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AreHighFrequencyTradersRiggingtheStockMarket?
Weblogpost.Phil'sStockWorld[Phil'sStockWorldBLOG],Newstex.Aug7,2012.

Abstract
Noneavailable.
CaseyResearchasks,"Canregulationseverleveltheplayingfieldnowthatcomputershaveenteredtheworldof
investing?"Iask:Dotheyevenwantto?~Ilene
AreHighFrequencyTradersRiggingtheStockMarket?
ByDougHornig,CaseyResearch
Highfrequencytraders(HFT)havenointerestinanycompanywhosestockthey'retrading.
Theydon'tcareaboutitsearnings,whatsectorit'sin,norwho'sontheboardofdirectors.
Theyneitherknownorcarehowitfaresintechnicalanalysis,andtheydon'tgiveadamnaboutitslongterm
prospects.
Likelyasnot,theydon'tevenknowitsname.
Attheendofeveryday,aftertradingtensofmillionsofshares,theydon'twantasingleshareofstockontheirbooks
atall.
Whatattractsthemismakingatinyprofitonanopportunitythatcomesandgoesintheblinkofaneye.
Andtorepeatthatoverandover,untilthetinyprofitsfillabigbagwithdollars.
Wheredoesthatleavethe"stayathome"trader?
ThepotentialadvantagesofHFTtolargescaletradersisoneofthemostcontroversialtopicsininvestingtoday.
Itarrivedsofastthatmanyinvestorshavebeenleftscratchingtheirheads,wondering,"WhatisHFTanyway?Where
diditcomefrom,andshouldIbeworriedaboutit?"
ToenvisionhowHFTplaysoutintherealworld,here'sanexcellentillustrationfromanarticlebyBryantUrstadt,
writingintheMITTechnologyReview:
"Imaginethatamutualfundentersabuyorder,tellingitscomputertostartbyofferingthecurrentmarketpriceof
$20.00asharebuttotakeanyaskedpriceupto$20.03.Ahighspeedtrader...canusea'predatoryalgo'toidentify
thatlimitby'pinging'themarketwithsellordersthatareissuedinfractionsofasecondandcanceledjustasfast.It
mightstartat$20.05andworkitswaydownto$20.03,cancelingandreorderinguntilthemutualfundbites.The
traderthenbuysclosertothecurrent$20.00pricefromanother,slowerinvestor,andresellstothefundat$20.03.
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Becausethehighfrequencytraderhasaspeedadvantage,heisabletodoallthisbeforetheslowerpartycancatch
upandoffersharesfor$20.01.Thisspeedyplayerhasfoundthebuyer'slimit,gatheredupandsoldanorder,and
snippedafewpenniesoffforhimself."
TherearetwofactorstoconsiderinHFT:thefederalgovernmentandthespeedoflight.
That'sbecause,althoughlightisthefastestthingintheuniverse,itsvelocityisfinite.
Thesunthatweseeisthesunasitexistedabout8.3minutesago.
That'showlongittakeslighttocoverthe93millionmilestoEarth,andit'sameasurableamountoftime.
Downherethough,onthesurfaceofourplanet,distancesaresomuchshorterthatwetendtothinkofthetime
requiredforlighttogofromanygivenPointAtoPointBasnegligibleandformostpurposes,that'strueenough.
Itusuallydoesn'tmatterthatittakesateensybitlongerforalightbeamtotravelfromNewYorktoSanFrancisco
thanitdoestoChicago.
ButwithHFT,itreallydoesmatter.
Intimespast,analyzingthemarket'sdailyactionswassufficientfordecisionmaking.
Overtheyears,astechnologyadvancedelectronictradingtools,thatperiodshifteddowntohours,thenminutes.
AnalystswatchedstockscontinuouslyontheirBloombergterminals,andatthefirstsignofimpactfulnews,they
boughtorsold.
Simpleenough.
Thesedays,ofcourse,everyonehasaccesstothesamebasictools.
Evenstayathomedaytraderscanusecomputersoftwaretoautomaticallyexecutetradeswhenpreprogrammed
conditionsaremet.
Becauseeachinventionofthealgorithmictraderwassoeasilycopiedandcloned,someseriousmarketplayershave
goneinsearchofsustainablecompetitiveadvantageswaystogivethemselvesanedgethatisnotsoeasilyeroded.
Theystartedbuildingsectorspecificsoftware.Theytargetedtheirmodelsatnewgeographies,watchingtheentire
world'smarketstogether,insteadofinisolation.
Theysoughtactionablepatternsfromthemassivepilesofdatatheywerecollecting.Theyappliedsocialscienceto
theirmodels.Arbitragestrategies.Crowdtheory.Gametheory.Allforabetter,fastertooltopickwinninginvestments.
Aseachfirmfoundanadvantageinthemarkets,theircompetitorsaimedtooneupthem.
Somebuiltsmartersystems,hiringawayengineersfromMicrosoftandGoogle.
Theyfocusedonfastercode,pushingtheenvelopeofparallelprocessingandsimulationtechnology.Theyinvestedin
artificialintelligenceandflexiblepatternrecognition.Anykindofcuttingedgescience,really.
Otherssimplyputtheirsystemsclosertotheexchange,togainafewmillisecondsoverthecompetition.
ThuswasbornHFT.Itcouldn'tevenhaveexistedbeforetheadventofsuperfastcomputersandtheabilityof
programmerstowritesomeverycomplexalgorithms.

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Giftedwithallthiselectronicmarketanalysis,intrepiddatasleuthsbegantonoticepatternsemerging.Theysaw
opportunitiestoarbitrageinefficienciesinthemarketsandbegantotradethosealone.
Enterthelawofunintendedconsequences.
Butitwasn'tjustthetechnologicalarmsracethatgottheballrollingtowardHFT.Italsorequiredalittlenudgefrom
governmentregulatorswhowereblissfullyunawareofthelawofunintendedconsequences.
Washington,DC'sinvolvementwastheresultofnewtradingoptionsthatappearedinthelate'90s,likeelectronic
communicationsnetworks(ECNs)andAlternativeTradingSystems(ATSs).Inbrief,thesearetradingsystemsthat
arenotregulatedasexchanges,butexistasvenuesformatchingthebuyandsellorderssolelyoftheirown
subscribers.
AsBennSteil,economistandseniorfellowattheCouncilonForeignRelations,argues:"thehistoricregulatorymodel
isbasedonthenotionthattherearelogicaldistinctionsbetweentherolesofexchange,brokerandinvestor.
Technologicaldevelopmentshavebrokenthatdownentirely."
Governmenttooknote,ofcourse.Securitiesregulatorshavealwaysconsideredasoneoftheirprimaryfunctionsthe
responsibilitytoseethatmarketsare"fair."
Whenthestayathometraderorinvestorbuysorsellsastock,heshouldbeassuredofatleastanequalopportunity
ofgettingthebestpossibleprice,everytime.
Thegovernmentfearsthatifthisconfidenceintheintegrityofthesystemweretobecompromised,thewhole
financialhouseofcardsmightcometumblingdown.
Yettheproliferationofnewsystemsandexchangesmeantthattherewereboundtobepricevariancesamongthem
atanygiventradingmoment.
Inevitably,thiscreated"unfair"arbitrageopportunitiesforthosesmartenoughandquickenoughtotakeadvantage
ofthem.
TheSEC's"solution"camein2007,intheformofRegulationNMS(NationalMarketSystem).NMSallowedanystock
onanyexchangetobetradedonanyotherexchange,withtheorderautomaticallyfilledatthebestbidorbestoffer.
Butforthatkindofpricediscoverytohappen,eachordermustberoutedtoallpotentialexchangelocationsatthe
sametime,beforeanytradecanbeexecuted.
Whichiswherethespeedoflightcomesin.
Atlast,somethingthegovernmentcan'tregulate!
Ifeveryorderisroutedtoeveryexchangeattheexactsametime,thentheoreticallynotradercangainalegupon
othersbybeingfirstinline.That'swhattheSECintended.
Unfortunately,it'snotanachievablegoalinthisuniverse,wherelightspeeddictatesthevelocityatwhichdatacan
traveloverafiberopticnetwork.
Thespeedoflightfactor:Ittakesabout100millisecondsforlighttotravelfromNewYorktoSanFrancisco,butmuch
lessthanthattomakeittoanearbyneighborhood.
Notadifferencethathumanscandetect...butcomputerscan.Andtheycanfillthegapbetween,say,10and100
millisecondscalledthe"latencyperiod"withacomplexseriesofinstructions.
Ifyouwanttoexploittheprofitpotentialinherentinthislatency,whatyoumustdoissiteyouroperationscloserto
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thesourceoftheactionthantheotherguy.You'llchoosetobesnuggeduptothetradingfloorinNewYork,the
centerofmostfinancialtransactions,ratherthantosetupshopinMiami,Dallas,orSanFrancisco.
That'scalled"proximitytrading,"andit'saccomplishedthroughthephenomenonknownas"colocation,"anotherof
today'sbigbuzzwords.
NewYorkistheobviouschoiceforthis,andsureenough,therearetwohugecolocationdatacentersinthecity.
Manhattan,however,hassomeseriousdrawbacksmostobviously,thepriceofbuyingorleasingrealestate.
Thenthereisthevoraciouspowerconsumptionofthesemassiveserverfarms,alsoprohibitivelyexpensive
downtown.Finally,thereisthefrighteningfearofdataloss,companies'needfordataprotectionifsomethinggoes
badlywrongonWallStreet.
NewJersey:Hence,intheUSyou'llfindmostofthesefacilitiesinNewJersey.
It'samillisecondfartheraway,butmanycompaniesarewillingtomakethetradeoff,andthey'vedefinedaswathof
landthatinthetradeisknownas"thedonut"asemicirclearoundNewYorkCitywithawidthof3070kilometers.
Withinthedonutlietheidealcolocationsbasedontheparametersoflandavailability,poweravailability(including
backup),constructioncost,andlikelihoodofeffectivedisasterrecovery(whichgoessofarastotakeintoaccountthe
projectedblastradiusofasmallnucleardevice).
Enormousoutlaysofcapitalarerequiredinordertobuildoutcolocationcentersaroundtheworld'sfinancialcenters,
andnoonewouldbotheriftheydidn'thaveclientswaiting.
Butclientsarereadywithcheckbooksinhand.
Highfrequencytradingisnowestimatedtodriveatleast50%ofthestockmarket,withsomepushingitsshareas
highas70%.
Italsotakesaboutaquarteroffuturesmarkets.
Anditishighlylucrative.AccordingtoanalystsattheTabbGroup,HFtradersearnedaround$13billioninprofitin
2010thenumberwasprobablymuchhigherlastyear.
HFThasreceivedafullmeasureofnegativepress.Butthere'snothinginandofthepracticeitselfthatisbad.
Atitscore,it'snodifferentfrombusinessasusual.Marketmakershavealwaysstoodreadytoexecutebothbuyand
sellorders,profitingoffthespread.
Thisiswhatprovidesliquiditytothetradingfloorandkeepsthesystemrunningsmoothly.
Ifanyonefromanindividualtoamammothfundwantstotradeastock,theycan.
ThebigdifferencebetweenHFTandanindividualtraderisthatmachinescandoitfasterandmoreefficiently,making
adjustmentsinfractionsofasecondifneedbe,andensuringthatinvestorsdorealizethebestpriceontheirtrades.
Fluttering:Atthesametime,though,HFTtechnologypermitstheextremelyrapidplacingandwithdrawaloforders,
uptothousandsoftimespersecond.And,itisthisspeedthathasleddirectlytooneofthemostcontroversialof
HFT'spractices,aploycalled"fluttering."
Usingthistechniquewherethousandsofordersareplacedandthenrapidlycanceledbeforetheyareactedupon
highfrequencytraders'computerscannibbleatthemarket,untiltheyfindapatternorananomalythatexistsfor
onlyamoment(somethingthatsimplymaybeduetothemhavingalowerlatencyperiodthanacompetitor)andcan
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thenexploitit.
Sincetheseanomaliesresultindifferencesofonlypennies,andsinceweasretailinvestorsplantoholdourstocksfor
farlongerthanaminute,whyshouldwecarewhatHFTtradersdo?
Weshouldn't,defendersofthepracticesay.
Infact,theymaintainthatbypullingbidsandasksclosertogether,they'reprovidinguswithafreeservicethathelps
usbenefitfromproperpricediscovery.
Moreover,theyclaimthatthey'rewellpositionedtorightashipthat'stippingprecipitously,andtosteeritbacktoward
fairvalue.
Theysaythat'spreciselywhathappenedduringtheinfamous"FlashCrash"ofMay2011,whentheDowplunged
nearly1,000pointsinlessthan20minutes.
Investigationsafterthefacthaveshownthatthemeltdownwasinitiallytriggeredbyone(human)traderwho
accidentallytriedtosellamassiveamountofS&P500futurescontracts,settingoffastringoftopplingdominosas
othertraders'stoplimitswerebreached.
HFTdidn'tcausethecrash,sayproponentsinfact,itsavedtheday,bringingthemarketbackbeforehumanscould
react,byrightpricingtheassets.Innumerablesmalltradesquicklystairsteppedthemarketbackuptonominalvalue.
OthersareratherlesssanguineincludingtheSEC,whichcalledHFTa"contributingfactor"intheFlashCrash.
FinancialSpam
CaseyExtraordinaryTechnology,whichcontinuouslycoversemergingtechnologies,notesthatHFtraderscangouge
investorswhoplacemarketorders.
Smallertradershaveprobablyallexperiencedbuyorsellordersthatwerefilledatsomepricethatseemedoutof
whackwithwhateverthestockwasdoingonthatparticularday.HFTcouldbetoblame,somesay.Ifthatisproven,
theninevitablysmallertradersriskbeingaffected.
Andtheheisttakesplaceinalegalareathatisverygreyindeed.
SteveHammer,founderofHFTAlert,explains:
"[Fluttering]isnotenoughtimetogetanexecution.It'sillegaltoputinaphonybidoraphonyofferbutthat's
what'shappening.HFTscreateinessencefinancialspam,whichincreasesthelatencyinthesystemandallowsthem
topushpricesinonedirectionortheother.Peopleseeinglotsofvolatilityinastockwhoputinmarketordersare
givingthesystemslicensetosteal.Iftheycancrossthemarketandlockthespreadforafractionofasecond,they
cantakeoutanylimitorderaboveorbelowthatprice,resultinginaverybrief,wideswinginthepriceofthatstock,
56%inasinglesecond,eventhoughifwe'relookingweseenochangewhateverinpriceorspread,yetherecome
allthesetradesthroughthatareoutsidethespreadatthatpointintime."
AnotherclaimisthatHFTisdestroyingthefuturesmarkets,i.e.,thosewithalegitimateneedforhedgingareseeing
theirpositionsblownupbyhighfrequencymanipulatorswhocausesuchvolatilitythatthehedgersareforcedinto
unnecessarymargincalls.
WhereverthetruthaboutHFTmaylie,thetempestithascausedwasboundtogeneratesomenewregulations,and
ithas.
ArecentSECproposalwouldeliminateonecontroversialtacticofhighfrequencytraders:the"flashtrade,"inwhich
exchangesalertdesignatedtraderstoincomingorders.
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Criticscallitavariationoffrontrunning,anold(andillegal)practicethatinvolvestradersbuyingandsellingin
advanceoflargeorders.
Nasdaq,meanwhile,announcedanewpolicyinMarch,underwhichitwillchargeitsmembersatleast$0.001per
orderiftheirnonmarketableordertotraderatioexceeds100:1.(Nonmarketableordersarethosepostedoutside
thenationalbestbidandoffer.)
Thefeewillbelimitedtothoseindividualmarketparticipantsthatsendinatleastonemillionordersperday.
Marketmakerswillalsobeexempted,eventhoughsomemarketmakingfirmsareconsideredHFTshops.
Intheend,itwouldappearthatwe'dbettergetusedtoHFT.Itislikelyheretostay,regardlessofnewregsorwhat
wemaythinkofit.
Technologicaladvancementisageniethat,onceout,canneverbeforcedbackinthebottle.
Intheinvestmentmarkets,traderswillalwaystrytousenewtechnologytogainanedge,countertraderswillalways
seekwaystonegateit,andgovernmentwillalwaysinvent"fixes"thatareastepbehindthetimes.
Forourreaders,manyofwhominvestinacompanyforweeks,months,oryears,HFTwillmakelittledifference.But
tobeonthesafeside,alwaysplacelimitorders,nevermarketorders.
Technologydrivesindustry,andnotjustonthetradingarena.WithCaseyExtraordinaryTechnology,wekeepour
readersuptodateonnewadvancesandtheopportunitiesforprofitthatcomefromthem.CheckoutCasey
ExtraordinaryTechnology.
DougisahighlyrespectedcontributortoCaseyResearch.Fromhisearlydaysasafreelancewriter,Doug'sindepth
research,detailedmarketknowledge,andavidcuriosityaboutwhatmakesmarketsworkhavemadehishundredsof
articlesstandoutandgetattentioninacrowdedarena.
DougwritesforCaseyExtraordinaryTechnology,CaseyDailyDispatch,andotherCaseypublications,aswellas
producingarticlesforgeneralInternetdistribution.ReadmoreofDoug'sinsightsatCaseyExtraordinaryTechnology.
Credit:ilene
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CopyrightNewstexAug7,2012

Title

AreHighFrequencyTradersRiggingtheStockMarket?

Publicationtitle

Phil'sStockWorld[Phil'sStockWorldBLOG]

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Publicationyear

2012

Publicationdate

Aug7,2012

Year

2012

Dateline

Aug07,2012

Publisher

Newstex

Placeofpublication

Chatham

Countryofpublication

UnitedStates

Publicationsubject

BusinessAndEconomicsInvestments

Sourcetype

Blogs,Podcasts,&Websites

Languageofpublication

English

Documenttype

Blogs

ProQuestdocumentID

1032623768

DocumentURL

http://search.proquest.com/docview/1032623768?
accountid=63064

Copyright

CopyrightNewstexAug7,2012

Lastupdated

20120808

Database

ResearchLibrary

Copyright2016ProQuestLLC.Allrightsreserved.TermsandConditions

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