Retired IB’R explains high frequency trading programs

As anon points out, high freq. trading is dominating currently. Those in the “know” have said that high freq. trading is about 70% of market volume. Very scary stuff.

For a primer on the issue I recently received a recent communication from a friend with his observations on the topic:

High Frequency Trading Programs (HFTP) collect a ¼ of a penny rebate for every transaction they make. They’re not interested in making a gains from a trade, just collecting the rebate.

Let’s say an institutional investor has put in an order to buy 15,000 shares of XYZ company between $10.00 and $10.07. The institution’s buy program is designed to make this order without pushing up the stock price, so it buys the shares in chunks of 100 or so (often it also advertises to the index how many shares are left in the order).

First it buys 100 shares at $10.00. That order clears, so the program buys another 200 shares at $10.01. That clears, so the program buys another 500 shares at $10.03. At this point an HFTP will have recognized that an institutional investor is putting in a large staggered order.

The HFTP then begins front-running the institutional investor. So the HFTP puts in an order for 100 shares at $10.04. The broker who was selling shares to the institutional investor would obviously rather sell at a higher price (even if it’s just a penny). So the broker sells his shares to the HFTP at $10.04. The HFTP then turns around and sells its shares to the institutional investor for $10.04 (which was the institution’s next price anyway).

In this way, the trading program makes ½ a penny (one ¼ for buying from the broker and another ¼ for selling to the institution) AND makes the institutional trader pay a penny more on the shares.

And this kind of nonsense now comprises 70% OF ALL MARKET TRANSACTIONS. Put another way, the market is now no longer moving based on REAL orders, it’s moving based on a bunch of HFTPs gaming each other and REAL orders to earn fractions of a penny.

Currently, roughly five billion shares trade per day. Take away HFTP’s transactions (70%) and you’ve got daily volume of 1.5 billion. That’s roughly the same amount of transactions that occur during Christmas (see the HUGE drop in late December), a time when almost every institution and investor is on vacation.

HFTPs were introduced under the auspices of providing liquidity. But the liquidity they provide isn’t REAL. It’s largely microsecond trades between computer programs, not REAL buy/sell orders from someone who has any interest in owning stocks.

In fact, HFTPs are not REQUIRED to trade. They’re entirely “for profit” enterprises. And the profits are obscene: $21 billion spread out amongst the 100 or so firms who engage in this (Goldman Sachs (GS) is the undisputed king controlling an estimated 21% of all High Frequency Trading).

So IF the market collapses (as it well could when the summer ends and institutional participation returns to the market in full force). HFTPs can simply stop trading, evaporating 70% of the market’s trading volume overnight. Indeed, one could very easily consider HFTPs to be the ULTIMATE market prop as you will soon see.



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7 responses to “Retired IB’R explains high frequency trading programs

  1. anonymous

    Suspect story on HFTPs is a bit more complex in terms of net costs/benefits/risks

    Elegance of capitalism is lots of very smart (and wealthy) guys often place opposing trades and are always seeking new arbitrages in markets with ever-increasing tech but a fairly constant pool of IQ (and risk judgment) to place bets; many famous models/software/algorithms have bankrupted allegedly smart guys over the past 20+ yrs

    Some of these same smart quants accused of dominating HFTP today had their faces nearly ripped off during some of the mkt events of ’07-’08

    Wasn’t part of demise of Greenwich’s Amaranth HF due to poor speculation on various energy (?nat gas) securities and biggest profiteer was allegedly Houston’s Centaurus (on opposing side of many of those bets)

    Didn’t Paulson make his bold, multi-billion dollar short bets against mortgage-related securities back in ’05-’06? Someone took the opposite side of those trades….perhaps some well-paid traders at Bear, Lehman, Merrill or Citi? Point is Darwinian selection is an ongoing game in trading mkts…a game among allegedly smart adults who should know how to manage risks to survive the various “once in a century” events that happen more frequently than pseudo-precise models predict….but lots of high-IQ guys with fancy models have weak risk judgment

  2. kidding really?

    This is scary stuff and I agree 100% and I will add this past week we also saw large increases in AIG, Citi and some other not so great financial companies % increasing by a large amount. We all know things are not getting better at these companies and know that the Government is the largest holder of these companies. It was simply quant funds (computer program strategies) buying back stocks they were short. Without these shorts there is a vacuum lower in the market if things turn down as short sellers are natural buyers when things dip. This market is due for something similar to what we saw last year and maybe worse.

    It’s really likely since Obama said on Friday his administration saved the economy and financial markets. MISSION ACCOMPLISHED Mr. President you fool

  3. Krazy Kat

    Chris & Retired IB’r:

    The link below is the source of the discussion of HFT which is quoted verbatim above (whomever sent it to RIBr got it from there). It is from a contributor to Seeking Alpha who is from that class of commenters known as perma-bears. That does not make him wrong, but a review of his article titles going back to mid 2007 indicate a consistent slant. That said, if you have invested with his perspective, you would have done very well on a relative basis since 2007 and just might have gotten out of 2008 with a modest gain. Of course, perma-bears can miss out on real rallies when they occur and I am sure his views kept his followers out of the rally since the March lows. He may be correct that the market will experience another major pullback but if he was short or flat, he has had a long four months.

    Aside from his motivations, I think his analysis is a bit flawed in at least one regard: conflating program or computer driven trading that is being done by actual (institutional or ETF) investors with HFT that is nothing more than profit seeking by traders (the concept of computers “trading with themselves”). Many large institutions and ETFs trade via computers that use algorithms that try to lower their VWAPS (volume weighted average price). The stock exchanges brought in various large traders (Goldman, Renaissance (Simons), GETCO and others) as SLPs (supplemental liquidity providers) to help “grease” the market. There is nothing wrong with this function as long as the SLPs are only one end of a buy-sell transaction rather than both sides. There is also nothing wrong with this as long as the trader does not pass along his trading flow to his prop desks which can then use their faster computers to front-run the trades as discussed in the SA piece (Goldman has been accused of this by some observers). BTW, have you wondered who the biggest buyers of super computers are these days? Hmmm.

    The link below is to a decent artile on HFT and Shumer. It notes that the NYSE suggests HFT makes up nearly 50% of trade volume. Still high but not the 70% suggested in the linked article.

  4. Question for IBer

    This has been very helpful … could you just explain one thing?

    ” … High Frequency Trading Programs (HFTP) collect a ¼ of a penny rebate for every transaction they make. They’re not interested in making a gains from a trade, just collecting the rebate.”

    Who is paying them these 1/4 of a cent rebates?


    Old School Grump

  5. Walt

    Dude –
    Stick to selling dirt. You are way over your head here. We are all screwed, and the real shit is still yet to come in terms of the financial collapse, but it has nothing to do with HFT, and everything to do with the Fed’s artificially propping up a broken market, and not allowing a natural correction via free market capitalism. All stuff you wouldn’t understand. But trust me, we are about to be hit by a brick. Then we will all look to Obama to save us, and give up our God given rights in exchange for help. That is the plan. TOTAL redistribution of wealth.
    Anyway, what is going on with Stephanie Seymour? No news recently. What I would do to that little minx!!!!
    Red Sox are going down again, more often than Linda Lovelace, my friend. It sucks to be you, Weasel Boy!!
    Your Pal,

  6. Retired IB'er

    Krazy Kat wrote:

    “There is also nothing wrong with this as long as the trader does not pass along his trading flow to his prop desks which can then use their faster computers to front-run the trades…”

    I was under the impression that front-running is exactly what is going on. HFT trading identifies buyers of quantity and buys the shares to resell, thus making a tiny profit. But I am not expert having been on the M&A side and not the trading side.

    Old School Grump wrote:

    “Who is paying them these 1/4 of a cent rebates?”

    Through HFT a dealer places itself “in between” a trade so the “final” buyer pays the incremental cost.