How Headline-Reading Robots Are Changing the Marketplace

So, five years later, we find out the Flash Crash was "caused" by one English guy "spoofing" in his basement. Really? Want more evidence there's little use for us humans without high-speed servers in the marketplace? Here's a fascinating piece in Slate on The Next Big Thing in algos -- news-reading bots that can trade options in a nanosecond (ht@aaljechin):

"On the afternoon of Friday, March 27, as several news outlets reported at the time, somebody apparently made $2.4 million from a tweet. That tweet was a bit of breaking news from Wall Street Journal writer Dana Mattioli ...

"Quicker than any human seemingly could have done it, someone—or rather something—bought $110,530 worth of cheap options on Altera, a company that makes digital circuits. Over the next several minutes and until the end of the day, as humans digested Mattioli's takeover rumor at human speed, Altera's stock price rose. When all was said and done, those cheap options had resulted in a $2.4 million profit. Speculation immediately centered on the idea that an automated program (a "bot") had scanned the tweet, interpreted its meaning, and instantly bought those options based on an algorithm. The robot had read the tweet and made a killing on it before anyone knew what was going on."

This apparently happened other times, and via the same broker. We've known about news-reader bots for some time now. These algos digest headlines from news organizations -- and presumably tweets -- and somehow analyze them and turn it into a stock transaction idea.

We've also know about algos that gauge sentiment via Twitter and Stocktwits, and devise a strategy to benefit from it. But, this is perhaps a scary step further. As the post later notes, options specialists and market makers (if they still exist) are essentially the "house." They have to take the opposite side of order flow. They all have machines now that can adjust their markets quickly to spikes in order flow, but they can't adjust quickly enough to defend against this. The best hope is to not get picked off on too much quantity; there's zero chance to react to the news itself fast enough, especially if this kind of trade is going to the options pit first, instead of scooping up stock itself.

It's important to note that front-running news in the options pits has existed as long as options pits themselves. I was a market maker on the AMEX back in the dark ages, and our markets got picked off countless times. Way back then, we humans got clipped by other humans. But you had time to play some defense. We knew the players we had to watch out for so we made either small-quantity or wide-price markets. And, if it started feeding on itself, we could move the whole options board. In return for getting hammered with this at times, we had markets that look a mile wide by today's standards, so we could make some back via the spread.

There's also a crucial difference other than the sheer speed of the algos. Their actions seem perfectly legal. Back in the dark ages of my floor trading days, many of these pick-offs front-ran non-public news. That's not allowed, of course. Many resulted in class actions -- I was still getting "pennies" back on long forgotten losses years after I left the AMEX.

These bots, however, don't seem to violate any laws so long as we allow the high-frequency trading orders to begin with. These are public tweets, available to everyone at the same time. What's more, they take on error risk. The post describes a hyper-reaction to news in United Air that was six years old at the time.

I suppose the downside is that it will dry up liquidity in the options space. Who wants to leave any size out there ready to get picked off in a nanosecond? The problem is I've heard about this liquidity risk forever. And volume sets records every year. Maybe it's machine vs. machine, but someone's in there making markets, and someone probably always will.

I do have to say it's pretty impressive to write this algo to begin with. It has to read and interpret news and then decide on a course of action, all in a fraction of the time it took me to write that sentence.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.