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High Frequency Trading

Flash Orders Come Under Fire from Capitol Hill

By Sam Hopkins
Monday, August 3rd, 2009

The NYSE is "not a fan" of flash orders; London exchange heads are scrutinizing them as we speak.

But most investors are still in the dark when it comes to the world of lightning-quick bulk trades.

Here's what high-frequency trading and flash orders mean to you. . .

High-Frequency Trading: Volatility in Microsecond Increments?

It's a simple fact that volatility scares investors. . . We have beta to measure a stock's movement compared to patterns in the S&P 500. People flock to safety in bonds, the dollar, and gold when seas get rough, and the Chicago Board Options Exchange has its fabled VIX volatility index to show just how off-kilter the market is at any given time.

Last autumn, the VIX was through the roof:


VIX volatility index

Volatility is, in fact, way down from autumn '08's highs, and the VIX has retreated to a channel between 20 and 30.

But it shouldn't surprise you that the government's twitchy arthritic knee is kicking out hard at volatility as it continues to react to the global financial meltdown of 2008.

The target du jour is flash orders, where computers at high-frequency trading firms can find tiny inefficiencies in the market and display bid/ask rates without executing a trade.

U.S. Senator Charles Schumer (D-NY) says that these flash orders are to blame for increasing volatility, and that if the SEC doesn't act, he will.

"If allowed to continue, these practices will undermine the confidence of ordinary investors and drive them away from our capital markets," Schumer said in a July 24 letter to the SEC.

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With all due respect to the senator, political statements like his own often do more to undermine investor confidence than to boost it.

The Dow just had its best July in 20 years, and indexes related to the VIX reflect low volatility, as well. These include the Dow-based VXD index and VXN, which measures volatility in the top 100 Nasdaq stocks.

That doesn't mean that pernicious players aren't out there, ready to unleash volatility with torrents of flash orders and off-the-board trades.

Recent history has conditioned us to be wary of backroom trading strategies where algorithm-driven deluges of shares hit the market. "Quant" (quantitative) hedge funds helped exacerbate the market debacle last year by using automated signal interpretation to shift shares. It turned out that some of the signals — say, rising first-time home purchases — used data that didn't stand up to human scrutiny.

Steve Christ on Flash Orders

Steve Christ, my colleague who has written extensively on the VIX, says the key volatility barometer is down because put (downside option) volume is low.

"If these flash orders were working to the downside, people would be screaming bloody murder," Steve tells me.

Steve and many other seasoned traders liken high-frequency trading to pit trading that proliferated in the 80s, where slight pricing differences were exploited by those physically present and privy to NYSE bid/ask spreads before the broader market found out.

Prevailing logic says everyone should have the same information — or at least be able to find it.

A two-tiered exchange system, then, isn't fair play because whoever has more info can front-run the market.

Yet high-frequency batch traders contend that their supercomputers defragment the market by bringing slight inefficiencies and gaps in data to light, thereby creating liquidity.

And it is true that retail investors make use of high-speed trading technology to boost their own efficiency. All the self-directed accounts or brokerages sending orders every millionth of a second become part of a larger strategy to achieve economies of scale, moving massive amounts of shares quickly. Clearing houses see time as their ultimate advantage, and there are plenty of boring old "buys" and "sells" circulating at the same speeds as new-fangled flash orders.

Like it or not, you live in a world where microseconds matter. Unless you're Superman, there will always be a lag between what you can achieve with your gut instinct and well-placed market bets and the capabilities of firms that spend millions on trading machines.

In short, high-speed trading is here to stay. It's a technological trading advance necessary to keep up with processor power improvements and a growing number of share and ETF offerings, as well as greater numbers of market participants than ever before.

Flash-trading, on the other hand, may be banned if the political echelon really has its torches out. Needless to say, high-frequency trading firms and exchanges that cater to their lucrative business will find other ways to make money in the blink of an eye.

By educating yourself and keeping abreast of all the investment tools at your disposal, you can beat the market bogeyman and minimize volatility in your own portfolio.

Regards,

Sam Hopkins
Sam Hopkins

P.S. Steve Christ's Wealth Advisory is just what it sounds like: not a knee-jerk political response or a psychic's best shot at fortune. . . just top-notch tips and winning investments from one of the best market mavens in the game. His "Lazy Investor's Portfolio," for example, is optimized to keep you in the green and keep volatility out. Even Steve's holdings purchased before last year's downturn are still up into double-digit territory! To learn more about TWA, check it out today.





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Comment by Lawrence Gill on 2009-08-03
What a whitewash. Some of their actions are flat out front running. They'll use different words and give different reasons, but that is exactly what some of their actions are. They very simply pay a fee to get market data before the rest of the market gets to see it. They then profit from this data to the detriment of the rest of the market.
Comment by Joachim Mueller on 2009-08-04
The markets are rigged and the little guys just get the crumbs from the table.

If someone pays for having an advantage I call it plain corruption. But that is the nature of the financial businesses. They pay the big bonuses to the "talent" that finds novelty ways to screw the other market participants. There are no ethics whatsoever.

Everyone endorsing those tricks should do some soul searching. Money is not everything and it does not justify everything.
Comment by Chris on 2009-08-05
Honestly, it's the "pernicious players," as you put it, that make this such a danger. There will be people front running and sculpting the market so long as HFT becomes a common aspect of trading. I agree that it's unlikely to change any time in the near future, but hopefully measures will be taken to prevent these sorts of things from happening.

Chris
Comment by a New Era Begins on 2009-08-05
As if they had any other choice but to clamp down on it! Most people don't know exactly how flash trading works yet they still clearly need someone to blame for why things are so bad right now. Because all these people can't seem to finger the real culprit (the gov't) due to obesity, food additives, apathy, the un-education of America, 150 milltion of them on pharmaceuticals, 30 milltion on food stamps, 30 million on anti-depressants, and 4 million in prison (fed+state+county)......... I guess they'll have to slap somebody on the wrist for pillaging their 401k's and feel REALLY good about getting the "bad guy" just like an old John Wayne movie.
Comment by Paul Sutton on 2009-08-05
Some months back I noted a moderate-volume ETF that seemed to have bid and ask orders popping up all over the place on a Level 3 screen. For fun, I tried to get a fill on a few shares; no dice. The orders were bogus. The presenter had no intention of filling them. If the orders were bogus, then so too were the prices. See how this works? Then you read that the investment banks are posting huge profits immediately following their being bailed out by the feds, and in the fine print it notes that the profits were on their "trading desks." As if. And who do you think contributed to these profits, if not individual traders being ripped by flash trading? If they truly want to eliminate this - and they certainly should, and so should you - you'd need to separate the "market host computers" from the "market makers" and make it illegal for them to trade both client money and their own. I've no objection to GS, for instance, managing their own money OR their client's money, but when they manage both on the same computers, common sense tells you that some percentage of their profits were made off their clients. It is front-running; it is illegal; shut it down. Now, with a scare on, we'll see if volume doesn't dry up just a bit in the markets. Then maybe we'll see whether this rally in the face of higher unemployment, still-plunging housing prices in the sun belt, increased savings rates, lower spending, increased corporate profits based on layoffs and lower revenues rather than increasing sales, record deficits, and the list goes on, is for real or just manufactured by shilling the market, front-running, and irrational exuberance. Or whether there really is a good reason for this market rally...

Been a mystery to me as to why it's even gone up, let alone this much. Take the flash orders out and then let's see what happens. Are we all being gamed and fleeced?
Comment by ant on 2009-08-09
And when in a nano second the herd runs in the wrong direction, and the flash order beats them to it, but ... everything goes awry then the flash order companies will get a bailout, as long as they are with the ultimate loser team Goldman Sachs
Comment by Ron Slade Sr. on 2009-08-09
Joachim Mueller is absolutely right. The entire business model is essentially corrupt and represents the greatest scam since the Mafia took over Las Vegas.

What is truly amazing is no amount of corruption seems to have any deterrent effect on "investors". People will stand in line to get taken to the cleaners.
Comment by Jake Puttick on 2009-08-12
Its easy.. the markets are running on printed money being payed for buy the public, issued to banks, In turn the tables are rigged, the mainstream press issues tips/storys of all the companys that need public money saying they are the next big thing, the big boys put their money in first followed by the trust funds +PI's The big boys pull out with the cream, and leave the trust funds +PI's with a loss, its is going to be the biggest theft of public wealth in history and its only half way done.. Part 2 gold will crash with PI's money when the banks/governments flood the market they are waiting for the last few Investers to get on board as they drop the markets the sheepole will run to gold expecting to be saved.
Watch and see..
Criminals running the senate,fed, and the banks as always...Your debt = their profit..