Tuesday, February 21, 2012

High Frequency Trading are destabilising Financial Markets

By Sam Chee Kong, 20/08/2011

“ Markets are purely about Speculations. There is no more such thing as INVESTING  in the markets. It is just Speculation on different timeframes “

Traditionally we have the market that is made up of retail and institutional investors together with the market makers that facilitates these investors. In the last couple of years,  there have been much changes in the investment landscape and that is High Frequency Trading or HFT for short. HFT accounted for about 70% of daily trading volume in NYSE, 60% in Europe and 50% in Asia. In other words there is a paradigm shift in the traditional Investors Buy and Hold market to a Trader’s market.

HFT or High Frequency Trading refers to large and very fast execution of quote orders by computers programs which will create cascade like buying and selling.

Trading cycles what seems to be days and weeks now are being done in milliseconds and nanoseconds. In other words market has shifted from the traditional (fundamental and technical analysis) with long term holding for equity appreciation to short term trading that benefit only the speculators. The strategy of investing today refers to ‘here and now’ rather than ‘buy and hold’.
  
As we know HFT is the main culprit during the infamous May 6, 2010 “Flash Crash”, where the Dow plunge more than 700 points in just a few minutes only to recover a few minutes later. The whole process was initiated by the sale of $4.1 billion of security by US money manager Waddell & Reed Financial Inc and was accelerated by other HFT traders.

The multiple orders coming from multiple locations and multiple HFTs had resulted in what they called the “QUOTE STUFFING”. The number of quotes coming in simultaneously from the HFTs just overwhelms the computers at the exchange and basically jammed it.  That is why during that time there are a lot of stocks that are trading with the absence of buyers or buyers bidding at very low prices and this is one of the main contributor to the Flash Crash of 2010.

The new trendy word in HFT trading is ‘SHAVING’. It refers to the use of ultra high speed computers to engage in high speed computing so as to shave off the time in buying and selling of stocks, often within nanoseconds.

Just to give you a glimpse of what technology are available in the financial markets nowadays. People like Nanex who developed the NxCore which is a streaming WHOLE MARKET data feed (ticker plant) and comes with an API (Application Programming Interface) for developing your own trading software. It essentially brings the whole market, like the hyperactive US Options Market (OPRA) which transmits over 1.7 million quotes per second to your desktop. NxCore only requires a low end Pentium 1.0 Ghz with 80Mb hard drive to receive and database 1.4 million quotes per second or over 6 billion quotes per day and with a CPU usage of less than 5%. It can accomplish this task is because of its award winning proprietary data compression technology. It is basically like Co-Locating your PC next to the Data Farm Servers in NYSE.  

NYSE is known to have leased space INSIDE their data warehouse for HFT platforms. This is also call Co-Locate. The closer you are to the data center, the more picoseconds you will likely shave off. In other word the big boys are practically trading directly from the exchange lock-ups !! And of course these exchanges are making a killing out of renting these spaces. Forget about the exchange imposing rules to deter HFT  because they themselves are in it as well.

India is also on the way to promoting full scale HFT, as a senior official from one of India’s Stock Exchange said that ‘its bourse is allowing large brokerages/fund managers to place their terminals inside the bourse so as to speed up their orders’.

A few years ago, trading firms are talking about milliseconds. 1 millisecond is 1000 of a second, however milliseconds is already history. In the past 2 years trading speed had been shaved down from milliseconds to microseconds and now nanoseconds. Recently they are talking about reducing the speed of execution down to picoseconds. A picoseconds is one trillion of a second or put it rather naively it is like one second in 31,700 years.

According to Donal Byrne, CEO of Corvil, a high speed trading technology company specialize in providing low latency network management, suggested that in a not too distant future trading speed will be reduced to picoseconds.

A good example of a Flash Crash generated by HFT can be seen in the stock chart of Brown Forman.  It took only one second to bring down the price of Brown Forman from $70 to $16.64, a 75% or $7.5 billion loss for a $10 billion dollar company. The chart below shows the price, size and time action of the stock.



The reason for the competition to ‘race to zero’, is because it enable them to ‘front run’ their competitors. By front running it means it effectively put them at the front of the queue and have priority over other orders and help them react faster than others. According to some people in the know, Citadel which is one of the HFT heavyweights receives order flow from brokers like TOS. When they receive orders, they can decide whether or not to fill your order according to your price. If they fill you up then they will know exactly what are the small players buying, their market sentiment and momentum. By totaling the retail orders they are able to judge market sentiment on a particular price and also the pain threshold of the weak holders.

Predatory HFT programs are design to block retail investors from making successful trades against the house or Wall Street. An example in the following shows how the game of front running being played. Say stock ABC is being traded at the bid of $1.00 and ask $ 1.02. As a retail investor key in an order to buy at $1.02, normally it will get filled. But HFT programs which is ‘able to see’, will automatically raise the ask price to $ 1.03. So the next bid price will be higher and automatically set as $1.01, so that the HFT programs make the human investor to buy higher at $ 1.03 instead of $ 1.02.

According to Themis Trading Analysis white paper the profits generated by HFT and Algorithmic (algos) trading can go as high as $ 3 billion a year even though margins generated from each trade ranges from $0.01 - $ 0.02. Although they are not making much money from such spreads but they are making a killing from liquidity or Volume rebates of 0.005/share from the exchange. It is reported that Goldman Sach’s HFT trading alone revved up something like 2 billion shares a week and you times that with $0.005/share and times again 52 for the rest of the year and the figure surely adds up!!

In short, HFT trading is just basically latency arbitrage and those with ultra high speed computer hardware will always stays on top. And with its predatory HFT programs which is design to trigger cascade like buying and selling and also front running the chances of them losing in the market is minimal

HFT have already made its presence in Asian markets. If you pick any top five counters in any Asian bourse especially the Indonesian JSX. Just go to the ticker tracking and you will be able to see some action of HFT. As an example, say counter ELTY trading at 156 rupiah, when you click the stock tracking you will be able to see many transactions done at 156 with similar lots size say 20 lots per transaction. Sometimes there will be 200-500 transactions of 20 lots at 156 rupiah done within 2-3 seconds. This is the footprint of HFT because there is no way any human can key in so many transactions within 2-3 seconds.

In essence financial markets are rigged like the casinos. In the game of Black Jack, if the casino loses money on a particular table it will first attempt to change the deck of cards. If the table continues to lose then they will change the croupier and if it still loses then eventually they will close the table. They will always change the rules as in financial markets.

The main reason the exchanges are not banning HFT is because it is providing liquidity to the market, tighten the spreads and hence lowers brokerage costs

In financial markets, if you win consistently the big boys will deploy predatory HFT programs that will allow them to step in front of a trade which they are able to ‘see’ and front run the retail investors and thus reducing their profits. At the end of the day the markets are design to benefit the FEW and not the majority average Joes. In order to make money and survive, you need to understand the rules of the game and also learn how to exploit the weakness of the big boys.

For the moment the traditional method of investing using due diligence in fundamental data and technical analysis may still work for the retail investors. But they have to expose themselves to frequent bouts of 40-60% decline in markets.

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