From the May 01, 2010 issue of Futures Magazine • Subscribe!

High frequency trading lowdown

High frequency trading (HFT), which is like day-trading on near fatal doses of amphetamines, sometimes seems like an investment fringe activity. In reality, it is central to how we trade now. Estimates vary, but Andy Nybo of Tabb Group estimates that HFT strategies account for 61% of trading activity in U.S. equity markets (see “In the majority”). CME Group reported on their fourth quarter earnings conference call that 43% of the trading volume on CBOT came from proprietary trading firms, primarily algorithmic, which probably means high frequency trading. Over recent years, almost every measure of HFT on just about every exchange shows it going up — fast. Perhaps more disturbing to some is that a very small group of participants are making up more than half the volume (see “Crowding everyone else out”).

Individual trades vary in duration. High frequency trades are those on the very short end of this spectrum. There is no rule as to when, exactly, a trade lasts so long that it can’t be counted as high frequency. Presumably, if you have to ask, you are not quick-witted enough to understand the answer. As a rule of thumb, however, it seems any trading plan where trades last longer than a second is something else — day-trading, perhaps.

One reason why it is difficult to give an upper boundary to high frequency trades is that high frequency traders do not think about how long their trades last. They think, rather, in terms of market structure and market economics. Market economics change as trade duration lengthens. Here we will analyze high frequency trades in terms of the ways they exploit market structures of various types. Roughly speaking, we will also be starting at the shorter end of the spectrum and working our way up.

Flash trading
Perhaps the least defendable form of HFT is something called flash trading, at least pertaining to equities. Under SEC-regulation NMS rules, exchanges must route buy orders to other exchanges when that exchange is offering a better price. In which case, the exchange loses the transaction fee, which it does not want to do. Flash orders are, in part, an attempt to end run this rule. If an exchange allows flash orders, it displays the order for 500 milliseconds before routing it elsewhere, which means that for a twentieth of a second, certain traders have a monopoly on trading information.

That monopoly is pure gold. Assume your research tells you that Hatfield and McCoy Conflict Resolution Consultants, which is currently trading at $50 a share, is a buy at any price up to $50.20. You put in a buy order for 50,000 shares of Hatfield and McCoy with a $50.20 limit. Quick Joey Small’s software reads your order and puts in an IOC (immediate or cancel) order to sell you 100 shares at $50.01 and your software eats it. “Hmmm,” says one of Quick Joey’s subroutines to another, and puts in an order to sell you another 100 shares of Hatfield and McCoy at $50.02 and, again, you get your shares. Quick Joey sells you shares in one hundred lots all the way up to $50.20. When your software balks at $50.21 a share, Quick Joey sells you every share you will buy at $50.20 a share under the assumption that as soon as they take care of you, the price of Hatfield and McCoy will drop to $50 a share. Many traders have noticed that prices seem to shoot through their stops much more frequently now than they used to. This is why.

Incidentally, in the old days, IOC orders used to be called FOK orders, which stood for fill or kill. Reverting back to older and, in many ways more honest, terminology, you just got FOKed.

However, in the options world, eliminating flash orders would create added cost to customers if their orders are redirected to another exchange and that exchange has a maker taker pricing structure. If a customer has 200 lots to sell at the NBBO (National best bid/offer) and gets 100 done at one exchange exhausting the bid, the remainder would be flashed to market makers before they are sent to another exchange. If that option is taken away and the order is sent to another exchange that charges a taker fee and is filled at the NBBO, the customer is not better off.

It is important to understand that Quick Joey Small took your money not because he is smarter or even because he is faster than you are. He took your money because Joey and his cohorts have a monopoly; they have non-public information specifically about customer orders. If your order had been broadcast widely, you would have gotten better fills.

Among other things, the history of the markets is the history of insiders, floor traders, for example, taking advantage of outsiders, which would be you. At one time, for example, market prices would scrawl across your television screen with a 15-minute delay. There was no technical reason for this, but the delay gave insiders a 15-minute advantage and that was reason enough. These days the delay is a fraction of a second, but that is enough to make some people very rich (see “Low latency = high profits”). And more to the point, it is a way to take money out of your pocket.

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