Mar

9

High-frequency finance can revolutionize economics and finance by turning accepted assumptions on their head and offering novel solutions to today’s issues. This comes from an interesting article on the topic:

In high-frequency finance:

The first step involves the collecting and scrubbing of data.

The second step is to analyze the data and identify its statistical properties. Due to the masses of data points available for analysis (for many financial instruments one can collect more than 100,000 data points per day), identification of structures is straightforward– either there is a regularity or there is none.

The third step is to formalise observations of specific patterns and seek tentative explanations/ theories to explain them. Fractal theory suggests that we can search for explanations of the big crisis by moving to another time scale — the short term.

On a short-term time scale, we study how regime shifts occur and how human beings react. The large number of occurrences allows for meaningful analysis. We study all facets of a crisis– how traders behave prior to the crisis, how they react to the first onslaught, how they panic, when the going gets hard and finally, how their frame of reference which previously was a kind of anchor and gave them a degree of security breaks down and how later, when the shock has passed, the excitement dies down, there is the aftershock depression and then eventually how gradual recovery to a new state of normality begins. It is possible to build maps of how market participants build up positions and how asset bubbles develop over time.

High-frequency finance opens the way to develop "economic weather maps".

Just as in meteorology where the large scale models rely on the most detailed information of precipitation, air pressure and wind, the same is true for the economic weather map. The development of such a global economic weather map has barely started. The "scale of market quake" is a free service. It is a very interesting experiment. You can read the paper "The scale of market quakes".

I believe these are really exciting developments. More than 15 years ago it was expensive to find end-of-day data and I would update together with my dad the files of the stocks I was interested in using data from the newspaper. Today we have huge online databases available to the average trader. The computer I had at the time and the SW I could afford would allow me to do some technical analysis building indicators and that's it. Today I use Tradestation.  I can program and automate my indicators, studies and strategies. It is a huge advance for average traders like me. High frequency finance is now the new frontier and if you want to be profitable, there you can still find the sort of inefficiencies you need. However, it cannot be accessible to everybody. Once again, you need the data, the computers and the math/statistical expertise. It is getting more and more complex. Moreover, to trade on such a short time frame you need to have very very very low commissions that the average trader cannot obtain. Would you expect something different?

The question I have is whether there are inefficiencies in longer time frames that the big guys do not even bother to consider: the leftovers of their meal. At the 60 minute level or even the daily time frame. I had the privilege to talk with one of the best traders of Wall Street (he trades mainly the emini) about this issue and he believes that this is the only way to stay on the market for the average guy. There is a way to profitable in these time frames. It worked for him. Inefficiencies at micro structure level must be so important that the few big players in the business that can afford that type of game are making a lot of money. In fact, policymakers have started to look into it, but it is very sensitive and interests are huge. With time, competition will increase also in that area and it will become more difficult even for them. But for now, they make billions. As far as I am concerned, I feel like a little fish that lives under the rocks and comes at night out after the sharks have made their dinner and left something back, which was not worth for them wasting time. The search continues.

Paolo Pezzutti is the author of Trading The U.S. Markets, Harriman House, 2008

Sushi Kedia writes:

In the spirit of Daily Speculations, where observations of small fish swimming up predict coming quakes in Japan, investing ideas that can be hypothesized before testing by observing characteristics of oaks etc. etc, one keeps wondering what would qualify from market data points as the proverbial rats, birds and smaller creatures that behave distinctively before coming changes in weather, terrain, storms and big winds. Even if jokingly, when a friend reminded me few days ago that Finance is the art of moving money from hand to hand until it disappears and while I know that fractals make the same ideas appear at every scale making the big and the small equal in their eventual outcomes, one simplifies the notion of fractal finance to the simplest possible that it is the art of moving money from hand to hand across any size, until it disappears. That brings one to a more easily imaginable notion of visualizing the food chains in the markets at action looking at distinctive behaviours of the smaller creatures.

Is retail behavior a richer source of predicting large moves or is the professionals' action a better gauge? Or is it that both used together produce some finer ideas?Does the behaviour of small caps and micro caps provide some extra insights into the markets? Distinct expansion or contraction of range is one obvious thought stemming from Chair's latest post.

So many have been talking about a potential crash coming by, suddenly in the last week or so, one wonders which minnows and sparrows are they watching to get such "feelings".

Are there any distinctive behaviours in volume and open interest too that forebode a coming change in the winds? Has some master of the universe quietly assembled in some corner of this world the mythical all encompassing indicator that captures time, price, volume, open interest? The equivalent of the General Theory of Everything in the markets? How far are the scientists in the markets from the equivalent of an 11-Dimensional M Theory?

Even if this set of simple(ton) queries generates from the specs a list of ideas they have felt over their long years in the marts as precursors to large moves, it would be highly useful to compile them and explore what testable theses can come up from them, for Einstein did say and believe that an ideas should be simplified as much as possible, but not more.

Russ Sears comments:

It would appear to me, that on the anniversary of the turn-around in the markets, it would be wise to review what the Derivative Expert / leading fractal proponent and his teacher/mentor were saying last year at this time.

As I recall, his predictions were that doom was inevitable and that it was just the beginning. The future was clearly going to be worse than the Great Depression. His only hope was, he prayed, every night, and in the morning when he woke up, "he was wrong"…

His teacher was not as sure as him, but thought it was more likely than not, going to be more terrible than imaginable, also.

Yet, I do believe there is considerable turbulence and potential for chaos theory, to occur whenever people allocate resources…However, the markets are the best mechanism for catching those grossly misallocated resources and shuting down those chaotic loops of turbulence that man has devised. While the derivative expert still could be proven right in the long run. One must consider that there are some strong forces of learning from your mistakes built-into the system also. Non-the-less no matter how certain our demise may be, the rebound shows that care must still be taken thinking one way, up or down, is the only direction.

While I will disagree with the Derivative Expert, that the markets are built on a time fractal, a quick look at the human situation shows that herds, large and small, are no protection from irrational thinking. Dr. Dorn and I have been working on a paper, that I will be presenting on April 13 in Chicago at the Enterprise Risk Management Symposium that will discuss this further. It is not directly related to chaos theory or fractals. But one sentence to ponder concerning fractals to whet your appetite: "Individuals, businesses, industries and even whole economies, all, can become victims of mania and panic".
And I will have more to say on how this does more closely tie into fractals and chaos theory in other works, time and receptive audience permitting.

Jeff Rollert comments:

The last 12 months remind me more of the eye of a hurricane.


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