Insights from High Frequency Trading World

Sean Hendelman, CEO of T3Live, was featured on a panel at the High Frequency Trading World Conference in New York yesterday. Sean runs high frequency trading strategies at T3 Capital Management, a separate but affiliated company with T3Live. The event itself was the largest of HFT events that I've attended so far seemingly pointing to the increasing interest in the business and, in particular, the greater awareness of HFT following the May 6th flash crash event. There was even a panel with strictly institutional investors where the broad conclusion seemed to be: we have no idea what HFT is doing to us. I also met a venture capitalist at the event who is looking to break into the business by funding a shop or strategy. Market participants all across the spectrum are recognizing the prevalence and staying-power of HFT and looking to 'get in on the action'.

My takeaway from the event

If I had one key takeaway from the event it would be: computers are faster than humans traders. It is amazing how crystal clear this message has become as I listen to HFT practitioners speak about their businesses. As I have written in the past, the manual side of the business requires more sophistication than ever as HFT has come to dominate the efficiency-creating spectrum, an arena daytraders found profitable in the past. With HFT now driving fantastic efficiency in US equity markets in terms of short-term supply/demand pricing, profitability in scalp-style daytrading has diminished. As a general rule, traders continuing to find success have been expanding their timeframes to profit from inefficiencies over longer time periods. Below is my summary of Sean's panel, let us know what you think!

Volume and Latency Concerns: The Need for Speed

Moderator: John Cogman, VP, Autobahn Sales, Deutsche Bank Securities
Adam Afshar, President and CEO, Hyde Park Global Investments
Chris Bartlett, Director, Nobilis Capital
Sean Hendelman, Chief Executive Officer, Managing Partner, T3 Capital Management
Tim Cox, Director of Execution Services, New York, Bank of America - Merrill Lynch
Feargal O'Sullivan, Head of Trading Solutions, Americas, NYSE Technologies

The motives for latency reduction

The discussion started with participants giving their thoughts on the motives for latency reduction: why do you want to be the fastest and how important is latency? Sean took the lead stating that the lowest latency is a key component of his business and he strives to achieve the lowest possible latency for his strategies. The barriers to entry are quite high with costs that many cannot afford when getting started. Bartlett chimed in to say that latency is a product of the particular strategy employed. For a particular strategy, the relevant question is: can you get the fill you need? How that question is answered will drive your latency needs.

Afshar, CEO of Hyde Park Global, a 100% robotic trading firm based on artificial intelligence, went about re-defininig the goal of HFT. He explains that the purpose is to deal with the non-linearity of price data by splitting up data in chunks and small enough time sets whereby it can be modeled linearly. He believes the limitations for HFT will not be technology as it is falling in price over time, but rather strategies are becoming more intellectually complicated. The real challenge is finding the talent capable of creating profitable strategies.

Bartlett threw some numbers into the debate to define the HFT playing field. The ultralow latency is largely needed for capitalizing on fleeting arbitrage opportunities and typically lives in the 100-200 microsecond land. Normal HFT players, the likes of liquidity providers and rebate traders, are somewhere in the 500 microsecond in latency. The accuracy of these numbers can certainly be debated but for the average daytrader suffice it to say that it's far faster than even the human eye can see and interpret the Level II.

Afshar once again reiterated his belief that, in the end, it will simply be a matter of the smartest people winning the race. He used GETCO as an example, the largest electronic trading firm in the world. Founded by two guys in Chicago just over a decade ago in 1999, the firm quickly became a powerhouse in the liquidity provision space because they had the best ideas. While they're definitely major technology user, their business grew out of nothing to something because of programming ingenuity.

The keys to the technology itself

Sean took hold of the discussion centered around the technology angle and used O'Sullivan's clarifying remarks about the pyramid of HFT players. The top of the pyramid is a very small, select group that engages in ultra-high frequency trading while just below and lower are the vast majority of traders that do not strive to be the absolute fastest in the market. Sean argued that while technology costs may be falling over time, maintaining a place in the top of the pyramid continues to require substantial investment costs. The goal with designing a architectural system is to keep it light and flexible. Large institutions often struggle with dinosaur technology because changing one piece requires the updating of many other pieces. In order to remain adaptable, technology must be kept as light as possible. O'Sullivan added that not only does complexity drive the need for technology but also the efficiency of the code itself in executing the operations.

Regulatory impact on HFT operation

Afshar explained how he thinks about the goal of technology: reducing friction costs. He contended that lowering transaction costs and the time in which money is tied up are the key purposes of buying new technologies. Regulations, in effect, impose arbitrary friction costs on traders.

Sean jumped in to say that regulation isn't really a major problem at the current time. Most HFT firms are already going through the process of pre and post-trade checks through brokerages. The checks on the order side are extremely rapid and nothing to worry about. Yet, the quote side has significant room for improvement. As Bartlett added, there is just a ton of data to receive and interpret on the quote side slowing processing capabilities down.

Measuring latency

Some very intriguing discussions on measuring the latency ensued. Bartlett spoke about the ineffectiveness of using the Windows clock because it is only precise down to about 15 microseconds. If one uses the exchange timestamps, they're all different and simply don't match up because there's no universal clock that can be synched to efficiently.

Sean changed the discussion a bit and gave HFT participants the easiest way to measure latencies of various vendors and exchanges. Build two of the exact same strategies and run them simultaneously with the one variable being a particular vendor. Whichever strategy gets the print is the fastest, no more discussion needed.


Brandon R. Rowley
"Chance favors the prepared mind."

WRG High Frequency Trading: Evolving Market Structure

The first panel on day one of the World Research Group's Buy-Side Tech: Global Equities Trading Summit was titled "Examining the Evolution of Market Structure for North American Equities: US & Canada".

Thoughts on the evolving market structure

The first panel was questioned as to whether high frequency traders add liquidity to the market or drive fragmentation. Joe Saluzzi of Themis Trading, an outspoken critic of many HFT practices, started the discussion by arguing that the current market is far too fragmented. While the duopology structure of several years ago with just the NYSE and Nasdaq was not ideal, the dozen exchanges and 40-odd dark pools creates far too much fragmentation. Deborah Mittelman, Executive Director at UBS, chimed in to say that she believes HFT does both, adds liquidity and drives fragmentation.

Matt Samelson, Principal at Woodbine Associates, contended that his studies of the top 40 securities by volume show that HFT certainly adds liquidity. I was a harsh critic of Samelson in my summary of the last conference because he didn't seem to recognize that the debate has moved beyond what he was researching. I was happy to hear him admit, after speaking with Saluzzi, that the complaint about the lack of liquidity in small caps may be legitimate. He clarified that his study was based on the 40 most liquid names and substantial research has yet to be done on the explicit and implicit execution costs in lower volume stocks.

Anthony Barchetto, Head of Corporate Strategy Group at Liquidnet (a leading dark pool provider), laid out some hard numbers on the state of US equity market structure. There are currently 13 registered US exchanges with 10 of them owned by the top four players: DirectEdge, Bats, NYSE and Nasdaq. These 10 account for 98% of the lit volume. While opinions on dark pools range dramatically, Barchetto maintained that current volume is about 30% in dark markets and 70% in lit, and this ratio has been relatively unchanged for the last few decades.

Another panelist talked a bit about market makers and said he believes these participants need to be granted greater advantages in today's markets. In order to smooth out volatility in prices, market makers are essential. Yet, without any significant advantage over other players there is no ability to enforce obligations on them.

Saluzzi ended the discussion by arguing that the core of the issue is with the exchanges which over time have transitioned from issuer, investor-focused models to for-profit constituent-driven pricing models. In his words, the equity market "ecosystem" is out of balance with such a large share of volume dominated by HFT. Investors are disadvantaged because exchanges now cater to the HFT players that create volume. Saluzzi proposed the creation of two distinct markets, a superhighway with HFT and then one that caters in particular to small and mid caps and reduces HFT participation. While the mechanics of how this would work are unclear, the sentiment is shared by many.

More posts to come on this conference...


Previous posts on the WRG Conference:

WRG High Frequency Trading: Bookstaber on The Future of Finance ~ October 27, 2010


Brandon R. Rowley
"Chance favors the prepared mind."

*DISCLOSURE: Nothing relevant.

WRG High Frequency Trading: Bookstaber on The Future of Finance

I had the privilege of attending the World Research Group's Buy-Side Tech: Global Equities Trading Summit. Longtime readers will remember I attended this conference five months ago and wrote up my thoughts then (Day One & Day Two). With different speakers and topics this second time around was just as interesting and enlightening. This post will cover the first speech of the conference with more posts to come this week.

What lies ahead in financial markets

The conference's Keynote Speaker was Rick Bookstaber, Senior Policy Advisor to the SEC. Bookstaber is a brilliant and influential mind (I discussed his derivative market reform ideas a while back). There was so much great content in his speech titled "The Future of Finance" that I am at a loss where to start.

Bookstaber began his speech by tracing the history of information proliferation. He articulated that we are living in a new age where firms "hide information in plain sight". While disclosure rules are effective in forcing companies to release information, Bookstaber rhetorically asked, "who actually reads (or believes) a company prospectus?" He told a story of surfing on a beach where he, as a novice surfer, pushed out into the ocean and tried to surf. After nearly killing himself, a much more experienced surfer warned him that the way the waves break on this particular beach leads to a very dangerous end of the run if you don't know what you're doing. This helpful gentleman recommended that Bookstaber move down the coast to another, safer beach. While there were warning signs at the beach, Bookstaber ignored them, exactly what we all do now as we've become immune to the relentless disclosures of risk. This is certainly a concept the SEC must study because disclosure is useless if no one reads it or firms muddle the waters by simply listing every imaginable risk.

A new risk to companies is the concept of "viral information flow". Firms can no longer control with any degree of certainty the news that travels around about their businesses. We don't know what will go viral and what will never gain traction.

Bookstaber's explanation of the flash crash

Bookstaber briefly explained what he believes happened during the flash crash and likened it to the 1987 crash. An exogenous shock exposed the structural deficiencies in the market. Like the portfolio insurance of 1987, today's market was filled with many retail stop loss orders and aggressive high frequency traders. With markets now moving faster than humans could intervene algorithms simply hit the next bid in the book. Obviously their computers cannot read intention and hit bids at silly levels, literally down to a penny in some stocks.

The real question then is, why is the order book so thin that this could happen? Bookstaber postulates that decimalization is a primary reason. Market makers need to collect spreads in order to be willing to take on the risk of assuming positions. He thinks minimum increments in stocks should reflect the "true" spreads and allow market makers the ability to profit. With a reliable business model for profiting from spreads, regulators could increase the market makers' obligations in liquidity provision. Another idea would be to give priority to liquidity providers willing to commit to a certain amount of time to stay on the book.

Algorithmic shredding the tactic now

A strategy now pervasive among HFT desks is termed algorithmic shredding. The goal of the algorithm is to shred information that would otherwise have been useful to other market participants. This term can refer to the breaking up of large orders into small, individual orders and using smoke screens of false bids and offers and other games to shield intent.

Bookstaber's discussion of this topic got me to thinking about game theory in economics. I recently listened to an interview with a Head Trader, Kurt Kujawa from Cortina Asset Management, on block trading and equity market liquidity. Kujawa laments the declining use of block trades among institutions and harshly criticizes the change to "young kids just throwing their orders into an algorithm" for execution.

It occurred to me that in the relatively transparent world of the past, the early adopters of algorithms likely found better results in execution. Yet, as everyone has now adopted the algorithm transparency is gone and blocks are only found in dark pools. So, in the end, we may find that we have worse execution for all. When everyone is anonymous and only out for themselves, we may end up with worse results overall.

Don't worry too much about May 6th

Bookstaber is not particularly worried about the implications of May 6th. In his book, A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation, he outlines products that can create a crisis. Systems that have tight coupling and complexity are prone to 'normal accidents'. He defines tight coupling on his blog:

Tight coupling is a term I have borrowed from systems engineering. A tightly coupled process progresses from one stage to the next with no opportunity to intervene. If things are moving out of control, you can’t pull an emergency lever and stop the process while a committee convenes to analyze the situation. Examples of tightly coupled processes include a space shuttle launch, a nuclear power plant moving toward criticality and even something as prosaic as bread baking. (Source)

Along with tight coupling seen in high frequency trading, complexity is clearly present with programs and codes few can understand. Therefore, with tight coupling and complexity HFT will have normal accidents. The real question is whether this creates a crisis which Bookstaber believes it does not. While losing 500 points in the Dow in a matter of minutes is scary and shocking, it quickly rebounded and now we have some safeguards in place to prevent it from happening again (individual stock circuit breaker so far).

Creating robust systems

Bookstaber discussed his "cockroach theory" for robust risk management systems. He critiques the use of value-at-risk (VAR) because it is pro-cyclical. Prior to a crisis volatility and correlation is low yet when a crisis hits both jump, oftentimes unexpectedly and dramatically. VAR will lead firms to increase risks at just the times they should not and will comfort those taking on the greatest amount of risk just before collapse.

Over-optimization to a particular financial environment will inevitably lead to disaster as the environment changes. Species throughout evolution that were perfectly optimized to particular climates or landscapes go extinct when the world changes. Yet, the cockroach while not a greatly optimized species, can survive is all kinds of environments helped with its simple defense mechanism of running away as wind crosses the spines on its legs.

Much more to come from this conference...


Brandon R. Rowley
"Chance favors the prepared mind."

*DISCLOSURE: Nothing relevant.

High Frequency Trading (HFT) Hits Mainstream on 60 Minutes Last Night

High frequency trading has now left the corner of the financial world and hit the minds of Main Street's 401(k) and mutual fund owners. The May 6th flash crash left investors of all kinds wondering, "what the heck happened?" Last night, 60 Minutes covered the topic in a short 13-minute story attempting to explain what HFT is, how it works and what happened on the frightful day in May when the Dow Jones Industrial Average lost 600 points in minutes before rebounding.

Tradeworx explains their HFT operations

Tradeworx CEO, Manoj Narang, has recently been one of the only HFT practitioners to allow the public limelight to shine on his operations. Narang shows how his firm is attempting to extract pennies from the marketplace in return for creating valuable liquidity for everyday investors that wish to buy and sell stocks. While he admits that his trading does not concern itself with company fundamentals or the capital-raising function of the market, he asserts that his goal is the same as any other participant: to make money. But is his definition of liquidity the right one? Liquidity, on average days, is arguably needlessly high in many stocks and ETFs. Yet, on May 6th, when it was needed most, Tradeworx shutdown their trading.

Clearly, no market participant is willingly going to lose money just for the sake of continuing to provide liquidity to the market. No one will catch a falling knife unless they believe the odds are in their favor to make money on the trade. Without stringent regulation and control of HFT firms, they have no fiduciary duty to anyone to continue making trades in the market during calamitous times. HFT has grown exponentially in recent years and their primary defense against allegations of unfairly extracting profits from the markets has been their beneficial liquidity provision. We must ask though: what good is liquidity if it's there to rake in pennies when you don't need it, and entirely gone in the rare instances when it's desperately needed?

Themis Trading strikes back

Joe Saluzzi of Themis Trading is not a fan of many types of HFT. He believes that any market participant making money everyday, day in and day out, must be paying for an unfair advantage. The secretiveness of most HFT firms certainly lends credence to the belief that these firms are engaging in unsavory behavior. Though arguments along these lines are countered by Lawrence Liebowitz, COO of the NYSE, who argues that accusations of uneven playing fields for those willing to pay for it have been around since the markets began.

Thinking about this sparked the vague recollection of something I read in Gerald Loeb's The Battle for Investment Survival a couple years ago and after searching I located the following excerpt from his book about his job in 1923:

In those days telegraph connection with New York markets was irregular and fast service was confined to only a very few security houses with privately leaded wires. I had noted that it was the custom in San Francisco for the local bond traders to "arbitrage," as they called it, by concealing rapid changes in the New York market of various bonds popular in the west. The bought these bonds cheaply in San Francisco when the New York market stiffened suddenly or sold them in the west at what seemed concessions in the price when they knew the New York market was sharply lower. In this way the local traders handled a few orders at a wide profit per order. I felt that the best way for me to break into this institutional field was to give a service that was calculated to bring me a great many orders at the low standard New York Stock Exchange commission for each. So I began to keep all the western traders posted on the New York changes just as a matter of accommodation. Instead of my trying to grab an undue spread, I told them the story and left it to them to route their orders my way instead of the competition. It took only a few days for me to develop one of the largest bond businesses of that type in the city. When the others started doing the same thing, I had the lead because I was there first and had forced them into adopting my method.

In my opinion, the value of information has always been very high. All market participants, in one way other another, are trying to gather information and deploy strategies before the general market recognizes the value. Even those outside of HFT shops still use a extraordinary amount of technology to receive and assimilate information to create trading strategies. Statistical arbitrage opportunities will always exist in one form or another, the only hope is that over time the margins on such opportunities will continue to be squeezed.

I believe this is quickly becoming the case in US equity markets as HFT strategies have proliferated. The tactic of manipulating prices is clearly something the SEC must work to eliminate and systemic risk issues should be addressed. So-called latency arbitrage, on the other hand, will likely take care of itself. We are already seeing inter-market strategies take hold as the next wave in innovative strategies with intra-market opportunities in US equities largely being reduced to razor thin margins.

The race for technological superiority is and will be persistent but ultimately code complexity will be the defining factor between those that triumph and the many HFT firms that will fail. The video below is well worth watching and the shots of the new Mahwah data center are impressive to say the least. The new world of trading will play out in microseconds, there is no going back. The public study of HFT must continue as regulators have clearly fallen behind in the race and situations such as May 6th cannot happen again otherwise confidence in the integrity of markets will continue to erode.

Source: CBS 60 Minutes

Brandon R. Rowley
"Chance favors the prepared mind."

*DISCLOSURE: Nothing relevant.

Trillium Fine Nothing to do with High Frequency Trading (HFT)

On Monday, September 13th the Financial Industry Regulatory Authority (FINRA) announced sanctions against Trillium Brokerage Services, LLC and several of its employees totaling $2.26 million in total fines. (News Release) Trillium has been fined $1 million with another $1.26 million levied against nine traders, the Director of Trading and the Chief Compliance Officer.

Everyone is mis-interpreting this case as a blow to HFT, it's not

The interesting piece of this sanction is how it has been portrayed by FINRA and some prominent bloggers out there, particularly Zero Hedge, as a fine against a particular HFT strategy. FINRA's news release states that the fine is for the use of "an illicit high frequency trading strategy and related supervisory failures". But, upon reviewing the facts of the case, these were not high frequency traders.

Perhaps the crux of the problem is the lack of a standardized definition for what HFT entails. At the very least, any definition of HFT should include the concept of automated strategies. HFT strategies are programmed ahead of time and executed by blackboxes, or computers. This case does not involve HFT but typically very astute financial bloggers are mistaking it as the first major blow to HFT. Well, for better or likely worse, it's not.

Trillium traders were manual, proprietary traders gaming stocks by layering the bid or offer with orders they never wanted to have filled so they could garner fills on orders on the other side of the book. The traders were creating the appearance of buying or selling interest for price improvement on their orders.

Let's create a hypothetical example: say a trader wants to have 500 shares filled on the bid at $10.05. Using the strategy in question, he puts in his limit order bid for 500 shares at $10.05. Then he begins offering relatively large orders on the offer to induce other market players to hit his bid at $10.05. Say the inside offer is $10.07, this trader comes in at $10.09 showing the market his intention to sell 10,000 shares. The other colluding traders join the offer by offering stock at $10.10, $10.11 and so on to create the appearance of significant selling pressure.

Traders outside this ring watching the stock immediately react by hitting $10.05 to exit their positions or to enter a short in the stock. The Trillium trader in question receives his fill for 500 shares and then cancels his 10,000 share offer. Subsequently, he repeats the entire process on the other side of the book to attempt to exit his position at higher prices.

Nowhere in any of this process was there computerized trading employed. On the contrary, the manual trader is actually trying to game HFT! As the action states these traders engaged in this strategy "to take advantage of trading, including algorithmic trading by other firms". High frequency traders (computers) are nearly always the first to react to changes in the order book. Many other traders react as well, worried that the 10,000 share offer will push the price down. Yet, in this case, and in the case of what happens over and over all day long in stocks across the board, the offer is "fake" -- there is no intention to have it filled by the trader entering it.

FINRA charges that Trillium traders used this strategy 46,000 times over time, likely over weeks and weeks, not in a few hours as Barry Ritholtz incorrectly assumes (Note: I heart Rithotz but he's wrong here). Also, his solution would not solve this problem, namely mandating that all bids and offers last for 2 seconds. While this would raise the level of risk to the manipulating trader, it would not wholly stop this practice from happening.

Yet, some HFT do this all day long, just differently

Now, I am not saying that there aren't high frequency traders out there manipulating the tape. There most certainly are. What I would say though, is that it is much, much harder to prove. What makes this case easy to prove is two things: 1) it involves a colluding group of nine different traders, and 2) their orders were "often in substantial size relative to a stock's overall legitimate pending order volume".

A high frequency trading system is one entity and uses very small orders. The manipulation is to profit from very small spreads and, when manipulative, involves quote stuffing, not large quotations. The only way to battle this problem within the HFT arena, as Sean Hendelman and I have been arguing, is to tax order cancellations (or messaging traffic as Senator Kaufman argues, a very similar concept). As I'm finishing up this article I've just been IMed Felix Salmon's post today and he's exactly right.


Brandon R. Rowley
"Chance favors the prepared mind."

*DISCLOSURE: Nothing relevant.

Flash Crash Causes $200 Million in Losses, Circuit Breakers Need Fixing

The flash crash on May 6th exposed serious structural flaws in today's equity markets. The Dow Jones Industrial Average dropped more than 600 points in just a few minutes almost reaching down 1,000 points on the session before dramatically rebounding. Major Dow component, Procter & Gamble (PG), collapsed over 30% in minutes while Accenture (ACN) saw its share price literally drop to one penny. A shocking "324 securities suffered price moves of more than 60 percent from their 2:40 PM prices leading to the exchanges cancelling more than 20,000 trades". Financial market participants will not soon forget the afternoon of May 6th.

Arguably the greatest amount of damage from the event was inflicted on investor confidence in the stability of the equity markets. Since May 6th, equity mutual funds have seen outflows of funds now totaling over $60 billion. While worries about European sovereign debts and a slowdown in the US have been clear factors motivating selling, the flash crash worked to exacerbate investor fears.

On top of the loss in confidence, many investors believing they were being prudent actually lost money by having their stop losses triggered in the wild gyrations. "A staggering total of more than $2 billion in individual investor stop loss orders is estimated to have been triggered during the half hour" resulting in, based on "a very conservative estimate of 10 percent less than the closing price", "losses of more than $200 million".

The SEC's quick response was to institute circuit breakers on stocks to prevent the event from occurring again in the future. Any stock that trades 10% above or below the prices over the previous five minutes will be halted for five minutes. The goal is to aid price discovery by allowing the market five minutes to come to a consensus of the correct price.

Yet, as soon as this rule was adopted we began finding problems with false halts because of anomalous prints. In late June, Citigroup (C) was halted from an out-of-market print while late July saw the same in Cisco (CSCO). These stocks trade millions and millions of shares a day and should not fall victim to a poorly designed system.

Clearly, this problem must be studied and changed. The simplest solution, in my mind, is to make circuit breaks trigger ONLY with two consecutive prints greater than 10%. This seemingly avoids the current problems yet maintains the intended stability in prices.


"Strengthening Our Equity Market Structure"
SEC Chairman Mary L. Schapiro
September 7, 2010


Brandon R. Rowley
"Chance favors the prepared mind."

*DISCLOSURE: Nothing relevant.

High Frequency Trading Regulation Should Promote Deep Markets

Senator Ted Kaufman has been a leader in critically assessing the impacts of high frequency trading on today's financial markets. Kaufman wrote a letter to the SEC on August 5^th highlighting key issues the Commission should review. Most notably, Kaufman argues that "regulation should aim not to facilitate narrow spreads with little size or depth of orders, but instead promote deep order books". A deeper market will create greater stability and confidence for investors.

The purpose of equity markets

Kaufman starts his letter by restating what the Chairman of the SEC, Mary Shapiro, has said are the market's two primary functions. First, "capital formation, so companies can raise capital to invest, create jobs and grow" and second, "attracting and serving long-term investors to help facilitate the capital formation process". While this is clearly the underlying purpose of financial markets, traders have long served the role of making markets and providing liquidity to improve the efficiency of moving capital between stocks and markets.

Rethinking years of regulatory goals

For a long time now, accepted wisdom has been that regulators should aim for lower transaction costs by fostering competition between brokerages for commissions and by improving liquidity to narrow spreads. Yet, is it possible we have reached a point of diminishing returns?

Wider spreads with a large protected quote size on both sides may facilitate certainty of execution with predictable transparent costs. Narrow fluctuating spreads, on the other hand, with small protected size and thin markets, can mean just the opposite -- and actual trading costs can be high, hidden and uncertain. Deep stable markets will bring back confidence, facilitate the capital formation function of the markets and diminish the current dependence on the dark pool concept. At a minimum, the Commission must carefully scrutinize and empirically challenge the mantra that investors are best served by narrow spreads. In reality, narrow spreads of small order size may be an illusion that masks a very 'thin crust' of liquidity (which leaves market vulnerable to another flash crash when markets fail their price discovery function only next time within the bound of circuit breakers) and difficult-to-measure price impacts (that might be harmful to the average investors and which diminish investor confidence). [emphasis mine]

The narrow spreads fallacy can be witnessed by any active market participant executing orders. Sean Hendelman and I previously proposed an order cancellation tax which we believe would go a long way in exposing what is the real, wider spread and make the bid and offer more dependable and thus more efficient in the long run.

While a good number of studies have been released that purport to show that spreads have narrowed in the most liquid names, it is well worth considering whether that narrowing has actually improved the price discovery process. Meanwhile, opponents of HFT simply argue that the minor narrowing of spreads in already liquid stocks is irrelevant and the true problems are widening spreads in thinner securities. In that case, it is the worst of both worlds: wider spreads and less dependable quotes.

Explicit versus implicit costs of trading

Kaufman continues in his "Market Structure Solutions" attachment to the letter with nine wide-ranging, comprehensive suggestions, several of which I will discuss in future posts. On the spreads issue he succinctly summarizes his belief:

While some regulations might widen spreads and raise the explicit costs of trading, those outcomes along should not disqualify such rules from being considered. Indeed, policies designed to protect large quote sizes on the bid and offer and to mandate or incentivize significant resting liquidity be provided at multiple price points would result in wider spreads, but also offer greater certainty of execution and make trading costs more predictable and transparent for investors. Simply put, it may be better for investors to pay the spread they can see than the price impacts they cannot see or effectively measure. [emphasis mine]

It is crucial to understand that the costs of trading are both the explicit upfront fees as well as the implicit expense of poor execution of an order. Human traders have recognized the difficulty in executing large orders because of illusory bids and offers that cancel at a moment's notice coupled with the free-riding high frequency traders that snatch up liquidity alongside in hopes of profiting from the larger trader moving the price. The SEC should examine both costs and design regulation around reducing, or at least making transparent, total trading costs.


Brandon R. Rowley
"Chance favors the prepared mind."

*DISCLOSURE: No relevant positions.

Forget Support & Resistance, Areas of Volatility in High Frequency Trading

Support and resistance can be seen as the entire basis of technical analysis. While most technicians would distinguish between these two levels based on expected buying or selling pressure, T3Live's Sean Hendelman sees them quite differently as a high frequency trading practitioner:

"Support and resistance are one in the same. Namely, points of increased volatility. These areas increase the uncertainty of future direction and therefore volatility."

Short-term Support in the Past

Traders have long used support levels as areas where they expect buyers to step in and hold because there were buyers at that level previously. Price levels exist because people, consciously and unconsciously, create them. Traders and investors remember their entry prices, or at least they see the cost basis on their brokerage statement. These prices are therefore breakeven levels for many with a vested interest in that price.

Often, by expecting others to be buyers at the level, technicians only work to further solidify the existance of support through their own buying. The idea of a vested interest is also why breaking a support level is seen as a sell signal. Those that accumulated expecting the level to hold ditch their positions and eager shorts enter believing no buyers remain.

Support in the High Frequency Trading World

Support and resistance have become far more elusive and the risk of entering trades based on them has drastically increased in the last 18 months. Short-term technical levels are now extremely fluid.

Volatility increases opportunity and the wild oscillations around technical levels grant HFTs the ability to profit by beating manual traders in and out. Consider the 2008 crash with the VIX reaching a high of 89%: short-term traders were offered incredible opportunities as volatility soared. Think of a large whole number in AIG as a microcosm of this type of uncertainty and volatility. The high frequency trader jumping in and out in microseconds, even nanoseconds, can scalp pennies back and forth.

Two unprofitable scenarios now occur much more often at support levels with the influence of HFT: 1) rapid breakdowns and 2) false breakdowns.

A trader does not risk to a level, he risks to whatever price he receives upon exit when the level breaks. As high frequency traders are typically first to the trade in the downdraft when a support level breaks, the price to exit is often much further away than anticipated. By the time he has hit the bid, the manual trader has lost far more than his pre-determined stop.

False breakdowns occur when a support level is broken but the stock does not continue lower, at least not within the trader's timeframe. How often does today's discretionary trader short the low only to find the stock subsequently swept higher? High frequency traders will buy new lows and force weak hands to cover as the stocks pushes back through the short price.

The high frequency trading world has very different interpretation of support and resistance and given their speed, it is tough to compete in that world.

Adapting Trading Strategies

Running stops is as old as trading itself. Floor traders on the NYSE used to run stops intentionally for bucket shop owners so the shoe string margin players would be wiped out. Squeezing out larger, weaker players is a tactic used since the day Wall Street was paved. High frequency traders' manipulations around technical levels are just today's modern application of an age-old strategy to beat others at the same game.

Short-term traders had it easy for a long time, buying breakouts and shorting breakdowns to make predictable profits. But this strategy in a more range-bound tape coupled with high frequency traders can be disastrous. Avoid the temptation, don't battle the machines. Let the machines kill each other and don't step in the ring.

Traders must anticipate moves to much greater degree and they must be happy with the size they have accumulated once the trade gets under way. Adding through levels can and will destroy many potentially profitable trades as HFT throws the trader in for a spin.


Backlink: Wall St. Cheat Sheet

Discretionary Traders in the Brave New HFT World

Last week's high frequency trading conference by the World Research Group helped me form a much greater understanding of HFT systems and the future of the industry. (My summaries of the event here: Day One & Day Two) Much of the discussion focused on the race for the lowest latency which I suspect was somewhat due to the high number of vendors in attendance and on panels. Yet it was reiterated by actual practitioners multiple times that the clear victors in the end will be those with the most creative and innovative programming uncovering and exploiting inefficiencies in the financial system. While hardware will always be important, it has been of an out-sized focus for the last couple years and T3 Capital's Sean Hendelman, in particular, does not believe that will continue. Software will reign supreme in the end and the brightest computer scientists will garner the largest share of the profits. Jeremy Muthuswamy, Professor of Finance at Kent State University believes we have only "scratched the surface" on HFT computational complexity and expects quantitative modeling to evolve incredibly in the coming years.

The Brave New HFT World
The takeover by the machines was overlooked by many active traders as HFT grew rapidly during the 2008 crash because the human trader still had ample opportunity to profit in a wildly volatile equity market. As market conditions have dramatically changed over the last 18 months, the edge computers have has reeked havoc on the P&Ls of traders unwilling to adjust their strategies. In my personal opinion, dedicated scalpers are a dying breed. The most difficult part of the equation for a hyper-scalper is maintaining discipline and emotional control under an impulsive, rapid fire strategy of buying and selling. Not only is the opponent now an unemotional black box, it is faster, much faster. Trades are now happening in nanoseconds, far faster than the couple microseconds required for a human eye even to see a bid or offer appear in the Level II. With that speed comes an inability for the human scalper to control their downside risk as positions move out of their favor far too quickly. This of course causes a high degree of stress and blurs judgment. Scalpers have found themselves outmatched on speed, emotion and risk control as HFT has grown. For the most part, a scalper's edge has been stolen from them.

There was decent amount of discussion during the conference on deciding the target latency to achieve through hardware investment. Latency is of importance only relative to what the strategy requires. HFT practitioners distinguish between strategies needing ultra low latency and those only needing low latency and those not as concerned. Regular traders often think of HFT simply as fast computers yet there is a high level of differentiation in terms of latency even within the HFT universe. The thought of being able to beat the computer on speed is almost comical as they are discerning among themselves the varying levels of latency.

Also worth noting is the much more complicated manner in which a computer can rapidly and accurately assess risk and reward scenarios. Typically a trader will judge risk and reward based on perceived levels while watching a Level II or by gauging trading levels on a chart. Yet, black boxes can calculate risks immediately based on percentages not dollars, the bid and offer interaction, the frequency of bids hit/offers paid in a manner far more sophisticated than the human daytrader attempting to measure trades through visual interpretation of the Level II and a chart.

As I have stated in the past (here) HFT is requiring traders to become more sophisticated. The computers will win in the very short-term trading game, there is no doubt. That does not preclude discretionary traders from finding a way to be profitable. It simply forces traders to study, learn, adapt and evolve.

How to Survive & Prosper
Ultimately, not being an HFT programmer myself the question is: how does the discretionary trader live in this brave new world? In a recent interview on Wall St. Cheat Sheet with President of First New York Securities, a prominent NYC-based proprietary trading firm, Joe Schenk made his business model clear: "Contrary to popular belief, our business is proprietary trading not day trading. Though we may trade intra-day, we are not day traders." This is a very important distinction and firms ahead of the curve have invested in HFT infrastructure while refocusing the manual trading to strategies beyond the very short-term.

Later in the interview with First New York was an excellent recognition by Donald Motschwiller: "But the guys who truly trade the markets the best — the most talented guys in the firm — they trade the markets intuitively. They’ve seen it so many times and are so confident in the decision making process that they’re not reacting." From my experience, this is absolutely true. The best traders have an unexplainable gut feel that they are in tune with and trust in their decision-making process. Any technical or fundamental analysis does not represent hard and fast rules. The rules only work within the context of the overall direction and movement of the tape. Fundamental guys buying financials in 2008 without respect for the downward momentum would have seen painful losses. Likewise technicians highlighting a head and shoulders pattern in June 2009 failed to respect the incredibly strong bid that had entered the market. Intuition can certainly trump strictly quantitative strategies.

Simply put you will not win in the quantitative space; your approach must be different. In order for traders to succeed in a highly quant-driven tape they must develop a feel for the overall market and understand the ebb and flow of particular stocks and markets. Feel is very abstract, nearly impossible to teach and for the most part will only come through years of experience. But there are two particular daily activities I believe traders can do to help significantly shorten the learning curve. First, follow prices. Making a purposeful effort to memorize prices will allow you to contextualize any movement over time. This includes internalizing charts in order to know the history of prices. Second, read read read. The only way to understand the prevailing psychology is to gauge price reactions against headlines. There are many great financial blogs out there that help in determining broad sentiment.

In general traders need to understand trend and volatility. Trading with the trend is more important than ever as programs often exacerbate moves far beyond anticipated levels of support and resistance. Volatility is absolutely crucial in predicting the possible reward scenarios. While reward is measured in a pure dollar or percentage sense, traders must also appraise the probability of that reward coming to fruition. Lower volatility times yield lower returns and therefore require tighter stops.

Beyond developing feel, I believe traders are well-served by studying fundamentals. Trading plans must be arranged well before the stock hits the buy or sell points. Most important for me is background research on the underlying companies. My best trades have always occurred when I have the greatest amount of conviction in the idea. This conviction is only gained by putting in-depth research on the idea. Holding stocks for longer periods of times will only be consistently profitable if you are correct on the motivating factors behind the buying or selling. While it is probably not necessary to know the long-term debt to capitalization ratio of a given firm for example, it is important to recognize catalysts and know their impact in order to swing trade effectively. With technical levels becoming more fluid than ever before, the ability to hold through tumultuous volatility is only possible by intertwining fundamentals into the equation in order to maintain confidence in the trade.

At the end of the day, as argued by Muthuswamy, "so went the pit trader for the electronic trader, so will the quant human trader go for the robo trader." Admitting the inability to compete as a human is the first step, the second is to find a new method. There is huge opportunity in swing trading as volatility remains elevated currently at 27%. High beta names have huge ranges on daily basis. The keys for out-performance over the next few years will be those that are in tune with the tape and those that generate fundamental conviction for their trades.


Backlink: Wall St. Cheat Sheet

World Research Group Summit on HFT (Day 2)

I attended the second day of the World Research Group's Summit on "Buy Side Tech: High Frequency Trading" (day one summary here). Yesterday was only a half day and I missed the first panel but below is another rundown of what I found to be interesting.

Data Centers
I caught the second panel of the day with Adam Honoré of Aite Group, LLC and Kevin McPartland TABB Group. There was a good deal of discussion on the topic of co-location. The NYSE has taken the most political approach as McPartland sees it promising the same latency for all participants located within the Mahwah data center in New Jersey. The NYSE built the 400,000 square foot, 2-story fortress last year to accommodate the burgeoning demand for proximity hosting of high frequency trading firm servers. The NYSE has promised all firms within the complex a 70 microsecond latency which it will accomplish by literally cutting all the wire lengths the same for each rack.

Neither Honoré or McPartland see any game-changing regulation in terms of co-location. While many complain of the unfair advantage this provides in terms of ultra low latency, McPartland pointed out that disallowing exchanges from providing the space around the matching engine would only work to drive up the real estate across the block as proximity will continue to matter in terms of the needed travel distance for data.

While the NYSE has fully dedicated itself to the hardware side of the business with its $250 million investment in Mahwah, other venues such as BATS and Direct Edge do not have such data centers. Honoré saw the NYSE as making this major CAPEX decision in spite of its shareholders because it marks a venture into an entirely unproven business model at this point. This investment requires significant upfront costs and substantial continuing upgrade and maintenance costs. Only time will tell whether this is a viable model. Given current rental rates on space and future expectations, the project should be profitable. Yet, the frenzied race for ultra low latency could slow or even end entirely should a plateau in demand be reached.

Honoré postulated that given the possibilities of co-location, all geographic barriers have been erased and he expects to see high frequency firms arise across the globe that trade US markets.

Muthuswamy on Market Efficiency
The two-day conference ended with a speech by Jayaram Muthuswamy, Professor of Finance at Kent State University, titled "Does High Frequency Trading Make Markets More or Less Efficient?" Muthuswamy's speech was the real reason I attended the second day and while he's a PhD and talked over my head to some degree, I enjoyed the speech nonetheless.

Muthuswamy talked quite a bit about computational complexity. He believes that the winners in the HFT space will ultimately be those that discover and exploit the most arcane relationships and patterns. He touched on the idea of efficiency in the equity markets and believes we have semi-strong efficiency. Strong form efficiency does not exist explicitly demonstrated in takeover situations where a stock often sees a large burst to a higher level and then trades flat at the bid price. In theoretical strong form efficiency, the stock would trade flat and the bid would have no impact on the price.

He briefly touched on the advantages and disadvantages of HFT. Advantages being enhancements in connectivity between markets and assets, lower transaction costs overall, the encouragement of high levels of creativity and more efficient markets as information is assimilated more rapidly than ever before. Disadvantages include glitches such as May 6th, the unfair player advantage where HFT could possibly hurt traditional participants such as "flashing" which most venues have now banned and the exacerbation of volatility.

While his list of advantages seem self-evident for the most part I wonder how Muthuswamy would answer critics that claim May 6th was not necessarily a result of a glitch. The move away from a mandated liquidity provider, namely the specialist system, to liquidity providers that have no obligation and are often directional has many implications. Tradebot and Tradeworx, two of the largest HFT firms, admitted to shutting down their systems prior to the flash crash. In this scenario, we did not see a glitch rather a conscious decision by the human operators of the machines to remove their liquidity provision precisely when it was needed most, a time of increased volatility. It would appear that designated market makers clearly failed in their role to maintain orderly markets. The oft-repeated idea that HFT was not a negative influence because stocks bounced back just as fast as they fell is simply hogwash.

Ultimately, the question for the non-human is: where does the discretionary trader fit into this brave new world? My thoughts on this coming up.

Where is HFT Headed? World Research Group Summit

I spent the afternoon off the trading floor attending the Buy Side Tech: High Frequency Trading Summit put on by the World Research Group. Our CEO and Managing Partner of T3 Capital Management, Sean Hendelman, was featured on two panels discussing a variety of aspects of high frequency trading development and the future of HFT.

I arrived late after trading the morning with the panel discussion on "Assessing the Growth of High Frequency Trading in Futures, Options, and FX" in progress but heard a few interesting tidbits worth repeating. One panelist noted how HFT strategies based on speed now have so many competitors in US equity markets and options that major profit potential is becoming increasingly limited in terms of the latency game. The future of the industry lies primarily in trading across asset classes and across global markets. Global currencies offer significant arbitrage opportunities as the landscape is still quite fragmented with many different exchanges across the world. For example, there are only 4 fiber-optic lines running from London to New York and being on the right line with the highest speed is crucial and speed arb is still possible in that space.

Another highlight was the idea of the high frequency trading style becoming a strategy into which investors would want to put their money within a portfolio. Like the desire for exposure to various asset classes within a portfolio, it is feasible to think that in the future there could be a demand for an exchange-traded fund that invests in HFT strategies. There is certainly a natural attraction for portfolio managers to a non-economic, no-risk strategy.

The last interesting comment I heard was out of Mark S. Longo from theoptionsinsider.com who noted the distortive impact of non-economic volume particularly in the options market. While many market participants use "unusual" trading activity in options as an indicator of possible future movement, many arbitrage strategies in the HFT universe may be creating false signals. Dividend arb or fee arb are two examples that can cause a surge in volume that is entirely non-directional in strategy. He finished by mentioning that investors would be wise to look more toward open interest and other readings along with unusual trading volumes.

The next panel discussion was entitled "Build or Buy? Strategies for Determining the First Step in Implementation" and Sean was one of four participants with another very intriguing guest being Adam Afshar, President of Hyde Park Global Investments. Hyde Park creates robotic artificial intelligence programs designed to self-adjust their trading to optimize results, a fascinating concept to begin with.

The primary thrust of this discussion came from Sean and Afshar telling interested observers to focus on the strategy before considering the build or buy decision. Broad consensus between panelists seemed to be that buying was the best option when starting out because of the time to market and lack of expertise but this will likely grow into a hybrid operation over time as you demand higher control over your data and execution. By Afshar's estimates it would take a firm $5-10 million to fully setup low-latency execution in-house involving direct feeds, co-location, etc. Yet, Sean stressed how important it is to have a strategy that works first because despite seemingly common opinion that HFT shops simply setup and make money, it is actually extraordinarily difficult to find profitable strategies as the vast majority of strategies fail and the ones that do work can go out-of-favor very rapidly.

Next up was a half an hour presentation by Matt Samelson of Woodbine Associates titled "The Impact of High Frequency Strategies on Spreads and Volatility on Highly Liquid U.S. Equities". The presentation was a summary of the $3,750 "ground-breaking study" available from the firm with their basic argument being that spreads tightened in 2/3 of the 39 most liquid stocks throughout 2008-09 and therefore the "traditional" market participant is better off, not worse off, as HFT has grown as a share of trading volume. While this presentation purported to defend HFT against attacks, it accomplished nothing in terms of engaging in the contemporary debate. While T3 Capital runs HFT strategies and welcomes defense against much of the misinformation out there, this presentation was sorely lacking only working to regurgitate old arguments. It's as if he were a philosophy professor that taught Descartes' Meditations and simply didn't bother to acknowledge the circularity objection to the "I think, therefore I am" statement (even though I don't believe this is a crippling refutation but that's another discussion). The current debate has moved far beyond his presentation.

The anti-HFT crowd believes traditional market participants are being disadvantaged in illiquid securities, not liquid ones. And, I won't be one to join the stereotyping, most of the "anti-HFT" crowd are not anti-HFT per se. They are against strategies that they believe hurt the retail trader/investor and there's clearly merit to many of their thoughts on the problems with the current market structure. The primary issue within the liquid security universe is not the spread but the overall true trading cost as the ECN fee structure encourages an absurd level of liquidity provision in stocks not needing any. Samelson also explained a bizarre statistic of "realized spread" in which they measured where a stock was trading five minutes after an HFT trade and claimed that the majority of the time the stock had gone in favor of the counterparty to the trade. The use of five minutes is highly arbitrary and is completely irrelevant in the HFT world especially rebate traders who may have been in and out of the stock multiple times by the time five minutes has elapsed.

The second panel discussion with Sean was titled "The Drive for Zero Latency: Optimizing Existing Systems for High Frequency Trading Strategies" moderated by Jayaram Muthuswamy, Professor of Finance at Kent State University. Muthuswamy offered a stimulating academic perspective on the current race for low latency. While the concept of the limiting factor in latency ultimately reducing to the speed of light was mentioned, the discussion shifted towards the various areas of possible latency reduction. It is not simply the distance and speed of execution, it is also quote speeds coming in and the speed of interpretation, the complexity of the algorithm code and its decision-making speed, routing speeds, and regulatory hindrances among other things. Sean also pointed out the importance of low latency during times of market stress where inefficiencies are high and HFT can find substantial opportunity. These volatile times, like an FOMC announcement for example, act as a perfect test of the capabilities of an HFT system.

Ultimately, Muthuswamy finds HFT to be a source of incredible progress. He maintains this belief even while he mentioned an email from his friend Eugene Fama, often regarded as the father of the efficient market hypothesis, where Fama stated his beliefs on the growth in HFT in one line: "excessive HFT can be deleterious to market efficiency". Yet, even with the incredible growth, Muthuswamy believes we are only "scratching the surface" of what is possible particularly in statistical arbitrage between any and every market and asset class around the world. He hinted that in his speech tomorrow he will attempt to hypothesize what the ultra low latency game will be dependent on ultimately: the complexity of the underlying code.

Goldman Just Does Not Lose

Goldman Sachs' first quarter earnings for 2010 feature some absolutely out-of-this-world results. The company did not have a single losing day in their trading division in Q1 2010. Out of the company's $12.775 billion in revenues for the quarter $10.25 billion came from trading and principal investments (80% of revenues). Pre-tax earnings from the division came in at $4.685 billion representing 91% of Goldman's total $5.159 EBT. Goldman Sachs earned only 9% of its quarterly earnings from their investment banking and asset management and securities services divisions. Goldman is not an investment bank, it is a proprietary trading firm.

Goldman has never been willing to disclose how much of its revenues come from market making activities versus trading their own book. Yet, 72% of their trading revenues came from their Fixed Income, Currency & Commodities subset even while GS stated in its filing: "FICC operated in an environment characterized by strong client-driven activity, increased volumes across several businesses, tighter bid/offer spreads and a decline in volatility levels." While a pick-up in client trading volume is helpful, market makers do not benefit in an environment of tighter spreads and lower volatility, only investors do. Revenues from equities represented 23% of quarterly revenues in the trading division. Yet, also stated in the release: "Equities operated in an environment largely characterized by an increase in global equity prices and a decline in volatility levels". This can only benefit a firm with substantial longs on their own books or a firm highly engaged in particular high frequency trading strategies.

Goldman's trading net revenues are simply astounding. On 35 days in the quarter, GS made over $100 million from trading. Their worst days in trading still cleared $25-50! I realize Goldman is an excellent firm with the brightest minds on the Street but really?

I don't want to make any outlandish conjectures but I cannot help but have a great deal of skepticism towards these results. In a world of ever-increasing efficiency, I don't see how a firm can go full quarters without a single day of losses while clearing hundreds of millions of dollars. At the very least investors must know what they are buying when they purchase shares of GS. It is a proprietary trading firm that has done exceptionally well in recent years. Whether those returns can continue, I do not know but the sheer enormity of the returns makes me cautious. While this stance on my part may be foolish, I would rather stay away without a much clearer picture of how they are making so damn much money and never losing.


Update: My buddy, Elliot Turner, over at Alata Zerka has an excellent piece on this topic as well that includes some more probing questions and thoughts on Goldman's business model.

Here's What Happened on Thursday

The trading of securities is a complete abstraction of the real world. Financial instruments place value on what is real and then trade between buyers and sellers. The inefficiency in finance occurs, will always occur, and sometimes dramatically occurs when financial instruments becomes divorced from the value of the underlying asset. Thursday's stock market crash was just such an event. Financial assets traded relative to other financial assets, not the actual value of the underlying.

The structure of our markets has changed over time. My friends, Joe Saluzzi and Sal Arnuk, over at Themis Trading summed it up well:

Today, the human specialist model has been replaced by an automated market maker model. Our market structure has evolved. It has evolved, not by design,
or a well-thought and reasoned plan, but it has evolved to cater to masters of expensive technology, deployed unfettered by participants whose only concern is to squeeze out every last picosecond and fractional cent before they move on to other countries’ markets and asset classes.

The New York Stock Exchange, in days of old, had a human specialist at the trading post for every traded stock on the exchange. These specialists were required to maintain an orderly market in the trading of shares throughout the day matching buying and selling orders. Should the sell-side or buy-side become overwhelmed in an individual company, the specialist had the obligation to take the other side of the trade, providing liquidity.

Now, stocks are maintained by designated market makers (DDMs). Each stock now has an automated DDM providing liquidity to the market. These DDMs fall under the heading of high frequency trading (HFT) strategies which now entirely dominate the equity markets. These strategies are enacted through "black boxes". Programmers write algorithms instructing a computer to buy and sell based on a pre-defined set of rules. HFT is estimated to produce approximately 70% of the equity market volume. These strategies claim to provide much-needed liquidity to the market.

One of the problems with these quant-based strategies is that they will always be victims of tail events. They are based on probabilities yet finance has consistently underestimated these tails. These tails are typically much fatter than financial statisticians model them to be. The market failed Thursday largely because of a structural issue. The market is dominated by algorithmic trading now as I have written about in the past (here and here and here). The problem, as we saw on Thursday, is that these strategies provide volume, not liquidity. The specialist model provided liquidity because it was there in times of stress. HFT is not there in times of stress.

It now seems consensus on the Street that the "fat finger" story is probably erroneous. I posted on Thursday, perhaps irresponsibly, about the possibility of a fat finger trade in PG triggering the sell-off. Now, that much of the dust has cleared, here's my estimation of what happened.

A lot of sell-side paper (institutional sellers) came into the S&P futures pit in Chicago. The market started to fall somewhat aggressively. The NYSE, seeing a huge sell-side imbalance, switched over to a "slow market" attempting to find buyers to match the selling orders rather than just knocking the market down. Unable to receive an immediate fill on these orders routed through NYSE, the algorithms quickly cancelled their orders and routed them through other electronic communication networks (ECNs). These other ECNs though, having lower liquidity, could not handle the influx of selling orders and many individual stocks and ETFs rapidly declined because of the lack of bids (limit order buys) on the book.

Add to this unforeseen problem between NYSE and ECNs a massive wave of selling from HFT trying to short with the downward momentum. Other HFT firms which have strategies typically working to keep spreads tight began to lose money as the tail event started occurring. Many of these HFT firms actually shutdown their computers during the crash. Tradebot Systems and Tradeworx are two examples of firms just choosing to shut off the computers completely in the midst of the storm. Tradebot often represents 5% of the equity market volume on a given day. So HFT, heralded for its liquidity-providing activity in the market, had several providers simply turn off when liquidity was needed most mixed with those that joined the selling only exacerbating the collapse.

The market essentially traded into a vacuum. There were no bids on the way down and then subsequently there were no offers on the way up. So, in extremely dramatic fashion, the market lost and regained nearly 700 points in just minutes. Here's a good note from Paul Kedrosky's Infectious Greed:

I wondered just how much money was made and lost during the glitch, so I looked at all PG trades done below $50. It was only 205,000 shares at an average price of 46.5, just about $15 below where P&G traded before the glitch. So the total lost in outrageous trades was at most $3 million or so, a drop in the bucket. (Broadening the range to $55 increases this total only modestly to about $4.4 million.)

Some major selling and then no bids whatsoever followed by no offers whatsoever, that was the story. Clearly, the NYSE didn't understand the possible consequences of initiating a slow market and DDMs horribly failed to maintain orderly markets. Other general HFT failed to provide liquidity as well, joining the momentum or simply turning off when needed most. This is a significant structural problem in the equity market.

Now, let's not fool ourselves into thinking that the selling is unjustified. After a non-stop 70% rally off the March 2009 lows seeing only two 9% pull-ins, the market is due for a correction. Sovereign debt problems in Europe are creating significant fears of contagion across the globe. The problem with Thursday is how it damages investor confidence and crushes any retail investor using stop-loss orders.

Equities Dive as Greece Downgraded to Junk, Gold Surges

The stock market took a dive today dropping 213 points (1.9%) as Standard & Poor's downgraded the sovereign debt of Portugal two steps to A- and then soon followed with a cut of Greek debt to junk status at BB+. S&P warned that investors in Greece's government notes could recoup as little as 30% of their initial investment should Greece restructure its debt. The euro crashed to new lows on the year now trading at $1.316. The VIX, commonly referred to as the fear gauge, vaulted 30% to close at 22.81, now well off the lows of earlier this month at 15.23. Executives from Goldman Sachs spent the day on Capital Hill being grilled by Senators. I didn't hear much that was unexpected.

The downgrade of American International Group (NYSE:AIG) by Keefe, Bruyette & Woods that I highlighted this morning hit shares hard. AIG dropped 16% for the day taking out any short-term support level. AIG was a classic momo play and typically these plays collapse when the momentum stalls. There is very little fundamental justification for even the $37 price shares are trading at after today's fall.

Gold had a strong day today gaining 1.25% fueling a 1.68% jump in GLD (NYSE:GLD). I doubled my initial position early this morning and then doubled it again in the early afternoon. Yet, I sold 1/3 into the NYSE close because the electronic futures market failed to hold new highs when the GLD ETF was closing for trade at 4:00PM. While GLD looks excellent on a chart closing above prior resistance levels, I took some caution given the lack of confirmation from the futures market. Below are the charts highlighting my thought process. I am looking for a move to new highs in this market and now have a solid cost basis to hold for a move.

There was a great documentary released in early March titled "Quants: The Alchemists of Wall Street". Even with its strangely morose overtones it is well worth watching if you are curious about financialization of our economy. This short film hits on the several decade wave of securitization that we have seen from our banking system and the recent rise of high frequency trading.

Forget GS, Keep Rallying!

The market was helped today after March new home sales data showed the largest jump in 47 years, a 27% surge. The data release launched equities to new highs for the ongoing rally. Don't get too excited though, the sales numbers are bouncing off the record lows in February. The market left behind Microsoft (MSFT) and Amazon (AMZN) which lost 1.3% and 4.3%, respectively, after their disappointing earnings reports. Goldman Sachs (GS) was also weak losing 1% on day. It didn't matter though, the Dow gained 70 points for the day and closed at new highs. So much for GS marking the top! It's clearly being thought of as an isolated incident even though investors suffer from a complete lack of knowledge as to how deeply systemic the GS practices were and still are.

Definitely check out Barry Ritholtz's "Ten Things You Don’t Know (or were misinformed by the Media) About the GS Case" on The Big Picture. He argues that the case against GS is not weak, it is not a one-time incident, the SEC director is a "bad ass" and GS will lose or settle.

My chart of the six primary strategies of high frequency trading was published over on Zero Hedge, one of the largest market-related blogs out there. It's getting a good amount of attention and plenty of comments.

My buy on gold (GLD) yesterday turned out pretty well today. The $114 level will be my area to add into the position. I also picked up a small position in Agnico-Eagle Mines (AEM). The $62 level will serve as a nice technical buy trigger and with earnings on April 30th, AEM has the possibility of jumping into the report. Q3 2009 was a brutal report so we'll see if the fundamentals have improved next Friday. Nike (NKE) took the day off, just holding it.

The World of High Frequency Trading

Originally posted on the T3Live Blog

With all of the recent interest in high frequency trading, I put together the chart below explaining what we see as the six primary strategies of buy-side short-term algorithmic traders. This chart excludes the subset of algorithmic trading dedicated to the execution of buy-side funds with longer-term interests. These six strategies are what short-term traders contend with on a daily basis and understanding their methods is useful.

Earnings Receive Muted Response

More positive earnings reports but the Street is so far has had a muted response. Google (GOOG) beat on top and bottom line but is trading down 5% pre-market. General Electric beat on the bottom line, missed on the top, is trading down a quarter of a percent. Bank of America (BAC) smoked estimates but has faded the initial move higher and is now down almost half a percent. This is hardly in-depth analysis but worthwhile to notice a seemingly altered reaction to these reports as the first week of earnings season ends today. The more subdued reactions in prices may signal a slowing of the upward momentum as earnings season rolls on but I am not reading too much into it.

Tokyo was down 1.52% last night. Oil is down about 2% pre-market and gold is down 1% as well. Seems like some slight changes in market complexion and we may see some selling. I am still long Nike (NKE) but sold out of Whole Foods (WFMI) and Las Vegas Sands (LVS) earlier this week. I was probably a bit premature on those sales and they had not reached my ultimate targets. Should we receive some downward pressure, I may look to re-enter these two.

The Securities and Exchange Commission is now considering putting tags on high frequency trades to track potentially manipulative trading tactics. Check out Themis Trading for a brief article and Senator Kaufman's response.


Disclosure: Long NKE.

Markets Up 7 Days, Volcker Rule Looks Likely

• Tokyo gave back most of yesterday's gains down just under 1% last night. London is flat and US futures are near flat-line as well heading into quadruple-witching tomorrow.

• Forgot to mention that I was dead wrong about the change in language in Tuesday's FOMC policy statement. The Fed kept the "exceptionally low levels...for an extended period" within the statement making it nine statements now reiterating that stance. Clearly, the Fed is erring on the side of inflating rather than risking changing course too soon. Looks like the Fed is dedicated to continuing the greatest expansionary policies we've ever seen until inflation overcomes the deflationary pressures of deleveraging and it shows in the numbers.

• Great debate going on in the blogosphere on high frequency trading. Cameron Smith wrote an impassioned defense of HFT in Traders Magazine on March 17th claiming it "benefits all investors". My friends, Joe and Sal, over at Themis Trading struck back with a strong counter-argument on their blog. Smith's defense of HFT is overreaching, attempting to support the entirety of the field while the Themis guys see the detriments of particular abuses practiced in within the HFT arena. It is very reasonable to recognize the broad-based quality gains that have come with the ever-increasing use of faster and more efficient technology while understanding that not every player provides a benefit to the market structure as a whole. Check out the debate!

• I am long Las Vegas Sands (LVS) overnight and looking for a move through $21 in the coming days. This is a high momo play with nothing in terms of upside resistance until $30 once $21 is cleared. I've got a small position now but will buy aggressively if and when the momentum picks up.

• The dollar has been taking a break after its 10% bounce off December 2009 lows. The DXY Index is holding 79.50 so far. Is the long-term bottom in or has this been a short-term bounce? Time will tell.

• Bernanke and Volcker were on the Hill yesterday testifying about financial regulation. The Volcker rule would inhibit commercial banks from having proprietary trading desks. This seems like a completely reasonable idea hearkening back to the days of the Glass-Steagall Act of 1933. Let's not forget, this Act served us well for 70 years before being repealed in 1999. It seems to me that most people agree that deregulation of financial markets took a step too far and re-introducing basic divisions between guaranteed institutions and risk-seeking firms makes a lot of sense. I wonder what Goldman Sachs (GS) will do? Probably drop access to the discount window and remain as a lone-standing large investment bank. JP Morgan (JPM) likely is forced to spin-off its large hedge funds.

Structural Changes in US Equity Markets

Knight Capital Group recently commissioned a study entitled "Equity Trading in the 21st Century" that explores the major structural changes we have seen in the markets so far this century and the impacts it has had on investors and traders. I will not offer an opinion or recommendation but rather just summarize the transformations the authors present. The professors who authored the paper offer well-argued perspectives and it's worth the read if you are interested in the regulatory angle. But, based on previous interest in our articles on high frequency trading, it seems that many would find it worthwhile to examine the changes that have fostered a system where HFT dominates the tape for better or worse. So, how has the market changed?

Displayed Depth Has Increased
Within six cents of the national best bid and offer, the depth of the book has seen a dramatic increase recently. From 2003-2009 the depth looks to have averaged around 2,000 shares on the bid and offer for S&P 500 companies. Yet, in just 2009, the book saw a dramatic jump in displayed quote volume leaping from lows of 1,500 shares to over 4,500, a 200% increase. The depth, to be sure, is not necessarily indicative of actual executed volume. We argued in an earlier paper that this is largely a result of HFTs providing bids and offers that they intend to cancel without a fill such that the "real" depth is much less than displayed. Note: the inclusion of stocks outside the S&P 500 based on nominal share sizes is misleading. We would rather see these stocks on their own graphs or a logarithmic graph to interpret it logically.

Average NYSE Trade Size Has Consistently Fallen
Average trade size on the New York Stock Exchange has consistently fallen for the last six years. At the beginning of 2004 average trade size was over 700 shares while now it is slightly over 300 shares. The hyper growth in automated trading strategies has helped cut average trade size in half in five years. Large-scale investors have utilized algorithms to execute orders in an effort to hide their intentions and reduce price impact. Splitting up large orders into smaller and smaller pieces minimizes the impact of any single order on the market and can reduce other traders’ abilities to capitalize on their inefficient order flow. Many scalp-style active traders have found order flow more and more difficult to read because falling transaction costs have allowed institutions to invest heavily in algorithm development in order to hide their intentions while executing orders.

Average Quotes per Minute Skyrocket, Then Return to Earth
Average quotes per minute coming through skyrocketed in the Panic of 2008 when markets became the most volatile they had been in decades. Quotes per minute went from below 50 to over 500 in five years before falling back to more normalized levels as volatility slowed. Quotes per minute are now around 200, still roughly a 900% increase in the last six years.

Cancels to Executed Steadily Rising
Early 2002 saw a cancellation to execution ratio of ten to one, but that ratio has steadily climbed over the years. Now, the Nasdaq sees 30 cancels for every execution according to Knight Capital Group’s research. This increasing ratio and the upsurge in average quotes per minute is consistent with a market that has become HFT dominated with greater total volumes coupled with lower average trade sizes.

NYSE to Become a Museum
Volume on the New York Stock Exchange has collapsed and it seems like it won’t be much more than a decade from now that the NYSE Floor will be turned into a museum. Regulation National Market System (NMS) was passed in 2005 and opened the NYSE up to increased competition. At the beginning of 2003, the NYSE executed 80% of the total volume. This ratio has plummeted as electronic communication networks (ECNs) gobbled up market share. The NYSE ex ARCA accounted for only 25% of all volume by the end of 2009, about a 70% decline in market share in just five years. NYSE Euronext has wisely invested in ARCA so the company is far from doomed, but the physical floor will likely be an exhibit in the not too distant future.

All these charts are consistent with the growth in high frequency trading as a means of increasing efficiency, making the execution side of the business largely computer-driven. The days of the floor broker are rapidly disappearing. Automated trading is here to stay and participants need to learn how to adapt.



All charts are excerpted from "Equity Trading in the 21st Century" commissioned by Knight Capital Group and authored by professors James Angel of Georgetown University, Larry Harris of the University of Southern California, and Chester Spatt of Carnegie Mellon University published on February 23, 2010.