Monday, May 19, 2014

Lord Abbett on High Frequency Trading: The Tricks of the Trade

From Lord Abbett:

Although the influx of rapid trading techniques can influence trading conditions, steps may be taken to mitigate their impact.  

High-frequency trading (HFT) involves rapidly buying and selling securities, typically with a holding period of less than 10 seconds, in an attempt to capture relatively minor profits across a number of trading venues. This rapid activity gives high-frequency traders a broad presence in the equity markets, and they generally are responsible for up to 70% or more of the overall daily trading volume. But while most high-frequency traders use algorithms—that is, mathematic formulas used to execute trades—not all traders who use algorithms are high-frequency traders.

Proponents of HFT suggest that its market presence can compress bid/ask spreads and, therefore, improve liquidity within the equity market. But narrower bid/ask spreads comprise a relatively small cost in the trading process. A much larger cost is incurred when the execution of a trade affects market prices. For example, if a buy order pushes the price of a stock higher as the trade is being executed, this movement can negatively affect the return on that investment.

Due to HFT’s effects on trading conditions, executing a trade without influencing a stock’s price has become more challenging. This is the primary reason why HFT can affect the creation of alpha1 by investors who remain focused on investment fundamentals. As a result, these investors need to take the proper precautions to mitigate the effects of HFT.

Techniques Focus on “Footprints”
High-frequency traders use several techniques, many of which begin by identifying time or volume schedules that fundamentally focused traders may use to avoid influencing market prices when trading. The identification of these “footprints” provides the HFT program with an opportunity to trade ahead of existing orders at better prices.  

One HFT technique that can influence market prices involves the relatively small rebates offered by equity exchanges in order to generate trading flow and, consequently, revenue. Once an HFT program identifies the footprint of an existing order, it can trade ahead of that order—thus potentially affecting the price of the stock—while also collecting a rebate. The HFT could then fill the existing order at a price that is disadvantageous to that investor. Meanwhile, the high-frequency trader would benefit from the rapid accumulation of rebates that it collected from the various trading venues.

Another way an HFT program might transact with an investor is in the market-making capacity. This process may start with an HFT program identifying an existing order and how much price discretion the order has to buy or sell a stock. Price discretion could be determined, for example, by the existing order’s response to a series of offers to sell stock from a high-frequency trader. Once this discretionary amount is identified, the HFT program could trade ahead of the existing order and then fill that order at its price threshold. As a result of this process, the market maker would provide the investor with liquidity, but at a potential cost of moving from its initial price toward its discretionary threshold.

HFT programs also can use so-called predatory algorithms. Once an HFT program identifies an order, it might adjust its quotes for the stock, therefore prompting the investor to adjust as well. For example, if this process results in an investor raising its bidding price for a stock, the HFT program might sell the stock short 2 to the investor at that price. Yet, considering that the sequential bidding process inflated the price of the stock, the HFT program could cover its short position once the stock price presumably reverts to tis previous level....MORE
HT: Themis Trading