High-frequency trading has plagued the markets for years, giving Wall Street's elite an unfair advantage over everyone else. Now a new stock exchange is throwing a wrench in the works. And the Big Banks
high-frequency trading software
- IEX Exchange Short-Circuits Wall Street's HFT Cheaters
- Why the Twitter Flash Crash Should Make You Angry
- Unless We Act, High-Frequency Trading Will Crash the Markets
- The Truth About High Frequency Trading and The Coming Market Crash
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The Twitter flash crash on Tuesday that very briefly shaved 140 points off the Dow Jones Industrial Average should be of great concern to retail investors.
That short and sudden dip in the markets, caused by a false Tweet on a hacked Associated Press account that suggested President Obama had been injured in a bombing at the White House, was yet another reminder of the risks that high-frequency trading (HFT) poses to the markets, and to retail investors in particular.
Simply put, HFT is the practice of using supercomputers to execute trades in milliseconds.
Because high-frequency trading accounts for at least half of the market, any hiccup in the system can have an instant and dramatic impact, as we saw with the now-infamous flash crash in May 2010 that sliced 1,000 points off the Dow in 10 minutes.
As if that weren't already treacherous enough, HFT firms increasingly have added social media inputs, like Facebook (Nasdaq: FB) and Twitter, to the mix, to scour their feeds for news that could affect stocks.
So now even something as absurd as a fake Tweet can move markets.
"Algorithms used to trade off news headlines, now they trade off tweets. That's very dodgy, very shaky ground," Oli Freeling-Wilkinson, chief executive officer of the London-based analytics firm Knowsis, told Reuters.
That's because high-frequency trading, or HFT, doesn't add to market liquidity, stability or efficiency -- but it could cause a catastrophic market crash.
Here's what's wrong with allowing high-frequency trading, what HFT practitioners say they're doing that's good for the market (which is rubbish), what could happen based on what has already happened, and what to do to fix this black hole.
The problem is HFT is based on a lie.
High-frequency traders send out tens of millions, if not billions, of orders to exchanges that are never meant to be executed. They are fake orders designed to dump manipulative information onto the nation's exchanges.
And while other market participants are not actually forced to adjust their bids and offers or engage in any of these trades, allowing access to the exchanges to manipulate anybody in any way is something that ought to be outlawed.
Exploiting an Unfair AdvantageIn the HFT world it's all about speed. Without it, HFT wouldn't be possible.
There's nothing wrong with employing external innovations that speed up computers or the time it takes for information to get from one server to another. But HFT takes it to an entirely different level.
As I write this, chains of fixed microwave towers are being erected to send market data and orders between New York and Chicago because electromagnetic radiation travels only 2/3 as fast in glass fibers as it does through the air. The towers were designed and are being built by a pair of HFT entrepreneurs who already have HFT customers lined up.
And as soon as this winter passes, Hibernia Atlantic's Project Express will be dropping a more direct new generation transmission cable across the Atlantic so data and trade executions can travel faster between New York and London.
The new cable will reduce the 30 milliseconds travel time it takes now by only a few milliseconds, but space has already been leased to the only takers, the HFT crowd.
It may be unfair that some players are able to pay for a speed advantage by employing new technologies, but it's certainly not illegal.
What should be illegal, and is an abomination, is that the SEC allows exchanges to serve high frequency traders by leasing them co-location space next to the exchange's servers.
Not everyone can afford that access. But because it can be bought, HFT players have a significant speed advantage over everybody else who expects the SEC and the nation's regulated exchanges to guarantee equal access to get data and place trades.
Trust Me, It's Not About LiquidityThe HFT crowd argues that they act as market-makers and add liquidity wherever they practice their trades and both markets and investors are better served by their activity.
That's absolute nonsense.
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 DoHigh-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.