I'm hearing a lot again about high-frequency trading and the dangers it poses to market stability. Let's go back. Perhaps some of you caught the October 7, 2010 edition of 60 Minutes
titled "How Speed Traders Are Changing Wall Street." A description of that program begins, "It may surprise you to learn that most of the stock trades in the U.S. are no longer being made by human beings, but by robot computers capable of buying and selling thousands of different securities in the time it takes you to blink an eye." How does that impact options traders?
Those of us who were in trades on May 6, 2010 got a taste of just how dangerously this new game might play out for both stock and options traders, if rumor-mongers are to be believed. Depending on the source, high-frequency trading is blamed for starting the process or just for exacerbating it once an erroneous order triggered stops on automated systems. If you believe the impact of that day and the blame heaped on high-frequency traders has sent HFT firms scurrying for a dark place in which to cower, you would be wrong. Chicago was hosting the High-Frequency Trading Leaders Forum 2011 as June drew to a close, with that forum titled "How Speed Traders Leverage Cutting-Edge Strategies in the Post-Flash Crash World."
The forum wasn't intended for us retail traders, of course. It was intended for those entities with enough money to buy the software, hardware, brainpower and access that allow high-frequency traders to jump in front of our trades and those of smaller and less well-endowed institutions, too. Maybe that allows them to do more, some knowledgeable bloggers claim. I can't validate the bloggers' information and so won't include their arguments in this article, but some bloggers are noting "quote stuffing" activity moving into the options market. They point to recent flashing of quotes generated at a speed which indicates high-frequency trading, they say, those quotes often outside the NBBO.
How can we beat high-frequency traders at their game? Should I have attended that forum to find out how to do so? No, I can't beat them, not even if I go back to college and follow up the mathematics courses that I was required to take as a physics major with other courses that would somehow turn me into a quant. The fastest computer I can buy and the most up-to-date software won't help me when even the 60 Minutes crew couldn't gain access to BATS and Direct Edge's electronic trading exchanges. If I somehow morphed into a quant with super special algorithms and financed a super computer, I would still be at a disadvantage if my super computer wasn't located within close proximity of my preferred exchange's servers. I would be at a speed disadvantage, in particular, because proximity to the exchanges' servers matters in the teeny fractions of a second in which the HFT firms can jump in front of other trades. Those bloggers such as Tyler Durden theorize that the recent options quote-stuffing activity was meant to give one high-frequency trading firm's super computer a teeny fraction of a second advantage over the others. The battle of the high-frequency trading firms is on, if he is to be believed.
If I can't beat the high-frequency traders or even hope to ride closely on their coat tails, what can I do as a trader? Last week, Jon Najarian, CNBC commentator and co-founder of Option Monster, accepted former market maker Dan Sheridan's request to speak to a group of traders. Najarian warned traders that they needed to take into account the effect of high-frequency trading. I remember the quiet old days of the mid-2000's, when summertime trading meant that options traders had eons to make a trading decision. They might leg into all four legs of an iron condor, for example, working the trade to get the best price. I didn't tend to do that, but I certainly legged into some positions. Sometimes traders would be right to leg in and sometimes, not, but if they were good technicians and the markets favored them that day, they had a decent chance of improving their trade.
Not so now, Najarian warned. These days, he says that if you leg into trades, high-frequency trading means that you may be "taking on more risk than you think you are." This isn't a new tune for Najarian. In a Skyped conversation with Howard Lindzon in July, 2010, Najarian espoused the view that high-frequency trading itself wasn't the problem. It was the fact that these high-frequency traders are allowed to step in front with an order only a fraction of a penny ahead of other orders, not by a full penny, if that market is quoted in pennies. If someone is allowed to step in front of someone else, they should have to do so by a full measure of whatever that measure might be in that market, a penny or an eighth, whatever. He called this ability to step in front with a small fraction advantage "the most nefarious practice Wall Street has ever created" in that July, 2010 conversation. When speaking to the Sheridan group recently, he also complained that these high-frequency traders have no responsibility to make a market.
"Maybe someone will wake up," Howard Lindzon ventured in that conversation with Najarian. We can only hope, but the fact that Bart Chilton, Commissioner, U.S. Commodity Futures Trading Commission, was presenting at the High-Frequency Trading Forum makes me doubt that meaningful changes will come about any time soon. Also, a CME Group study released in late June, 2011, "showed no evidence that high-frequency traders drive up volatility or increase costs for investors," at least in the futures exchange. In fact, the CME study concluded that as "algorithm-driven firms did more business, prices became less turbulent and liquidity improved," a quote attributed to Bryan Durkin, chief operating office of CME. Spreads narrow, he said, an effect that Najarian conceded when speaking to the Sheridan group.
I don't think the bloggers who blame HFT would agree with that study. I know what I think, but I have no proof. I know what my impression is of what's happened to the markets as high-frequency trading firms became more prevalent. Even if I weren't trying to trade this stuff and even if I agreed with that CME Group study, I would tend to agree with Najarian's take on this as being a "nefarious" practice. It just doesn't seem fair. You make up your own mind.
Although I've heard other comments that we've had a number of mini Flash Crashes in individual equities since that May 6, 2010 flash crash, I just haven't seen a big movement toward reform. We have to learn how to trade in this environment. For me and some other traders I've met, that means making sure you're staying on top of needed adjustments. That's particularly true when looking at end-of-day adjustments, since even the indices tend to gap many mornings.
You've already heard these suggestions. I just thought they might be needed again since that forum indicated to me that high-frequency trading had grown mainstream enough that those forums will be repeated across the globe, according to the press release. Yippee.