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.

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.

HFT Forcing Traders to Become More Sophisticated

In recent years, high frequency trading (HFT) has become a buzzword even in the mainstream media. HFT has been attributed as a contributing cause of many events, including the velocity of the 2008 crash and the duration of the 2009 rally. Active traders perhaps did not see the effects of HFT on their trading results in 2008 because volumes were highly elevated as panic set in. However, 2009 was a year of struggle for many in the active trading industry. I believe a significant catalyst behind this struggle has been the increased presence of HFT.

While high frequency trading is highly profitable for the companies developing the algorithms, few understand how they work in any detail. HFT shops are filled with mathematical and computer science Ph.D's writing sophisticated algorithms that no one outside the industry can comprehend. A report out of TABB Group in July 2009, a financial markets research and strategic advisory firm focused on capital markets, claimed that while HFT firms represent only 2% of the 20,000 trading firms in the US, these firms account for 73% of all US equity trading volume. HFT firms are a force to be reckoned with and a reality in today’s markets.

What is high frequency trading?
High frequency trading, also known as algorithmic or black-box trading, is the use of computer programs for the execution of trading strategies. The program is written such that all decisions for time of entry, price and quantity are pre-defined and executed without human intervention. Algorithmic trading has long been used by buy-side institutional investors to execute large orders effectively by minimizing the price impact of the order. Rebate algos have also been around for a while seeking to provide liquidity and capture the rebates paid by ECNs. Active traders see these algos constantly creating the bid and offer in high volume large cap stocks. More recently though, there has been a large explosion in predatory algorithm development. Predatory algos attempt to detect larger players in the market and front run those orders.

While HFT has increased liquidity and tightened spreads in large cap names, small cap companies have actually seen spreads increase according to NYSE Arca data. Investment Technology Group’s trading costs for small-cap stocks were 40% higher in Q2 2009 than Q1 2008, reflecting the inability to get trades processed and rising commission costs. Joseph Saluzzi of Themis Trading, a lone voice in bringing HFT to light, has argued that this is because of predatory algos.

With HFTs as dominant players in the market, active traders need to learn as much as they can about them. First, high frequency trading strategies are highly dependent on ultra-low latency. Many shops have their servers co-located on the exchanges to provide the fastest possible execution. Second, the coding is under constant evolution because of exceptionally high competition among participants and the micro precision of strategies that means they may only be effective for days at a time.

So, what is the active trader to do?
Clearly, any strategies that have an edge based on speed are out the window with the increase in high frequency trading. While the active trader used to front run the order of the institutional desk that was inefficient in execution, now even the small trader’s order is front run by the computer algorithm. Every human trader is now the inefficiency with their slower execution. Entering and exiting stocks will also be tougher. Any active trader is quite used to seeing his order front run immediately as he shows his bid or offer making it more difficult for him to get a fill. There is a high likelihood that active traders must become used to paying an added toll to HFTs for entering and exiting their positions.

The trading business is forever changing, that we know for sure. Level II strategies based on speed of execution are certainly on the decline. Active human traders must therefore become more sophisticated. First, minimize the impact of HFT by trading “in-play” stocks that have large volume from “real” players. Second, avoid non-volatile stocks trading below average volumes. Third, greater anticipation based on sound technical analysis is also needed. Most of us will need to fight hard for better prices and avoid the temptation to buy highs or short lows as algos are programmed to manipulate prices around these areas. Fourth, many of us will need to cut down our size and look for larger moves in stocks. Scalping very small moves is not nearly as profitable when a predatory algo scalps 3 cents from you on your buy and another 3 cents on your sell, just as a hypothetical. Also, levels in stocks are not as clear-cut because algos are programmed to push stocks through the level to shake out weak holders. But, if you can begin trading for dollar moves on less size, you’re less likely to notice the 6 cents you paid as a toll and you’ll be able to give the stock a little extra room around levels.

In order to successfully navigate through the choppiness that HFT has brought into equity markets, traders must spend an increasing amount of their after-hours time researching and learning levels. Spend more time analyzing charts on multiple time-frames. For traders who focus on very small timeframes, now might be the time to take a step back, decrease size, and look for setups and levels on higher timeframes. The higher the timeframe, the more powerful the setup and level and the harder it is for an algo to overtly cloud the area. Additionally, familiarity as to how particular stocks trade around levels helps provide the confidence necessary to follow-through on your ideas. Traders need to develop a universe of familiarity—a core group of “in-play” stocks and sectors—to follow each and every day. The more often you we trade a particular vehicle, the more familiar we become with how algos work in that particular stock.

These are not fail-safe rules but HFT is a reality and it is here to stay. Active traders must adjust and come to find a new edge beyond speed of execution. Where there’s movement, there’s opportunity and the survivors in our business will become more sophisticated in order to continue trading profitably.