High Frequency Trading Backlash

Within the past few days, CNBC, BNN, Zerohedge, and even the New York Times have been publishing stories about high frequency trading and predatory algorithms. It’s really quite amazing how quickly this story resonated with the public. The back lash seems to be spear headed by a Joseph Saluzzi from Themis Trading, an agency broker who spurns algo’s for more discretionary methods of price improvement (tape-reading). Now that’s one way to save your business model, sue the competition! I’m sure in ancient times, if one had the right connections or could form a mob you could just have them summarily executed.

Now I’m sure Mr. Saluzzi is dead right, there are algos that see your order first, flash orders to find liquidity, and even trade against existing agency algos but who’s to say this didn’t exist in the first place? Originally you had market makers and specialists who for years got to see all order flow and were compensated handsomely for taking additional risk when needed. Every now and then they were run over by mass selling but there was plenty of compensation the 99% of days with little to no panic.

Then came the scalpers, rooms full of traders would watch prints and Level 2 quotes or the NYSE Open Book to figure out how the specialists were going to price a given stock. They learned how the specialists would trade and react and trade accordingly. These guys were the original day traders, no picking direction, just watch the specialist.

Along came the NasDaq, ARCA, and ECN’s rendering the specialists less and less useful and hence less signal for the scalpers. These guys then learned how to ‘read’ the algo’s. The first algos were relative simple Iceberg orders, instead of showing 50,000 in the book a buy side trader could show maybe 1000 and automatically reload. A scalper could front run a large buyer or utilize them as a guaranteed stop loss on a directional punt.

Then along came PEG orders which gave the buy side trader the ability to match the bid within the range. No problem for the scalper, he/she could ladder his bid up and see if it was followed, short stock and sell it back to the PEG buyer; Exactly as explained by Saluzzi in his white paper. The scalper could make a handsome salary for himself from $100,000 to $300,000+ a year with no overnight risk. This trading didn’t really effect too many people because it wasn’t highly publicized and it was run by relatively small, independent traders.

Wherever there is return, capital will flow seeking it. So institutions hired PhDs in Computer Science to replicate these strategies and leverage the inefficiencies of the buyside traders. Instead of a few stocks it could be ported to thousands and levered up to huge amounts. All of a sudden the returns made millionaires and left the rest of the people scratching their heads. And here we are today with Themis Trading leading a charge to basically destroy the competition and return agency trading to its roots of tape-reading and order flow knowledge.

One of the main tenants, and what arrouses the ire of retail, is his contention that this somehow rips off retail trading. My thoughts are the following:

  • Rebate trading may cancel/replace order faster then it can be hit or lifted but it adds a layer of liquidity otherwise not normally there. For example, if a stock is 10.03 x 10.10 and you try to hit the 03 bid and it is cancelled before you can until your filled at 10.00 even. You may think you were robbed, when in fact if the HF trader wasn’t there, the stock would have been 10.00 x 10.10 in the first place. There was no natural buyer till 10.00 even. In many cases the HF trader offers you an opportunity to trade before a natural buyer improving liquidity. He’ll do it if he thinks he can profit from it of course but whats wrong with that? Additionally one needs to remember that its highly doubtfull that his accuracy is 100% so you will occasionally get the better of him/her.
  • Regarding co-location, even retail these days has the opportunity to co-locate strategies through various brokers such as Genesis and Lime. Does it offer an unfair advantage in speed compared to someone’s E-Trade account? Of course it does! You get what you pay for. Ask any day trader if they would prefer Redi Plus or LightSpeed execution platform and hands down LightSpeed would win because ITS JUST FASTER. So are you to tell me the Redi user should sue? Retail traders are at a disadvantage exactly because they are RETAIL, if they had a specific edge they would not be considered retail but institutional.

So don’t get all worked up about this, it will be interesting to see who wins this battle and since Mr. Saluzzi seems to have gotten the momentum of the crowd behind them and considering the enviornment, I would put my money on him. More interestingly it should open the door for a new opportunity for some smart individuals to make a mint of the new rules and regulations.

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~ by largecaptrader on July 25, 2009.

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