High Frequency Trading

[Saz]

Alright, going to summarize my notes from this, mostly for my own benefit. If anyone knows anything about this please correct me. Crazy interesting topic.

High Frequency Traders essentially employ computer automated trades to outpace the rest of the market. Having an advantage in execution speed allows them to employ a diverse set of trading strategies, most of which all but guarantee a profit when done correctly. Arbitrage is the most obvious, capitalizing on bid/ask spreads or divergent prices between exchanges and flipping back and forth between positions before the rest of the market can adjust. They also can take up directional strategies, being the first to learn about market relevant news or trends and then beating the rest of the market to certain profitable positions. There are several types of strategies I won't go into, but the basic premise is they trade on speed and thus have a first mover advantage, and can capitalize on any trading strategy that rewards such first movers.

Now here is where it gets really deep. Because HFT can corner a market, and leave little reliable profit for anyone else (even large sophisticated institutions), many financial institutions have set up Dark Pools to better match trades. The premise is pretty simple, no one knows what trades are available in the dark pool, so there really is no informational advantage. Rather than going to an exchange and publicly announcing I'm looking for someone to buy X shares at Y price, that bid goes into a dark pool and remains private, until an appropriate counter-party looking to buy X shares at Y prices is found. The way it was explained to me is like the Priceline bidding app. A hotel will offer to sell you a room at a lower than advertised rate, they simply don't publish it publicly until someone bids at that rate. Large financial institutions need a non-public market like this to match trades, because otherwise high frequency traders would pick up on any public information and bring it to market quicker than any other institution.

Now, many HFT's have gotten wise to dark pools, and will carefully place bids in a number of various dark pools to feel out the waters. They will put in small bids at a variety of prices in a variety of pools, and depending on which trades end up matched, can learn a bit about the composition of the dark pool. Using algorithms, many HFT's can figure out what institutions are selling what shares at what prices in a dark pool, based on a very small amount of feeler bids being put out. To the extent that HFT's can figure out what is being offered in a dark pool, they can incorporate that supposedly non-public knowledge into their trading strategy to make a profit. For example, if a large institutional investor is trying to sell a ton of X share in a certain dark pool, that share price will probably drop shortly in the future. And because dark pools are private, only HFT's who have figured this out will know, giving them a huge market advantage.

However, once multiple HFT's start employing this strategy, dark pools become unregulated markets. Each HFT has their own algorithm and commits a certain amount of capital to making these feeler trades. Some algorithms are better than others, some HFT's make more feeler trades to better figure out what is in the dark pool. This creates information mismatches among the HFT and there effectively becomes a market within the dark pools. One HFT may think a big institutional investors is selling X amount, another may think a big institutional investor is selling Y amount. The difference determines what price the HFT wants to buy or sell at and so you end up with a pretty liquid market, all within these non-public dark pools.

Now institutions have changed up these dark pools to better serve their own interests. They put minimum bid amounts on certain dark pools, minimum complexity requirements, etc essentially to filter out these feeler trades HFT's are using to try to figure out what is in the dark pool. In order to ensure that other hedge funds and investors can participate in the dark pool market, they may also change up the matching tactics for a given dark pool. So rather than the first person to put in a bid at a certain prices getting the shares, they may give the shares to the largest offer of a certain price that comes in a given time frame, or they may split the shares among all the bidders at the same price.

The issue is: does anyone really know what the ENITRE dark pool market looks like. Large HFT's may have a guess, since they play in every pool to a certain extent. But their information is imperfect and based on these feeler bids. The institution running the dark pool may know what is in it's dark pool, but it has no idea what is in anyone else. Goldman can tell you all about the contents of it's Sigma X pool but ask them what's in any other pool on the market and they have no idea. And since this is all non public, no one actor is able to actually see the whole market so we have no way of judging it's overall health or efficiency.

I will add more soon but jesus f**k christ there are some smart people designing and playing this game.

[exploited]

Yup, nothing like generating many millions in profit by earning fractions of cents every tenth of a second.

[eynon81]

[Saz]

"Any sufficiently advanced technology is indistinguishable from magic.'"

It's shocking how close we are too perfectly efficient markets.I know non wants to whip out the pitchforks but this is just a necessary path on the road to perfectly efficient frictionless markets. The work HFT's are doing today is rapidly approaching a point where the market is not only perfectly efficient, but increasingly anticipatory.

I'm listening to a presentation now and the guy is explaining how to stake out a position in the market without HFT's and their algorithms figuring out what stake you are trying to buy and essentially incorporating that knowledge into the market before you can even solidify your position.

[Saz]

God help anyone stupid enough to think they can beat the market

[Saz]

Alright, I updated it.

Another interesting question with regard to the overall efficiency of a market involving these players is whether the benefits of a more efficient market outweigh the costs of certain traders having an informational advantage within the market.

Plus, there is also a concern that because of HFT traders, something like 40% of market activity is now performed by computers operating on complex algorithms. This is to say there is a ton of trading activity that is based purely on the movement and trends within the market and not on the quality of the underlying assets or the fundamentals of a company's stock.

Thoughts?

[eynon81]

[Saz]

HFT's really weren't responsible for the crash though. There was once instance in 2010 where a perfect storm of events caused a bunch of algorithms to essentially death spiral, and wipe about a trillion off the markets in literally seconds. But this was quickly corrected once the humans looking at the screens realized what was going on and corrected it. It does hint at the problem of having so many trades being computer automated though, it radically increases leverage. A small event can cause a chain of instantaneous and automated reactions that can drive a market to absurd highs or lows. However, I think this issue could be solved by simply upgrading and improving the kill-switches the SEC already has in place.

Yes, it is speculation to a degree but that does not imply it is useless. Look at the arbitrage example. HFT's can do it better than anyone else and technically it's naked speculation, buying high and selling low and doing it quicker than than anyone else to turn a profit. But because it do done so quick, there is almost no gap in the markets. An efficient and effective market should not present opportunities for such arbitrage and as more HFT's enter the markets, their margins are collapsing because the markets become every more efficient as just about every arbitrage opportunity has been taken. It boosts liquidity and makes it easier for the market in general to allocate buyers with sellers and borrowers with lenders because the public market is damn near perfectly efficient.

With regard to the informational advantage: it's unfair but not necessarily bad. Again, the example I heard spoke about the rothschilds during the napoleonic wars. They would have messengers send carrier pigeons from the battle field to provide constant updates about how the war was going. Since the rothschilds got the information first, they had a huge trading advantage over most everyone in the market. But society also benefited by getting much more timely news about how the war was going, so on balance their unfair activity was socially beneficial. HFT's are much the same. It's also important to remember that no one is really locked out of becoming a HFT trader. Anyone can put up the capital to buy the fiber optics and accrue the same advantages HFT traders today enjoy.

[Saz]

[Stratego]

HFT is like playing poker with exposed cards.