Monday, November 22, 2010

The Jump & Dump!

I've been reading up a lot around liquidity and ran into the story of how two postgrads, Rahul Savani (Computer Science) and Ben Veal (Applied Math.), won the Penn-Lehman Automated Trading Competition in 2005. That's University of Pennsylvania and yeah, Lehman Bros (back in the good old days of selling mortgage backed assets).

Savani and Veal's algorithm, Jump and Dump, dominated the other algorithms completely in the competition, by realizing that all of the competing algorithms focused only on market data and not any "reality checks" on price sensibility. Commented by a Wall St. friend of theirs, "... Often a strategy is successful because it anticipates how the other market participants are likely behave/react and then exploits them. "

Here's how they did it, it was brilliant and deceptively simple!


The strategy of Savani and Veal is simple to describe and even elegant in its own twisted way. The basic idea is to "clear out" one side of the market --- for instance, to simply buy all shares in the sell book. This has the effect of leaving a buy book, and thus a bid, but no sell book, and thus no ask.

The next step is to immediately place a buy and sell order at a very large price --- larger than the highest price paid to clear out the sell book. Since there is no ask, and the bid is far below this large price, this pair of orders becomes the new bid and ask, effectively leaving the current buy book far below the bid/ask.

The third step is to then self-execute a small number of shares with the new bid or ask, thus causing the last execution price to also be near the new large bid/ask.

The effect of these three steps is to (a) leave the strategy with a large long position (from the initial purchase of the sell book), and (b) move the bid, ask, and last price to a price far above the prices paid to acquire the large long position.

You can see where this is heading. Any strategy that only places orders with limit prices relative to the current bid, ask, or last execution price will blindly follow the artificial inflation in the market created by these steps, and begin trading near the new price. As long as there is enough such liquidity at the new inflated prices --- and in the recent competition, there was plenty --- the Savani and Veal strategy can then quietly start dumping its long position for far more than it paid for it. Genius incarnate.


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