What High-Frequency Traders Actually Do

High-frequency trading (HFT) 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.

High Frequency Traders 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 higher frequency trader expects to profit from if the directional bias their computers pick up is correct.

High-frequency trading 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 high-frequency traders make their money, although they do that, too.

What the high-frequency traders actually do more is "high-frequency quoting."

They [high-frequency traders] have their computers send out their own bids and offers, or quotes, to all the exchanges, almost all the time.

Why High-Frequency Trading Is a Scam

Let me make this perfectly simple...

High-frequency trading is a scam. It should be outlawed.

Period.

Regulators, namely the pimps and panderers at the Securities and Exchange Commission, and the exchanges, all of them, are in on the game.

The game of isn't arbitrage, isn't fair, isn't consistent with the keeping of "fair and orderly markets," and so should be illegal.

In case you don't know, here are the rules of the game...

  1. Pay the exchanges to "co-locate" your servers next to their servers, at the locations where they house them (and rent space to you for that explicit purpose).
  2. Get access to quote information (what stocks are being "bid" for at what price and for how many shares, and what is the "ask" price and number of shares that sellers are trying to unload), and be able to place your own bid and ask quotes as fast as technologically possible.
  3. Get yourself a bunch of money to trade with. You'll need millions, so maybe form a partnership to raise money or partner with some banks that don't already have their own high-frequency trading desks, you know, the ones that want to hide what they do.
  4. Get yourself a few nuclear physicists, rocket scientists, and computer wizards to write algorithms that can read quotes on both sides of every stock to determine patterns, the depth of markets, and how many shares you can buy or sell and then sell or buy in a matter of less than one-hundredth or one-thousandth of a second.
  5. Get your computers to fire off fake bid and ask quotes all the time to see how that changes others' quotes, in anticipation that they might show how bad they want to buy or sell, and when you get to a place where you can fire trades to buy and sell, almost simultaneously, buy and sell or sell and buy however many shares you can to lock in a profit, no matter how small.
  6. Get busier and busier doing this more and more, because you're only working for a tiny profit on every trade, so do it to trade at least 3.5 billion shares a day, which is half of all the shares that the nation's 13 exchanges trade daily.
  7. Get faster computers and bandwidth and execution speed. If you reach some limit, go the other way. Figure out how to slow down other traders by gumming up the systems everyone uses; you know all the exchanges' systems that the SEC is supposed to be ensuring provides everyone fair and equal access to. Jam them all up with crazy amounts of fake quotes to increase "latency" (the time it takes to get from A to B for a computer, for other people, like mutual funds and pension peons) so you can head fake them and get your own trades off.
  8. Get rich gaming the system!

Look, it's not even a 12-step program. Just eight simple steps.

You can do it yourself. No one will stop you.

It's all legal, you know.

Suggested reading:

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.

Read full bio