My question, then - how does high frequency trading generate profit for those engaged in it?
Yes, we have had previous threads on the subject, but I don’t think a consensus was reached as to exactly how people can make money from the practice. In one of those earlier threads, the emphasis seemed to be placed on mispricing of stocks, i.e. exploiting the difference in bid/ask prices for the same company on different exchanges (at the millisecond level of variation).
Bottom line: where does the profit come from in high frequency trading?
Thanks!
ETA: ‘Eavesdropping’ seems illegal, at least from my naive perspective. For the purposes of this thread, I am hoping to learn of the strictly legitimate ways of exploiting high frequency trading (or ways that used to be legal).
There is nothing illegal. When you place a trade, it gets put into a queue at the price you specified together with all other people’s trades. The queue is public information and can be seen by anyone. It is called “Market Depth”, “Market Book” or “Level II” depending on whom you’re getting the feed from. Usually it is not as detailed as what the HFT traders look at, because when humans look at it, they can’t absorb that much info. HFT traders’ computer programs can.
I just want to say that I have to go out for the rest (or at least most) of the evening so won’t be able to respond for a long while. Please don’t misinterpret my silence as lack of follow-up interest or, worse, as ingratitude.
The profit comes from the same place as the profit in any other market: Buy cheap, sell dear. The only difference is that HFT means you’re just being quicker, to snatch up those cheap buying opportunities and dear selling opportunities before anyone else has a chance to.
The easiest one to understand is the one in the NYT article. Suppose I want to buy 100k shares of a stock. There are currently 100k shares being offered at $10.
I submit the order for 100k shares. It goes to all of the exchanges via fiber optic cable runs, with some routing delays. When the order reaches the closest exchange (to me), the HFT has a very high performance computer that strips the message for my order out of the packet (directly, using bleeding edge technology) and it immediately sends a BUY order to buy those shares of stock that I wanted to buy.
The HFT computer is connected by a higher speed link than the one I am using. So the BUY order hits the computers at the other exchanges I sent my order to BEFORE my message gets there!
So the shares I wanted to buy are now gone. Now, the HFT computers put those shares they just bought back on the market for a penny or so more a share. Since I want to buy 100k shares, I buy the rest of the shares for a penny more.
So they have robbed me of a penny times 100k, and they are doing this on a massive scale across the entire stock market. Over the aggregate it is thought that these guys were stealing billions of dollars.
*note that this behavior is “legal” under current law (probably). It is still de facto theft.
I think the expectation would be that a) no one sees your information until it’s in the public queue, and b) people can only add to the end of the queue. If there was a single, governed queue of information like this, then #a would count as insider trading and would be illegal. The problem would seem to be that there isn’t a central queue. The market is the computer equivalent of people yelling across the hall at each other, except the people can run faster than the speed of sound. Obviously, that causes some oddities from what we would expect.
My assumption would be that either a central queue will be established, or at least each tradeable asset will have one for itself, before too long. That would resolve issues like this.
Well, actually, the fix is to make it where the “shouts” all reach everyone at exactly the same time. This was done originally by automatically delaying sending the messages to the closer exchanges (the people right next to you) with a software script. This didn’t always work exactly perfectly. Now, they use reels with miles of fiber optic cable on them to create delays.
There’s more complex scams that weren’t explained in the articles. Somehow, the big investment banks were running other schemes where when their clients want to buy a lot of shares, the fact that this buy order exists gets deliberately delayed a bit in a “dark pool” of trades. The information is sold to HFTs, who abuse it to make a little bit of money, and pay a kickback.
All of these schemes seem to rely on the simple fact that news, any news, affects the price of a stock. If you can find out what the news is before your competitors, you can make money from the predictable shift in stock value.
Why not a system where orders are accepted (and published) only at half-second intervals, and all those orders get equal priority? (Sage Rat’s central queue might be a prerequisite for this.) Make it quarter-second intervals if 490 milliseconds seems an excruciatingly long wait to find out if you’ve bought a stock.
Another “high-tech” way to game the market (which may be separate from, but enhanced by, HFT) is to observe order flow, deduce institutional algorithms, and make the orders you predict they’re about to make. That approach can be one-upped: Feint the observer into making predictable trades, and take advantage.
A few years ago, I saw an interesting YouTube by a trader claiming to demonstrate illegal() HFT activity; however when I rechecked the YouTube had gone pay-for-view or such. ( Apparently it is against regulation to place an order you fully intend to cancel. I’m not sure how to prove the charge: “Your honor, by coincidence 300 microseconds after I placed the order I tuned to CNN and saw a news report!”)
Legitimate high frequency firms (most of them, IME) are essentially just market makers. As you said, they arbitrage minute difference between fungible or highly correlated products.
The entire *industry *only made $1 billion last year. Compare that to the $5 billion that JP Morgan made last quarter. The whole thing is a tempest in a teapot, IMHO.
The entirely legal practice of jumping ahead of orders as you describe could be almost eliminated by repealing a specific part of Reg NMS that prevents “locked” markets. See here:
(Caution, hypothetical): I run a mutual fund and am buying 10 Billion worth of Microsoft. I think it’s the right time to buy at 40.00$. Since my fund consists of 10$ MSFT, I’m buying 1B of MSFT (25 Million shares). I send the order to buy. It goes to the first exchange, which can get me 1 Million shares. Ok, so I have 960 M left. But at the first exchange, the HFT shark sees that I have an order to buy 25 Million shares. He then buys up the shares at 40.00 at the other exchanges before my order gets there and the price is now 40.05. So he makes 1.2 Million dollars from what? In virtue of sitting closer to the computer? I’m betting that the big investors will eliminate this one way or another, and that they don’t think it’s just a tempest in a teapot.
If you send a $10 billion order to the market, you will move the market. Period - HFT or no HFT. The entire job of a trader at a large mutual fund is to execute orders at the best price with minimal market impact. It’s not as easy as simply pressing “BUY.” No one has a right to liquidity at a price just because they want to buy. If a whale comes in to a market looking to establish a position, the market will react based on the new information. If It’s been that way since before the days of trading under the Buttonwood Tree.
Assuming your example happens as you describe based on technical market microstructure advantages (lag between the SIP and true exchange BBOs), I agree it shouldn’t happen. Eliminate the bad regulation that creates the opportunity.
It IS something that should be reformed, but it is not the horror that the popular press makes it out to be. As noted above, there are legitimate HFT firms that are doing things like providing more timely arbitrage between markets, or allowing the mutual fund manager to get the best price for a large trade.
As indicated by others, the effect on small retail investors is not that significant. For one thing, if you are actually INVESTING, shaving a fraction of a cent on your purchase price shouldn’t make that much difference to you. The “frontrunning” effects they are talking about are small enough that it shouldn’t even make a difference to a swing trader. If you are a daytrader trying to skim off small changes yourself, well good luck with that.
As a retail investor with a brokerage house, you should realize that very often your orders don’t even REACH an exchange. Brokerages may fulfill orders in house, and do, for the more heavily traded securities. If you buy 200 shares of MSFT through Schwab, for instance, it’s quite likely that they just credit your account with 200 of the shares out of the pool they already have and debit the order price. There are regulations as to how they manage in house fulfillment or internalization, but generally they like it, because it allows them to play the spread, and the customers are happy because the order got filled immediately. Your broker’s options for handling your order:
Granted, an order has market effect proportional to the size. But we are talking about a middle man that has no function other than to create a wider margin so he can insert himself into it. He doesn’t facilitate anything. A broker has a function, an exchange has a function, but these situations we are talking about exist because some middle man is quicker and has access to information that he shouldn’t have (ethically).