Demystifying High Frequency Trading

High Frequency TradingThe media recently flipped the floodlights on the new black box de jour: High Frequency Trading (HFT). Only a handful of people who work closely with the exchanges truly understand HFT, so I asked for some color from my friend and top pro quant trader Fari Hamzei from Hamzei Analytics.

Damien: Fari, why is High Frequency Trading one of the hottest new topics in the financial media?

Fari: HFT firms deploy co-located servers at the exchanges/ECNs and Dark Pools. As a result, they take advantage of seeing some of the order flow using very high speed computers with very low latency. The computers execute trades ahead of both retail and institutional orders. The execution times are in milliseconds due to co-location.

HFT is an extremely profitable business — over a $20 billion run rate now. These days, HFT can account for up to 60% of the volume in certain equity names. HFT firms also get liquidity rebates from exchanges/ECNs for their order flow they provide to the exchange — about $0.005/share.

However, this is not market making. Rather, this is artificial volume creation. As evidence for this fact, please look at share trading volumes in Citigroup (NYSE:C), Bank of American (NYSE:BAC), and CIT Group (NYSE:CIT). On some days their combined volume is 10% of all US equities! That’s unbelievable! We have three stocks out of over 5000 names with a constant bid/ask present in the three to five cents range!

In addition to seeing the order flow mentioned above, HFT computers can see institutional flash orders. The Associated Press reported that, “So-called flash orders allow certain members of Direct Edge, Nasdaq and BATS exchanges access (for a fee) to buy and sell order information for milliseconds prior to that information being made available to the public. High-speed computer software can take advantage of that brief period to allow those members to trade ahead of those orders — at better prices — and therefore profit from advanced knowledge of buying and selling activity.” Sen. Charles Schumer is fuming about this issue.

Fari Hamzei

Fari Hamzei

Damien: Is HFT the mystical black box de jour, or a fundamental change in the auction process?

Fari: HFT is a trading strategy, not a necessary component of the auction process. HFT is all high-speed algorithmically driven arbitrage — for example, pairs trading, cross-asset arbitrage, etc. HFT uses predictive models borrowed from the advanced artificial intelligence world. Examples include parallel neural nets. I have some experience in this area because I did some work for a major CBOE market maker back in 2000-2002.

High Frequency Traders claim to be market makers — a necessary component to the auction process. They claim the liquidity they add to the market has lowered volatility and helped narrow spreads. However, this is not true because, unlike a traditional market maker, High Frequency Traders have no requirements: No minimum size to display, no minimum time to display a quote, and no capital commitment to a client.

Damien: Do High Frequency Traders have an effective monopoly because they use cutting-edge computers as well as highly advanced mathematics?

Fari: I don’t think so. There are very low barriers to entry to becoming a High Frequency Trader. All you need is to become a client of a sponsoring broker.As a result, this will eventually cause market saturation and reduced HFT margins. Only the biggest, fastest  computers will be making money consistently.

Damien: How will HFT affect retail traders?

Fari: HFT will affect retail traders big time because HFT firms have no market making obligations. They can walk away during a time of duress in any given equity — for example, when a bad earnings report releases, Hight Frequency Traders can simply walk away and cause the stock to fall off a cliff, thereby seriously damaging the small retail trader.

A great real example is when the SEC banned short selling in 19 financial stocks last fall. We saw spreads widen by 40% and volume dry up. HFT firms could not participate because they could not quasi-safely arbitrage the trades.Mini Ad Premium 2

Damien: What can retail traders do to use HFT to their advantage, or at the very least incorporate the awareness of HFT into a trading plan?

Fari: Retail traders cannot do anything. HFT happens too fast — even for institutional traders much less retail traders.

Legally, some form of restrictive regulation needs to be put in place, fast. Unfortunately, at best these regulations will go in effect some time in the future and cannot be retroactive. In my opinion, these are more reasons to trade stock index futures — which is what we do at Hamzei Analytics.

Lastly, I recommend retail investors learn more by reading excellent articles such as Zero Hedge’s “Goldman’s $4 Billion High Frequency Trading Wildcard.”

Damien: Fari, thanks for taking the time out of your busy schedule to help us better understand this mysterious niche in the markets. And, congrats on your recent quotes in Barron’s!

Fari: Anytime. Thank you very much!

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Click hereto read my Review of Fari’s excellent book Master Traders.

This article was originally posted at Green Faucet.