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David White is a software/firmware/marketing professional and a long time investor. He has worked in the networking field, the semiconductor equipment field, the mainframe computer field, and the pharmaceutical/scientific instrumentation field. He has bachelor's degrees in bioresource sciences... More
  • High Frequency Trading Can Be Insider Trading 1 comment
    Mar 21, 2010 9:35 AM | about stocks: SPY, QQQ, DIA, HOG, X

    High Frequency Trading is essentially extremely fast trading. There are many strategies. Some of these strategies involve options and futures trading as well as equities. I will limit this article to equities trading only, for simplicity’s sake.

    One of the strategies for HFT is called stealth. Big orders can be termed an iceberg. Since they are big it is generally cheaper to break the iceberg up into smaller orders. This can allow a smart computer program to identify an iceberg quickly. An HFT program can then buy ahead of most of the iceberg’s trades (in a BUY iceberg case) . Then the HFT can effectively sell to the iceberg at a slightly higher price. In another case, some major players receive FLASH notices of trade requests for say 30 microseconds before others see them. With their super fast computers, they can buy (or sell as may be appropriate) ahead of those trades. Then they can sell quickly at a slightly higher price. They don’t have to sell to a particular requestor. Their quick scans can tell them that the preponderance of orders is of one type. Another strategy may be predictive (not need flash, which not all HFT users have access to) by following the micro trends in the UP and DOWN volumes in a stock. The actual strategy is more complex than this, but you get the idea. Usually this kind of HFT will only be done on highly traded stocks. Some players even get paid a tiny fee for providing liquidity. In total HFT is said to provide approximately $21B/year in profit. This is no small enterprise. According to Zero Hedge, High Frequency Trading accounts for 73% of all US equity trading volume. There are many more strategies than those I have simplistically outlined above.

    How can High Frequency Trading be insider trading? Actually there are a lot of ways. One is through the FLASH notices that I have described above. However, I am only really writing about one very abusive case in this article. Specifically I am writing about High Frequency Trading in highly shorted stocks. In most cases, you could say that HFT traders were taking the same chances as every other investor. This is not true of course, but they do have the risk of down movements as slower traders and retail investors do.

    In highly shorted stocks, even this is not really true in these short time periods. Once a stock has been shorted by 10%, the uptick rule is in force. The HFT traders have to worry much less about the stock going down in the small timeframe they are dealing with (presuming they are playing it to the upside). This is a hugely unfair advantage. More than this, they can actually engineer short squeezes -- a job made easier by the uptick rule. This is the situation that I find most disturbing. HFT can feed a short squeeze, especially if it is of the predictive type of HFT. If a lot of HFT players are playing the stock at the same time, they can just be selling to each other, Then each transaction will drive the price of the stock up. When the short squeeze really starts, the little profits they usually make are multiplied many fold. Many shorts are forced to cover. The stock price can skyrocket quickly. Some retail investors are fooled into entering the quickly rising stock on a price and volume basis. They can quickly find themselves holding a far over inflated equity. The bottom can fall out for them quickly. The HFT players, who operate in microseconds, are long gone by then. The non-HFT shorts that were forced to cover have also lost money. These people were often investing to the shrot side on a fundamental basis (too bad for them).

    Now some might say this is true of most stocks to a large degree. Why am I making such a big deal about highly shorted stocks? The real reason is that it leads to what I consider serious crime. Some one can start a rumor about one of these stocks. The price can skyrocket. The HFT traders are not singled out by a high volume of stock or options purchases, as they might have been in the past. Instead they are hidden to a large degree in the heavy volume of many HFT players. They can commit this crime of improving their HFT results without specifically identifying themselves as culprits. Another method might be for a brokerage house or a group of brokerage houses to among themselves agree to raise their recommendations on a highly shorted stock, even though the fundamentals may not justify a higher recommendation at all. If they spread these raises out over time, they could keep the stock in a short squeeze mode for a long period of time (or many great days of short squeezes with some retracements in between). The brokerages could then use their predictive model HFT on this stock to make huge profits. Again they are not singled out by big options or stock purchases. Can I say I have proof of this happening? No, I do not have the kind of proof to take to court. However, it is reasonable to presume that it does happen. If I have thought of it, some on Wall Street have been greedy enough to do it.

    The Congress and the SEC should see the truly huge possibility for abuse in this area. What I have described above is likely already illegal. However, the possibility of some one getting caught and convicted are probably slight. If it is hard to prove guilt in these cases, it is better to do away with the possibility of this abuse. HFT trading should be outlawed for any stock for which the uptick rule has been invoked. This will not level the playing field. However, it will prevent retail investors from buying into the worst of the fast moving suckers’ rallies, which are most likely to make them poorer. It will help to prevent brokerages from as blatantly lying in their recommendations about stocks in order to further their HFT gains. Perhaps this restriction should apply to stocks that are over 5% shorted, not just those that are over 10% shorted. If you believe the markets and the brokerage houses should have some integrity, you should support this restriction. The SEC should be able to easily identify if HFT trading is occurring on a stock.

    Now some might argue that this might seriously impact the liquidity of the affected stocks. This is a valid concern. However, there are few stocks that are more than 10% shorted. It might be good if they actually had less volume. With the uptick rule in force, they should still have limited negative movement due to the removal of the HFT volume. If you wanted to include stocks shorted only 5% in this rule change, you might have a bigger problem. That might be solved by specifying the use of only specific types of HFT on stocks that are 5% to 10% shorted. If good regulations were developed for these stocks, the average investor would benefit. This is what Congress and the SEC should want. Wall Street will find a way to make good money with HFT without these extreme and likely often abused cases.

    Do I think brokerages sometimes give false recommendations in order to aid their HFT programs? Yes, I am virtually certain it happens in some cases. Do I think some HFT trading houses start false rumors in order to help their results? Yes, again. Do I think some Hedge Funds and/or brokerages may sometimes act in collusion in their HFT trading? Yes. The market has recently been described as a slow melt up. If 73% of the volume is due to HFT, who do you think is responsible for the melt up? Who do you think is making the most money from it? If HFT is responsible for most of the up move, who do you think will be left with most of the down move? If the whole system could be easily changed without inducing a major financial meltdown, I might recommend that. Unfortunately, I don’t believe now is the time to mess with a very complex system. HFT undeniably does provide often needed liquidity to the markets. The small changes I have recommended might right some of the worst abuses. They would have little overall effect on the healthy functioning of the markets.

    If you want to convince yourself of the truth of any of my assertions, all you really have to do is to think of the pronounced phenomenon of sector rotation. A sector becomes hot for a few weeks. Then it drops out of favor as other sectors become hot. Cyclicality is normal to a degree, but is it normal to the degree we see it? If tech stocks are a good bet for much of the year, why can't they be a hot but slower rising sector in all of the upturns? The most obvious explanation is that the HFT traders take their profits, then they give the sector a rest. The sector falls on its own with the lower volume. In not too long the sector is again ready for the HFT folks to give it another rise. Often this happens irrespective of news. For instance, in Jan. the tech sector rose before earnings. Then though earnings were good the sector was flat to down. HFT volume does seem to be the most likely explanation. The HFT players do not even have to lower the volume dramatically, they can merely shift the algorithm being used to a highly safe one from an aggressive predictive one. This is an example of why timing the market can be a losing proposition for non-insiders.

    If you want to avoid the worst of HFT, avoid the most highly shorted stocks.

    Good Luck trading.





    Disclosure: I have no positions in these stocks at this time
    Stocks: SPY, QQQ, DIA, HOG, X
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  • Armando Alizo
    , contributor
    Comments (234) | Send Message
    Frankly I'm not too concerned about shorts, most traders on the short side are big boys and they should know what they are doing and the rules of the game. I am opposed to FLASH pricing - there is no reason to give an advantage to one trader over another in the market.


    But in any case, HFT should be seen primarily as a competition between market makers that has negligible impact on intermediate and long-term traders/investors.


    Yes, big mutual funds can get "hit" by HFT when trying to accumulate or distribute large blocks of stock (which could indirectly affect the "little guy" invested in the fund), but that's why most individuals should stick to using Index funds or ETFs, since the vast majority of mutual fund managers have demonstrated that they can't beat their benchmark.
    23 Mar 2010, 10:11 AM Reply Like
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