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Programmed Trading

The good, the bad and the controversy


Done by
Choo Hongming Kent 080886B05
Yeo Shao Wei 081368J05
Yang Yuzhao 081094J05
Eu Li Qing Sandra 080885L05

Programmed Trading is having a bigger impact in the market today. It is used in many
ways, most notably in the field of High Frequency Trading. The objective of this report is
to examine the different types of strategies used by these traders, as well as the effects
on the market. We have found that the High Frequency traders employ a range of
questionable practices: liquidity rebate trading, the usage of predatory algorithms and
engaging in flash trading. This has led to positive feedback in stock prices, as well as a
more volatile market. We then examined some anomalies in the market volumes using
over 10 years of data from NYSE. Lastly, we looked at the development of some
regulations concerning programmed trading.
Contents

1. Introduction .......................................................................................................................................... 3
1.1. Places where algorithms can be found ......................................................................................... 4
2. High Frequency Trading (HFT)............................................................................................................... 5
2.1. Questionable Practices ................................................................................................................. 5
2.1.1. Liquidity Rebate Trading ....................................................................................................... 5
2.1.2. HFT and predatory algorithms .............................................................................................. 7
2.1.3. Automated Market Maker (AMM)........................................................................................ 8
2.1.4. HFT and Flash Orders ............................................................................................................ 9
3. Effects of Flash Trading ....................................................................................................................... 11
3.1. Positive Feedback........................................................................................................................ 11
3.2. Volatile markets .......................................................................................................................... 11
3.3. Significant HFT impact on Market Volume Anomalies ............................................................... 13
4. Regulations.......................................................................................................................................... 16
5. Conclusion ........................................................................................................................................... 18
Appendix ..................................................................................................................................................... 19
Bibliography ................................................................................................................................................ 23

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1. Introduction

Programmed trading is simply trades that are pre-programmed using algorithms before

being sent to the main market to be executed. Hence they are also known as algorithm

trading.

With improvements in computer processing speed and the widespread use of electronic

execution in capital markets, algorithm trading has become popular. In addition, with

the onset of decimalization, algorithm traders have more incentive to trade as they can

maneuvers themselves through micro movements of the stock market. The increasing

usage can be seen in the charts below (Taiyabi, 2009). It was also noted by (Tabb

Group, 2009) that in July 2009, 73% of US equity volume was generated by

programmed trading.

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1.1.Places where algorithms can be found
1. Designated Market Makers (DMMs), which are assigned by the exchanges, uses

algorithms to match orders in the markets (NYSE, 2009).

2. Complex Event Processing is when firms compute market conditions to look for

short term trading opportunities. E.g. Statistical Arbitrage between stock futures

and underlying stocks (Taiyabi, 2009), gauging market sentiment using twitter

(Rodier, 2009) .

3. Order Execution programs are algorithms which help people get better prices

for their trades. They use smart order routing to hide your order, reduce market

impact or achieve a certain price of transaction (Aite Group, 2009). A common

example would be an iceberg order which breaks down a large institutional

order into smaller orders and sent out over the course of a day. The next small

order is only sent when the prior order is filled. (Interactive Brokers, 2009)

4. High Frequency Trading Firms

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2. High Frequency Trading (HFT)

HFT is defined as trades that are executed over a short period of time using low latency

and fast execution programmes. Firms engaging in HFT make money from trading

large-scale turnover of numerous positions, making a small return on each turnover.

(Gibbs, 2009). High frequency trades are achieved through expensive technology and

through co-locating HFT servers next to exchange servers. Notably, the NYSE is building

a new $400 million facility in Manwah, New Jersey to cater to growing number of HFTs

(Miller, 2009). Interestingly, only 2% of the 20,000 trading firms in the US are HFTs but

they generate up to 73% of the trading volume as discussed earlier (Kerevan, 2009).

With such high volume traded, some of the HFT firm’s practices have come under

scrutiny.

2.1. Questionable Practices


2.1.1. Liquidity Rebate Trading
Exchanges and ECNs have been offering brokers and traders rebates for adding buy

or sell orders in displayed and non-displayed venues (NYSE, 2009) in order to

attract liquidity. As long as the order is filled, the market centre pays the broker a

rebate and charges a premium to the broker who took the liquidity away. However,

this has led to trading strategies solely designed to obtain the liquidity rebate (Arnuk

& Saluzzi, 2009).

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How Liquidity Rebate works:

Step 1) HFT spots the pattern of Institutional Player (IP)’s algorithm market orders through

a series of trades.

Step 2) HFT, knowing that IP will continue the pattern, goes ahead of IP, places limit orders

and buys shares at $20.01 from the market. HFT then earns rebate of $0.001 per share for

providing liquidity when the limit of is executed.

Step 3) HFT then places a limit order at 20.01 to sell all its shares to the IP player and earns

liquidity rebate of $0.001 per share again.

HFT firm has made no money from change in price it has earned 0.002 cents in

rebates. However the result is that the institution pays $20.01 instead of $20.00.

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2.1.2. HFT and predatory algorithms
As discussed earlier there are programs which help institutions split their orders,

however there are also algorithms counter which seeks to detect such institutional

orders and try to get ahead of these institutions.

As seen from the diagram below, the HFT firm employs a predatory algorithm that

moves the national best bid and offer (NBBO) so that an institutional algorithm also

has to follow it. A real life example of this might have happened on 15 July 2009

after Intel reported strong earnings (Duhigg, 2009).

How Predatory Algorithms work:

Step 1) HFT spots the IP’s algorithm pattern which is pegged to NBBO. Currently now offer

price is at $20.00.

Step 2) The HFT will now participate in the buying in order to move the NBBO until it

reaches the maximum range set by the IP. This is as the IP algorithm orders are pegged to

the NBBO.

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Step 3) Once Offer = $20.10 reached, the HFT will sell all its 100,000 shares. Knowing that

IP is the main demand in the market which has a maximum price of $20.10, they also sell

short as they know price will not rise above $20.10 as there is no strong demand above

that. This is why stock prices can move 10 cents or more in a matter of seconds on

low volume. (Arnuk & Saluzzi, 2009).

2.1.3. Automated Market Maker (AMM)


Another tool that the HFT firms have is that the AMM, they use this to ping the

market for the limit orders for reserve book buyers.

How Automated Market Maker Works:

Step1) The HFT would send a “ping” algorithm to test for the current demand

starting from $20.05 to $20.03.

Step 2) If there is no reply from the institution, the order is cancelled.

Step 3) When the ping receives a reply at $20.02, the HFT will initiate realizes that

the limit order for the institution at $20.02. Hence the HFT will buy everything from

the market below $20.02 and sell to the IP at $20.02. (Arnuk & Saluzzi, 2009).

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This results in the institution paying higher than the original market price. Such

cancellation of orders is also noted in a research done by (Prix, Loistil, & Huetel,

2007) on the German Xetra exchange, where they found that 65% of orders were no

fill deletion orders.

2.1.4. HFT and Flash Orders


Flash orders are orders that are pre-routed into darks pools 1 and ECNs2 before

heading out to the main market. These orders usually exist for less than 30

milliseconds and hence do fall under NMS regulation. The diagram below

demonstrates how flash orders works.

HFT firms can exploit the information from this flash order as they speed advantage

against other investor. Hence they can front run trades ahead of others using the
1
Dark pools are crossing Networks that provide liquidity but it is not on the order books
2
Electronic Communication Networks (ECNs), are computer systems that facilitate trading of financial products
outside of exchanges

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information from flash order. Let’s say an institution places a limit order of $20.05

and the market is trading at $20.03, the HFT sees this flashed in the dark pool; he

will then buy everything below $20.05 in the market and sell to the institution if the

institution fails to get executed in the dark pool. An example of a dark pool is Sigma

X which belongs to Goldman Sachs (Jeria & Sofianos, 2008). As can be seen below

the parent orders, which are large instituitional orders are broken down, in smaller

child orders and are routed to Sigma X, the dark pool, before enterting into the main

market.

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3. Effects of Flash Trading

3.1.Positive Feedback
Positive feedback is the movement of stock prices in response in a move in the same

direction. For instance, when one algorithm identifies and opportunity, on the upside or

downside, this pushes prices in one direction. Soon other algorithms might follow as

they spot the move in that direction push the price in that particular momentum. This

will lead to a positive feedback loop that causes prices to have exaggerated movements.

(Federal Reserve Board, 2006). This was one of the reasons attributed to the market

crash in October 1987, when the feedback loop got out of control, where the (Jones II,

2000) “selling would actually cascade instead of dry up."

In addition, many institutions place stop limit orders and algorithm orders that are

pegged with the NBBO, hence this movements caused by the HFT firms also trigger

other orders by other institutions. This is akin to lighting a HFT lighting these orders

and juicing the markets to move.

3.2.Volatile markets
Such exaggerated movements mean larger price swings and therefore more volatile

markets. Although many exchanges and brokers have lauded that programmed trading

was for market making to smooth prices and provides liquidity to the market, thus

decreasing the volatility of the market (Quinn, 2009). However, according to (Kedreth

C. Hogan, 1997), he examined whether there was a relationship between program

trading and volatility and volume. He concluded that there was a “strong correlation

between aggregate market volume and volatility is due to the relationship between

program trading and volatility”. Notably he pointed out that sell side trading, which

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consists or trades that aim to improve order execution by using smart order routing,

are the notable contributors to volatility. A similar observation was also made by (Hahn

& Lee, 2007). This could be due to the fact that HFT firms have their own proprietary

algorithms that sniff how the sell side firms algorithms and hence hijacking those trades

and which hence exaggerates moves as stated earlier.

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3.3.Significant HFT impact on Market Volume Anomalies
Below we cited an example for a volume anomaly. The total trading volume for the 4

stocks on 25th August 2009 added up to 2.126 billion shares. Such volume is unlikely to

be attributed to institutional investors, short covering, as short interest has been at year

lows (refer to appendix 4), or proprietary firms trading alone.

The trading volume of the 4 stocks represented 37% of the entire NYSE trading volume.

NYSE had a total of 3,162 stocks that traded on the 25th August 2009. These 4 stocks

represented only 0.13% of the total number of active stocks during the day. However,

their trading volume accounted for 37% of the NYSE volume for the day. Detailed

charts about price of a stock and their tremendous volumes can be seen in the monthly

and daily charts in appendix 1 and 3. In appendix 3 we see a tremendous surge in

these low priced financial stocks after C, FNM, FRE and BAC after Oct 2008 but an

overall drop in NYSE, hence these stocks might have been targets for HFT firms possibly

due to their low prices. Notably the surge in volume of FNM and FRE was not

accompanied by price changes which are likely caused by of HFT churning.

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Another example, AIG, is a high volume churner as the total volume of shares traded for

one of the day is close to the total number of free float shares (Stacey & Scholtes, 2009).

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Notably, these anomalies occurred after the introduction of the Supplementary

Liquidity Providers which was put in place to after the Lehman meltdown in Oct 2008,

the SEC aimed to provide sufficient market liquidity. (SEC, 2009) Unlike DMMs who

have the obligation to maintain an orderly market in their stocks, quote at the NBBO a

specified percentage of the time, and facilitate price discovery at the open, close and in

periods of significant imbalances, SLPs are only obligated to maintain a bid or offer at

the National Best Bid or Offer (NBBO) in each assigned security at least 5 percent of the

trading day. This means that SLP’s can trade for its own benefit and therefore the

recent volume churning in low priced financial stocks might be due to their appearance.

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4. Regulations

With the recent discrepancies in trading volume, Senator Kaufman has highlighted the need

for the SEC to look at how certain advantages such as high frequency trading and flash

trading are giving rise to a segmented market (Durden, 2009).

The issue of flash trading has come under scrutiny and on Sept 17 2009, SEC has

unanimously voted to ban flash trading (Reuters, 2009). However, the ban will take some

time as the SEC would need to consult the public first.

An alternative way to curb flash trading that has been proposed by the SEC is to reduce the

volume traded on dark pools by lowering the trading threshold from 5% to 0.25%. This in

turn, reduces the number of flash orders displayed in the dark pools. (Tsang & Kisling,

2009)

Another effort taken by the SEC to prevent the churning of volume on the stock market

would be to require all large traders to self-identify themselves using an identification

number when non-broker dealers trade (Mehta, 2009).

Also, one other proposed measure is to treat “actionable Indicator of Interest” (IOI) 3as

regular quotes to be displayed publicly (Younglai, 2009). What traders did was to send out

these automated IOIs to gauge the price and quantity demanded of a certain stock. This

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Orders routed to dark pools usually sit and wait for execution but some brokerages would send out quotes to
other markets to gauge the interest. These quotes called actionable IOI do not commit the trader to buy or sell and
are thus open to abuse (Spicer, 2009).

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leads to price discovery by traders who could then front-run others. The legislation is still

trying to define these IOIs but argues that they should be treated as formal bids and offers

that should be displayed publicly.

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5. Conclusion

Although firms claim the HFT and dark pools help provide liquidity, we can see from

illustrations above that their presence actually increases cost for the investor. In addition,

the firms have no obligation to remain in the market at all times. Imagine that one day bad

news hits the market and these HFT firms decide not to participate in the market because

of excessive risk. Given that they generate up to 70% of the trading volume, their departure

would mean a significant drop in volume. This would result in the in the inability of an

investor to get out of his position as he previously thought that there was ample liquidity.

Current reports about high frequency trading only touches the tip of the iceberg as there

are still many uncertain issues regarding retail order flow and overall market structure.

(2476 words)

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Appendix

1. Daily Market Volume


Bank of America Corporation Citigroup

Fannie Mae Freddie Mac

NYSE

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Goldman Sachs Group JP Morgan

2. AIG Daily and Monthly Market Volume

AIG Monthly market volume AIG Daily market volume

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3. Monthly market volume

2009 2009

Figure 14: Bank of America 10-year Monthly Market Volume Figure 15: CitiGroup 10-year Monthly Market Volume

2009 2009

Figure 12: Fannie Mae 10-year Monthly Market Value Figure 13: Freddie Mac 10-year Monthly Market Value

Peak

Rough
Average

Volume

Figure 14: NYSE 10-year Monthly Market Value

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4. Short Interest

AIG Bank of America Corporation

Citigroup Freddie Mac

Fannie Mae

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