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
