Thursday, May 24, 2007

Cycles of Market Technology: A Quick Brief History

Jaime shows us historical examples of how trading technology and innovation allow individual traders to exploit market inefficiencies and leverage themselves onto the same playing field as the institutions. Below he describes the trends in the kinds of artillery used by market participants and highlights the constant battle between innovators who create advantages in trading and the larger market forces who either adopt such technology or try to eliminate it.
Anyone who’s been paying attention for the past 5 years and witnessed the mutation of the NYSE into the second half of the NASDAQ can pretty much sum it up in one word: Assimilation. When I first started trading in Sept ’96 I didn’t even use charts.


Because trading the order flow you actually saw on the screen back then was effective. What you saw on the level II and Instinet (let’s not forget selectnet) was actually real. In it’s current manifestation, I would venture to say that the data (orderflow) on the Level II, NYSE Open Book, and all the other ECNs books combined probably only represents about 20-30% of what’s really there.

[Ed. Note: He's got a point. Firms like Jones Trading and Cantor do an increasing business by matching huge block trades over crossing networks that never hit the market tape. Here's an article that appeared today in Traders' Magazine]

Call me crazy. I’ve only been staring at this data for the past 15 years.

Level II displays resemble vicious little meat grinders today in comparison to the conveyor belts of cash that they were a decade ago. You may ask, “Who is running those little meat grinders?” Well, that would be all of the Gang of "THEM"; [Ed. Note: I think what Jamie is saying, is that the Gang of "THEM" is all the specialists and ECN’s and market participants that are on the Level 2 display.]

Just as we will witness the extinction of the NYSE specialist, as algorithms creep deeper and deeper into our trading networks, so too will traders at electronic firms fall by the way side.

Since Harvey Houtkin started exploiting the SOES network back in the early 90’s, plans were set in motion by the Gang of "THEM" to weed out everyone, for good. As one friend and trader has pointed out to me on more than one occasion, HYBRID ("Have your bags ready in December").

Lucky for you and me that innovation has never been spawned by the Gang of "THEM". That means for traders who use technology that leverages their experience and strategy can often do well and create a sustainable advantage before the market changes once again. This cycle follows the theory of innovation diffusion:

Innovative and early adopting traders embrace technology and use it to their advantage against existing market structures --> early majority traders get wind of the technology, begin applying its advantages on a greater scale, and get the attention of market operators --> late majority and laggard traders get the least amount of benefit of such technology before the rules change and render the original advantages as marginal or useless

It’s the Gang's job to eat it once it matures, and then, in turn, use it to there advantage, or in most cases, shelve it. It’s the natural cycle of things in this industry. The period from 1996 - 2000 was a day trader's wet dream.

In 2001 when NASDAQ replaced the SOES network with the Super Montage system that game was over. As a result, many traders migrated over to the NYSE.

Still technologically slow, the listed market was viewed as fresh meat by the most experienced NASDAQ traders and the feeding frenzy began. Once again, exploiting inefficiencies in a markets order entry system was a fun and profitable game. Slowly but surely, one rule change at a time, they have once again successfully locked out most competition.



Ray Pellecchia said...

Interesting post, though I respectfully disagree about specialists; I believe they add value and will adapt to the new, more automated environment. But this chapter is still unfolding. If you and your readers want to keep up with the latest on the NYSE Hybrid Market, I run a blog for NYSE at

Thanks and keep up the thoughtful commentary.

Anonymous said...

Thanks for your comment.

I’m sure we could both give compelling arguments as to whether or not the specialist will be around in a couple of years. The topic of focus should actually stick to what value the specialist adds these days if any.

When Grasso ran the NYSE he did quite an outstanding job convincing publicly traded companies to leave NASDAQ in hopes of less volatile lives over at the NYSE. For a number of years the NYSE was less volatile and myself along with many other day traders were happy trading on the exchange. It’s no secret that the NYSE was slow to adapt to electronic trading; and the specialist was a big part of that.

Let’s face it; No one wants to loose their job, not to mention the iconic status of the exchange itself.

The NYSE isn’t less volatile anymore. One Hundred share prints are prevalent. The Specialist looks and acts like another ECN and so does the nyse open book.

When you look at the NASDAQ and I see how it performed on 2-27 in comparison to the NYSE you have to ask, “What’s different?”

One has a specialist, one doesn’t. Remove the specialist and you have NASDAQ.