The Fear Index or Profits at the Speed of Light

As a topic for the IT column of a small seaside village newsletter, The Fear Index and The Speed of Light may appear to be a bit of a stretch.

Robert Harris’ “The Fear Index” is a thriller about a physicist creating a computer algorithm that gauges the level of fear in the financial markets to accurately predict share price movements. The main protagonist uses this algorithm in his computerised trading system with spectacular results.

The book is based on some very real financial machinations, namely the Volatility Index (VIX), which financial insiders often refer to as “The Fear Index”. The VIX is an indicator of the level of panic in the market. It is used, as well as many other indicators and trends, to manage inherent risk in the market.

A stock broker’s primary objective is to make money for his clients (and himself). Risk management is to a stock broker what a parachute is to a fighter pilot. Ever since tulip bulb shares were first traded in Holland, as early as 1593 and spectacularly crashed in 1630, brokers have worked hard to minimise risk. They devised strategies and financial devices to achieve this aim. It seems to work for the most part, but ever so often, it just doesn’t! The 1930’s stock market crash is one example, the Global Financial Crisis of 2008, which was precipitated by the American sub-prime market collapse, another. Sub-prime derivatives were one of those financial vehicles used to reduce, or spread, risk.

By late 2008 it had become painfully obvious that the financial wizards of Wall Street, the “Masters of the Universe”, had been lulled into an unrealistic sense of invincibility. Unprecedented profits had supercharged their egos. Their resulting hubris and a financial system, made incredibly complex by the very devices meant to reduce risk, preceded their spectacular fall from grace.

Not for long, mind you; it turns out that the guilty participants in this giant shemozzle are apparently “too big to fail”. Predictably, those most severely hurt by the crash, mum & dad investors, pensioners and home owners, are “too small to do a damn thing about it”!

Stock Exchanges, brokers and investors have always been at the forefront of harnessing computing power to drive their businesses. Even small investors can now make use of software that will place buy and sell orders automatically at preset levels. Larger investors, like hedge funds and investment banks, have been using these systems for years. It has been suggested that the sudden drop in stock prices during the GFC was significantly accelerated by automated trading systems issuing massive sell orders when their preset levels had been reached.

Now, one would think that our disgraced Masters of the Universe would take the opportunity to rethink and change the system. Apparently, that would mean throwing out the baby with the bathwater; or should that read: throwing out huge profits with the broken system? But it gets worse: Almost without notice, automated trading systems have evolved into something that appears to be utterly crazy to a simpleton like me.

I am talking about a particular from of “Algorithm” or “Robo Trading”, known as “High Frequency Trading”. HFT is a form of computerised trading entirely executed by computers. Buy & sell order are placed so fast and so often, that no human trader could come close to match it. So fast in fact, that the physical distance of the computers placing the orders to the computers receiving them, has an impact on the profits taken. Indeed, Stock Exchanges offer major HFT companies office space in their buildings to reduce the length of the data cables connecting them. Buy orders for a particular stock are often followed by sell orders within a fraction of a second. Some analysts estimate that this type of trading accounts for up to 70% of overall volume traded on major stock exchanges!

If you have been wondering about the Speed of Light reference in the title, here’s your answer: Tenuous the reference may be, but buy & sell orders are travelling mainly via fibre optics cable at the speed of light! So is this what it has come to: 70% of global stock market profits determined by the cosmic speed limit?   

Proponents of this type of trading point out that liquidity in the market becomes more efficient, thus benefitting financial markets as a whole. Personally, this argument has me baffled as much as the mantra repeated by economists the world over: The need for economic growth!

Growth, come hell or high water; growth, without which we will surely perish; growth on a planet of, clearly and undeniably, limited resources!

Only one thing is certain: Computers will continue to play a major part in determining humanities future. If you believe in God, pray that he may help us all. If you don’t, I suggest you place your head between your legs and…