The sworn enemy of high frequency trading, Themis Trading, has a new "white paper" out titled "Latency Arbitrage: The Real Power Behind High Frequency Trading." In my opinion, this paper is better written than Themis's prior missives on the subject of HFT, which is rendering them obsolete as traders, yet there are some glaring errors in the report that undermine its points.
The paper attempts to illustrate by way of example how exactly the latency arb algos are eating your lunch - let's call them LAHFT for short. Themis describes it:
Here’s an example of how an HFT trading computer takes advantage of a typical institutional algo VWAP order to 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 the NBBO 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 and cheaper.
4. The institutional algo gets nothing done at $25.54 (as there is no stock available at this price) and the market 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 from the HFT at $25.55 or $25.56.
7. The HFT makes $0.01-$0.02 per share at the expense of the institution.
Now, item #2 above is the first problem - it implies that the LAHFT "knows" that there is an order that is coming in to buy stock. This is not correct. Themis continues to imply that the LAHFT is frontrunning orders, which is simply not the case. What is happening is that the LAHFT is reacting to publicly available trade data faster than other people are. The LAHFT computer does not see your buy order and trade ahead of it. What MAY happen is that the HFT algo is offering stock, and when they get lifted, they go and lift offers on other market centers. Again, this is nothing new, and is a basic, old, trading strategy - they just do it faster. Similarly, HFT Latency Arb algo's may see (and react to) publicly available trade data before JoeSixPack, but there is nothing immoral or illegal about that. The LAFHT can see the publicly available data that shows 100 shares of ABC just traded on exchange ABCD, and go lift offers on exchange WXYZ. So can you. They just do it faster than you. You are free to go write the software code to process the information faster - there is no secret club you have to join - all you have to do is do the development work and pay for the connection.
Even more importantly, though, Themis writes
"6. Because it is following a volume driven formula, the institutional algo is forced to buy available shares from the HFT at $25.55 or $25.56."
NO. NO. NO .NO .NO.. NO ONE is forced to buy shares from anyone else. If the institutional algo thinks the price is to high, it can sell stock instead of buying it. That's the beauty of markets. NO ONE forces you to trade at a price you don't want to. The LAHFT is not forcing anyone to lift their offers or hit their bids. If the institutional algo is leaving a footprint that lets everyone see what it's doing, that's it's own fault. Again, this is especially ironic because Themis's Saluzzi has previously admitted that he's a "tape reader" which tries to do EXACTLY what he complains about: forecast stock movements based on trading volume patterns. Why Saluzzi continues to think it's ok for him to try to do this, but not for a computer to try to do it faster is beyond me, and it's why I continue to write these reubuttals everytime he pens a piece against the technology that's making him obsolete.
ps - The term "predatory trading" is redundant: trading is predatory.
For more on the subject of high frequency trading, see:
We Fear What We Don't Understand
You Really Shouldn't Care So Much About Flash Trading and
Dark Pools Are Not The Enemy