The New High Frequency Trading Landscape: Man Versus Machine

Includes: DIA, QQQ, SPY
by: Benzinga

By Hilary Farrell, Benzinga Staff Writer

Last week, 11 financial and Wall Street firms, including the Security Traders Association and NYSE-Euronext, issued statements on future practices for fair markets. Perhaps not surprisingly, the subject of high frequency trading came up as a prominent issue affecting today's trading exchanges.

High frequency trading is the use of computer programs, tools and sophisticated algorithms to trade the markets. Positions are held for short periods of time, and the algorithms often move in and out of these trades in small increments. The key components of high frequency trading are speed and aggregated profit.

High frequency trading has received criticism for being unfair, and even though high frequency trades make up to 70% of all equity trading volume in the U.S., it is rarely discussed in retail circles and financial media. co-founders Joel Elconin and Dennis Dick have over 30 combined years of experience in the markets, and are both outspoken advocates of educating traders about the differences between algorithmic trading and "predatory" high frequency trading practices. Dick said:

This is where the gripe starts - with the predatory aspect. I would define a predatory HFT strategy as any automated strategy that seeks to profit from other participants' order flow - by stepping ahead of those orders, getting a sneak peek of orders, or finding large orders to step ahead and front-run.

The Dangers of Predatory Practices

Elconin and Dick compare predatory high frequency trading to a poker game, one where the opponent can "sneak peek" a hand before the cards even hit the table. Unfortunately, a lot of stock market "poker players" are unaware that this peek is so widely available, let alone with minimal regulation. Dick commented:

Retail orders do not go directly into the market for the most part. Those orders get routed through a matrix of complexity - there will be up to hundreds of firms that actually get to take a sneak peek at theseis orders, and decide if they want to trade against them.

The order flow getting into the market is filtered; in the marketplace itself, you basically have no uninformed orders. Those orders get internalized and traded against, before they actually get to the public market. Orders don't go directly to the exchange, and [they] are looked at by all these firms looking to get a step up on everyone else; take the opposite side of dumb money. That's a huge edge, and that's what's happening in this market - privileged participants getting a sneak peek.

Ultimately, predatory high frequency programs and trading strategies further widen the gap between the "haves" and the "have-nots" of financial access. Dick explained:

Everybody should have the same chance to trade that order flow. What we're trying to do is make people cognizant of this, to adjust their trading strategies accordingly.

Among other dangers, high frequency trading affects overall fluidity, Elconin said:

In the old days, if someone wanted 200,000 shares of Johnson & Johnson (NYSE:JNJ) executed, there's no reason why that order in the old days couldn't have gotten done on a quarter or eighth of a point. But now, orders are broken up into very small pieces, and with the high frequency traders there it takes a lot of fluidity out of the marketplace.

Dick pointed to market open activity as another example:

We have trouble executing - like [in the] first five minutes when there's not a lot of liquidity. It appears to be there, but it's fleeting liquidity. When you try to hit it, it will move; it's just that fast. That's why you'll see (so much movement) in the open. When there's risk, they're not providing liquidity. Liquidity comes with a limited amount of risk.

High Frequency in 2010's Flash Crash and Facebook

High frequency trading is famously cited in the flash crash of May 6, 2010. Five months before the flash crash of 2010, Dick sounded the alarm, calling January's violence in Rambus trading an indicator of "things to come" on financial site Zerohedge.

High frequency traders make markets on all stocks. As they continue to take dominance, and as more and more liquidity providers are driven out of the market by these HFT predatory algorithms, the likelihood of a crash continues to climb. All it takes is a little bad news, and a breach in the HFT's algorithmic system's risk parameters, and we're in a lot of trouble. . . Rambus was one stock today. Imagine if it was the entire market.

High frequency trading hit the headlines again in Facebook's (NASDAQ:FB) now infamous initial trading day. (For more information on high frequency trading activity in Facebook, see Pre Market Info's video here.)

Popular and Predatory: Two High Frequency Strategies

1. The Tractor Beam: This occurs when high frequency traders find a large order on its way to being filled, hop in front of it, and turn around to sell ahead or against it. A recent example of this activity was in Johnson & Johnson around $67:

The high frequency traders find a large-size order, and they know there's a huge seller at $67 [from publicly-available information and filings], so they were selling at $66.96, $66.97. Then they turn around, and they get on the bid at $66.91, $66.92, scalping a few cents. This reduces volatility to a very low level and can actually lock in the price for a significant time period as more and more HFT players participate in the game.

2. High Frequency Penny Jumping: Penny jumping is found more often in small and mid-cap stocks and with a wider spread. Dick explained:

Say the stock has a $25 bid with a $25.50 offer. If you bid $25.01, the high frequency traders bid $25.02. If you bid 25.03, they bid 25.04. It's very predatory, because you can't even be on the bid.

More often, however, a "Penny Jumper" is on a micro level - jumping by sub-pennies, hundredths of a percentage point, or even smaller. Elconin said:

They're really not jumping ahead of you by a penny. [From] $25.01 to $25.02, the high frequency trader could be buying at $25.010…

The deluge of predatory HFT players trying to jump the order queue can flood the market and unfairly take advantage of the initial bid. Dick said:

You have the retail guy, then the high frequency penny jumper. Then the sub-penny jumper. It's a Then [all of a sudden] you have a high frequency tractor beam, and a big game of leap frog to get to the top of the order queue.

How does an investor experience more "overall fairness" in the markets against the machines and monsters? Exposure and education. Elconin explains:

One inherent flaw with high frequency trading [is] a high frequency program is just that. It's a program designed to do what it's been programmed to do. The flaw is that it's very predictable.

Knowledge is power. If you know where those high frequency traders are going to be buying or selling, then that's going to give you a little bit of an edge.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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