Who are these firms and how do they work?
Michael Lewis “The Flash Boys” will explain it for you.
Long story short, they trade faster than the rest of the market.
I didn’t read the article so it may explain it, but I watched an documentary on it a while ago and it’s basically what it says. People (well, firms) that buys huge amounts of shares and resell them for slightly higher. The interesting thing was how fast this happened. We’re talking about milliseconds.
People that actually relocated their business from somewhere in the US to New York…to Wall Street…to the actual trading floor just to lessen the actual distance the signal has to travel between the time they put in an order and the time it gets executed.
Think about it, if someone says ‘IBM did something good’ and my computer is set to buy 100,000 shares if it sees that news and I’m in Kansas, the guy in New York is going to physically get the news sooner and be able to buy the shares at a lower price. In some cases, he might be selling them by the time I’m buying them.
Another thing I remember hearing is that, each morning there’s a service that releases all the pertinent information for the day. Everyone has access to this data when the bell rings, firms and consumers alike. But you can bay a certain amount and get it XX milliseconds earlier or pay more and get it a few milliseconds before that (etc). Those milliseconds really matter.
Lastly, I remember one firms talking about putting in fake sell orders. If a stock is at, say $30.00, they’ll put in an order to sell 500,000 shares (for example), then watch everyone else react to it and start selling off, before even trying to figure out what’s going on. When the needles moves and the price drops, they’ll buy more stocks at a lower price and cancel the sell order.
The little documentary I watched was one that CNBC did in place of their normal lunch hour show a few years back when some HF company fat fingered something and sold millions of shares that they weren’t supposed to. The nature of their business (HF trading) meant things happened way to fast for them to stop it before the entire market started falling apart.
Next up, flash crashes.
(FTR, it’s entirely possibly I got some of these details wrong, but, basically HF trading is what it sounds like. It’s essentially day trading, but moving a lot faster (sometimes even having comptuters watch for key words in the news about certain stocks and making decisions based on that) and being able to buy and sell stock far, far faster than a consumer can. If I buy stock it take a few seconds to a few minutes, for them it’s milliseconds.)
It’s a little worse than that. They’re not reacting to news about IBM, they’re reacting to your buy order. There’s already a sell order out there that your buy order meets the price on, but they don’t buy until you enter your order, then they buy specifically to resell to you. It’s like a bidding war where they can see your bid but you can’t see theirs, and even if you put in the winning bid they can jump the queue to buy before you do. At the level I trade at it’s literally pennies, I never bought more than a couple of thousand shares of anything in my life, and I don’t trade more than once or twice a month, sometimes less, but some of the big traders get bit pretty good. A couple of pennies times a couple of million shares turns into real money.
To add a few cents to the already very comprehensive answers given by others, a lot of the buy/sell orders made by high frequency trading algorithms are not actually meant to be executed, they are simply tools to test other market participants’ pricing. An algorithm might, for instance, post a small order and revoke it milliseconds later. The purpose of the order was simply to test whether there were others willing to buy or sell at that price. Do that repeatedly with small increments between orders, and you get pretty good information of what the market situation is like. There are regulatory attempts aimed at reducing this (for instance, by legislating that orders must stay active for a minimum period of time, or that a minimu percentage of orders must be executed), but this area of financial regulation is still relatively nascent.