High Frequency Trading
In the latest edition of CFA magazine, we take a look at various high frequency trading strategies and their impact on the overall market. You can read the article here:
Copyright (2013), CFA Institute. Reproduced and republished from CFA Magazine with permission from CFA Institute. All rights reserved.
I was trying to buy 500 shares of a preferred stock this morning, Principal Financial Group Inc. series B (NYSE:PFG-B). It is such a challenge to trade any type of illiquid issue as the execution of orders is nearly impossible in this HFT world. Here is the sequence of events.
At 09:39:08, the stock is offered on EDGX at $26.29.
I place an order to lift the offer. The shares trade but I get filled on zero shares. Knowing that my bid will cause a bunch of HFT programs to penny-jump me (step ahead of my order by a penny – which they immediately do), I cancel the order. The HFT penny jumper cancels their order as well.
At 09:39:29, the stock is offered on EDGX again at $26.32. I place an order to lift the offer. The stock trades at the exact same second. Again, I get filled on zero shares. I cancel the order.
At 09:39:41, the stock is offered on PCSE at $26.29. I place an order to lift the offer. The stock trades at the exact same second again, but I get filled on zero shares. I cancel the order.
At 09:39:50, I place a hidden order to buy the stock at $26.32. Five second later the stock prints in front of me at $26.33 (Obviously these hidden orders aren’t as hidden as they should be). I leave the hidden order to buy at $26.32.
At 09:40:05, the stock prints right through my hidden order on another exchange at $26.30. So despite my bid being higher at $26.32, thanks to the fragmentation in the market, I get filled on zero shares again (and the seller gets a worse price!)
At 09:40:20, the stock prints through my hidden order again at $26.30. Again, no execution for me. Frustrated, I cancel my order.
A few seconds later, at 09:40:36 a couple of HFT programs battle out for the top of the order queue, and the bid changes rapidly, as you can see below:
At 09:40:40, the HFT programs go to battle again fighting for the best bid.
This battle continues for the next few minutes. In fact, during one period of time from 09:44:53 – 09:46:35 (a total of just over a minute and a half), the best bid changes over 800 times, as these two HFT algorithms battle to be at the top of the queue.
At 10:07:14, I finally lift an offer and pay up to $26.35. The HFT firm scalps their few cents from me, and all the games are over.
Some serious issues are highlighted in these few minutes of activity:
1) Inability for market participants to access a quote.
2) Excessive quote pollution as HFT algorithms battle each other.
3) Market fragmentation can lead to inferior execution.
4) HFT penny jumping can discourage market liquidity.
The bottom line is that all of these issues discourage participants from trading illiquid securities – making these securities even more illiquid.
Another day, another flash crash. This flash crash occurs in one of your biggest DOW components, AT&T. Full analysis of this flash crash event:
What a fragmented mess in Kraft (KRFT) this morning. The stock opened for trading at $45.55, but then 18 seconds after the open, the stock starts to run up. It trades sporadically between $48 and $58.54 for the next 12 seconds, and then comes right back down.
Check out the tape:
Look at the size of the trades. It is all 100-500 share lots (note trade size is quoted in hundreds in the pic above). This was not a fat finger. There was not a huge buyer in the market. This was simply a lack of liquidity.
This is a stock that normally trades in a one point daily range. We have been saying this for the past year, there is very little liquidity in the first 2-3 minutes of trade. HFT participants do not provide liquidity when there is risk and uncertainty, and there is always uncertainty in the first 2-3 minutes, especially on issues with recent restructuring. Traditional market makers no longer exist. We are dependant on HFT liquidity, and that type of liquidity is unstable.
We need to incentivize other participants to provide liquidity during times of uncertainty, because HFT participants do not provide liquidity during these times.
Some market participant placed an order to buy 1 million shares of Citigroup this morning at a price of $29.80 Rebate traders and scalpers love to lean on sizeable orders, and many of them took note of this large bid. They began feasting on this order at approximately 10:20 ET when the stock price approached this large institutional bid at 29.80. Scalpers buy ahead of the large institutional order, some aggressive traders buying at 29.81. Others buy the stock at 29.80 by placing their bids on other exchanges (the 1M share order was bid on the NYSE primary exchange). These traders are trying to flip in and out of the stock for a cent or two, while collecting rebates in the process.
HFT rebate traders, and HFT internalizers were also feasting on this large order, as they bought stock from retail marketable sell orders at 29.80. (You can read more about internalizers here.)
All these participants were leaning on the huge institutional buyer at 29.80 in order to limit their risk. But then at a time of 10:27:50, the institutional bid that they were leaning on, suddenly gets taken out.
Some other institution slams 594K shares at 29.80 in one mighty blow, causing all the participants leaning on that bid to scramble for liquidity. The quick HFT programs and internalizers quickly slam out the remaining shares at 29.80, escaping mostly unharmed.
But slower traders, or non-co-located algo traders, scramble for liquidity causing a rash of sell orders to enter the market. Some scalpers may have placed sell stops below this 29.80 level as well. Those orders would also have been triggered.
This rash of sell orders caused a sudden spike down in the price of the stock, and the stock quickly fell to 29.43, as you can see on this chart.
A valuable lesson for manual traders should be learned here. Unless you have high frequency speed, and the ability to see orders coming up the pipeline, you are playing a very risky game by leaning on large bids. When those bids get taken out, it can get real ugly in a hurry.
Some participants were trading for pennies and they got absolutely creamed here. It’s like picking up pennies in front of a bulldozer. Eventually you are going to get run over. It’s a dangerous game leaning on bids and if you don’t have high frequency speed, the risk of this game does not justify the return.