the missed part contnues....
Richard: What are some other things you can tell us that I haven’t asked about?
Mr. Hunsader: I think it’s important to note that the great majority for High Frequency action occurs in only the top three dozen or so most liquid stocks. These are the “thickest”, meaning computers have the most bids and offers to “lean” on if markets collapse. The computers make money almost every time trading these stocks. Second, depending on who you believe 50 to 70% of all trading volume comes from the HFT’s yet 90 or 95 percent of all quotes come from them. HFT’s are constantly putting out bogus or fake quotes. This “quote stuffing” as it is referred forces other machines to slow down to assimilate the data thus maybe giving the “stuffer” a brief advantage. It is also used to flush out and see which bids are real. Also, an uninitiated trader may be fooled by thinking demand for a stock is there, when it is just noise.
One more thing about speed….. The National Market System (NMS) delineates how exchanges connect and how trading happens. How firms receive their data is something else. The SIP (Securities Information Processor) provides data to firms on a 10 gigabyte line. Both the NYSE and NASDAQ offer more specialized (think faster) quote platforms. NYSE “OpenBook” and NASDAQ “TotalView” offer data on a 40 gig line at prices ranging up to $60,000 a month. The NMS has regulations prohibiting one firm having a speed advantage over another. In 2012, the NYSE was fined $5 million for violating this rule and yet the practice is openly continued today.
Internalization is the practice of High Frequency Traders paying for order flow from retail brokerage houses like TD Ameritrade, E-Trade, Charles Schwab, or Scottrade. They in effect get a right of first refusal on these orders. Often these orders come from the “dumb” money who enter market orders and are easy pickings for the HFT’s to easily collect their “toll” spread. So these trades never make it to the exchange floors for competitive bidding. Eric Hunsader says 40 percent of all trades are either “internalized” or go to dark pools. There are thirteen different exchanges which a trade may get routed to. Each exchange like ARCA, Edge, or BATS has a systemic set of fees that it charges for takers of liquidity and an offsetting list of rebates it pays to providers of liquidity. These fees and rebates range from roughly a tenth to three tenths of a penny. Named the Maker-Taker system, it causes distortions in the way our markets operate. Courtesy of Mr. Dennis Dick here are simplified definitions:
Providing Liquidity: If you place a passive bid, or passive offer, you are a liquidity provider. You have added a bid or offer to the market. Typically, if your execution is not immediate (for orders placed during market hours), you are providing liquidity and can get paid a rebate from the exchange. There are HFT’s who base their entire model on collecting exchange rebates by providing liquidity
Taking Liquidity: If you take an offer or hit a bid, you are a liquidity taker. You have removed a bid or offer from the market. Typically, if your execution is immediate (for orders placed during market hours), you are taking liquidity. All market orders take liquidity, and on most exchanges are charged a fee for this.
Mr. Dick: The incentive for TD Ameritrade to sell its order flow should be clear. They charge $7 per trade. If they execute a 3,000 share market order and the rate for taking liquidity is 3/10 of a penny then TD Ameritrade is on the hook for $9. And lose $2 on the trade. If they sell the same market order to Knight for 2/10 of a penny they would collect $6 plus the $7 commission for $13 total. I don’t know if there is actual data, but the quality of the order execution is probably less than if the trade were exposed to all the exchanges for competitive bidding. Almost all retail market orders are internalized. If you put your strongest glasses on, it is all disclosed in the fine print. To justify the practice, many HFT internalizers will offer a sub-penny of price improvement to the retail orders. But in essence they are just jumping the order queue by a fraction of a cent.
Mr. Hunsader: What makes this even more unfair is that individuals are not allowed to bid in any increments less than a penny. I did a study collecting price action on sub penny trades from January 2006 through July 2012 that confirms the “penny hopping” scheme. 54 percent of these high frequency trades improved prices by less than 1/10th of one penny. The remaining 46 percent only increased prices by less than ½ of one penny.
Richard: Rob, how have the traders at Bright Trading adapted to the new HFT world.Mr. Friesen: One of the main adjustments we have been forced to make is to lengthen the time horizon of our trading. No longer are we the liquidity providers scalping for pennies in trades that lasted seconds. The HFT’s have taken over that role. Now our trades last minutes, hours, or even days and our profit objectives may be in dollars rather than cents. We have become much more research oriented. We shouldn’t be surprised about the rise of HFT in trading as many other industries have had automation replace human activity. When High Frequency Trading started to takeoff, we strategically decided that to compete in the game a firm needed to commit tens of millions to build the fastest, most robust computer systems……so instead of playing a game we couldn’t win we changed our focus.
As professional traders, we continue to evolve in hedged trading strategies which are not usually done by the retail trader or investor. HFT is unaware of our game plan, our time frame, or our reason for entering the trade. In some cases we may have to pay the penny toll, in other cases we may be able to remain passive and actually be a true liquidity provider. It all depends on the traders agenda which he will not advertise.
Our traders strive, as much as possible, to avoid notifying the HFT’s of what they are doing by avoiding Smart Routers, and instead routing to a specific destination with a marketable limit orders and pay the offer. I am very proud of Bright Traders like Dennis Dick that have adapted over the last few years and continue to excel in this trading profession they love.
What Does It All Mean?
At the end of the day High Frequency Traders in the large volume stocks probably are good providers of market liquidity and allow for average investors to easily transact. The “toll” is the penny bid/offer spread which is what you probably would have paid under the old specialist system. Some claim the HFT’s have caused bid/offer spreads in high volume securities to be tighter, thus benefiting investors. In times of turmoil and market corrections the HFT’s run for the hills and declines are exaggerated. This is scary and causes many investors to be wary of the stock markets. This is born out in the 17 percent volume decline over the 2011 to 2012 period.
Small illiquid stocks are another matter. The “penny jumping” is grossly unfair and distorts markets and often denies legitimate buyers and sellers from entering and exiting their positions. “Internalization” is a by-product of the “Maker-Taker” system the exchanges have implemented. Consumers certainly get poorer execution but the tradeoff is much lower commissions than in the past. Imagine you can trade 100 shares or 10,000 shares for under $10 at any number of discount houses
Paying tens of thousands a month for Direct Feed from NASDAQ “TotalView” or NYSE “OpenBook” on a 40 gigabyte line gives an advantage over receiving quotes over a 10 gig line from SIP. In my opinion it doesn’t really matter to a small long term investor. Once again, this is High Frequency titans battling over turf. It shakes the earth a little, but it doesn’t knock your house down.
If stock buyers are long term investors, then the HFT’s are not really a factor at all. While they exacerbate market declines, over time the market adjusts and is fairly valued. High Frequency Traders simply cause a lot of extraneous noise as they battle each other through the cat and mouse of order stuffing and spending millions to achieve the unachievable grail of speed of light order flow.
The one lesson to take away is that unless you are tied up with a reputable firm like Bright Trading that understands the trading landscape and will teach you to adapt to the new playing field, it is folly to be a day trader. The omniscience of the high frequency computers can see your every move and the land mines are everywhere. The structure of the markets has permanently changed. A human hand that can react in seconds is outclassed by machines operating in milliseconds and even microseconds. It is neither all good nor all bad. It is just the way it is.