Submitted by Tyler Durden on 08/03/2012 13:49 -0400
While the attached interview between the Casey Report and HFT expert Garrett from CalibratedConfidence will not reveal much unknown new to those who have been following the high frequency trading topic ever since ZH made it a mainstream issue in April of 2009, it will serve as a great foundation for all those new to the topic who are looking for an honest, unbiased introduction to what is otherwise a nebulous and complicated matter. We urge everyone who is even remotely interested in market structure, broken markets and the future of trading to read the observations presented below.
From Casey Report:
Interview with a High-Frequency Trading Expert
High-frequency trading (HFT) – wherein computers transact thousands of times per second with incomprehensible speed – now accounts for over 60% of all trades on American exchanges. How does this sweeping market change affect retail investors?
There are two very different answers to that question. Supporters claim that high-frequency traders (HFTs) are a net-positive market force because they provide liquidity and tighten bid-ask spreads. They say that high-frequency trading is rarely if ever used for nefarious purposes, and regulators make sure of it.
On the other side, detractors claim that HFTs regularly manipulate unaware investors and otherwise destabilize markets. They say that HFTs are a net-negative force on the market and should be reined in.
The answer surely lies somewhere in between. But which is closer to the truth? To find out, we talked to Garrett, an expert on market systems and high-frequency trading. Having experienced first-hand the problems HFTs can cause, he fits firmly in the “detractor” camp, for reasons you’ll read below. Garrett gave us excellent insight into how HFTs profit, along with tips on how to make sure they don’t profit at your expense.
I found this interview highly educational, and I hope you do too. It contains the kind of inside intelligence that separates the informed from the uninformed and allows us as individual investors to understand and adapt to our changing markets.
The Casey Report: Hello Garrett, and thanks for taking the time to chat with us. First, can you tell us your back-story and explain how you got into high-frequency trading and real-time trading research?
GARRETT: Sure. I worked for an asset management firm as a portfolio manager’s assistant. We used traditional fundamental analysis to calculate company prices. Beginning with the July 2011 crash, our strategy no longer seemed to be working. We lost a lot of our clients’ money – nearly 40%. It was brutal.
During that same time, I started to notice odd price movements on my charts, ones that I had never seen before. Prices would randomly spike in amounts and directions that made no sense. When I dug deeper, I realized the movements were too fast and too uniform to be human. Computers caused them.
My bosses didn’t understand this, and didn’t want to. I couldn’t raise my concerns because of the old-school culture of the firm. But that refusal to acknowledge the new reality – that computers were increasingly driving the market – was leaving my firm at an enormous competitive disadvantage. Essentially, the market was changing, and we weren’t adapting.
I began to study high-frequency trading on my own. I started by following a few professionals who were sounding the alarm, trying to alert investors that the game has changed. My favorite sources were (and are) Themis Trading and Nanex.
Eventually, I narrowed my focus to study the market micro-structure – which is basically what happens to orders after you click the “buy” or “sell” button on your brokerage platform. That’s where all the action is, and it’s where you can see exactly what the HFTs are doing.
I came to the conclusion that, because of HFTs, our markets are broken and fragmented. I left my old firm in mid-December, took my own money and started running my own shop, based on this premise. My strategy uses software to exploit the dislocations caused by HFT.
TCR: What made you think that high-frequency trading was behind those strange price movements you were seeing?
GARRETT: For one, the movement didn’t look like anything I’d seen in the past. It didn’t match human action. It was too fast, too consistent.
Anomalies would randomly pop up on my screen. A particular stock would drop 10% in one second, then run right back up a second later. I asked colleagues what these movements were and where they were coming from, but no one had an answer. Even the shortest-term charts, in which every data point represents one second and the data is extremely granular (or so I thought) didn’t yield any answers.
Eventually, through my own research, I realized that there was something more going on inside these one-second data points - something you can’t see on a standard chart. That’s where the HFTs operate – in milliseconds.
TCR: So you’ve made a career of exploiting the dislocations caused by HFTs. What’s your answer to the question on everyone’s mind: does high-frequency trading affect the average retail investor?
GARRETT: Absolutely, although the impact varies based on what type of investor you are. For a shortterm trader, someone who makes many trades per month, the effects are huge.
I think the best way to understand HFT’s impact on you is to understand its advantages over you. There are three major ones.
One, HFTs have better access to the market. They have what we call direct access, which means they don’t have to go through a broker to execute their trades. When you place an order with, say, Scottrade, Scottrade will choose which exchange the order goes to, and they’re going to execute the order where it’s best for them. They’re going to buy it at the best price they can and then sell it to you.
HFTs, on the other hand, can choose the exchange that they want to trade on. They can look at all the prices for a given stock on all of the exchanges and make their own decision, rather than having a broker make it for them.
Two, HFTs obviously have a major speed advantage over other investors. They glean this advantage in many ways: by putting their servers right next to the exchanges’ servers, by using very sophisticated equipment, and also simply by virtue of programming a computer to act on pre-set instructions, which it can do much, much faster than a human ever could.
Third, the best HFTs have an impeccable understanding of the market micro-structure: what happens after you submit an order to your broker? Where does your order go, how is it executed, how are orders prioritized? HFTs are experts on this, but very few retail investors even understand the basics.
TCR: It sounds like the average investor is seriously outgunned. But
HFT affects all investors to an extent, because stocks are now priced differently than in the past. The market used to consist mostly of investors analyzing cash flows and balance sheets, trying to calculate a company’s fair value. HFTs, on the other hand, react to movements in stock prices alone. That is not necessarily a bad thing, but since HFTs are responsible for two-thirds of the trading volume, we have the strange situation where they can set the price based on what they perceive others’ perceptions to be.
hmmmmmmmmmmmmmmmmmmmmmmmmmm where I have I heard this before?????????
TCR: What are trending movements?
GARRETT: Trending movements are when an HFT deliberately moves a stock price up or down for its own benefit. For example, a computer can submit an overwhelming number of sell orders, knock the price of a stock down a few percentage points, then buy the stock back cheaply.
TCR: That sounds like overt manipulation.
GARRETT: It is, which is why investors need to understand how to protect themselves. One of the most important tips I can give you is to never enter stop-losses into the market. There are algos designed to sniff out stop-losses and manipulate them against you.
I’ve seen this many times: prices drop 2-4%, clear out stop-losses, then run up for substantial profits. So the poor retail investor gets his stop-loss tripped and sells on the cheap to an HFT, whereas the HFT buys cheap and profits once the price ramps back up.
TCR: Many defenders of HFT claim that it is a net-positive force in the market because it provides much-needed liquidity and tightens the spread between bid and ask. Are those claims true?
GARRETT: As I said earlier, there are many different HFTs that do many different things. But in my experience, in the aggregate, both of those claims are false. High-frequency trading will reduce liquidity when we need it most, and will flood the system with nonsense at other times.
Case in point, computers regularly withdraw liquidity just before news releases. Oil is a great example. The other day, there was a status report scheduled at 10:30, and around 10:28-10:29, the buy orders on USO (United States Oil Fund, an ETF that aims to track oil) dried up. That doesn’t happen with human traders.
So anyone who wants to get out of USO before the news release is out of luck; they can either take a bad price or wait until liquidity comes back.
Contrast that with the end of most trading days, when HFTs are unwinding their positions; I actually turn my platforms off for the last 10 minutes of the day because the action is confusing and useless. Sure, there’s plenty of liquidity as the HFTs unwind, but the action is just nonsensical. There’s no new information being introduced, no price discovery. It’s just scalping.
The whole liquidity argument is just a justification. On net, HFTs hurt liquidity more than they help.
I also don’t buy the argument that HFTs keep the bid-and-ask spread tight. I’ve seen algorithms that quote as far away from the NBBO as they are legally allowed to.
http://www.zerohedge.com/news/interview-high-frequency-trader
Realist - Everybody in America is soft, and hates conflict. The cure for this, both in politics and social life, is the same -- hardihood. Give them raw truth.
| 
