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Guest Post: Deconstructing Algos, Part 1

Sat, Jun 25, 2011

Economy and News

From zero hedge – on a long enough timeline, the survival rate for everyone drops to zero

Submitted by The World Complex

Deconstructing algos, part 1

The third part of the series on information theoretic
methods of analysis for dynamic systems is taking longer than
anticipated. Crunching the numbers is killing me. So I’ll take a break
from it and look a little farther forward–how we can use the methods I
have been describing so far to forensically examine the algorithms used
in various high-frequency trading events of the recent past.

As seen on Nanex and Zero Hedge, there has recently been a lot of strange, algorithmically driven behaviour in the pricing of natural gas and individual stock prices on very short time frames. In an earlier article I pointed out that the apparent simple chaos we observe in the natural gas price appeared to be an emergent property of at least two duelling algorithms.

In this series of articles we will begin analysis of the algorithms
involved. Today’s discussion will mostly focus on framing the issues
that must be addressed in order to study unknown algorithms on the basis
of their time-varying outputs. Future articles will present results
from the various analyses.

We begin by looking at the activity in the natural gas price on June 8, 2011:

Let us also consider the pricing action in CNTY on June 21, 2011:

 

In
both of these examples (many more such examples exist) there are three
time series of interest to us–the bid price, the ask price, and the
prices of trades. Additional information which may also be of use are
such things as volume, size of bids, size of asks, and so on. In
principal both the bid and ask prices form continuous series which are
prone to instantaneous changes. The actual trades form a discontinuous
time series with obsrevations at irregular intervals.We
don’t have access to the code involved in these
algorithms–nevertheless, we can learn something about the computational
processes involved, within certain limitations. Unfortunately, just as
is the case in studying time series recorded in rocks, we have to make
some assumptions, and the validity of our assumptions goes a long way
towards predicting the success of our endeavours.

Our first assumption is that the bid price and the ask price are
being set by competing interests. This assumption is extremely
important. It is possible that the bid and the ask are both being set by
a single entity, or by two closely related entities who are using them
to manipulate the natural gas price. We will go though in some detail
the reasoning behind our assumption that there are competing interests
involved below.

Secondly, we are approaching this problem assuming that prices are set
and changed discontinuously in time rather than continuously in time.
Subtleties of this assumption are discussed in the introduction of Bosi and Ragot (2010).

The methodologies we will explore are as follows:

Cross-correlation of the bid and ask series over selected windows. We
choose limited time intervals rather than the entire record because we
expect that each series will sometimes lead and sometimes follow. Peaks
here will show whether one of the series leads or trails the other
consistently or whether each one leads intermittently, which would
support the idea that these are distinct dueling algorithms. It seems
likely that the bid price will lead as both are declining, and the ask
will lead as both are climbing. We should test this hypothesis.

One goal of this analysis will be to see if we can detect trigger
points, where one stops following and begins leading. We will locate the
times and see if the trigger can be identified, which is only likely if
the trigger is some change in either price series, the price of a
trade, the volume of a trade. Unfortunately, many other triggers are
possible, and it may not be possible to identify them if they are, for
instance, a random number generator seeded by, say, the
thousandths-of-a-second digit at the instant of some distant event like
the first pitch of a Yankee’s game or when the secretary in the front
office misspells ‘the’.

Phase space reconstruction–the relevant time series (bid prices, ask
prices, trade prices) each represent one-dimensional data sets. If the
algorithms used can be visualized in higher-dimensional phase space, we
may be able to reconstruct the overall architecture.

The advantage of this approach is that in principle the dynamics of the
system will be contained no matter which output of the model we use. We
only have measurements of the bid price, but have no idea what other
outputs are generated by the same algorithm, even if these unknown
outputs are critical to the decision-making module of the algo. The
reconstructed phase space

The difficulties here are that 1) the function may change from leader to
follower so quickly that the resulting trajectory through phase space
is too short to interpret; 2) there may be multiple players on both the
bid and ask, meaning the reconstructed trajectory through phase space is
an amalgamation of two or more different functions, the instant of
joining of which may be impossible to determine; and 3) it may prove
impossible to properly define windows for the data, again creating an
amalgamation in phases space of two or more different functions.

Epsilon machine reconstruction–We will need to try to identify the
actual “work” done by these programs. How do they decide on a price? How
do they “decide” to drop or raise their offer? Do they change? How are
we to recognize when an algorithm changes its behaviour when all we have
to deal with is the output? Can we recognize when the structure of the
computation involved in the decision-making part of the algorithm
changes, given our extremely limited knowledge of that structure?

These questions may be addressed using the ε-machine reconstruction approach suggested by Crutchfield (1994).
The objective of this approach is to use an open-ended modeling scheme
to describe the computational structure objectively, so that different
practitioners working on the same data will come up with similar
(hopefully identical) constructs. By encouraging an heirarchical
architecture of undefined complexity, the method allows investigators to
identify changes in behaviour of the the system.

This particular approach is built around discrete computation, so is
amenable to data which are discrete rather than continuous in time. We
assume that the discrete outputs (the time series, or stream of values)
is the result of a computational process which is knowable. The data
have to be organized, and (this is the key) repeated states are identified. It is possible that these states will be identified from the reconstructed phase space portraits above;
alternatively they may be be defined by particular observations. These
states may be identified as key strings of data, or may be recognized in
complex functions by reconstructing the state space in a higher
dimension. The ordering of the states is significant, as the state that
appears first before another particular state is referred to as the predictive state, and the following state is the successor state.

The ε-machine is constructed by
identifying all the predictive and successor states and  calculating the
probabilities of all of their observed relationships. If more than one ε-machine is inferred, the sequence of these first-order ε-machines can be used to build a higher-order ε-machine. Given sufficient data, you may construct ε-machines of arbitrary order.

Information theory–as seen in recent articles, information theory may be used to characterize the complexity of the ε-machine reconstruction and the probability density.
The yet-to-be completed third part of that series concerns methods of
using information theory to find the optimum window length for creating a
probability density plot of the reconstructed phase space. The
subsequent parts of this series will concern itself with the analyses
described above on the nat gas and CNTY algos, as well as others as they
are found.

Given the limitations of time and computing resources, I can’t guarantee
a timeline. I regret that my speed of analysis is six or seven orders
of magnitude slower than the incidents in real time.

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