Insider Trading, Or Not

I actually kinda like talking about insider trading because it's a topic that can have a lot of gray areas in it and requires some legitimate careful thought.  Despite having worked on Wall Street for many years, I'm well aware that insider trading questions are frequently not cut and dry, which is why we were usually trained on the maxim "If you have to ask, don't do it."  I wrote a few posts on this topic earlier, but it's come back into play with a vengeance this week, with the crackdown on "expert networks."

Uninformed populist ragers will act shocked, and scream "OMG!  So wall street takes all of these industry insiders, re-labels them "experts" and then sells inside information?!!!  How unfair!"  Now, I just want to clarify one thing - the point of expert networks is to allow people who want to do real due diligence to get the information they need by talking to people who know what they are talking about!  The vast majority of the information in these sessions is almost certainly perfectly legal to share.  It's also entirely possible that there are people who mistakenly disclose information that they should not be disclosing and are guilty of misappropriating material non-public information - but I'd guess that they are a minuscule minority.  My point is only that expert networks are positively not inherently evil.  In an ideal world, this is how everyone would do research - talk to experts.  Instead, we rely on greed, the desire to make a quick buck, penny stock touts, and Cramer.  But I digress. (Here's a pretty decent description of Expert Networks)

Let me just give a few quick examples:  If you want to know about how ETFs work, you might pay to have a conference call with me, and I would explain it to you.  Talking to me, an expert in the field, is a great way for you to quickly get a grasp of a concept or industry in a short amount of time, without the journalist or mutual fund industry bias that you'll get reading white papers on the 'web.    

If you want to know about the effect the expiration of Apple's exclusive AT&T contract might have on the mobile phone industry, you might contact Gerson Lehrman (one of the "expert network" pioneers), who would (for a fee)  put you in touch with the former VP of sales for Sprint, who could explain the entire process to you.  Nowhere in the chain is the goal supposed to be to get the current VP of AT&T to comment on material nonpublic information about his company's subscribers or business plans.  The expert you are talking to knows this (or is supposed to know this!) also - and doesn't want to go to jail  or get fired just to make you rich and get $200 an hour for himself.    

If you want to understand the effect that higher fuel prices might have on Wal-Mart's distribution costs, you might talk to a shipping company about the number of miles they drive each year, and how that might change with economic conditions and higher commodity costs.  

If you want to understand the process by which BP will have to close down its leaking well, you contact an expert in the field who could explain to you in an hour what you might otherwise spend 2 weeks researching on your own. (A friend of mine actually mentioned that he talked to some Gerson Lehrman experts on this very subject, and they ended up being wrong about their prognosis!)

Is it possible that one might encounter a policy-ignorant industry insider who shares material non-public information?  Of course it's possible - but it's positively not the goal of expert networks.  The goal is to allow investors to gain an in depth knowledge of a business from people who understand that business.  Increased due diligence is a good thing, and  insider trading is a bad thing - but the two are not even close to synonymous.

Amazingly, in the wake of this week's FBI activity on insider trading, the boys at Themis, Sal Arnuk and Joe Saluzzi wrote and absolutely embarrassing article attempting to liken high frequency trading to insider trading.  Sal and Joe are not idiots.  I don't generally agree with their view of the use of technology in the markets, and view them as victims of the progress in technology, trying desperately to cling to their niche by maligning their opposition - but at least they usually try to make well reasoned, factually sound arguments.

Their piece today, however, was utter nonsense.  It's so bad that I hate to call attention to it, but it needs to be corrected, and it touches on insider trading topics I've addressed on this blog previously.  Themis writes (emphasis theirs):

"We believe that if the FBI and SEC feel that information that investors are getting  from some “expert networks” is defined as inside information,  then a case can be made that the data that the exchanges are providing could also be considered an “expert network”.  The question becomes is the information that the exchanges provide in their private data feeds considered “material, non-public information”?  It is certainly not widely disseminated but is it non-public information?  We realize that anybody can subscribe to the data feeds and this is most likely the defense the exchanges will use.  But is it realistic for most investors to subscribe to these data feeds and then establish the computing capacity to analyze this information.  The fact of the matter is not all investors are looking at the same information.  Whether this is technically inside information is not for us to decide."

Readers should have no confusion on this matter:  this is not non-public information.  In fact, it's quite public - it's available to anyone who wants to subscribe to it - for a fee.  Remember from my prior post - "public" doesn't mean you can get it online in 15 seconds via a Google search for free.  I've tried to repeatedly make the point that this is another reason why high frequency trading is a better model than the old NYSE specialist model:  the specialist model was a tight Old Boys' club - you couldn't become a specialist just because you wanted to and had the ability to - you had to crack the club.  It was positively non-public in terms of opportunity.  Today, however, the process has become democratized - anyone who has the ability and the means can compete in the world of high frequency trading, using PUBLICLY available data that doesn't cost millions of dollars a month.  It's not just the rich, it's not just men, it's not just certain ethnicities - it's democratized.

So when Sal and Joe write "whether this is technically inside information is not for us to decide,"  I can only hope that they are being intentionally disingenuous and that they in fact are fully aware that this is not anything that can even be intelligently debated as inside information, and are simply trying to write a fear/hype piece to mis-educate the masses.   Just because John has access to information that Jane doesn't have does not mean that John's information is non-public, or that he has some unfair advantage.  All investors are rarely looking at the same information - the important point is that investors have the opportunity to have access to the same information.  If you still don't understand this, please read PeterPeter's comment on Themis's Business Insider post, which reiterates a number of points I've discussed on this blog previously.

-KD

FINRA:Trillium HFT Fine

FINRA has fined Trillium for "using an illicit high frequency trading strategy."

"WASHINGTON — The Financial Industry Regulatory Authority (FINRA) today announced that it has censured and fined New York-based Trillium Brokerage Services, LLC, $1 million for using an illicit high frequency trading strategy and related supervisory failures. Trillium, through nine proprietary traders, entered numerous layered, non-bona fide market moving orders to generate selling or buying interest in specific stocks. By entering the non-bona fide orders, often in substantial size relative to a stock's overall legitimate pending order volume, Trillium traders created a false appearance of buy- or sell-side pressure.

This trading strategy induced other market participants to enter orders to execute against limit orders previously entered by the Trillium traders. Once their orders were filled, the Trillium traders would then immediately cancel orders that had only been designed to create the false appearance of market activity. As a result of this improper high frequency trading strategy, Trillium's traders obtained advantageous prices that otherwise would not have been available to them on 46,000 occasions. Other market participants were unaware that they were acting on the layered, illegitimate orders entered by Trillium traders."

In case this isn't clear, it seems that what Trillium was doing was trying to induce other market participants to react to their orders.  In other words, Trillium might submit a bid a few cents below the current best bid for a large number of shares, expecting that other market participants (probably other HFT algos) would see this bid and either lift the current offer, or improve the current best bid.  Trillium would be waiting on the other side of the market with a sell order - which is the one they really wanted to execute all along.  The buy orders, although it's possible they could have been executed, were never intended to be executed, and are referred to by FINRA as "non-bona fide."

There's a big problem with Trillium's strategy:  it's illegal.  It's called market manipulation, and they got bagged for it.    Ironically, most of the same people who are/will be happy that Trillium is getting punished for this behavior would also be happy that the participants who Trillium was trying to fool got fooled.  In other words, it's been made quite clear that the Populace At Large does not like the trend of traders, be they high frequency (moreso, lately, obviously) or low frequency, reacting to publicly displayed quotations by changing their own quotes. or lifting bids / hitting offers in response to publicly displayed quotes.  Those are the very traders Trillium was trying to (illegally) take advantage of.

-KD

Someone Will Always Have the Data First

I'm going to keep this short and sweet.  Scott Patterson writes in the Wall Street Journal:

"Some fast-moving computer-driven investment firms are getting an edge by trading on market data before it gets to other investors, according to market players and researchers who have studied the trading.

The firms gain that advantage by buying data from stock exchanges and feeding it into supercomputers that calculate stock prices a fraction of a second before most other investors see the numbers."

Listen up now - someone will always have the data first, and someone will always have the data before you.  It's a fact of, well, data transmission.  The guy in San Fran will get the data a little later than the guy in Chicago.  The guy in midtown Manhattan will get the data a little later than the guy in downtown Manhattan.  The guy on a DSL connection will get the data a little later than the guy on the fiber connection.  The guy next door to the stock exchange will get the data a little later than the guy who is co-located at the data center.  The guy using the internet will get the data a lot later than all of them.

Again, the important fact is that this data is open to anyone who is willing to make the investment in it  - not just a secret cool kids club that requires you to work for a specific blue blooded Wall Street firm.  Anyone can do it - if they are willing to invest in the business.  

The "Hey - it's not fair - he's getting the data first and reacting to it faster than I can" argument is total baloney.  

EDIT - as I mentioned in the comments: also notice that 15 years ago the sophisticated market participants had real time pricing information, while retail schmucks were left calling an automated phone system and punching in their tickers to get 20 minute delayed quotes (come on - I know I'm not the only one who remembers that).  Today, less sophisticated investors have easy ample access to "real time" quotes which are in fact seen 100 MILLISECONDS after they are published, and thus 100 ms after the fastest market participants. So the retail data availability time lag has been decreased from 20 minutes to a number of milliseconds.  Sounds like improvement to me. 

-KD

More on High Frequency Trading

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.

-KD

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

Calling Out Matt Taibbi on Dark Pools

So, I wrote this explanation of the reality of dark pools earlier today.    Then, after having a few going away drinks with some friends, I read Taibbi's piece "Goldman Lobbies Senate, Says Full Transparency Sucks," which pretty much proved my point - that people railing against dark pools almost certainly don't understand what they are angry about.  Goldman Sachs put out a presentation attempting to explain to the ignorant masses on the internet how the markets actually work.  It's a pretty decent presentation, which ZeroHedge has an even better version of here.   

Now, let's get to Taibbi's analysis:  "One friend of mine put it this way: say Goldman buys a big block of stock from a pension fund in a dark pool. Now they have shares they want to get out of and flatten out their risk. So where do they sell? Well, a big chunk of it might go to the retail schmuck who has no idea what’s going on. He’s buying 1000 shares of whatever at $28, not knowing that Goldman has another 50,000 shares to go. Next thing you know, the schmuck’s shares are at $27."

You don't have to be a professional trader to understand why Taibbi's "friend's"  logic is batshit crazy.  In fact, I'd expect any intelligent journalist who endeavors to write financial articles with impact to understand this simple concept:  If you're Goldman Sachs, your business model is not, has never been, and never will be to buy large blocks of stock from pension funds in dark pools and then unload them on unsuspecting retail "schmucks" at lower prices.   Buying at $28, selling at $27.  Sounds like a barnburner business plan - sign me up! (/sarcsm).

There's an old allegory about the farmer who bought watermelons for $10 and sold them at market for $9.  His friend asked him, "How will you make money doing that?"  "VOLUME!"  He replied.

That's basically what Taibbi's suggestion is:  that Goldman Sachs is buying large blocks of stock from pension funds, and turning around and selling small pieces of these blocks to poor innocent retail investors, thus driving the price down.  Somehow, I guess Taibbi believes, GS will make up for it in volume! By the way - there is almost no reason for any retail investor to use dark pools - since retail investors don't need to worry about other traders acting on their visible supply and demand - because it's so small.

I went back and pulled another Taibbi quote on high frequency trading, just for the fun of it:

"The people who are actively innovating on Wall Street are all involved in the business of gaming the system to take advantage of short-term price swings. The people who invest money for the long-term and stick with their investments are punished in this environment."

Hey Taibbi - guess what - that was my point:  you've been complaining about high frequency traders scalping visible supply and demand, and now you're complaining about the antidote to such high frequency traders.  It  may make for good click bait among the ignorati (I just coined that word, and I love it) - but it doesn't make sense in the real world.  Pick your battle - hate one or the other - or even neither - but as long as you hate both, you're proving your ignorance.

-KD

ps - usual disclosures - I do not, and have never worked for or received any compensation from Goldman Sachs.

Dark Pools Are Not Scary Shady Places That Rip Off Average Investors

The next step in the discussion about high frequency trading leads logically to the topic of dark pools.  I'm constantly mind-boggled to see the same people who were railing against high frequency trading proceed to dark pools as their next target.  Why is this so surprising to me?  It's simple:  dark pools are the antidote to high frequency trading.  They're where you go to hide from the computer algorithms who are making lightening fast trades in reaction to the bids and offers you post in the marketplace.

Let's take a quick step back.  One component of high frequency trading is what I'll call "pattern mappers" - algorithms that try to deduce how stock prices are going to move based on the bids and offers that are lining up in the marketplace on open books.  For example, if XYZ normally trades one million shares a day, and there is a bid posted for 100,000 shares, it might be reasonable for a high frequency trading algorithm, or any other market participant for that matter, to assume that there is more demand for shares than there is supply, and that the price of XYZ will go higher.  Of course, there is no guarantee that this will happen, and the person buying 100,000 XYZ may not ever change his limit.  So, the algorithm, we'll call her Patty Pattern Mapper, buys stock in XYZ hoping to sell it to the buyer at a higher price.  The big buyer, we'll call him Donnie Dark Pool, has other options though.  Instead of exposing his bid to Patty's pattern mapping algo on the NYSE, he can enter his order in a dark pool, where no one can see the order.  If, and only if, there is someone on the other side of his trade willing to sell shares to Donnie, the stock will trade.

Now, there are some key facts about dark pool trades that lots of people either ignore or fail to understand.   First, all dark pool trades, like any other trades, are required to be reported to the tape within 90 seconds.   Second, all dark pool trades, like any other trades, in accordance with Reg NMS, are required to take place within the inside market - the NBBO - national best bid/offer.  So, no matter how much Karl Denninger would like to construct an example where a stock is trading at $10 on the "open exchange" and there is a seller in a dark pool willing to sell shares at 9.90, which are instantly snatched up by Goldman Sachs  for $9.90 to resell to the open market at $10 - that simply does not happen.  The dark pool either routs the seller's order to the open $10 bid, the stock trades at $10 or better in the dark pool,  or no trade takes place.

Third, and most importantly, trades in a dark pool, or in any other marketplace, only happen when there are matching supply and demand for shares at a given price.  One misconception is that dark pools somehow unfairly allow buyers to buy large blocks of stock without moving the price.  Huh?  Yeah - they can buy large blocks of stock if there is someone willing to sell large blocks of stock.  Otherwise, they can either raise their bid in the dark pool until they find liquidity, or not buy shares.  It's impossible to buy "large volumes of shares" at "small volume prices."

An erroneous critique related to this third point is that "large supply of stock should make prices go lower in an open market."  David Weidner's column on Marketwatch gives an example of this common thought error:

"The problem, of course, is that bulky trades move markets. If I'm at Merrill Lynch and I need to unload 500,000 shares of XYZ, I can place the order in dribs and drabs -- through the multiple public markets out there including the Nasdaq, EDGE and Arca. But that order still is going to pressure XYZ's share price. Also, I'm going to be giving myself away. It also means that XYZ's share price should be lower because there are more shares for sale than buyers. That's how free markets are supposed to work, right?"

Is that how free markets are supposed to work?  If I want to sell stock at $15, large amounts of it, then the stock should trade lower?  No - I don't think that's a requirement of good, free, efficient markets at all.   Although, it is one area of market inefficiencies that the high frequency pattern mappers are experts at implementing.  The truth is that if I want to sell 1mm shares of stock at $15, the price need not go down at all.  The price goes down only when there is no one willing to pay $15 and I lower my limit to $14.95.  Then, when I exhaust the demand at $14.95, the price goes down again when I lower my price to $14.90.  Supply of stock at a given price (say $15) does not make a stock go lower.  Supply of stock at increasingly lower prices without a corresponding match in demand makes a stock go lower - this is a key point, and is not semantic nitpicking.  We're so accustomed to trading off of what we think other traders are going to do that it requires some philosophical forethought to understand this concept.   

In the ideal market, I believe that the entire marketplace would be dark - we need not even see bid and ask prices - just one last price.  Everyone can enter their bids and offers - their supply and demand - into this one big dark pool, and trades would print as matches were made, with no one worrying about being out-traded by Patty Pattern Mapper.

I believe it's totally consistent to have the view that both dark pools and  high frequency trading algorithms which exploit the bids and offers they see on open exchanges are ok.  However, I think it's logically impossible to be against both these pattern mappers and the dark pools which enable other traders to hide from them.  Furthermore, I believe its clear that individual investors are not disadvantaged by dark pools, and elimination of dark pools would result in higher execution costs.

-KD

Using High Frequency Trading as a Scapegoat Has Jumped the Shark

Matthew Goldstein at Reuters wrote an article about what can go wrong when investors use stop-loss orders. A stop loss order is an order to sell your stock when it reaches a certain level to the downside - ie, if GE is trading at $16, and you want to lock in profits if it starts to fall, you can enter a stop-loss order to sell at $15. Then, if GE hits $15, your order will be entered into the marketplace. The catch is that if GE is plummeting and there isn't a lot of liquidity, you could sell your stock much lower than $15.

So, Goldstein describes a few investors who didn't understand that their stop-loss order doesn't guarantee them execution at their stop price. They were trading a lightening fast moving highly speculative biotech stock called Dendreon, around the time that Dendreon had news imminent regarding a potential cancer treatment drug. The stock started to fall, stop loss orders were triggered, stock was sold at a low price, and the stock quickly rebounded.

There are two real stories here: one is that the stock may have plummeted because a trader entered a "fat fingers" order in error - perhaps typing an extra zero onto the end of the order, and the other story is that someone intentionally may have leaked misleading information about the drug trial results in order to manipulate the stock. There's actually another story, and that's the danger of "market" orders, and how investors should never used them. Goldstein, however, decided to jump on the populist bandwagon, and blame high frequency trading for the price action in Dendreon's shares. He even titled his post "The Victims of High Frequency Trading." Talk about jumping the shark!

Goldstein's hack piece prompted Zero Hedge to write a post titled "Was HFT Responsible For Investor's Massive Dendreon Losses?" I think that even the guys at Zero Hedge know that the answer is "no," but they are in the business of generating page views, hence, the post.

I'm going to address some other concerns that the uninitiated may have about damage done by high frequency trading (HFT):

Did HFT kill Michael Jackson? NO

Did HFT cause the breakup between Jon & Kate Gosselin? NO

Was HFT responsible for Obama winning the Nobel Peace Prize? NO

Did HFT get Kourtney Karsdashian pregnant? NO

Is HFT helping Osama Bin Laden hide in the mountains of Afghanistan? NO

Did Jonathan Paplebon allow 3 ninth inning runs on Sunday against the Angels, resulting in the end of the season for the Boston Red Sox because of HFT? NO

Can HFT spread swine flu (H1N1) ? NO

Could HFT beat George St. Pierre in the octagon? NO

Can the dominance of the NY Yankees be explained by HFT? NO

Did HFT cause the tsunami in Samoa? NO

Did HFT help Iran obtain nuclear facilities? NO

Does HFT hate health care reform? NO

Put. Down. The. Pitchforks.

-KD

You Really Shouldn't Care So Much About Flash Trading

disclaimer: do not waste your time getting sidetracked into OTHER aspects of high frequency trading - this post is about one thing: FLASH TRADING. do not leave me comments about how much you hate high frequency trading - focus on the simple facts of flash trading, and I will be happy to engage in a dialogue with you.

First, let's step back and remind ourselves what flash trading is: when you enter an order on certain exchanges, you have the option to elect to have that order "flashed" to members of that market center to give them the opportunity to match prices that may be available on other exchanges. You, as the order executor, elect to have your order flashed because if the order is executed internally, you don't have to pay an additional charge to route your order out to another exchange. It's that simple. Let's make it a little more concrete: GE is trading $16.50 - $16.51, but you execute your orders on DirectEdge, and the best offer is currently on ISLD. When you enter a flash order in DirectEdge to buy 100 GE @ 16.51, all it does is give potential sellers in DirectEdge the opportunity to sell it to you at $16.51 before DirectEdge routes your order out to the other exchange. There is no theft, there is no front running, there is nothing to rant and rave about.

Now, I have all the respect in the world for Barry Ritholtz. I think he's a tremendous blogger who gets to the truth behind the data, and behind many biased mainstream media reports. Generally, he knows what he's talking about. So it was with dismay that I returned from a weekend out of town, sat down to catch up on some of his recent posts, and found this diatribe against flash trading. Ritholtz's piece arose because the SEC has proposed a ban on flash trading. Next they'll debate it, discuss it, hear comments on it, and vote on it.

A few months ago I wrote my most-read post ever, titled "We Fear What We Don't Understand." Let's revisit the flash trading component of that piece:

"Now, the intent of flash orders is to allow participants in a given market center the opportunity to improve the current bid or offer so that an order doesn't need to be routed away to another market center.

An example: let's say GE is trading $11.45-$11.50 at DirectEdge, but that there is an $11.46 bid on ISLD (an ECN). If you submit an order to sell stock at $11.46 on DirectEdge, they flash this order to select market participants to offer them the opportunity to fill your order - otherwise the order gets routed out to ISLD and you (the seller) have to pay an extra fraction of a penny for the routing. As I tried to explain on some other posts regarding flash trading, this is basically a hyper-speed modernized version of how the NYSE specialists used to verbally quote orders to offer people in the crowd the opportunity for price improvement: "if GE was 11.25-11.27 50k up, and you walked in to sell 50,000 shares, the specialist would say out loud “25c bid 50,000, 50,000 at 26c, SOLD.” Anyone could say "TAKE or BUY'EM" before the specialist said "SOLD" which would result in the seller getting price improvement to $11.26 and if no one interrupted him, the trade was done at $11.25. Markets have NEVER been setup such that every participant has the same opportunity to trade on every quote."

There was also an op-ed in the WSJ a few weeks ago defending and explaining flash trading. The op-ed is accurate, well written, and clear, yet Ritholtz still managed to take offense to it:

"The WSJ had an Op-Ed last month, In Defense of ‘Flash’ Trading, that suggested that “Flash trading is like offering to sell your house to your neighbor before you officially put it into the real estate listings.”

That description is, of course, utterly false. We have alternative exchanges where you can offer stocks privately to other willing buyers (i.e., Instinet). Flash trading is more like having access to private info from the sellers, knowing what they will accept, stepping in front of legitimate buyers, and then flipping the house to those buyers while capturing 0.001% of the transaction. No benefit to the seller, to the neighborhood or to anyone else — all at a small cost to the buyer."

I can't fathom how someone as intelligent as Ritholtz could screw this concept up: when you "step in front of legitimate buyers" it means you are paying more than anyone else. Thus, it's not possible to pay the highest price and then flip it back to the buyers who are willing to pay LESS and make a profit. If you buy stock against a flash order, and offer it out again, you're taking risk - you're not stealing fractions of a penny from anyone or arbitraging anything - what you ARE doing is helping the person who flashed the order in the first place by offering them price improvement and eliminating routing costs.

Now, there is certainly the POSSIBILITY that instead of John Q FlashMan seeing the flash order - let's say it's an order to buy GE - and instead of offering to sell stock to the flash order, he decides to act illicitly and buy stock in GE as fast as he can, before the original GE order gets completed. This is called front running - it's blatantly illegal, and you'd be hard pressed to find anyone who would argue that it's defensible. However, if the traders entering flash orders constantly find themselves being frontrun, well, guess what - they'll stop entering flash orders. They are not idiots. Guys using flash orders are highly cost sensitive, (that's the very reason they use flash orders in the first place!) and notice when their execution costs (both explicit: commission/fees, and implicit: impact costs, or negative costs associated from other trading ahead of their orders) increase - if flash orders are hurting them, they won't flash them.

Flash trading is a non-issue that people like Chuck Schumer and Ted Kaufman have jumped on in an effort to make it look like they are fighting for the little guy's rights on Wall Street. The reality is that a ban on flash trading will have little to no effect on any sort of market dynamic, and will not help the little guy at all, but will increase trading costs for some traders.

-Kid Dynamite

We Fear What We Don't Understand

"For those who believe, no explanation is necessary. For those who do not, none will suffice." - Joseph Dunninger.

I've resisted writing a piece about high frequency trading lately. Although I have a very good understanding of the subject, I see it as a kinda lost cause to try to educate people about - uninformed people want to believe that computers are front running them, stealing their money and manipulating the markets. People who understand equity trading know that this is just the culmination of technology advancement and competition for spreads, which has resulted in equity bid/ask spreads being narrowed to their lowest levels ever. There has never been a better time for the individual stock trader to execute orders: our bid ask spreads are narrower than ever. A high frequency trader may have a computer program trying to scalp a penny or a fraction of a penny from you - but this is better than it's even been - better than the days of specialists scalping 1/8ths and more.

I left a comment stating as much on Floyd Norris's latest article "What Should be Done," only because he got it precisely backwards when he wrote "In one sense, this is a return to the bad old days. Before reforms, the Nasdaq market kept the bid-asked spread for the brokers. The public had to buy at a higher price and sell at a lower one." On the contrary - high frequency trading has resulted in competition to capture those exact spreads, and has narrowed them drastically.

In my opinion, reaction to high frequency trading is all about the quote at the top of this post if you change the word "believe" to "understand." I will at least try to educate those who do not understand high frequency trading, so that they can form intelligent opinions - although I still fear that "no explanation will suffice."

Joe Saluzzi of Themis trading has gotten a ton of press based on a paper he published about the evils of high frequency trading. It's important to notice that Saluzzi is an execution trader, and that algorithms and high frequency traders make his life very difficult, because no human can do the job as well as an algorithm can. Saluzzi concludes his paper "We also recommend that institutions use algo systems only for the most liquid of stocks. Anything less must be worked, the same as in the “old days.” Institutions need to re-learn how to “watch the tape” and take advantage of, or work around, high frequency traders." Or, institutions can embrace technology and use or develop better algorithms. Either way, Saluzzi's suggestion that it's kosher for him to execute the orders by "watching the tape" to gauge optimal timing, but that it's unfair for a computer program to do the same thing reeks of hypocrisy. The best comment I've read on the subject was this (emphasis mine):

"Frontrunning is trading in front of a customer order. It is illegal. Collecting and analyzing publicly available information and trading based on your insights is legal. And guess what, someone will be the fastest and most accurate in doing this. The result of their actions is to translate meaningful information (strained from a stream of mostly noise, it's incredibly difficult to do) into price changes which make the price more accurate relative to what's knowable at the time. Unfortunately for people like Saluzzi, a 19th century "tape reader", a lot of the information that quicker, more talented, machine-using, more insightful players uncover is information about large size that he's trying to deceptively move without anyone knowing the truth about what he's doing. There's nothing wrong with what Saluzzi is trying to do. What's wrong is crying foul when the one-sided benefit you wanted to obtain is defeated by people who have made a bigger investment in what's important for trading. The big winners in all this are small traders who are not fleeced by large professional size deceptively getting them to buy or sell at insufficient prices. I can understand Saluzzi's campaign against technology and modern information processing, it's his ox that's getting gored. The thing that's truly hilarious is that what Saluzzi wants to be legal, his "tape reading", is just another example of where professionals have an edge over the little guy. But it would never occur to Saluzzi to outlaw what HE does, only what his competitors are doing better than him."

Let's get one thing straight: front running is when someone sees your order and executes ahead of it. It's illegal, and no one is advocating it. What many of these high frequency trading algorithms do, however, is not front running. High frequency trading is about using computers to do what human traders used to do - take advantage of available information (such as orders that are visible in the marketplace) and try to figure out where a stock is going. They do it better than humans can do it. They try to figure out what you want to do, and try to profit from what they think you want to do. They do it faster and more accurately. That's called trading - it's the nature of the beast.

If you put in a limit order to buy 100 shares of IBM at $80.50, and a computer or anyone else immediately bids $80.51 for IBM, that's NOT front running. That's someone willing to pay more for the stock than you are. It doesn't matter if that someone hopes to buy the stock and offer it back to you immediately like a high frequency rebate trader, or if they plan to hold it in their IRA for 50 years. Similarly, if, at the time you bid $80.50 for IBM, stock is offered at $80.51, and as soon as you put your bid in someone takes the offer, that's NOT front running. You had the opportunity to take that offer - you chose not to. This is the first key realization people need to make.

The next realization is that no algorithm can force you to pay more than you want to for stock. One thing the algo's do is "psyche you out" - when you bid $80.50 and you see the $80.51 and $80.52 offers get lifted, you might get nervous and panic. That's your problem. If you put your limit order in and go to the kitchen to make yourself a sandwich, you'll probably find that your order is filled when you get back. Any algo that expected you to panic and lift stock from them lost on their gamble. You can defeat the psychological game by refusing to play it (place your order and don't stare at the screen) - or by lifting the offer in the first place, paying the narrowest spread you've ever paid due to the massive competition by various high frequency trading algorithms to maintain quotes on the inside market.

Let's talk about Chuck Schumer's proposed ban on "flash" orders. Flash orders are a little bit trickier. From the NY Times article:

"When buy or sell orders are submitted to marketplaces like Nasdaq, they are sometimes flashed to a collection of high-frequency traders for just 30 milliseconds — 0.03 seconds — before they are routed to everyone else. In that half-second, (sic) fast-moving computer software can gain valuable insights regarding growing or declining demand in certain stocks and can trade ahead of other market participants, pushing prices up or down.

Although anyone can gain access to flash orders by paying a fee, they are useful only to traders who have computers powerful enough to act on the data within milliseconds"

First, note that ANYONE can gain access to flash orders. Similarly, anyone can gain access to co-located servers at the NYSE to have super fast execution speeds. These are not just available to a select chosen few - they are available to anyone who wants to make the investment in capital and technology. Now, the intent of flash orders is to allow participants in a given market center the opportunity to improve the current bid or offer so that an order doesn't need to be routed away to another market center.

An example: let's say GE is trading $11.45-$11.50 at DirectEdge, but that there is an $11.46 bid on ISLD (an ECN). If you submit an order to sell stock at $11.46 on DirectEdge, they flash this order to select market participants to offer them the opportunity to fill your order - otherwise the order gets routed out to ISLD and you (the seller) have to pay an extra fraction of a penny for the routing. As I tried to explain on some other posts regarding flash trading, this is basically a hyper-speed modernized version of how the NYSE specialists used to verbally quote orders to offer people in the crowd the opportunity for price improvement: "if GE was 11.25-11.27 50k up, and you walked in to sell 50,000 shares, the specialist would say out loud “25c bid 50,000, 50,000 at 26c, SOLD.” Anyone could say "TAKE or BUY'EM" before the specialist said "SOLD" which would result in the seller getting price improvement to $11.26 and if no one interrupted him, the trade was done at $11.25. Markets have NEVER been setup such that every participant has the same opportunity to trade on every quote."

The problem is if systems receiving flash orders can then turn around and hit that bid in front of the seller. That is blatant front running, and needs to be stopped. Here's a quote from a user of flash quotes explaining why he doesn't want them banned - a key point is that no one forces you to place flash orders:

"responding to: "there are different forms of HFT. Flash is clearly frontrunning and anyone who says otherwise is delusional. its designed to cheat "

Not true.

It is designed to keep orders from being routed-out under Reg NMS - which saves the person placing the trade money.

I am a small fry (sole employee of my small stat arb company) placing small to modest sized limit orders directly on ECNs. If I want to avoid paying a route-out fee when my order would otherwise become marketable on another exchange or ECN, the best execution + cost structure that I can get is to first have an order flashed locally to see if I can have a fill on the local ECN.

If a HF trader on the ECN gets the flash and 30ms later fills my order, I avoid paying a route out fee. If no HF trader responds to the flash, or the flash never existed because it got outlawed, then I end up paying a route out fee.

That is the intent behind flash orders. It keeps orders that become marketable more frequently on the local ECN rather than having them route-out....

I keep saying the same thing over and over again... but anyone who cares about orders flashing and doesn't want them to flash should just send the order through a different venue. It isn't rocket science. If you don't like the facilities provided by Direct Edge to execute your market moving large institutional order, then place it on Island.

Why is that so friggin hard?

No one is forced to place any order types that they don't like, or use any ECN that they think disadvantages them.

If your broker forces you to place trades on venues that flash orders and you have no control over it, then you need to get a better broker.

Outlawing an order type that some people actually like to use under certain circumstances is ridiculous.

More constructively - make flash default to off, so that a trader needs to explicitly ask for a flash, and make all brokers who don't pass on fine grain order control to their customers set the default to off...."

I'm somewhat indifferent when it comes to flash orders - on the one hand I don't care if they get banned if they are being prolifically front run, but on the other hand I like the suggestion of defaulting the flash order status to "off" and allowing traders to still flash their orders to try to get price improvement. If traders are getting worse executions on their flash orders because they are constantly being front run, then they will stop using them.

Let be take a brief detour to negate one blatatly erroneous insinuation made in today's financial times article:

"Themis also suggests reintroducing the New York Stock Exchange's curb on program trading that would apply whenever the market was up or down by more than 2 per cent for a day. This constraint was removed in October 2007, which is - maybe not coincidentally - when world stocks peaked."

The NYSE never had curbs that prevented program trading. The NYSE used to have curbs that imposed restrictions on index arbitrage orders, a specific subset of program trading, after market moves of a certain magnitude. The curbs ensured that index arbitrage buy orders had to be executed on a downtick, and that index arbitrage sell orders had to be executed on an uptick. It's basically like the uptick rule for short selling, only it applied to buy orders as well. This had little or nothing to do with high frequency trading, and is completely irrelevant to the discussion, except for the ludicrous assertion that the removal of the curbs somehow may have led to the depression of the markets. If Themis thinks that high frequency traders are manipulating the market higher, they need to realize that the re institution of NYSE index arb trading curbs would have no effect.

While I'm on the topic, let me debunk a few more of Themis's blog posts. Saluzzi's assertion that high frequency traders were manipulating the price of CIT higher so that it would be eligible for a rebate was proved wrong before he even published it, when the price failed to maintain the $1 level. CIT was trading massive volume because it was in the process of basically declaring bankruptcy - not because HFT guys were manipulating the price. Second, Saluzzi's post titled "The Three HFT Horsemen" is perplexing. He alleges:

"The three HFT horsemen are C, BAC and CIT. These three stocks traded 860 million shares today which is 10% of all US Equity volume. Think about that – 3 stocks in a universe of over 5000 U.S. stocks represented 10% of the volume. How could this be? Look at the intraday chart of all three of these stocks and you will see a something in common: an early morning move followed by a flatline with a very tight range (around .05). Meanwhile, while these stocks were flatlining the market was heading higher. The S&P 500 gained around 10 points in the afternoon (or 1%) but these 3 stocks did not move. There was a constant bid to these stocks yet anytime they wanted to lift there seemed to be a constant offer just a few pennies higher."

Never mind the fact that C and CIT are low priced stocks that should theoretically trade in tight ranges: what is the problem with this? As a trader, Saluzzi should be sending thank you notes to the high frequency traders for making sure the price of the stock didn't move much at all - this makes his job easy, regardless of if his client is a buyer or a seller of stock. There was ample liquidity all day, and the prices barely moved. This is a good thing.

I am a capitalist. I like competition in markets. Our competitive markets have resulted in evolution to the point where traders have written computer algorithms that do the job traders used to try to do by hand - profit from stock movements and from what they feel net supply and demand for a given stock is. This is the main reason I'm against most attacks on high frequency trading. SOMEONE will always be the best - the fastest - the closest - regardless of if you ban co-located servers, or install mandatory latency in order execution pipes. Would there be anything really wrong with making sure that all orders placed are valid for a 1/2 second or a full second? No, I don't think there would be - and that might be the kind of compromise that we move toward - but we need to recognize that the playing field will never be level. It never has been level and it never will be level - there is always someone smarter than you, and it would be a shame to try to legislate that edge away.

-KD

full disclosure: no agenda here: I do not run a high frequency trading system, and a ban on HFT would not have much if any impact on my life. market position: short the market.