Saluzzi on the Typical HFT Scenario

Wednesday, September 16, 2009

Joseph Saluzzi has a great breakdown posted today about how HFT algorithms profit in smaller, thiner stocks:
While we would agree that the large cap space is in fact a playground for at least one style of HFT (rebate-driven), and that liquidity is added by HFT in the top 100 large cap stocks, and spreads are tightened as a result in the top 100 large cap stocks, we agree with the NYSE study that shows that outside that group of stocks, volatility has increased, and spreads have widened.

We do not believe that this is due to a LACK of HFT in the space, but rather it is due to predtory algorithmic HFT preying on less liquid stocks. There is plenty of HFT in small caps! We battle them every day for our clients. And buyside traders comment to me daily that each day it is like a cage match out there. As soon as they start buying a stock, bid, or take on offer, wheels are set in motion where, the buyside footprint is detected, predatory HFT accumulates positions in front of that presence, and sells it back to the buyside higher. The presence of HFT in small and midcap stocks is actually much more obvious than in large cap stocks, by many accounts.

Typical scenario:

1. Buyside trading desk receives an order from PM to buy 200,000 FSLR (First Solar).
2. Trader1 places bid in ECN for 135.20 for 25,000 shares with reserve book showing 200 shares, and discretion, or pehaps an arrival target algorithm, which does something similar.
3. Trader1 takes 600 shares at 135.30, and bids 135.25 for 24,400 showing 200, with discretion.
4. HFT1 automatically bids 135.26 and takes 1,000 shares up to 135.31.
5. HFT2 automatically bids 135.31 and takes 1,300 shares up to 135.35.
6. HFT3 automatically bids 135.35 with discretion up 3 cents from there.
7. Trader1’s algorithm floats his bid up to 135.35 and takes 1,300 shares up to 135.40.
8. Trader2 at another institutional firm, who already had an algo in place to be 15% of the volume, sends in 800 shares to buy at the market; FSLR now ticks 135.55 with a building depth of book on the bidside.
9. Trader1, frustrated, at his own lack of buying volume, and the fact that the stocks jumped 40 cents on less than 5,000 shares, takes stock up to 135.75 to catch up on volume. He bids 135.60.
10. HFT1 and HFT2 continue to bid ahead of him and accumulate shares. At some point HFT dumps the shares much higher than their buy price.

The HFT is not making pennies here. It is making dimes and quarters and more. Is HFT in small caps? A good many of us would answer differently than the WSJ article.
Saluzzi's description is dead on. It's up to regulators to decide if this creates more efficient markets.


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