The Terrifying Graphic That Shows Stock-Trading Robots Taking Over the Financial World

Robots have taken over the financial market, and we're all going to die.

That's my (not totally unfair) summary of the reactions from pundits stemming from a neat animated GIF from the market-research specialist Nanex. Here's a look at what all the fuss is about:

Source: Nanex, LLC.

Be patient, the graphic cycles through from 2007 all the way until the beginning of 2012. You'll know when you're getting near the end though, because it gets crazy!

How crazy? Crazy enough to elicit reactions like these:

Reuters' Felix Salmon wrote: "It's certainly fair to say that if you take a long, five-year view, then you can see a clear rise in trading activity. But it's also fair to say that there's something quite literally out of control going on here. ... The stock market today is a war zone, where algobots fight each other over pennies, millions of times a second."

Over at Huffington Post, Mark Gongloff breathlessly noted: "Along the vertical axis is the volume of high-frequency stock trading on various exchanges, which are color-coded. As you can see, high-speed trading was almost non-existent in 2007, but has completely blown up and overwhelmed the stock market in the past few years."

Even well-known futurist Ray Kurzweil is writing about this

...the GIF charts the rise of HFT trading volumes across all U.S. stock exchanges between 2007 and 2012. The initial murmur, the brewing storm, the final detonation: Not just unsettling, it's terrifying. ... we don't know is [sic] what the long term consequences are of all this hyper-volume as depicted by the Nanex GIF and the kind of systemic risks created from the market's ongoing evolution from human traders to rapidfire AI. Sometimes things go wrong, a software glitch, an algorithm gone rogue and the music stops, like last week when Knight Capital (NYSE: KCG  ) lost $10 million a minute when it's [sic] trading platform went haywire...

But alas, it shows none of that
I sat through the animation over and over and over again, scratching my head and wondering how in the world all of that had been concluded from this one (admittedly nifty) display. It's obvious that there's some big change going on here, but it wasn't clear to me what that change was.

To figure it out, I contacted Nanex.

Nanex founder Eric Hunsader walked me through exactly what we're seeing here. What Nanex has done is compare the number of quotes versus trades that are happening each second. Since high-frequency trading (HFT) programs like to search out trading opportunities by flooding exchanges with quotes -- that is, quick pings with buy/sell prices, but not actual trades -- a high ratio of the number of quotes versus trades indicates that an HFT program is at work in a particular stock. This is even more apparent when measured on a per-second basis, since human traders simply can't operate that quickly.

So, if a ticker had a quote/trade ratio high enough -- Ding! Ding! Ding! -- there's likely an HFT there. To create the graphic, then, Nanex summed up the total number of tickers with an HFT presence each minute over the entire five-year span.

So what the GIF shows is the presence of HFTs across tickers in the market. As you watch the squiggly lines grow during the animation run, what you're seeing is the fact that in 2007, HFTs were trading very few different tickers. By 2012, they were transacting in a much more diverse group.

Take a look again.

Source: Nanex.

What this crazy-looking screen-grab from the graphic doesn't show is the overall trading volume from HFTs. Nor does it show a destabilizing effect from HFTs. Nor does it show anything about how HFTs are harming individual investors, institutional investors, or any other investors in between.

All that this shows is that over the past five years, high-frequency traders have traded in a wider variety of tickers -- between 500 and 1,000 different tickers for much of the day in the screen grab above. We could put together a very similar graphic for participation rates of pretty much any industry, trend, or product that's growing: people reading news online, iPhone users, or even the number of daily Facebook "likes."

And, notably, in the post on their site, the folks at Nanex didn't claim that this showed anything more than it actually does.

The scary conclusion that just wasn't there
Whether increased participation from HFTs is a good or bad thing is up for debate, as is whether steps need to be taken to limit the activity of HFTs. And that's a debate that needs to happen, but it needs to happen based on solid facts and a good understanding of what's really going on.

This particular graphic, however, was assigned meaning that was never actually there. To me, this suggests a high level of fear (whether warranted or not) of HFTs, a lack of understanding of what HFTs are doing, journalistic laziness, or, probably, a bit of all three.

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Fool contributor Matt Koppenheffer does not have a financial interest in any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.


Read/Post Comments (26) | Recommend This Article (53)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 10, 2012, at 2:48 PM, whyaduck1128 wrote:

    Skynet is activated.

  • Report this Comment On August 10, 2012, at 3:08 PM, mhy729 wrote:

    At least the vertical scale isn't logarithmic...yet.

    An interesting read...thanks for the article. I especially like the closing paragraphs, starting with "What this crazy-looking screen-grab from the graphic doesn't show...." Nevertheless, I'm quite certain HFTs had something to do with the "flash crash" of two years ago, and no doubt investors who had stop-loss orders for their positions got screwed that day. I will never use market orders, buy or sell...ever.

  • Report this Comment On August 10, 2012, at 3:55 PM, TMFKopp wrote:

    @mhy729

    Thanks!

    "Nevertheless, I'm quite certain HFTs had something to do with the "flash crash" of two years ago"

    Yes, they were certainly involved. Not necessarily starting the trouble, but providing some of the fireworks that freaked people out.

    "no doubt investors who had stop-loss orders for their positions got screwed that day. I will never use market orders, buy or sell...ever."

    I'm with ya.

    I've honestly never seen the logic in stop-loss orders, so I don't generally use them. But yeah, with the computer traders out there, it's probably a generally good idea to avoid them. And market orders are are generally terrible idea as well...

    Matt

  • Report this Comment On August 11, 2012, at 4:02 PM, TMFAimeeD wrote:

    Couldn't help but cue up "In the Hall of the Mountain King"

    http://www.youtube.com/watch?v=dRpzxKsSEZg

    works a little TOO well if you ask me...

  • Report this Comment On August 11, 2012, at 8:38 PM, neamakri wrote:

    One thing you did not mention is that NYSE pays stockbrokers if they have a large volume of trades. That's right, they get paid to trade more often.

    I believe there is a bill in congress to assess a tax of 0.3% on trades. I can certainly afford that small tax; and it will absolutely kill a lot of HFT. If you can, support passage for this bill.

    HFT is not based on the value of a company, it is just gaming the system like a Las Vegas casino; putting the odds in their favor. HFT is sapping money from the stock market like a vampire squid.

    And lastly we are sure that the computers can run amok at the slightest provocation. It's proven.

  • Report this Comment On August 11, 2012, at 11:44 PM, Capivara wrote:

    I watched it a few times, and between late 2007 and mid 2009, basically the length of the Bear Market, the most notable thing is that the activity of HFT would spike at the end of every trading day. What I think the big concern about HFT should be is if it can be used to push markets around, especially during times of duress. Maybe its a baseless fear, but I do remember the markets getting pushed down in waves of selling at the end of sessions throught the bear market. Was there a connection or were the HFT bots just responding to volume spikes?

  • Report this Comment On August 12, 2012, at 10:43 PM, irvingfisher wrote:

    It sure is pertty though, innit?

  • Report this Comment On August 13, 2012, at 9:49 AM, TMFBent wrote:

    If the color scheme had been different, people would have reacted differently. In other words, if there were more HTF tickers on exchanges coded colors like blue and green, rather than reddish orange, the fuss would have been much less. You make a chart that looks like flames, and people will react to it pretty much as if it's a fire.

  • Report this Comment On August 13, 2012, at 10:40 AM, suntzu777 wrote:

    Almost all things are a double edge sword. I like my cheap trading prices from etrade. I get them because a computer does it instead of a human. The other side of that sword is that computers trade for free or put up prices for free so any bussiness would naturaly use them. I used to use an 8 percent stop loss back before 2004. Now I just check manually a couple times a day. This prevents a computer from stoping me out.

  • Report this Comment On August 13, 2012, at 11:11 AM, rkwilli96 wrote:

    I strongly believe that these trades have only one purpose, to steal money. They contribute nothing and take money out of trades that, generally speaking are retirement accounts that have been invested in Mutual Funds.

  • Report this Comment On August 13, 2012, at 11:15 AM, rkwilli96 wrote:

    High frequncey trading should not be confused with the exchanges useing computers to trade. they have been authourized under the guise of keeping markets fluid, and the big players where given a .3 sec advantage over the rest of the markets so they could wee an order, swoop ing and grab shares and then resell them to an already existing order. this adds what?

  • Report this Comment On August 13, 2012, at 11:28 AM, mdk0611 wrote:

    mhv729 - As opposed to a stop-loss order, a stop-limit order would have minimized the damage.

    neamakri - You're fine with a $30. tax on a $10,000. trade? Good lord.

  • Report this Comment On August 13, 2012, at 1:03 PM, TMFKopp wrote:

    @TMFBent

    "If the color scheme had been different, people would have reacted differently."

    Wow, great point, I didn't even think of that.

    Matt

  • Report this Comment On August 13, 2012, at 1:55 PM, Darwood11 wrote:

    Great post.

    As for the accompaniment, my vote goes to "The Sorcerer's Apprentice" by Dukas.

  • Report this Comment On August 16, 2012, at 5:47 PM, samfoolcisco wrote:

    We have a tax rate for stocks held for more than one year and a higher one for stocks held less than one year... Why not have one more level: an even higher tax for stocks held for less than 24 hours? If the model for HFR trading business is still a good one given the lower margin, it will continue. If not, it will stop. For sure the IRS can use the extra revenue.

  • Report this Comment On August 17, 2012, at 9:54 AM, gurbanz wrote:

    Wired has a mind-bending article about this too.

    http://www.wired.com/business/2012/08/ff_wallstreet_trading/

  • Report this Comment On August 17, 2012, at 11:43 AM, schmittm wrote:

    A 1% tax on all HFT transactions would probably bring this to an end. If not it would solve the national debt problem.

  • Report this Comment On August 17, 2012, at 12:28 PM, erkaye wrote:

    Nice graphic, but the naiveté of the author is almost as breathtaking. While it is true that if we limit our analysis simply to the volume of trades, there is virtually no information from which to draw any kind of conclusion. The article inexplicably fails to include the purpose of the HFTs, which is price discovery, a euphemism for front running. Generally speaking this is considered illegal activity, and why this form of front running remains legal is is beyond me. I fully agree that the idea of adding a tiny trading tax, essentially unnoticed by investors, is an excellent idea. I would take it one step further and make the tax only .01% but apply to any bid or ask trade entered, but not to completed trades.

  • Report this Comment On August 17, 2012, at 1:28 PM, TMFKopp wrote:

    @erkaye

    You may want to double-check the definition of "price discovery" (http://www.investopedia.com/terms/p/pricediscovery.asp).

    Also, to conclude that HFTs only purpose is front-running is, well, we'll leave it at "very wrong."

    Matt

  • Report this Comment On August 17, 2012, at 2:39 PM, IlanBigfoot wrote:

    A $30 tax on a $10,000 trade is fine. Just make sure it only goes into effect if one holds the stock less than a day. Or an hour. Or a second even. And fund the SEC WITH IT!

  • Report this Comment On August 17, 2012, at 4:00 PM, DevilMO wrote:

    Stories are circulating that these robots are what the auto gasoline industry are using to manipulate the gas costs. For example, the refinery fires were read by the bots as a problem however within hours, the refining capacity was picked by other refineries. The problem focused upon by the bots caused the prices to spike within hours.

  • Report this Comment On August 17, 2012, at 6:05 PM, magoo52 wrote:

    I don't understand HFT and why I should care. At high speeds these programs can only be trading with other programs. Looks like zero-sum to me. Who makes money and who loses? If I only use limit orders, why should I care?

    Also, it should be a log plot to properly compare percentage increases. Using linear y axis makes it look more extreme than it really is.

  • Report this Comment On August 17, 2012, at 8:58 PM, gowanz wrote:

    The Investing world has a choice. Control the robots or be controlled by them. To be or not to be. That is the question.

  • Report this Comment On August 17, 2012, at 9:31 PM, ManagingIt wrote:

    When I think about this I draw an analogy to the old computer fraud technique of funneling all the partial cents from interest rate transactions to a single account. I myself feel that this activity is automated theft/syphoning of money from the market perpetrated against the anonymous masses. It has made the market much more volatile. Harm can not be assesed/defined because it involves so many and such a small slice from each person in the entire market.

    Personally I would like to see this activity stopped but failing that I agree with putting a tax on it that would not hurt a human trader but would assess a significant tax on this activity.

    Finally, the markets were created for another purpose and this activity does not fall into any of those purposes

  • Report this Comment On August 17, 2012, at 10:06 PM, mahelan wrote:

    Thank you, a very interesting subject and very nice presentation of the phenomenon. - The graph reminds me of a noisy "amplifier". A stable system measures the output and feeds the measurement back to the input with a negative phase thus maintaining a stable output. However (Nyquist stability criterion), the delay of the feedback, the speed of the systems response and the feedback amplitude matter. A stable negative, frequency limited, feedback might start oscillating and become unstable if it would be made faster (for example high frequency trading). -So, from a control theory point of view, the author is correct: The trading speed shall be limited, or the entire trading system to be redesigned. In any case, algos developers should learn some of the modern control theory (regularly used in almost every engineering field, robotics included).

  • Report this Comment On August 21, 2012, at 7:07 AM, dbtheonly wrote:

    Ilan,

    I'd rather a one cent surcharge per share traded.

    I like your idea of using the funds for the SEC as well.

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