The Nuts and Volts of High Frequency Trading

Courtesy of Penguin Publishing

Michael Lewis' Flash Boys ends with "all that one needed to discover the truth about the tower was the desire to know it." So, although parts of the book will be discussed throughout, I advise you to read the book- I would not hold my breath for another movie. 

First, a definition: high frequency trading, according to Investopedia, is "a program trading platform that uses powerful computers to transact a large number of orders at very fast speeds." Essentially, someone creates a rule or algorithm, and the algo searches through an incomprehensibly large stream of data to find information that it can turn into trades based on the rule. Logically, one could conclude that due to increased trading volumes- HFT was responsible for over 50% trades in 2012- that the markets are more liquid, spreads are lower, and technology is being leveraged to create new financial powerhouses like Citadel.

Before we form any opinions, let's see how electronic trading has helped HFT firms secure an advantage. When an order to buy, say 10,000 shares of a company, is placed, all those shares won't necessarily be on the same exchange. Regulation NMS requires brokers to trade at the National Best Bid and Offer, or the lowest ask and the highest bid for their customer. The regulation, does not however, specify to what exchange the trade goes to. Often a larger order will not be able to find all the shares it wants to buy or sell on one exchange. The trade can fulfill a portion of its shares on NYSE, a portion on NASDAQ and a portion on BATS, etc. When a broker places the bid to buy these, a signal is sent to the exchanges that it wishes to trade on, but due to differences in distances to each exchange's servers, the orders do not arrive at precisely the same time with differences in milliseconds, 300 of which it takes for you to blink or for Gene Wilder to steal your chess piece. 

Here is where HFT firms have the advantage. Their computers can see, process and act on this information (from the first exchange it gets to) before your trade reaches the other exchanges. This is the first charge that Lewis levels at HFT firms, and he calls it "electronic front-running." The second offense, according to Lewis, is "slow-market arbitrage," and that is when two stock exchanges (or more) have different prices for the same security. For example, say you wanted to place a big buy order for Yum! Brands because you sincerely believe the market has not priced the unbounded future success of Taco Bells' Waffle Taco and the Mountain Dew Kickstart Black Cherry into the stock price of Yum! Brands. If you place a big order, which occurs on the NYSE, that will bump up the price of Yum! Brands slightly and for long enough that HFT firms can exploit the differences in prices across exchanges. The third offense is the focus of a future posting.

So, these algorithms can process information faster than a human blink, and eliminate arbitrage, on the other hand, they could give HFT firms an unfair advantage (by seeing big trades reaching one exchange and acting on them before they reach the other exchanges). Please think about this, do some research, and we will meet right back here soon for a blow-by-blow recap of the Brad Katsuyama and Bill O'Brien fight on CNBC.

links to various articles:

http://www.forbes.com/sites/billconerly/2014/04/14/high-frequency-trading-explained-simply/

http://www.cnbc.com/id/101552392

http://www.nytimes.com/2014/04/14/opinion/krugman-three-expensive-milliseconds.html?action=click&module=Search&region=searchResults&mabReward=csesort%3Aw&url=http%3A%2F%2Fquery.nytimes.com%2Fsearch%2Fsitesearch%2F%3Faction%3Dclick%26region%3DMasthead%26pgtype%3DHomepage%26module%3DSearchSubmit%26contentCollection%3DHomepage%26t%3Dqry134%23%2Fhft%2F7days%2F&_r=0

x