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The 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 (C), Bank of American (BAC), and CIT Group (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
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.
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!
If you are interested in real-time market analysis, click here to follow Wall St. Cheat Sheet on Twitter.
Click hereto read my Review of Fari’s excellent book Master Traders.
This article was originally posted at Green Faucet.
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Thanks for sharing about the latest buzzing topic on HFT. I truly enjoy Fari’s insights.
Thanks, Jenny! Fari is an incredible veteran in the game.
“Parallel neural nets”? Absolutely not. 98% high frequency traders have strategies that do not have a black box in the middle of them. They want to know whats going on in all steps of the arb process. Some people use very restricted machine learning algorithms to data mine, but I’m fairly sure people don’t build their entire arb strategy around those things.
Fari said he has experience with parallel neural nets. He mentioned several examples of HFT. I think you may have misread that.
Parallel Neural Nets are used to predict intraday price action within the options order flow — Fari did it to predict options block trade Buy or
Sells. This is an example of AI world applied to options trading.
You are thinking of HFT for stocks. Our article goes way beyond stocks. We also dealt with options and futures. No one talks about these on other media outlets … at least that we know of.
“Causing prices to fall off a cliff”
At what point will people realise that if prices fall off a cliff because some idiot pulls out of the market – its time to double up. There is VALUE in a company (or asset – whatever), you are as bad as they are when you make these kind of arguements. The people who get killed the most are societal leeches who used to make money day trading, and provide zero value to the world. For the average joe-blow this has little to no effect as he trades a few times a year, stays long, and only sells when he needs to. His marginal loss is just that…. marginal.
The ability of the semi-rich (and second tier to the massive pools of capital Goldmans and others employ) few to lobby senators and the media into an ‘outrage’.
In short: its been a long time coming for day traders, good riddance.
Interesting thoughts. Although, I think it’s not a factual statement to say when an investment vehicle falls off a cliff there is suddenly value. LEH et al prove this point in a way that is more the rule than the exception when we account for the fact that stocks like Enron and World Com (not to mention the staple banks in this collapse) where some of the most widely held stocks, and those who chased value lost all their money. I would also take a look at an inflation adjusted chart of the S&P500 from 1972 until today. Unless you like losing money, there’s not much value there either.
Although you are correct that day traders do not provide social value, if you are going to rid the world of everyone in that category you better be prepared to annihilate everyone who does not deal in food, shelter, water, or medicine. Almost every remaining industry relies on artificially created demand (hence the importance of marketing).
To get back to a more detailed example, suppose the average person has 20,000 of a 200,000 retirement account in s stock like BAC (mentioned above). Now imagine the stock “falls off a cliff.” Most people are going to succumb to fear and sell — they are not going to have the guts to double down. As an experienced trader myself, I know for a fact that those who double down and win are very few and very far between …
Fair enough – at some point you have to step back and say. Hey there is all this hype – but what is the actual damage, who is taking it, and do we care?
And I would argue that you dont regulate to protect people who dont really provide any value.
Though the 30ms head start is BS and should probably go – but in the end it should disapear quickly enough.
Its a pretty fundamental question at the end of the day – about the level of regulation you are comfortable with. It is NOT simply “they are doing something wrong, lets regulate it and make everyone strictly better off”
Agreed. Thanks, Nick, for the good conversation! I look forward to your thoughts on future posts too.
You may have just signed the death warant for ALL investors.. including your despised day trader..
Not sure I understand your comment.