Analogies with stores/checkers/soda etc. are all flawed because they are based on something that does not exist in the markets, that is a fixed price. When you buy a physical good in a store they have a published price that you can trust to be what you will pay (in western countries that is the norm, not so in many other places.)
Conversely, when talking about equities markets there is no such thing as the stock "price". This is a short hand that is used. In reality, there are groups of people, some willing to buy shares at a variety of prices, and some willing to sell shares at a variety of prices. The job of the exchange is to match these 2 groups when the buy/sell prices intersect or cross. This gets complicated when there is more quantity on 1 side of the buy/sell than the other. Exchanges have rules how this imbalance will get resolved, most of the time it is based on who has been at that price point the longest.
The argument in favor of HFT is that it both increases liquidity of markets and reduces the spread - both favorable to most investors.
But they can actually see you attempting to buy stock, step in front of you, buy it before you, and then try to resell it to you for a higher price? That's bad behavior and reduces confidence in the free market. There needs to be regulation around things like that.
I don't understand how HFT increases liquidity, this Q/A[1] is a start at an answer. My conclusion is that yes HFT probably does increase liquidity at the expense of adding a tax on many of the transactions. Except this tax does nothing else to help the markets except to further feed the beast (profits) of companies running HFT.
So the real question to ask is: does a marginal increase in liquidity outweigh the financial cost? I'd argue that it is a tax on society with no real benefit. I've started to hear about auction's to improve the markets which is interesting and saves us from the millions (billions?) of dollars that HFTs pocket for themselves.
Which tax is it adding? You enter a limit order at a price, and you get filled at that price: that is true with or without HFT. With HFT, the spread is tighter, so either crossing or stepping inside makes your trade more efficient.
Perhaps my understanding of HFT is not complete. As I understand the HFT steps in between you and I and buys/sells the asset acting as a third party. When it does this it keeps part of the spread for itself--that's the tax I am referring to, profit for the HFT that as far as I understand serves no value.
No, that role is generally performed by the broker/bank (who don't like HFT, in general). I'm not sure I see anything wrong with that either though.
It is quite normal to take a spread in any industry - an orange seller steps between you and the farmer, for example. I would argue your broker does a lot less for you than a farmer, or high frequency market maker. HFT is generally known to shrink the spread, making trading cheaper for you than it would be without them. They still take a profit, because they take a risk.
I'd recommend reading a little about market structure - and preferably not from those with a narrative to sell.
It's not just increased liquidity, it's also a decrease in the bid/ask spread, which is the actual cost of purchasing. HFT drives those much lower, decreasing the cost for most participants.
We need to introduce 2 new players. Sally who has some of this stock that she needs to sell for as much as she can get and Bob who wants to buy some of this stock for as little as he has to pay. In the current market Sally gets $95 per share and Bob has to pay $100.
Matt looks at the bid ask spread and decides it would be profitable to make a market in that stock. So he simultaneously asks at $99.99 and bids at $95.01. If Sally and Bob were to come back now they each would get a better deal and Matt would make $4.98 on the deal.
For Matt to continue doing this that $4.98 needs to cover the risks he is taking, his operational costs, and some profit. An HFT is much more efficient at this than Matt driving down the operational cost & potentially calculating the risk more accurately.
HFT implies computers but computers do not imply HFT. You could automate the trading platform and give everyone equal access without it becoming a hardware arms race.
Katsuyama realized that his orders traveled along fiber
optic lines and hit the closest exchange first, where high
frequency traders would get a glimpse, and then use their
speed advantage to beat him to the other 12 U.S. public
exchanges and 45 private trading venues. HFT algorithms
could then buy the shares Katsuyama wanted, and then sell
them to him at a slightly higher price. [1]
I don't know if this is illegal or not, but I'll eat my hat if anyone gets prosecuted.
What is being described in this article is latency arbitrage and is not illegal. You will notice it specifically mentions that his order was changing the price on other exchanges, not on the exchange he submitted his order to.
He was taking advantage of multiple exchanges in order to hide his order flow, because as a natural consequence of market laws large orders move prices. He is just upset that other folks were better at finding his order flow than he was at hiding it.
Could one bleed the HFTs by putting out orders in one exchange, waiting for them to buy up the shares elsewhere, and then cancelling the order? Or just waiting for the HFTs to re-sell them at the previous/lower price and buying them afterwards?
Sure. That said in most regulatory environments putting orders into a market that you have no intention of trading is illegal. Enforcement and it's impact of profitability on this sort of predatory trading is an issue.
Yeah, but what about my second suggestion, which would be to just buy from one market and then buying the rest in other markets after the HFTs had re-sold the shares?
But it's not just identifying HFT systems that need to dump shares, the idea is to induce them to. So for example, suppose the bid is $100.00 and the ask is $100.05. You put in a bid for $100.10 which causes HFT systems to buy at $100.05 expecting they'll profit $0.05/share by reselling to you in a few milliseconds, but before that you change your bid to $100.03, causing the HFTs who now need to dump those shares to have to sell to you at a loss of $0.02/share (and causing you to pick that up as profit).
This sort of HFT gaming is very common. Some of it skirts around the regulations, some of it blatantly breaks them assuming (correctly) that it is more profitable to deal with the consequences than to change the trade.
Just remember that this is happening at very fast speeds, by participants that have mind bogglingly high risk levels.
Just had drinks over the weekend with a friend that works IT for a major exchange in the midwest. He was telling me how they set up the network interconnect cables from their trading systems to the co-located brokers. They are measured to be identical to the millimeter to satisfy all the high-speed brokers that want to sit next to the exchange and avoid any argument about who can get in quicker.
Yes and providing identical service levels to all co-located participants is a major profit center for exchanges now. Before that change in the market there was a whole class of consultant that would claim they could find specific racks in colo data centers that would give you latency edge.
But this latency is not about seeing other peoples orders before they enter the market, it is about reacting to market data quickly as it is disseminated to everyone.
The thing is, there are multiple markets not just one. So when you place an order to buy 100 shares of IBM, that order gets sent to many places to try to find the best offer to fill you.
If a HFT can see you submit that order to 1 market, and then beat you to the other 4 markets and buy up all the shares before you, that's frontrunning. That would be illegal if your broker did it, but HFT is not your broker, and just has the advantage of being faster than your broker.
What makes you say it's "not true"? What evidence do you have of that?
There are lots of things you are glossing over that complicate this picture quite a bit (like the fact that your broker is almost certainly executing on an HFT platform), but the biggest issue here is that no one can see your order until you place it on the first market.
Once that order hits the market it is public signalling data that should impact the prices on every other market. That some traders are more efficient at responding to that public signalling data than others is not an issue and in fact is a large part of why the markets are as efficient as they are.
As does purchased order flow, internal matching, preferred routing agreements, dark pools etc.
But given the simplistic nature of the discussion it is more accurate to say that in general HFT don't see your order before it hits the market than it is to say they do.
Okay, as long as people who actually want to understand the issue know that in many cases HFT firms can actually see orders before they become public although they don't actually do much to disadvantage a retail trader.
Yes, they can and it's called buying dumb flow from brokerages.
Now technically they write it off as helping you as they group small orders together and execute them, but that doesn't mean these market makers are making a profit off the transaction.
I work for a financial services company and I still don't invest in stocks. Not that high-freq trading is specifically the problem (maybe it is, maybe it isn't, I dunno) -- retail investing just seems like a sucker's game, though admittedly that leaves me a little stumped as to how a schmuck like me is supposed to grow his money.
Yup - http://en.wikipedia.org/wiki/Tobin_tax
You can make it very small to cut out almost all of these problems and it wouldn't be noticeable to any non-HF traders. It's not gotten very far in the US and is only partially supported in the EU (though I think there's something amiss with the EU proposal).
But why should we care? The thing I don't understand about the whole debate is, even if the HFTs are milking investors, so what? We're not talking about powerless individuals versus giant companies that we might need to protect, why not just let the investors deal with it by pressuring the exchanges into banning HFTs, or making new exchanges where HFTs aren't allowed? Is it just moral outrage because the HFTs are perceived to profit from "doing nothing"? Frankly, I'm at a loss why do so many people feel bad for the "poor" investors.
My outrage (not sure you could really call it that) is not some moral thing or based on a perception that they are doing nothing.
My issue comes from the fact that securities trading is based on the idea that we buy and sell parts of these securities under the idea we see value in the company. This fits best with a long term hold position but is not really that divergent with a day trader who buys AAPL today because he thinks news later today about some new product will cause the price to go up thus increasing the value of the company. He will sell later in the day because he thinks that it may drop later.
My issue with HFT is that these trades (well most of them) are not based on the value of the security but rather on the act of buying and selling itself. It is meta in a sense.
That in my mind creates a fundamental flaw in the marketplace around the true purpose of a securities exchange.
Do you like the fact that you are able to buy any stock you want pretty much whenever you want? And also can sell any stock you want pretty much whenever you want?
That's a service provided to you by market makers. And it's a service for which they get paid.
But is there any real externality to society, or are you proposing to tax it out of existence just to maintain the philosophical purity of the markets?
Can someone help me understand this beyond analogies please?
If I submit a buy order for 10 shares of GOOG with a limit of $1134 that order is going to show up in the data stream of HFTs only after it has become a valid open order on the exchange, right?
If at that time there is a sufficient volume of open sell orders at or below my limit, does my order go through or is there a way for an HFT to overtake my order?
The only way I can see how an HFT could possibly overtake my order is by offering to buy at a higher price than me before my order goes through, hoping that he could sell the shares to me later on for an even higher price.
But that's a pretty risky bet for the HFT assuming he needs to be out of the market before the market closes. It seems to me that the most likely victims are other HFTs because they are the ones who will quickly raise their limits when they see the price go up.
A low frequency trader like myself can just sit there and wait until the price comes down again or just walk away. Is there something I misunderstand?
[Edit]:
So, summing up the replies I got here, the only problem seems to be that my broker is allowed to send my order to HFTs before it goes live on the exchange. Wouldn't it be incredibly simple to ban this practice? If it's that simple to solve, why all the fuss about HFT?
If you submit a buy order for 10 shares of GOOG through a conventional retail website like ScottTrade or ETrade your order is going to be sent to an HFT firm that buys flow from from these retail websites.
If it's a limit order the HFT firm is going to immediately decide whether it wants to take the other side of your order (i.e. immediately give you an out that leaves you whole with 10 shares of GOOG at $1134) or whether they don't want the order in which case they might send it directly to a lit venue like NYSE where your order will rest in the open market.
If they take it, from there the firm is going to try to liquidate the position in the market now that they are short 10 shares of GOOG. It is up to their discretion on when they want to even out their portfolio. The idea is that sophisticated traders are able to better time and aggregate retail orders than the retail customer themselves and here is where they make money albeit with a little risk.
For one simple example since you only wanted 10 shares of GOOG typically you would pay a penalty for executing an odd lot (an odd lot is an order that is not an even multiple of 100). If the firm can collect 10 buy orders of 10 then they can avoid the odd lot penalty.
> If I submit a buy order for 10 shares of GOOG with a limit of $1134 that order is going to show up in the data stream of HFTs only after it has become a valid open order on the exchange, right?
False.
HFTs and other trading firms actually buy up the order flow from brokerages. In fact, retail investors making trades in their brokerage accounts are actually referred to as "dumb flow". Having access to the order flow and controlling the routing of it can allow them to jump in front of your trade.
For example, they could see that your limit order of $1134 came in when the lowest ask price was $1133.90. They could buy that for $1133.90 and sell it back to you at $1134 for a 10 cent profit.
It's not too much different than in the old days when the market makers would delay buy/sells calls to their pits to their own advantage in order to scrape a small profit on the spread.
> For example, they could see that your limit order of $1134 came in when the lowest ask price was $1133.90. They could buy that for $1133.90 and sell it back to you at $1134 for a 10 cent profit.
They cannot do that. They can't fill you at a worse price than NBBO.
You said best offer was 1133.90. If buy order is placed at $1134 with HFT firm they must either fill the order at 1133.90 (the NBBO) or pass it on to an exchange that has NBBO.
If you are arguing something else happens then you need to explain it clearly step by step in a timeline.
2. Trade gets routed to an HFT who will fill the trade
3. HFT notices a spike in GOOG interest over a few seconds and starts buying at 1133.90 driving the price up to 1134
4. HFT fills your limit order at the best price of 1134 which they themselves hold.
Despite what the other commentators here have said, limit orders are less safe than market orders to market manipulation. HFT's will buy up all that dumb flow with limit orders and then essentially run the prices to the limit orders in their favor.
At the beginning of 3. does the HFT have your order or are you saying that the market moves before the HFT receives the order?
As far as I know the first case is prohibited (actual front running). I don't see an obvious problem with the second case though there might be subtlety that I am missing.
"If I submit a buy order for 10 shares of GOOG with a limit of $1134 that order is going to show up in the data stream of HFTs only after it has become a valid open order on the exchange, right?"
Correct.
"If at that time there is a sufficient volume of open sell orders at or below my limit, does my order go through or is there a way for an HFT to overtake my order?"
You will get filled with at worse, your limit price.
"The only way I can see how an HFT could possibly overtake my order is by offering to buy at a higher price than me before my order goes through, hoping that he could sell the shares to me later on for an even higher price."
If I submit a buy order for 10 shares of GOOG with a limit of $1134 that order is going to show up in the data stream of HFTs only after it has become a valid open order on the exchange, right?
If at that time there is a sufficient volume of open sell orders at or below my limit, does my order go through or is there a way for an HFT to overtake my order?
If there is a resting sell order below the limit price of your buy order, nobody will see your buy order. The cross will happen as soon as your order hits the matching engine. You and your counterparty will get trade confirmations via your order entry port, and market data subscribers will see a trade report (10 shares crossed at $XX.YY) and the size of the resting sell order will change.
If you make a limit order at e.g. $1134, it's entirely possible that the best price is below $1134. For instance, if you enter that order right now, you should expect the order to execute at closer to $1130 (assuming a small order size). Your limit price is therefore a worst case.
Lewis is saying that in the absence of HFT front-running, you'd get the best available price at the time, say $1129.82. However, he alleges, HFT traders can front-run you and you'll instead pay e.g. $1129.92, meaning you overpaid for the stock. Note that this happens even though what you paid and the best theoretical price are both below your limit. So you're getting robbed, even though it's not apparent to you.
The point of the article is that you will lose the game because you're making decisions in macro time with old information and you're competing against robots that make decisions in nano time with newer information.
> If I submit a buy order for 10 shares of GOOG with a limit of $1134 that order is going to show up in the data stream of HFTs only after it has become a valid open order on the exchange, right?
No. Your broker might send order flow to HFT firms for payment. They have to fill you at the national best offer if they want to take the trade.
The other thing that can happen is that if your order is not marketable at the current exchange you are trading at but is marketable at another exchange then the first exchange can sometimes "flash" the order to selected participants to see if they want to fill the order so you can avoid forwarding the order to another exchange.
NYT => paywall (maybe a weak one but there nevertheless and I don't read rather than working around it).
Also I suspect (note I have read the NYT piece) that this is an equally original piece and the Michael Lewis with a book to sell has done similar interviews (or other PR such as press releases) with as many relevant publications as possible.
The actual Michael Lewis article (linked above) is 10,000 words. It's not (the expected) fluff piece for PR purposes. More reminiscent of how books used to be serialized/published in the press before going to print.
Definitely worth reading.
The piece here is fine for promting discussion but the info in the original work would make that discussion better. Its simple to Delete your cookies and/or just use incognito if the NYT is being a PITA.
It seems like the problem is executing a trade when the first buyer (or seller) comes along to take the other side of the trade, rather than waiting a bit to see if someone else will give you an even better price. That is, trades shouldn't execute immediately when prices cross. Instead it should start an auction.
If you're more interested in getting out a few milliseconds sooner than in getting a better price then the front-runner is doing you a service. Otherwise, it seems like the time needed to run a brief auction would be well-spent.
There already is an auction. It happens once per stock market tick.
You don't trade with the first buyer or seller that comes along you trade with the buyer or seller that submits the best price. If a whole bunch of them submit the same price you trade with the one that does it first (hence all the effort HFTs put into moving faster).
My understanding of high speed trading is that this has always been the point. I have to assume there's so much money in it that the obvious move to outlaw it as soon as it was devised was already pre-paid off.
If computerized grocery checkout machines would stop halfway through the 10 cases of discount soda you bought to raise the price on the remaining 5 cases, then this analogy would be what the article is talking about.
It's like saying Wal-Mart rips off its customers, because they use computers and their market power to buy stuff cheaply, and then they turn right around and sell it to their customers for more, making a profit 100% of the time.
The problem is not the HFT firms buying stock cheaply and reselling it for a profit. As the article points out the problem is investors placing a buy order, and the HFT firms seeing this buy order and snapping up the remaining stocks before the original buy order is fully completed.
This has the negative side effect of essentially making it impossible to buy for the listed price, even when there are supposedly enough shares available for purchase at that price.
As I pointed out in another comment, it's not just buying low and selling high; it's like Walmart interrupting a customer to jack up the prices on a purchase in the middle of that purchse, precisely because that customer is buying that specific item.
HFT firms don't see the buy order before its get to the market. They see that a bunch of quantity was bought so they raise their prices on the other markets. Because the purchaser had bad order routing, he moved the market and the hft firms were able to raise prices for what they believe the new market price to be.
Say you decide you want to buy up a bunch of property that's all on one street, and the market price for each property is listed at $100,000. Once word gets out that you made the first purchase for $100k, the prices on those other properties are going to go up, because if there's a buy at $100k, they might as well start negotiating at $110k, but they have no idea if there's a buyer who wants just one property, or all of them.
Now, only the buyer know how much he wants to buy. If he was smart, he'd go to each seller and execute at the exact same time so when word gets out of a purchase and prices go up, he's already purchased everything he wanted, the uptick in market prices actually benefits him.
It's the same thing with trading. If the guy is buying a couple thousand shares scattered across a dozen exchanges, he absolutely needs to make sure they get posted to the exchange at the same time, or he needs to break them up in small orders over a period of time so he doesn't affect the market with his purchases.
It's worth nothing that Walmart actually does change prices in real time. If lots of people start buying a particular item then the price for that item is automatically raised.
Conversely, when talking about equities markets there is no such thing as the stock "price". This is a short hand that is used. In reality, there are groups of people, some willing to buy shares at a variety of prices, and some willing to sell shares at a variety of prices. The job of the exchange is to match these 2 groups when the buy/sell prices intersect or cross. This gets complicated when there is more quantity on 1 side of the buy/sell than the other. Exchanges have rules how this imbalance will get resolved, most of the time it is based on who has been at that price point the longest.