The Truth about High Frequency Trading

by JT McGee

Learn how high frequency trading works so you can stop arguing like an idiot.

I’ve seen plenty of articles lately about high frequency trading, most of which completely exaggerate the effects of high-frequency trading and algorithmic trading in general.

Let’s talk about HFT, what it is, and how it actually works.

What is High Frequency Trading?

In short, HFT is trading securities, usually ETFs, really fast. In most cases, high frequency trading firms are interested in arbitrage. Arbitrage being a statically risk-free, or near risk-free investment usually the result of pricing discrepancies between one market and other.

As an example, we’ll use the Gold SPDR ETF (GLD), which tracks the price of roughly 1/10th of an ounce of gold bullion. Let’s say the price of the ETF is $190 per share. Gold is $2000 per ounce. How can you make money with this trade?

Easy. Buy the ETF, and sell an equal amount of gold on the futures market. If you buy 1 ounce of gold through GLD for $1900, and sell short 1 ounce of gold for $2000 on the futures market, then you’ve essentially harvested $100. Eventually, buying interest will push up the ETF, and push down the price of gold, until equilibrium is reached. Risk-free profits!

Okay, so that’s the basic explanation for high frequency trading as it relates to arbitrage. MOST volume from HFT firms is arbitrage, which is a good thing. Arbitrage creates more efficient markets, and arbitragers should be welcomed into any market.

Synthetic Options

Let’s say I want to bet on rising hamburger consumption. There’s not a really good way to do this. I could go buy a bunch of fast food then let it sit in my closet until demand (and hopefully prices prices) go up. But who is going to buy a dusty, month old hamburger? This isn’t very practical.

I could create my own synthetic option, though, by buying one security and hedging out all the parts I don’t like.

For example, I might buy 1000 shares of McDonalds, then short 20 shares of a smoothie maker to hedge out the impact of smoothies, short a French fry producer to isolate out French fries, and buy a derivative from Goldman Sachs as a bet on the average fast food employee hourly wage. Tada! I created a synthetic option, and pending that the Ph.Ds. and NASA astronauts that crunch numbers for me do it right, then I have a portfolio which will change in price due only to a change in consumption for hamburgers.

This is hardly complex by high frequency and algorithmic trading standards. I partially covered this in a post about how Wall Street brain drain actually isn’t brain drain.

Market Making

High frequency trading firms also participate in market making, which tends to be controversial. Some say that a high frequency firm can “front-run” the market by buying a security at one price and selling at another before a trader can enter the market themselves.

A HFT firm might buy Apple (AAPL) at $360.02 and sell it immediately to another trader for $360.03, effectively bringing together buyer and seller. Nowadays this is supposedly a crime. Just ten years ago humans, not computers, did this work and the bid/ask spreads were far greater than a penny per share. I guess it’s all relative. I’d rather have a computer doing the processing than a slow and costly human being.

Interestingly, no one complained when Wall Street used fractional quotations, which made brokers about as much money on each trade. One-sixteenth of a dollar was often rounded up to $.07, meaning investors got short-changed by three-fourths of a cent on each share they traded anyway. Now we get faster execution and pay less in spreads.

Who’da thunk trades would take less time to complete, cost less in transaction fees and yet we’d still find a way to complain about it?

Ticker Tape Trading

There’s a ton of insight that comes from who is buying and selling. This is why even individual investors look to see insider buying and selling activity.

Complex computer algorithms use the order book to “see” into the market before others can. Think about it. If Morgan Stanley just dumped 1 million shares of Sears Holding Corp. then maybe there’s a downgrade coming down the pipeline. A high frequency firm might hop on the momentum, using data “learned” (more accurately, guessed) from the available ticker information.

This borderlines on privileged information. But, again, the benefit is due to speed, not information asymmetry. You could do the same thing, you’d just have to pump billions of dollars into some serious fiber optic pipes. 😉

Events and Behavioral Finance

Most high frequency trading models don’t affect individual investors in a measurable way. This one does…no doubt about it.

Behavioral finance is a combination of economics and finance. In particular, it is a study about how we feel about things corresponds with the financial markets. For example, if investors start worrying about the future for the economy, they sell off small cap stocks. Small caps are included in the “risk-trade.” When investors are confident, they buy small caps. When they aren’t, they sell them.

So if the non-farm payroll report misses the mark on the first Friday of the month, investors go to sell off small caps. The NFP is released to everyone at the same time, but access to the market isn’t at a single speed. If you can get in on the trade first, then you’re set to profit on the following momentum.

Real Danger of High Frequency Trading

There is a very real danger with high frequency trading, and that is that absolutely none of the data used to make a trade as part of an algorithm is related to actual business valuation.

In the example of events based trading, a selloff of small caps may push down small cap values big time. Many of the companies that make up the Russell 2000 index of the smallest companies on the market trade fewer than 50,000 shares per day. As you can imagine, a ton of activity on the short-side of the market can push securities down due to an event that wasn’t at all related to the company.

But it’s what happens when HFT firms come into the market to buy and sell quickly on changes in the market’s mood. The Russell 2000 index includes 2000 stocks; you don’t really think the HFT firm cares to figure out which is worth owning and which isn’t, do you? They know they don’t want small caps! Sell the lot of ‘em!

Same thing with commodities; they’re part of the risk-trade. Sell ‘em off in mass on a loss of confidence! Buy the whole consumer staples sector for protection! Rawr!

Anyway, the moral of the story is the HFT creates both more efficient markets and less efficient markets. It also creates volatility. However, banning it, taxing it, and protesting about it won’t do all that much.

{ 9 comments… read them below or add one }

PKamp3 October 11, 2011 at 22:12

JT,

I’m rather ambiguous about HFT. There’s a decent amount of literature extolling the benefits for liquidity and volume (and reduced volatility), at least on normal trading days (http://www.futuresindustry.org/ptg/downloads/HFTLiteratureReviewJune2011060811FINAL.PDF). There is no doubt in my mind that HFT (in a normal market) helps price discovery, and I would hate to see the US go the way of Sweden and enact a transaction tax.

Reading the order book quickly I don’t have a problem with. Firms have been prop-trading for years by predicting the orders of their clients, and HFT traders are separated from the orders even more than the Chinese Wall at a firm can provide. Even when it was just traders on the floor, taller traders and those towards the front had informational advantages. However, I do have a problem with fake orders – entering orders that a firm doesn’t intend to place, either to overwhelm an exchange or to trigger other orders without putting any money at risk. I don’t know the best way to correct that.

I think we’ll see more and more algo and day traders move to longer timeframes when they can’t compete with the HFT guys (it’s already happening). From what I’ve heard from my trading friends, “all of the arbitrage opportunities are disappearing” on shorter trades. If arbitrage is all about (apologies to Mr. Buffett) picking up nickels in front of a steamroller, HFT is picking up the nickels and leaving the pennies.

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JT McGee October 12, 2011 at 06:15

I’m hoping that over time the financial tax idea does get shot down. I don’t know where we even got the idea that it might be a good thing. It’s like taxing Amazon transactions at a higher rate because it provides liquidity to the consumer good market. If you go to Wall Street to buy shares, an HFT desk might make .01% on the transaction by matching your order with another. If you go to Amazon, you pay for the 2-4% net profit margin they manage on all orders.

Amazon arguably made the consumer goods business faster and more liquid. They’re like the HFT that EVERYONE has used. Yet, no one wants to tax Amazon transactions because it’s a faster, better way to buy than going to the store. Everyone knows that taxing Amazon is a bad idea, but the same corollary can’t be drawn to Wall Street? Does not compute.

I think you’re right; we will see more algo/HFT traders flooding into longer timeframes. Especially right now, when the time value of money is exceptionally small, placing short-term trades is very profitable compared to the amount of risk-free yield you earn with cash. If rates revert to their historic average, a lot of these trades would be technically unprofitable. We have a boom in HFT right now, but once yield rises they’ll have to get shaken from the market and pushed into longer-term trades to maintain profitability.

Funny quote from Warren. I’ve never heard it. Munger is equally against HFT as a way to make money on Wall Street.

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PKamp3 October 13, 2011 at 22:42

If you want to start the Occupy Amazon movement, I’ll hype it since the sarcasm detector of the Internet will explode.

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LaTisha October 12, 2011 at 13:43

Random Guy from Occupy Wallstreet says, “High frequency trading took away my job and Wall Street is to blame. Ban all trading!”

I just wanted to be a part of the protest for a sec 😀

Volatility is good in my opinion as long as you know how to manage it. Options are a good way, the VIX, there are so many ways to make money but a market that doesn’t move, helps no one.

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JT October 13, 2011 at 09:46

I honestly like the volatility. I know people don’t like the idea of seeing red/green/red/green everyday, but it does create some great opportunities where the good gets sold off with the bad. Pick those good ones and you’re set. 😉

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PKamp3 October 13, 2011 at 22:44

LaTisha,

Unless we want all of our Covered Call writing retirees switching to Iron Condors and Long Butterfly Spreads? Yeah, you’re right (imagining what happens when it isn’t set up right). We’re better with volatility…

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LaTisha October 14, 2011 at 14:53

Gosh could you imagine? Retirees and Iron Condors definitely #twothingsthatdontmix 🙂

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PeterPeppers February 10, 2012 at 12:34

People are really dumb if you think HFT is a good thing. Its a good thing for NYSE, Nasdaq and the biggest exchange and biggest crooks in the CME Group. Its good for Goldman Sachs, etc.

It Kills the market. The S&P 500 futures are un-tradable 100% unless your on the floor. Any traditional analysis does not work once HFT’s “turn on”

Look at any intraday chart for the S&P and you will see a clear range of 1 – 1/2 handles where the biggest of all HFT’s, likely Goldman Sachs turns on and destroys the market. The market will bounce back and forth in a clear range for an hour, and the poof – they are out, likely making millions, and any retail trader gets wiped out for the day. Then the market moves on its way in the direction it was “supposed’ to go.

If anonymous wants to make a real impact – tell them to DDOS HFT datacenters colocated at the exchanges and watch the markets move as they should.

Anyone who enters the arena of trading is an idiot. Save your money. Unless your on the floor you will never make it. Its not possible to make. Maybe 1 in 1000 make a real living at it.

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JT McGee February 10, 2012 at 18:34

Small traders will most likely never beat the big boys, anyway. It’s not because of HFT – it’s because of experience and vast differences in capital and understanding of the markets. If you can’t win as a trader, then join the club. It’s nearly impossible – and it was even before HFT – to make money as a trader.

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