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The Truth About High Frequency Trading and The Coming Market Crash

According to high-frequency traders and their backers, the super-fast, computer-driven stock trading desks that employ HFT are a benefit to investors and exchanges here in the U.S. and wherever they ply their trades.

But that's not true.

In fact, if you know exactly what high-frequency traders actually do and how they do it, you'll know what the SEC hasn't figured out, namely what caused the May 2010 Flash Crash.

You'll also realize that it's only a matter of time before these market manipulators cause a real catastrophic market crash.

Today I'll talk about what HFT players do and how they do it. And tomorrow I'll tell you how HFT could destroy our markets and economy.

What High-Frequency Traders Actually Do

High-frequency trading is fundamentally based on how market participants (for this discussion I'm talking about stock markets) place their orders to buy and sell shares and how HFT players act on those orders.

For every stock that's traded there is always (or at least it used to be "always") a "bid" and an "ask" price. Sometimes you'll hear the term "offer" or "offered" price, those terms are interchangeable with the term "ask" or "asking price."

The bid price is the price which someone is "bidding," or willing to pay to own shares. The ask price is the price which someone is willing to sell shares, or is "offering" or "asking" to sell at.

Bids and offers each come with the quantity of shares that the buyer or seller want to trade. There are millions of bids and offers made all day long, every trading day.

In fact, for every stock there are many bids and offers at several different prices.

The best bid, the highest price someone is willing to pay and how many shares they are willing to buy, and the best offered price, the lowest price at which someone is willing to sell their shares, constitutes a stock's current "quote."

In the U.S. we call that quote the NBBO, or national best bid and offer. But there are almost always other bids at lower prices and other offers at higher prices for all stocks.

High frequency traders employ pattern recognition algorithms that look deeply at bids and offers on stocks to determine if the movement on the bid quotes or offered quotes implies a directional tendency.

Computer-driven algorithms are "reading" the quotes, the intentions of buyers and sellers as they put down their orders in real-time, to make a trade that the HFT player expects to profit from if the directional bias their computers pick up is correct.

HFT computers look at all the bids and offers wherever any stock is traded. Sometimes stocks are traded at several different exchanges or "venues" at the same time.

But trading the price discrepancies that sometimes occur because there are different quotes at the same time at different exchanges for the same stocks isn't where HFT players make their money, although they do that, too.

What the HFT boys actually do more of than high frequency trading is "high frequency quoting."

They have their computers send out their own bids and offers, or quotes, to all the exchanges, almost all the time.

How HFT Manipulates Markets

What they are doing is trying to influence, I call it manipulate, what other traders and investors do with their bids and offers. They are trying to fake or set-up other market participants to react to the quotes the HFT players fire out onto the exchanges for all the stocks they trade.

Only the HFT quotes sent out aren't meant to be acted on. They aren't looking to buy on their bid quotes or sell on their offer quotes.

Instead, they are sending out orders to "ping" markets.

Ping refers to how sonar works. For example, a submarine sends out a sonar beep which hits a target and sends back a sound (which sounds like a ping) which the sonar operator "reads" to determine the pinged object's distance and shape.

HFT players are constantly pinging stocks where their quotes are housed and displayed. They send out their orders to manipulate others to adjust their quotes, which get fed into the HFT algorithms to determine any directionality; then, if an opportunity exists the HFT computers buy or sell shares that someone else has put onto the market.

They aren't quoting constantly as bona fide "market-makers" are supposed to do, which they claim they are acting like. They are simply putting out millions of fake bids and offers which they pull almost immediately, just to read the movement of other market participants who react to the HFT come-ons.

It isn't illegal. But it is manipulation.

The buyers and sellers the HFT crowd trades with aren't forced to trade, they are willing to trade — it's just that the prices they trade at may have been manipulated.

High frequency trading accounts for at least 50% of all volume on America's 13 exchanges. The average number of shares traded daily at these exchanges is approximately 6.8 billion shares. The New York Stock Exchange's average daily share volume is about 1.6 billion shares.

HFT accounts for approximately 3.4 billion shares daily. But that's the low end of the estimates range.

Back in April 2010 when I first wrote about the dangers of HFT, I wrote "High-frequency trading (HFT) conducted by proprietary trading desks at big banks and private hedge funds accounted for 70% of equity trading volume in 2009, according to a paper released last month by the Federal Reserve Bank of Chicago."

Today estimates of HFT activity range from 50% of daily volume to as high as 78%.

That's what high frequency quoting and trading is. Mechanically, how it's done is another form of manipulation.

The Need For Speed

The whole game works on speed. HFT's high frequency quotes have to be able to reach their destination faster than everybody else's and they have to be able to cancel them just as fast, at least fast enough to not get them acted on, which is not what they want.

Once their pinging manipulates other players to move their quotes, the HFT computers have to be the fastest ones to get to the exchanges to buy and sell the shares they want. They do that sometimes, often enough, before the other players' computers have time to adjust their quotes or move out of the way.

How did the HFT crowd get so fast that they can make so much money off their slower counterparties?

They have an advantage because they pay the exchanges to place their servers (computer hardware) right next to the exchanges' servers at the exact locations where the exchanges' servers are housed.

How is that possible? It's easy, if not cheap.

For example, the NYSE built a 400,000 square foot data facility in Mahwah, NJ, just so they could rent server space to HFT outfits who wanted super-fast access to the Exchange's "matching engines."

That's right, the NYSE, which is overseen and regulated by the SEC, encourages HFT players to rent space from them so they can trade faster than everyone else who is supposed to have equal and fair access to trade on the New York Stock Exchange.

There's a huge difference in the time it takes for some players to place quotes and trade (huge can be as little as a few milliseconds) as opposed to those without the advantages that the HFT players pay for.

The term for the lag time it takes for the quote data to get from point A to point B in cyberspace (someone's server) is "latency."

Not being disadvantaged by latency is a huge boon to the HFT players. They can take advantage of tiny discrepancies in the bids and offers in the market that they help to set-up to profit from different prices, sometimes at different venues, but always where their speed advantage is a killer.

The pros call this "latency arbitrage." The TABB Group, a market data research firm, estimates that HFT desks make about $21 billion annually from latency arbitrage.

Obviously, there's a lot of money to be made in high frequency trading. And it's not illegal.

But it's not fair, either. And that's not even the problem with it.

The real problem with high frequency trading is that is has the potential to cause a catastrophic market crash.

Tomorrow, I'll tell you what the HFT crowd isn't doing that they say they are doing and what they are doing to potentially destroy our markets and the economy along with them.

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About the Author

Shah Gilani is the Event Trading Specialist for Money Map Press. He provides specific trading recommendations in Capital Wave Forecast, where he predicts gigantic "waves" of money forming and shows you how to play them for the biggest gains. In Zenith Trading Circle Shah reveals the worst companies in the markets - right from his coveted Bankruptcy Almanac - and how readers can trade them over and over again for huge gains. He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.

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  1. john ashton | October 15, 2012

    This boil needs to be cauterised and it is great that you continue to point this out. Regulation of the market is designed to make participants cleave to basic principles; full information, immediately available and to all, equality of access and execution, etc etc. This HFT is indeed a scam and for legislators and regulators not to immediately respond with a cautionary suspension of HFactivities only serves to demonstrate their culpability.

  2. A Donald - - Not The Donald | October 15, 2012

    Shah isn't the brightest and most honest person on the Planet; but he is close. With over 3 Billion HFT a day; who in their right mind (other than the Super Rich with so much discretionary income), would want to compete with this kind of Manipulation?! Get out! And Stay out! of the Market Now!

  3. George | October 15, 2012

    Very insightful and…frightening.How that cannot BE illegal?how can the exchanges favor HFTs at the expense of the millions of small investors,who are their lifeblood?If they scare the small fish away and end up onle with the pinging leeches in the pond,who' blame will it be?

  4. Gerardo Coco | October 15, 2012

    Is there any way to prevent such manipulation?

  5. DMC | October 15, 2012

    And how is this any different than the extreme advantage a trader on the floor has over someone phoning in a buy/sell?

    Answer: it isn't.

    And yet, somehow, the market endures…

  6. william darnall | October 15, 2012

    Wonderful missive Shah. The Feds just don't give a dam as there is too much money for the banksters. Keep up the great work.

  7. Hal McNeely | October 17, 2012

    ONCE AGAIN, WE SEE THE EROSION OF OUR INDIVIDUAL RIGHTS by the "selective enforcement"
    of SEC and other Fed oversight responsibilities in a vacuum of Leadership; we must, once again, cry "FOUL". Only a thousand baby ducks can run at our congressional representatives – peeping snd cheeping, flapping their wings – and get their attention! Peep on!

  8. Richard | October 23, 2012

    But if all these HFT players are sending out millions and billions of "ping" quotes to manipulate other players…doesn't those quotes confuse each of the HFT players computers just as much as the human players. Perhaps Shah you could explain how an individual HFT computer can gain an edge on directionality from calculated b/o depth of markets quotes when you are clearly saying that the DOP's are flooded with garbage quotes. If an individual HFT player does have an edge from this…wouldn't they also need a way to separate out not only their own individual HFT's garbage pings but also the garbage pings coming from other HFT players. People discuss HFT as if it is ONE big evil corporation. Forgive my ignorance…I completely understand the faster execution issue you talk of… but where i'm confused in regards to HFT is that obviously not only are they looking for an edge over us little guys but also over the other companies that also HFT.

  9. Richard | October 23, 2012

    Oops…from above DOP=DOM..sorry. Also Shah just a quick note from my own limited experience. I trade e-mini futures and it is very clear to me that the 10 deep DOM quotes i see on my ladder are far from the truth anyway. For example trading in the slower after hours on the e-mini S&P 500 you typically see 100-200 b/o on any given price level and yet when the market trades at any price tick you often only see single contract trades taking place even when the price stays at that tick for an extended time. Also you may see an obvious huge amount of buyers for example at a price point compared to the above offers and yet "suddenly" the price drops through that level for no apparent reason with no contracts being sold to justify it. I personally have come to the conclusion that the DOM quotes are yes indeed a pile of garbage and not worth watching…except as maybe a contrarian indicator. If the quotes seem loaded for one direction play the opposite. And finally like you say there is a huge amount of hidden b/o's out there everyday. I'll be trading in the normal trading hours and a price point may show a bid of 624 contracts and out of nowhere you'll see 832 trade then immediately another 300 and so on. Lots of people have no intention of showing anyone their hand in advance…and in my mind that's ample proof that the HFT machines can calculate all the listed B/O dom's they want…they can never factor in the "hidden" tigers crouching in woods with their sandbags. Do I believe no ones out to get me in the market. Hardly, I trust no one….it's such a shark infested den…always has been…always will be…machines or not. If there is a ligitamate risk of HFT's crashing the maret inadvertantly by all means shut them down…but to hope that by ridding ourselves of them will return us to a level playing field you got to be kidding me Shah. Human beings with big money have been driving up and down prices for years for the sake of dumping their positions on unsuspecting little guys. Them along with their paid for analyts "opinions".

  10. Don Swenson | December 21, 2012

    Great overview. The other factor is that HFT traders now focus mostly on 'price' movements (up and down). They could care less about 'value' or the Company management. Their entire focus is mostly 'price' movements in real-time. D

  11. Jeff P. in Canada | April 1, 2014

    The simple solution to all of this is a tax of $0.0001 for each share on all bids and on all asks. Most individual investors would not have a problem with this. But the HFTs could no longer afford to ply their trades. (excuse the pun) But this must be a tax on all orders and not just the orders that are filled. This will put these thieves out of business.

    • Robert in Vancouver | April 6, 2014

      Good idea Jeff.

      I wouldn't mind paying that tiny fee to make the market more honest.

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