Automated and high-speed trading: invented by a Hungarian on Wall Street

June 25, 2013

Here is a fascinating NPR interview with Thomas Peterffy, the Hungarian who invented not one but two things crucial to financial markets today: one of the first computer programs to price options, and high-speed trading.

 

Today one of the richest in America, Thomas Peterffy recounts his youth in Communist Hungary where as a schoolboy he sold his classmates a sought-after Western good: chewing gum. Let’s disregard for a moment Peterffy’s recent political activities and rewind almost half a century.

 

Peterffy was a trader on Wall Street who came up with an option pricing program in the 1970s. The Hungarian-born computer programmer tells the story of how he figured out the non-random movement of options prices, programmed it, but could not possibly bring his computer on the trading floor at the time, so he printed tables from his computer with different option prices and brought the papers in a big binder into the trading pit. But the manager of the exchange did not allow the binder, either, so Peterffy ended up folding the papers and they were sticking out of his pockets in all directions. Similar practices were taking place at around this time in Chicago, as MacKenzie and Millo (2003) have documented. Trading by math was not popular, and his peers duly made fun of him: an immigrant guy with a “weird accent”, as Peterffy says. Sure enough, we know from Peter Levin, Melissa Fisher and many other sociologists’ and anthropologists’ research that trading face-to-face was  full of white machismo. But Peterffy’s persistence meant the start of automated trading and according to many, the development of NASDAQ as we know it.

 

The second unusual thing Peterffy did in the 1980s (!) was connect his computer directly to the stock exchange cables, directly receiving prices and executing algorithms at high speed. Peterffy describes in the NPR interview how he cut the wires coming from the exchange and plugged them straight into his computer, which then could execute the algorithms without input from a human. And so high-speed trading was born.

 

My intention here is not to glorify my fellow countryman, by any means, but to add two sociological notes:

 

1. On options pricing automation: although the story is similar, if not identical, to what is described by Donald MacKenzie and Yuval Millo (2003) in their paper on the creation of the Chicago Board Options Exchange, there seems to be a difference. The economists are missing from the picture. The Chicago economists who were involved in distributing the Black-Scholes formula to traders were a crucial part of the process by which trading on the CBOE became closer to the predictions of the theoretical option-pricing model. But in the case of Peterffy and the New York Stock Exchange, the engineering innovation did not seem to be built around the theoretical model. I am not sure he used Black-Scholes, even if he came up with his predictive models at the same time.

 

What does this seemingly pragmatic, inductive development of algorithm mean for the rise of automated trading? Moreover, how does this story relate to what happened in Chicago at the CBOE around this time, where economics turned out to be performative, where the Black-Scholes formula was what changed the market’s performance (MacKenzie and Millo)?

 

2. On high-frequency trading: picking up on conversations we had at the Open University (CRESC) – Leicester workshop last week, Peterffy was among the first who recognized something important about the stock exchanges. Physical information flow, ie the actual cable, is a useful way to think about presence “in” the market. While everyone was trading face-to-face, and learning about prices via the centralized and distributed stock ticker (another invention in and of itself), Peterffy’s re-cabling, if controversial, put his algorithms at an advantage to learn about prices and issue trades. This also became a fight about the small print in the contractual relationship between the Exchange and the trading party, but Peterffy’s inventions prevailed.

 

So much for a trailer to this automation thriller. We can read the full story of Peterffy in Automate This: How Algorithms Came to Rule Our World, a book by Christopher Steiner (2012), who argues that Peterffy’s 1960s programming introduced “The Algorithm That Changed Wall Street”. Now obviously, innovations like this are not one man’s single-handed achievement. But a part of the innovation story has been overlooked, and it has to do with familiarity and “fitting in”. Hence my favorite part of the interview, where Peterffy talks about the big binder he was shuffling into the trading pit (recounted with an unmistakable Hungarian accent):

 

“They asked ‘What is this?’ I said, these are my numbers which will help me trade, hopefully. They looked at me strange, they didn’t understand my accent. I did not feel very welcome.”

 

The fact that what became a crucial innovation on Wall Street came partly from an immigrant with a heavy accent, is a case in point for those chronicling the gender, racial and ethnic exclusions and inclusions that have taken place on Wall Street (for example, Melissa Fisher, Karen Ho, Michael Lewis).

6 Responses to “Automated and high-speed trading: invented by a Hungarian on Wall Street”

  1. Yuval Says:

    Zsuzsi, I also listened to the Planet Money episode and was amazed, to be honest, that it was the first time that I heard Peterffy’s story! I know about Timber Hill (he was the founder), but never heard about his option pricing model.
    So, your query about ‘where were the economists in the picture (if at all)?’ is spot on. Maybe he did develop his formula on the basis of practices (either physical or algorithmic) and not on the basis of formalised knowledge (such as the no-arbitrage principle), I could not find out. I searched just now and could not find what exactly he used (there are some patents, but no description of the model/formula).
    There are interesting theoretical implications to each of the empirical outcomes. If Peterffy did developed his pricing model on the basis of practices, then it will be a nice example of moving from Techne to Episteme and would challenge the argument that Nassim Taleb has been promoting for a while now, the options trading was dominated by practices and that formal models were either just replicating what traders were already doing or maybe didn’t even exist…
    In addition, as you say, Peterffy clashed several times with the material nature of information (and, indeed, with the political-material nature of information) , when his use of printed model-generated prices was blocked and again when the re-cabling of the Qutron trading terminal was forbidden. There are a few in the SSF community who discuss the materiality of prices and it sounds like Peterffy’s story definitely calls for another research.
    Yuval

  2. Pierre de Larminat Says:

    Thank you Zsuszanna for this great piece of information! Indeed, this story has lots of theoretical implications.

    If I understood correctly what Peterffy says in the interview, neither did he base his own trading practice on preexisting trading practices or rules of thumbs nor on economic theories (or any general theory that explains price formation). Rather, he followed an empiricist probabilistic strategy: he took past events (return distribution of underlying assets, or whether options could finally be exercised for a profit or not) as the actual realization of random variables. Using such samples, he merely estimated probability distributions that he assumed to be persistent enough to be used for future investments whose payoffs are based on the occurrence of these events.

    Peterffy followed a kind of agnostic strategy that did not necessitate to pledge allegiance to any set of formalised knowledge other than the idea that an uncertain phenomenon can be tamed through a probabilistic approach. The strategy focused on an uncertain phenomenon: the probability of an option-trade. And it did not assume that the uncertainty of the phenomenon had a certain form, but it merely tried to estimate that form, based on the statistical analysis of past trades. What seems to have made the strategy so powerful was that using computers significantly boosted Peterffy’s calculation power (The kind of power about which Muniesa and Callon write in their 2005 paper about markets as calculative devices) while other traders relied on strategies that stood farther away from the actual uncertainty of the phenomenon, as estimated on the basis of past trades.

    Opposite to the BSM-model, Peterffy did not seek to (also) make sense of the reality, merely to profit from it.

    Pierre.

  3. zsuzsannavargha Says:

    Yuval,

    Good point on the challenge to Taleb.

    Then, if it’s really true that economists were not involved in this parallel development of options pricing, how does that change, if at all, the argument you’ve made about the performativity of financial economics in the Chicago options exchange?

    Roughly the same practices seem to have emerged in the NY trading venue but without the formal theory! How do we account for this? There was no statement as with Black-Scholes that “this is how prices work,” and the use of the model’s results by traders, on folded sheets, led to eventually (but not initially) confirming the model. This is what you showed.

    So, it could be a good idea to check how prices, volatility, etc changed in New York after Peterffy started computerized trading in the 70s. Is there a similar pattern as in Chicago? If yes, what does that mean?

    It would also be worth delving into the materiality of prices as demonstrated by Peterffy’s inventions and counterinventions:

    In 1981 Peterffy’s company chronicles that “Efforts are made to code and test a system that identifies potential delta neutral trade pairs. Our greatest challenge: how to electronically read the prices of options as they are posted.” (http://www.interactivebrokers.com/en/?f=564)

    Here it is explicit that trading models and the material of the price were intertwined problems.

  4. zsuzsannavargha Says:

    Pierre,

    You are probably right about the “agnostic” strategy, that is, he was not basing the programs on trading practices or rules of thumb, but it is still a question whether he used formal economic models. We do not know. I got the same sense from what I’ve read and heard from him so far, as he never mentions theory and it seems it was a process of pattern discovery based on past transactions. But maybe I’m wrong.

    Your way of formulating his pragmatic approach (he did not want to make sense of the reality but merely profit from it) is useful to understand how this line of innovation relates to the performativity story. The difference between wanting to describe the “laws of the markets,” on the one hand, and an inductive empirical method of finding regularities.

    One question then is about what statistical methods were used, if any, and another question is, were there others at the same time who were trying to estimate the trades but without using computers, so that Peterffy had a calculative edge?

    Perhaps we can find out more from the man himself…


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