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Author: yodaorange Big red star, 1000 posts Feste Award Nominee! Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 459186  
Subject: High Frequency Trading Tutorial Date: 5/9/2010 11:28 PM
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This was originally posted on the REIT board in response to a question there related to the Thursday 5/6/10 mini-crash. It is probably more pertinent on METAR since the issue is larger than just REITs.

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High Frequency Trading (HFT) Tutorial

Warning, this is a long post, as the topic is fairly complicated

Klee asked two specific questions on a different thread. Instead of veering way off topic, I decided to start this as a separate thread. Also, instead of answering Klee’s questions, I thought it would be helpful to add some additional details that I think are important to the discussion. I am far from an expert in these areas, but it might be that my information is a little more extensive that most REIT boarders. I have spent a lot of time studying REIT preferred trading which includes a few aspects of HFT. If anyone has more detailed knowledge about HFT, please speak up. In any case, here goes:

How do we know that HFT is important to Wall Street?

1) Wall Street firms pay large fees to “co-locate” their computers literally a few feet from the NYSE’s main data center. The computers are connected with fiber optics so the data can literally flow at the speed of light, as opposed to over copper wires. There is a nuclear arms race between different firms to have to fastest computers and fastest programs to be able to respond to the data these firms receive from the NYSE. The speeds keep getting faster every year. A few years ago, it was adequate to receive data 50 milliseconds (.05 seconds) after the NYSE published it. The state of the art now is somewhere in the sub 5 milliseconds range. Contrast this to main street investors like us that receive the data probably seconds after the fact.

Opinion #1: the fact that firms would go to this much trouble and work, tell you how valuable they think having this setup is.

2) Last year, the FBI arrested a former Goldman Sachs programmer for stealing Goldman’s HFT program. The programmer, Sergey Aleynikov was arrested as he was getting off of a plane at the Newark airport.

At the time, the US attorney said the following:

“The proprietary code, worth millions of dollars, lets the firm do “sophisticated, high-speed and high-volume trades on various stock and commodities markets,” prosecutors said in court documents. Facciponti said a person misusing the code might be able to “manipulate markets.”

Of course to many people the irony in the statement was/is that Goldman is likely using this software to manipulate markets. The other amazing fact is how quickly this programmer was arrested after he left Goldman. Somehow Goldman was able to persuade the US attorney of the seriousness of the alleged crime from a low level employee.

Opinion #2: Clearly Goldman assigned a high value to this software and/or they really did NOT want the public to see exactly what kind of trading the program did. If it was NOT worth a lot to Goldman, they would not have made a big deal about it.

Link to this story:
http://www.bloomberg.com/apps/news?pid=20601127&sid=aDH3...


3) During one period in 2009, Goldman reported profitable trades on 93% of the trading days. I am sorry, but I do think Einstein could achieve that success rate unless he had some type of inside edge. Goldman does NOT distinguish between HFT trades and “prop” (proprietary) trades. The average US investor does not understand that Goldman and other Wall Street firms have armies of people using brokerage house money and trading it every day. There job is NOT to service customers in any way. They do not interface with customers in any way. There sole job is to put Goldman’s money at risk by trading for maximal profit. So you can only speculate how much HFT played a role in the 93% success rate.

Opinion #3: Goldman is using HFT in a fashion that main street would consider illegal and/or immoral in order to achieve this success rate. There is also something about Goldman paying ~$600,000 average bonuses to every single employee in 2009. Looks like smoke to me.

What are the techniques that Wall Street uses HFT for?

Some of the techniques are public knowledge. Other techniques you have to make educated guesses at based on trading data after the fact. It is clear that all of the firms highly value the exact approaches and algorithms they use. I will highlight a few of the techniques that I am aware of.

4) “Flash” trading is the controversial practice where WS firms are able to see new bid/ask prices BEFORE anyone else can. Because their computers are co-located, they can react to the order and capture the order before slower systems know what hit them. This can be used in many different ways. Here is one simple way:

Last trade on ABC was at 10.15. Current bid is at 10.10, current ask is at 10.20.
New order comes to buy 1000 shares at 10.20. The HFT program can immediately decide if it wants to enter a new ask price of 10.1999 and take the 1000 share order. Yes, you read that correctly. Something else not widely known by the public is that these institutions can do “sub-penny” trades. So they can and literally do trades in .01 cent increments. You and I can only do trades in 1 penny increments. In this case, the person with the 10:20 ask price did NOT get to sell the 1000 share block. He is left holding the shares. The same technique can be used when selling shares. The other aspect is that you can NOT see these new bid and ask prices in advance. Yes, the purchaser of the shares did get a better price, so brokerage houses can justify this practice as adding liquidity to the market. This is called “sub pennying.”

When Flash trading was exposed in 2009, both NASDAQ and the NYSE said they would stop the practice. As of today, I understand that flash trading is still going on.

5) “Probing” to raise the price on low volume. Long story short, HFT programs can find out the real price someone is willing to pay for a large block of stock. Say someone wants to buy 100,000 shares and is willing to pay up to 10.50 per share. The current ask price is 10.20 per share. The HFT program will buy all of the shares it takes in order to raise the price to 10.50 before the order is filled. So the buyer will get all of his shares at 10.50, instead of getting them at 10.20, 10.21 etc. The technique involves putting in false orders that can be cancelled so quickly that the market never sees them Karl Denninger did a nice write-up on how this works, so I will not repeat it here:

http://seekingalpha.com/article/151173-hft-the-high-frequenc...

6) Index arbitrage was the original use for HFT. It involves selling an index like the SP500 while simultaneously purchasing the 500 stocks. In theory the index and underlying stocks track perfectly every single trade. In the real world, there is some time delay between the pricing of the indexes and stocks. Obviously, having the fastest computer and program give you a large advantage in this area.

7) My assumption is that the goal for all HFT trading is to finish the day owning no stocks or minimal stocks. The goals of the system are rapid, small profits as opposed to taking some kind of market direction bet. The programs do not care about direction of the overall market. What they care about is the next few seconds, minutes or hours of trading.

8) Many of the HFT programs are designated as “Supplemental Liquidity Providers” by the NYSE. Please take the time to read this NYSE link and speficically look at the SLP section.

http://www.nyse.com/equities/nyseequities/1167954368183.html...


The NYSE link says “Supplemental Liquidity Providers (SLPs) are upstairs, electronic, high-volume members incented to add liquidity on the NYSE.”
This is the program where the NYSE pays Goldman etc to provide this service. In theory they are supposed to make the market more efficient by always being an additional layer of buying/selling support in addition to the Designated Market Maker aka specialist. WHAT YOU SAW ON THURSDAY 5/6/10 WAS THAT THESE PROGRAMS WERE 100% WORTHLESS. The SLP programs got turned off ASAP and provided ZERO additional buying power when it was needed the most. Any argument about what a valuable service these programs provide should be seriously weakened by this one event.

9) There has been widespread speculation and discussion about how a Thursday type event is possible with all of the HFT programs running. I was NOT surprised at all to see an event like this occur. I did NOT predict it or forecast exactly how it was going to happen, but the fact that programs can move stocks that fast comes as no surprise to me and many others. IMO, we SHOULD expect this to happen more often. If I am a WS firm or a hedge fund, I am actively thinking about how I can cause a meltdown like this to occur. As we know, it is all about making money for those firms. They could care less about any collateral damage of anyone else losing money. So if I could orchestrate this to happen and get by with it, all the better. Bigger bonuses for the firm!

10) There is another large elephant in the room aspect to HFTs. It is widely reported that they currently account for ~ 70% of the trading volume on the NYSE. What is NOT reported is how they “are the market” as far as setting the direction. Even though their goal is to close all positions at the end of each day, you would think they would not alter the direction of the market. A number of people, myself included believe that these HFT’s are largely responsible for the runup in the market since March 2009. Normally runups like this occur in part because the public gets sucked in. In this case, the public has stayed away from equities. Most of the public money has gone into bonds. I am not going to go into the facts that lead me to this conclusion, so I will just state is as my opinion. Without the HFT programs, the Dow would never have gone about 9,000 IMO.

11) Bottom line for me is that nothing substantial is going to change. We can and should expect HFT programs to continue and dominate the market. IMO, any true economic benefit of HFT is vastly outweighed by the potential downsides. This was a minority held view before last Thursday. Even if it becomes the majority view, we can count on Congress, the SEC, NYSE, Nasdaq, etc. to take NO action to limit HFT. There is simply too much money being made by HFT to think it will be changed.

I will re-cover some of this material in the next REIT preferred chapter with specifics about how we are affected. Other than that, despite the length of this post, this is the sound bite version. There are many more stories and aspects to it, but I have tried to convey the essential points.

Congratulations if you made it this far . . .

Thanks,

Yodaorange
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