5 million per day.  The author states:

“Of the 30 high-frequency traders (HFTs) that I identify in my sample, eight earn positive overall profits on their aggressive orders. I find that all eight of these HFTs consistently lose money on their smallest aggressive orders, and these losses are NOT explained by inventory management.  These losses on small orders, as well as the more-than- offsetting gains on larger orders, could be rationalized if the small orders provided some informational value, and I model how a trader could gather valuable private information by using her own orders in an exploratory manner to learn about market conditions.”

“The private information about price-impact generated by an HFT’s small aggressive orders enables that HFT to trade ahead of predictable demand at only those times when it is profitable to do so (i.e., when price-impact is large).”

“Fundamentally, the model of exploratory trading rests on the notion that an HFT’s aggressive orders generate valuable private information, specifically, information about the price-impact of the aggressive orders that follow. When an HFT places an exploratory order and observes a large price-impact, he learns that supply is temporarily inelastic. If the HFT knows that there is going to be more demand soon thereafter, he can place a larger order (even with a big price-impact) knowing that the price-impact from the coming demand will drive prices up further and ultimately enable him to sell at a premium that exceeds the price-impact of his unwinding order. When an HFT knows that supply is temporarily inelastic, he follows a routine demand-anticipation strategy. The purpose of exploratory trading is not to learn about future demand, but rather to identify the times at which trading in front of future demand will be profitable.”

HFT’s will likely say that this exploratory trading is actually helping in the price discovery process but the author disagrees:

“The information that exploratory trading generates does not relate directly to the traded asset’s fundamental value, but rather pertains to unobservable aspects of market conditions that could eventually become public, ex-post, through ordinary market interactions.”

Our friends at Nanex yesterday published a piece titled Orchestrating Chaos where they graphically show what momentum ignition looks like.  They state:

“On December 26, 2012 at 11:02:59, the market suddenly exploded with activity (SPY dropped below 141.88 – a low set 12 days earlier on December 14). Approximately 3,800 March 2013 eMiini futures contracts (S$P 500) were sold during that second. We thought the sudden explosion in activity warranted a closer look.  What we found was fascinating. It appears the entire market-wide move may have been carefully orchestrated.”

“Exploratory Trading” or momentum ignition has nothing to do with the fundamentals of the stock market.  It is nothing more than a high-tech version of scalping.  The Harvard paper also strikes as just the opposite of the HFT claim that they “add liquidity”.  Maybe HFT’s are defining “add liquidity” as layering the book with higher offers and then sending some exploratory aggressive bids out to the market in an attempt to have others jump ahead and lift those layered offers.  If that’s their definition, then we think regulators may take issue with it.

 

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