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 boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.
Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.