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"It's like you're seeing the
Wall Street Journal
five microseconds into the future," said Kevin McPartland, a senioranalyst at financial services research firm TABB Group, at a seminar in November sponsored by TABB andSwitch and Data, a data center operator.
Secondly, it is about using HFT techniques, such as Predatory Algos, Immediate or Cancel (or “cancel andreplace”) orders, and Dark Pool Pinging, to determine what kind of institutional algo orders are in the market,such as those driven by commonly used volume weighted average price (VWAP) formulas, and how thoseorders will react if the bid / offer of a stock moves up or down. These techniques, all of which also benefit fromco-location, were initially outlined in our December 2008 white paper, “Toxic Equity Trading Order Flow on WallStreet.”
Armed with all this information, HFTs are able to achieve “(almost) risk free arbitrage opportunities,” accordingto a report by Jefferies & Company, Inc., an institutional brokerage firm.
To put it in layman’s terms, “those arethe types of investment strategies that arbitrageurs and hedge-fund managers drool over,” Richard Gates, aportfolio manager for TFS Market Neutral fund in West Chester, PA, who has studied latency arbitrage, told ablogger for
The Wall Street Journal.
Here’s an example of how an HFT trading computer takes advantage of a typical institutional algo VWAP orderto buy ABC stock:1. The market for ABC is $25.53 bid / offered at $25.54.2. Due to Latency Arbitrage, an HFT computer knows that there is an order that in a moment will move theNBBO quote higher, to $25.54 bid /offered at $25.56.3. The HFT speeds ahead, scraping dark and visible pools, buying all available ABC shares at $25.54 andcheaper.4. The institutional algo gets nothing done at $25.54 (as there is no stock available at this price) and themarket moves up to $25.54 bid / offered at $25.56 (as anticipated by the HFT).5. The HFT turns around and offers ABC at $25.55 or $25.56.6. Because it is following a volume driven formula, the institutional algo is forced to buy available shares fromthe HFT at $25.55 or $25.56.7. The HFT makes $0.01-$0.02 per share at the expense of the institution.It is currently estimated that HFT accounts for 60% of all share volume.
Based on our experience trading, weestimate that at least 10 percentage points of that is of a predatory nature. Based on current average dailyvolume of about 10 billion shares, that means approximately 600 million shares per day are subject to predatoryHFT. At $0.01-$0.02 per share, predatory HFT is profiting $6-$12 million a day. At about 250 trading days a
Nina Mehta, “High Frequency Trading Is a Tough Game,”
Traders Magazine Online News
, November 24, 2009, November 30, 2009<http://www.tradersmagazine.com/news/high-frequency-trading-tough-game-104672-1.html>
Sal L. Arnuk and Joseph Saluzzi, “Toxic Equity Trading Order Flow on Wall Street: The Real Force Behind the Explosion in Volume andVolatility,” Themis Trading LLC, December 17, 2008, November 30, 2009<http://www.themistrading.com/article_files/0000/0348/Toxic_Equity_Trading_on_Wall_Street_12-17-08.pdf>
“A Report on Information Arbitrage (IA) & Its Impact on Execution Quality,” Electronic Trading Desk, Jefferies & Company, November 3,2009, Page 2
Rob Curran, “Measuring Arbitrage in Milliseconds,”
The Wall Street Journal Online
, March 9, 2009, November 30, 2009<http://blogs.wsj.com/marketbeat/2009/03/09/measuring-arbitrage-in-milliseconds>
Ivy Schmerkin, “High-Frequency Trading Controversy Continues to Swirl,”
Wall Street & Technology
, November 23, 2009, November 30,2009 <http://www.wallstreetandtech.com/electronic-trading/showArticle.jhtml?articleID=221600663>