From Market Making to High Frequency Trading: A Brief History (part 4)
Nov 4, 2010
Posted by Jody Eisenman | Filed under Uncategorized
On May 6 of this year, investors were shocked to see the wildest short term gyrations in stock market history. In just 15 minutes, an already weak Dow fell almost 600 points to be about 1000 points lower on the day. It then quickly reversed itself, and ultimately closed around 350 points lower on the day. An SEC report about the now called “flash crash” blamed a huge market sell order from money manager Waddell and Reed in causing the mind boggling move. However, many people point their finger at something else; namely, the high frequency traders of Wall Street. Who are these guys and what do they do?
They have names like Trillium, Allston and Hudson River. They are frequently located in refurbished warehouses in out of the way locations, and their employees are generally computer programmers who have little understanding of stock market fundamentals. You can ask ten people to define High frequency trading (HFT) and get 10 different answers, but the most common definition I have seen is that use computers to enter and cancel orders in milliseconds in order to capture tiny spreads. Due to the fact that all orders are done electronically via computer (human intervention would be too slow), they have the ability to place hundreds of million, or perhaps billions of orders per day. Many of these orders are cancelled virtually immediately after entry. Even so, it is estimated that HFT traders make up 70% of the total trading volume today! This number was zero a few years ago.
According to a story on CNBC, a firm called Tradeworx (which is located above a Restoration Hardware store in Red Bank, New Jersey), trades an incredible 40 million shares per day on $6 million in capital. If you assumed that the average price of a stock they are trading is $20 (just a guess, but as good as any), that would mean that they are turning their capital well over 100 times per day! These traders have no interest in fundamentals such as asset values, price earnings ratios or balance sheets. Their only interest is to move in and out rapidly in order to capture tiny profits along the way. Did HFT cause or exacerbate the flash crash? I believe so. The more and more you remove human intervention, the more likely it is that something extreme can happen. For example, the stock Accenture traded as low as one penny during the flash crash, even though it was forty two dollars per share the day before. With human intervention, this would almost certainly never have happened. However, computers will only react to the data inputted (or as they used to say in my college computer classes, “computers are GIGO: Garbage in, Garbage out”. A computer set to trade this way has no ability to recognize that the price they are looking at bears no semblance to reality. All they are looking to do is to capture these tiny spreads (generally as low as a tenth of a penny per trade). The HFT’s will argue that all they are really doing is adding liquidity to the stock market. Perhaps they are, but at what cost?
Due to all the deregulation that was passed since 1987, the NYSE is no longer the dominant exchange on Wall Street. At present, about three quarters of all trades are done away from NYSE Euronext. The reasons are simple: better executions, lower trading costs, and less visibility. Many trades are executed through so called “dark pools”, where the bids and offers don’t even show up on standard quote machines. As such, it has become tougher and tougher for the SEC to regulate this, although it is not clear that HFTs are breaking any laws. One thing I will say with certainty is this: The less human intervention there is, the more likely another flash crash can and will happen. I believe investors should be concerned when one trader can remove $1 trillion in total market value in 15 minutes. The truth is that technology is moving much faster than the regulators’ ability to keep up with it. As such, they continue to remain at least a step or two behind.
November 6th, 2010 at 3:32 am
Let’s not forget the Norwegian day traders that discovered a systematic flaw regarding bid/ask pricing. They bought lots of shares at a low price, then drove the price up by buying fewer shares at ever-increasing price, then dumped them all at the high price. The net result being systematic, low-risk profit.
http://www.securitiestechnologymonitor.com/news/norwegian-day-traders-arrested-25971-1.html
Even though it isn’t strictly HFT, it depends on a lack of human intervention.