Profitting Faster Than The Blink of An Eye

Profiting faster than the blink of an eye isn't fiction, institutional trader’s robots actual do it, the practice is known as high frequency trading (HFT).

The non-fiction book called “Flash boys,” by Michael Lewis raised public awareness of HFT. Lewis grabbed centre stage and brought the controversial practice of flash trading to the public’s attention when he wrote that "The market is rigged" by HFT traders who front run orders placed by investors.

So what is HFT?

As the name suggests, speed is the essence of HFT, but we are not talking about fighter pilots with cat like reflexes, the type that always wins in a game of snap, or is able to hit the buy and sell button at a fraction of a second. The type of speed we are talking about is lightning fast, well beyond the capabilities of any human. To be able to execute trades at this speed, electrical engineers needed to construct secretive fiber optic networks of cables spanning hundreds of miles, running through mountains and beneath rivers. This enables data to travel between say Chicago to New Jersey at just 13 to 17 milliseconds. You probably got the gist of it, the faster the data travels the better the price of the trade and profit that the institutions make.

Then on the other end of the network sitting in an office, is a powerful computer running on a dedicated program trading platform, communicating a massive volume of orders at very fast speeds. Finally, complex algorithms, probably designed by PhD graduates in mathematics, analyze multiple markets and execute orders based on market conditions.

HFT is out of range for the retail trader. As Lewis suggest in his book, access to the super-fast fibre optic network and other technologies are barriers to entry, which enable the big Wall Street banks to gain even more control over the market.

So HFT is a game for the heavyweights, where the smaller players are not invited to play.

Nevertheless, the ecosystem works in strange ways and somehow we might still be able to ride on the buffalo's back, so to speak.

In other words, HFT practised by the institutional banks might actually help the retail trader.

How could that be possible?

With the volume of trades increased due to HFT activities of the institutional player, liquidity in the market is greatly increased. When a market is highly liquid, traders can move in and out of trades without having any impact on prices.

Another measure of the market's liquidity is the “bid-ask spread”.

This is the difference between what traders must pay to buy a stock (the “ask”) and what they get if they sell it (the “bid”). This difference represents the cost of trading. Sometimes the spread can be as much as 5 percent in less liquid markets. So the spread is a loss to the trader, but it’s a profit, or what a market-maker earns for risk and time spent making a market in whatever financial asset he buys and sells.

If you trade on short time frames, you need to be able to calculate the bid-ask spread and factor it into the cost of your trade, broker’s commission and taxes to know whether or not you should proceed with the trade. For example, if you anticipate a stock to rise by five percent during a given time frame, but the “bid-ask spread” is five percent. If the stock were to rise by that amount you still haven't broken-even, after factoring broker’s commission costs for buying and selling the stock.

You'll notice on the FTSE100 stocks the spreads are smaller, typically one percent, making it easier for traders to move in and out to make a profit. Compare this to stocks on the FTSE 250, a less liquid market, you'll notice the spread widens, making the cost of the trade more expensive for traders.

So the more liquidity, the more trades take place, thus the lower the bid-ask spread needs to be for market-making to be worthwhile. HFT now accounts for as much as half of all stock market trading in the US. The rise in trade volumes has coincided with a marked narrowing of the bid-ask spread.

But Eric Budish, Peter Cramton and John Shim believe that HFT can also sap liquidity as well as create it. One reason market-makers need to charge a bid-ask spread is to insure themselves against being the “dumb money” in the deal.

The reasoning is as follows: Assuming you were to take up a market-maker’s offer, you would do so because you probably have some reason to think it is good value. The bid-ask spread compensates market-makers for the risk that the customers who choose to transact are those with private information, a problem known as “adverse selection.” (A situation where seller might have information that buyer doesn't, or vice versa, about the stock)

The authors argue that HFT can make adverse selection worse.

For example, imagine Apple releases a buoyant trading statement regarding the sales of iPhones, which beats expectations and the stock shoots north. HFT firms, first to enter the game, due to their lightning speed advantage, take up “stale” offers of market makers to sell Apple stock, which now looks a bargain before the market-maker has time to withdraw them. This is known as “sniping”. But assuming that market makers plan ahead, to compensate for the time lag to respond, so what do they do? They push up bid-ask spreads, which raises costs for traders.

So the author argues that sniping, practised by HFT firms, also pushes up trading costs.

There is always a flip side to every argument.