Algorithmic Trading is Not High Frequency Trading

The 2010 flash crash was caused by "blackhat" HFT traders trying to game the system.

It was shown that one, some, or many HFTs were involved in "quote stuffing" which is bidding for stock and then pulling the order, something like 100k times per second. This gave the appearance of liquidity and demand, but it was fake, because as soon as someone would bid for the stock, they would pull their order. But another use of this was to essentially slow down the "ticker tape" of the NYSE. What was happening was that the "ticker tape" that showed the current bids and asks was slowing down, and by doing this, some HFTs could make use of the latency arbitrage. Colocated HFTs got their quotes for the best bids and asks directly from the exchanges, but other people were getting their quotes from the NYSE, so they were behind. I believe they were something like 30 seconds behind, so what would happen is that the HFTs had full reign to take advantage of others being blinded like this.

Of course, the side effect of this was that they "broke" the markets. Because of this latency, the NYSE suspended the markets temporarily, which then had the unintended consequence of forcing all the bids and asks to flow into the smaller exchanges, which didn't have the liquidity to handle the orders. There were so many sell orders, that basically all the buy orders for some stocks got taken out, causing the prices to plummet down to 1 cent or something like that.

I'm expecting another flash crash to occur at some point, so whenever I see heated market action, I place a bunch of trades around 25% below the current stock price, which I believe is just above the limits that the exchanges would use to roll back bad trades. (Un)fortunately, it hasn't happened yet, but I'm sure at some point it will.

HFT is about making money by supplying liquidity or making money by exploiting the portions of the system which are designed to supply liquidity. You don't want to end up with a position. You want to net out the day with no position in any stocks. HFT is done by an HFT fund which is usually trading off credit extended by an agressive hedge fund who they split the profits with.

Algos are about getting a trade done at the least cost. You want to buy 100M shares for fund XYZ or sell 10M shares for fund ABC. Algos are run by brokers on behalf of their buy-side clients. A simple algo is something like TWAP, the time weighted average price, which attempts to buy a large position over the course of the day gradually. The purpose of this algo is to avoid moving the market. This is suitable for the "build up a large position because I'm bullish on this industry" type of trade.

Another algo might be IQx, a package offered by CovergEx which tries to quickly execute the trade by sending it out to multiple dark pools and the major exchanges at gradually worse prices until the whole order fills. (Or at least that's my reading of the marketing material.)

Nanex makes a good case that it was HFT that caused the flash crash.

http://www.nanex.net/FlashCrashFinal/FlashCrashAnalysis_Theo...

I always find it interesting how much vitriol there is against automated trading, even among programmers. Too many people seem to believe that a small number of, ultra resourceful, nefarious folks are using unfair means to "game the system." The truth, as usual, is less interesting.

Doing this type of trading doesn't require millions of dollars and teams of PhDs. You don't have to know the right people and you don't have to know any secret handshakes.

Critics of high frequency trading are almost always misinformed. Some of the most informed critiques I have read about this stuff are the following books:

"A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation" by Bookstaber

"Traders, Guns and Money: Knowns and unknowns in the dazzling world of derivatives" by Das

And Nasim Taleb's work.

------- More to the point, the author is explaining something very basic (which journalists don't seem to understand): -Algorithmic trading is NOT a general term for all trading done with algorithms/computers. It refers to telling a computer to EXECUTE a specific trade. In other words, when your retirement fund decides to buy A LOT of AAPL, they naturally need to spread that trade over the whole day (or even several days). In the old days, human traders used to do it. Now it is mostly done by computer programs.

This is different from the kind of trading where a computer decides WHAT to trade (NOT HOW to trade). This kind of trading involves so many different strategies that it is silly to lump them together.

There seem to be other misconceptions: -The best and the brightest are working in Finance, instead of doing things more beneficial to society.

A quant colleague of mine, who has a PhD in Physics from an Ivy League school told me that he, and many of his friends, left academia because there were simply no positions for them.

-75% of trading is now automated, it is just computers trading with each other.

I hope someone will correct me if I'm wrong but I have never figured out if this 75% includes algo trading. If it does include algo trading (my guess is that it does), then I'm surprised it is not 100%. That is like saying 95% of TV channels are controlled by remote-control devices.

-People seem to think that wall-street traders make their money by "trading ahead" of mom & pop investors: your Dad buys 1000 shares of microsoft, a wily trader puts your dad's order on hold, buys it for himself, raises the price, sells his shares to your dad at a higher price...thereby making money off your dad.

Your broker is not allowed to 'trade-ahead' of you. At least in the places where I have worked, this is taken very seriously. Interestingly, high frequency traders (who are most frequently accused of this) don't actually have access to customer order-flow. High frequency trading hedge funds don't generally have any client orders. Places where the two co-exist are forced to have seperation. Traders from one department cannot share information with the other. As more and more client facing firms (sell-side) become automated, the chance of them actually coding up such cheats is even dumber.

Flash trading is often given as an example of people, in cahoots with exchanges, trading on others' order information. As far as I know, "flash" functionality exists to help clients trade more effectively. Large traders are VERY concerned about letting the whole market know that they are interested in some stock. Some exchanges offered the following functionality: if you are interested in buying a stock, you have the OPTION of giving other members of the exchange a chance to trade with you. If no one takes you up on the offer, then the order goes to the wider market.

I have to admit that a laywer friend told me that he opposes this functionality at his firm. If someone _really_ needs to know more, I suppose I could ask him to explain.

-High frequency traders trade so fast that mom & pop simply can't compete with them. Their computers/networks are just too fast and they can get closer to the exchanges than anyone else.

High frequency traders are not competing with mom & pop, they are competing with market makers. If two people hear a news item, the one closer to the exchange will naturally get the trade done faster (presumably at a better price). The same is (generally) true of people on the East Coast vs rest of the country (let's assume US financial system). The same is true of people who can click their mouse faster. Besides, there is no moral reason your Mom should be able to dump her Enron stock faster than Joe Trader.

etc., etc., etc. -------------

I should add that I am actually not at all comfortable with the role finance plays in world economy. I can't call myself a critic since being critical requires more complete understanding.

I am specifically opposed to things like direct market access. This is where any Joe Blow can use an API to setup his trading system. If he accidently leaves an infinite loop in his code, he can cause real problem. I remember sweating bullets (and almost trembling) when my boss asked me to flip the switch on the trading system I wrote. In reality, there are at least some protections built in to keep this from happening. However, I would like to see more uniform, consistent and better advertised rules.

I am also against the ability to trade by borrwing money from brokers (margin trading or leveraged trading). If an individual trader screws up, they wipe themselves out. If they borrowed money, then the consequences of their bad trades starts to seep out to others. If more than a handful of traders, trading on margin, go belly up, the lender could be in trouble as well...you can see how this could ripple across a system.

Closely related to allowing trading on margin is reliance on models. Say you have calculated that two stocks always move together. You _and your lender_ are so sure of this correlation that they think of it as the truth. What if your calculations or your assumptions were wrong? The consequences of this mistake may not be linearly related to the risk you thought you took. Read Nasim Taleb's work on this for more.

Finally, those who smell something fishy should broaden their concern beyond just modern trading system or even complex derivatives. I can see no principal, within the framework of free markets and individualism, which leads to condemnation of ever more automated and faster trading, more complex instruments and more dependence of finance. The best moral principal, I can think of, which opposes the current state of affairs, is the one uttered by Martin Sheen's character in the movie Wallstreet: "Create, instead of living off the buying and selling of others."

Wallstreet 2 was a piece of shit.

OP's misunderstanding of prop trading vs funds aside, I still think it can be argued that "HFT in its worst form amounts to high speed computerized rumor mongering".

For instance, take a look at the Nanex article What is the Bid/Ask spread of this stock? [1]. Rumor mongering in this case being gaming the weakness of the NBBO.

On a side note, I highly recommend reading through Nanex's Strange Days research section if HFT related market anomalies interests you at all [2].

[1]http://www.nanex.net/Research/bloodbot/bloodbot.html [2]http://www.nanex.net/FlashCrash/FlashCrashAnalysis.html