Wall Street Profiles: High-Frequency Traders

February 19th, 2018

In this seventh installment of my Wall Street Profiles series, I discuss high-frequency trading strategies.

Highlighted beautifully by Michael Lewis in the book Flash Boys: A Wall Street Revolt, high-frequency traders went to tremendous lengths to shave millionths of a second on their trade execution times. In doing so, they were able to take millions of dollars from the big Wall Street banks, the largest hedge funds, and individual traders. They also potentially had a role in the flash crash of 2010.

About High-Frequency Trading

High-frequency trading gained in prominence in the years following the financial crisis. When stock market trading became decentralized, banks had to route customer’s large orders to multiple different exchanges.

Hedge funds, mutual funds, and other clients ask banks to execute large stock orders (block orders) for them. To get the best price, the banks can’t just put their customers’ large orders into the open market — the market will move based on that order. They try to execute the trade in secret, splitting their order into small chunks over time.

Unfortunately, high-frequency trading firms are able to prey on stock orders to take tiny amounts of money per share, which over time can add up to billions of dollars in profits because of the massive amount of money that exchanges hands in the stock market.

In Flash Boys, Michael Lewis described three ways that high-frequency traders made money at the expense of ordinary and professional investors:

1. Electronic front-running

High-frequency traders will put small orders on multiple exchanges. When a large buy order enters the market, it will often get split into multiple small orders across multiple exchanges. When a trade on one exchange gets executed, high-frequency traders race to cancel their orders before the trade can be executed on other exchanges. After figuring out that the big investor needs to buy more shares, high-frequency trading firms will actually also buy shares, driving up the price against the big investor. The high-frequency traders profit from this electronic front-running, at the expense of the customer.

2. Rebate arbitrage

Exchanges would give high-frequency trading firms incentives (cynics would call it kickbacks) to provide liquidity in the market. These incentives were not perfect, and high-frequency trading firms would be able to collect these rebate incentives without actually providing the liquidity they were being paid to provide.

3. Slow market arbitrage

This was the biggest source of income for high-frequency trading firms. If an order comes into one trading exchange, moving the market on that exchange, high-frequency traders will race to take advantage of any discrepancy between the market-moving exchange and all of the other exchanges, which have not yet moved in response.

High-frequency trading occurs in (much faster) than the blink of an eye

High-frequency trading gets done not in milliseconds, but on the order of microseconds (one-millionth of a second). By comparison, the blink of an eye is 250 milliseconds (or 250,000 microseconds).

Since high-frequency trading strategies require speed, they fight in an arms race to shave microseconds off their trade execution time. Like race car drivers or Olympic luge athletes, tiny fractions of a second are the difference between victory and defeat.

For example, Michael Lewis opens Flash Boys by describing how a construction group spent millions of dollars to create a new fiber-optic line that was the straightest path between electronic exchanges in Chicago and New York. Because this path would represent the shortest (and therefore fastest) way to route orders between Chicago and New York, they were able to sell access to this line for huge sums of money to high-frequency trading firms.

To mitigate the advantages of high-frequency traders against the rest of the market, Flash Boys describes how Brad Katsuyama, a former trader at RBC, founded IEX, an exchange that is designed to be fairer to other market participants than other exchanges. Over time, its market share is rising, but it still represents a tiny fraction of the overall stock market.

Takeaways

High frequency-trading affects all investors, including index fund investors

High-frequency trading affected every investor in the stock market. Index investors were not immune to the effects of high-frequency trading.

While index investors do not directly trade in the market, index fund managers do trade to replicate the underlying index for their investors. As they buy and sell, they lose some of their returns to the high-frequency traders. As a result, the return of the index fund is slightly lower than the performance of the underlying index. This lag, called tracking error, can be measured and varies from index fund to index fund. While not all of an index fund’s tracking error is due to high-frequency trading firms, the ordinary investor does lose a (small) portion of their investment in “costs” to them.

Wall Street will go to dramatic lengths to obtain the tiniest of edges

The rise of high-frequency trading demonstrates just how far professional traders on Wall Street will go to obtain the smallest of trading advantages. They were paying millions of dollars to be a few feet closer to the stock exchanges. This enabled them to execute their trades millionths of a second faster than their competitors, which was the difference between making millions of dollars and going out of business.

When you have a trading edge, you don’t tell anyone

For many years, most of the Wall Street banks and largest hedge funds were in the dark about how they were slowly leaking money to high-frequency trading firms. Meanwhile, high-frequency trading firms were jumping over each other to get the latest technology, all the while keeping their strategies completely secret.

As described in Flash Boys, it took extensive detective work by Brad Katsuyama at RBC and others to uncover and try to neutralize the edge of the high-frequency traders.

So if a trading guru sells you a system that purports to make money through trading, it’s unlikely to be successful. The successful trading systems are kept secret, as their creators try to print as much money as possible before their competitors figure them out.

Why are you trying to day trade?

When you read about how brutally efficient high-frequency traders were able to extract money from some of the wealthiest and smartest hedge fund managers in the world, it’s a bit silly to think that you can make money by day trading or swing trading from your Fidelity or Interactive Brokers screen.

Conclusion

High-frequency traders took a lot of money from the market earlier this decade and kept it secret from the rest of Wall Street. It highlights that the tiniest of edges can be the difference between victory and defeat. Unless you are willing to go to the lengths these Wall Street traders took for an edge, stay on the trading sidelines and stick with an index fund portfolio.