HFT’s- High Frequency Trading and how it affects you

How does HFT’s work?

To answer that question, one must understand two processes in which this companies involve in- one is slowing down the tape and the other one is the market making.

TAPE, HOLD ON!!

The first thing that HFT’s does in order to get an advantage over human traders is slowing down the tape (Time & Sales window). This is a renewal to the oldest trick in wall street- the front running.

Front running is actually moving in front of the pending orders line. Like in a lot of other areas in life, whoever is the first in line should get the best available price. That means that if I was willing to pay the offer at 10$, there is a 10$ seller and I am the first in the line, I should get the next match between the seller and the buyer on the 10$ quote. But as traders found out real-time, it’s not necessarily the process that they get. Brokers were taking advantage on their ability to see the order flow in order to buy the stock at the bid price and sell it immediately at the offer (Ask price) as he knows that he has a guaranteed buyer and seller at his desired prices. This is a risk free profit.

Today, this form of front running is no longer legal- and HFT’s came out to fill the gap that the broker houses left. What they do is to take advantage of the lower technologies of the trading floors, in order to see the tape before them and jump in front of the line. They do it through quote stuffing. Quote stuffing is when they inject a large amount of buy and sell orders, amount so big, that the tape in trading floors and in stock market platforms are actually slowing down. In time that can last for 50 milliseconds, the algo’s matches a buyer and a seller and take the spread to their pockets. By that, they are actually playing the role of market makers.

Remember 2010 flash crush? The day that the DOW dropped 1000 points (9%) only to go all the way back up couple of minutes later? What happened there was that there were so many algo’s activated at once, that the tape slowed down in 2 whole minutes! What human traders saw at that moment was a market that is slowly shrinking until there was no market at all. All the bids didn’t show up because of the latency, what caused all the big players in the market to pull out their orders. HFT’ made the market disappear for a few minutes. When no one bid, the spread opens up- and the market crushes!

HFT’s are Market Makers

With its superior speed, HFT’s filling the role of market makers. Were you ever watching the time & sales window while trading? If you will look at AAPL’s tape for example, you will see the prints run with full speed- very hard to follow. Now think that you could slow down time and see the quotes run slowly. You could digest the prices before anyone else can. If you had that ability, you could buy the bid and sell at the offer and secure your profit on that trade (the spread). Sounds good right? This is exactly what the algo’s are doing.

Market makers at their naked form, matches buyers and sellers and make their money on the spread. They will fill your order only if their profit is guaranteed. They have the buyer and the seller in their hand.

HFT’s does more sophisticated market making. One way is by slowing down the tape. Other way is to take advantage of dark pools and trading floor low tech.

So how do they make their money?

Every trade that takes place, has two sides- ask and bid. The best price you can buy a stock and the best price you can sell a stock (NBBO- national best bid and offer). The difference between them is the spread. Let’s say ask price is 20.0 and the bid price is 19.99. Before the price declining, there’s a time window of a few milliseconds, in which the bid is going down to 19.99 and the ask stays at 20.0. so for a split second we have 2 pennies spread instead of 1. Here the algo’s are going into action, takes advantage on the slow tape of the market makers or the trading floors in order to sell short at 20.0 only to cover their position few milliseconds later at 13.99 or even 19.98. Would you take this trade?

When do they get into action?

The algo’s doesn’t operate at any market environment.  They wait for very specific conditions in the market, turned on for couple of seconds to minutes and then turn themselves off. The perfect environment for them is times of big volume (a lot of pending orders) and low volatility.

Now after you understood what are HFT’s, it’s time to understand how to make money on this knowledge.

REAL TRADE EXAMPLE

As we said, HFT’s turned on in prices that hold big order flow, like round numbers and strong support and resistance areas. This is an example for a real trade that I took on ES, after recognizing a fake out in which HFT’s took all the order flow, only to decrease the price back down to the range. 

I took 3 points on this trade: