Fast Traders' New Edge..."It is a rigged game"

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Fast Traders' New Edge..."It is a rigged game"

 

 

Fast Traders' New Edge

by Scott Patterson
Friday, June 4, 2010

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Investment Firms Grab Stock Data First, and Use It Seconds Before Others

Some fast-moving computer-driven investment firms are getting an edge by trading on market data before it gets to other investors, according to market players and researchers who have studied the trading.

The firms gain that advantage by buying data from stock exchanges and feeding it into supercomputers that calculate stock prices a fraction of a second before most other investors see the numbers. That lets these traders shave pennies per share from trades, which when multiplied by thousands of trades can earn the firms big profits.

Critics call the practice the modern day equivalent of looking at share prices listed in tomorrow's newspaper stock tables today.

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"It is a rigged game," Sal Arnuk, co-founder of brokerage firm Themis Trading, said Wednesday at a Securities and Exchange Commission roundtable discussion in Washington, D.C., referring to the trading activity, which some call "latency arbitrage."

While legal, the practice pushes the envelope of what is fair, critics say, and raises questions about the advantages some fast-moving traders are gaining in the market.

The SEC roundtable convened executives from trading centers and firms across Wall Street as the agency continues to probe high-frequency trading and the growth of dark pools, trading venues where trades take place away from the main exchanges.

High-frequency trading has come under greater scrutiny since the May 6 "flash crash," when some high-frequency firms along with a number of other active traders withdrew from the market, arguably exacerbating the stocks' swift downdraft that day.

High-speed trading, now estimated to account for about two-thirds of U.S. stock market volume, takes many forms, some entirely proper. Defenders say it reduces trading costs for all investors by adding volume to the market. Latency arbitrage is a type of trading that relies on ultrahigh speeds; it's not clear which firms engage in it or how pervasive it is.

Some firms pay tens of thousands of dollars a year to individual exchanges for premium access to their price feeds, industry players and exchanges say.

The SEC, in a broad review of market structure earlier this year, said information from trading-center data feeds "can reach end-users faster than the consolidated data feeds."

The latency arbitrage trade aims to game the so-called national best bid and offer price on a stock, which sets the price most investors use to trade.

The ability to estimate price moves ahead of the national best bid and offer price, which is consolidated electronically from exchanges, can give traders an advantage of about 100 to 200 milliseconds over investors who use standard market tools, according to a November 2009 report on such trading activities by Jefferies & Co.

An advanced look at exchange data and order flow can provide firms "the ability to forecast future prices" and "make adjustments to their orders in the market or send new orders which are based on this information," the report found.

Some investors are searching for ways to protect themselves. Rich Gates, co-founder of TFS Capital LLC, started becoming concerned about latency arbitrage in early 2009 after a Wall Street bank pitched the trade to his firm.

In hundreds of tests, TFS has found that some of its trades were getting picked off by firms exploiting the time-delay wrinkle. That was costing the firm money.

To learn more, TFS, which manages about $1.1 billion in mutual funds and hedge funds, devised a method to essentially bait firms into engaging in the trade. In effect, TFS proved that some traders were wise to a movement in a stock's price before it happened.

On a March afternoon, a TFS trader sent an order to a broker to buy shares of Nordson Corp., a maker of fluid dispensing equipment. The trader sent an instant message to the broker: "please route to broker pool #2," a request to send the order to a specific dark pool.

The trader told the broker not to pay a price higher than the midpoint between what buyers and sellers were offering, which at the time was $70.49.

Several seconds after the dark pool order was placed, the market price didn't change. Then the TFS trader set a trap: he sent a separate order into the broader market to sell Nordson for a price that pushed the midpoint price down to $70.47.

Almost immediately, TFS was sold Nordson for $70.49 -- the old, higher midpoint -- in broker pool No. 2, which didn't reflect the new sell order. TFS got stuck paying two cents more than it should have, suggesting that some seller knew the higher price was a good deal to nab quickly.

Such trades are "unusually suspicious," said Mr. Gates.

Most dark pool operators say they police investors for improper activities. Liquidnet, which runs a dark pool, had suspended 125 members through 2009 for suspicious trading since its launch in April 2001, the firm says.

Write to Scott Patterson at [email protected]

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Re: Fast Traders' New Edge..."It is a rigged game"

Shocking

V

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Re: Fast Traders' New Edge..."It is a rigged game"
saxplayer00o1 wrote:

 On a March afternoon, a TFS trader sent an order to a broker to buy shares of Nordson Corp., a maker of fluid dispensing equipment. The trader sent an instant message to the broker: "please route to broker pool #2," a request to send the order to a specific dark pool.

The trader told the broker not to pay a price higher than the midpoint between what buyers and sellers were offering, which at the time was $70.49.

Several seconds after the dark pool order was placed, the market price didn't change. Then the TFS trader set a trap: he sent a separate order into the broader market to sell Nordson for a price that pushed the midpoint price down to $70.47.

Almost immediately, TFS was sold Nordson for $70.49 -- the old, higher midpoint -- in broker pool No. 2, which didn't reflect the new sell order. TFS got stuck paying two cents more than it should have, suggesting that some seller knew the higher price was a good deal to nab quickly.

Such trades are "unusually suspicious," said Mr. Gates.

Sax -

Unless there is a lot more to this, what happened is how the market is supposed to work.

Let's see, TFS puts in a buy order (assumed to be a limit order) when the Ask hits $70.49 - (stated above to be the midpoint between the Bid/Ask spread.)

TFS then sets a "trap" by putting in a market order sell???  The sell order had to be at the market in order for the midpoint price to move down.  You can debate the "morality" of the market maker lowering the the Bid, but it is how the market works.  He sees a Buy limit order at one price - $70.49, followed shortly by a Sell order at the market?  So he drops the Bid, fills the Sell order at $70.47, then turns and fills the $70.49 Buy order and pockets $.02?  The market maker is under no obligation to lower the Ask price so the initial Buy limit order at $70.49 won't change when the Sell market order hits the floor.

Yup - just the way it's supposed to work.  People who use market orders to Buy and Sell are just asking the market maker to abuse them.  And he will gladly comply.  People seem to forget that the market maker's job is to keep a spread between the Bid and the Ask so the house he is working for can get paid for the trades they execute.

One additional question for our esteemed Mr. Gates - how does one differentiate between an "unusually suspicious" and a "usually" suspicious trade?

This was either (A) a very poorly written article that omitted key technical information regarding the execution of this trade "trap" or (B) it was a very poorly written article that accidentally gave a left-handed description of how the market functions normally with regards to the market maker keeping liquidity in an equity's price by moving the Bid and Ask price as trade orders hit.

IMO, I'm leaning towards answer "A and B".

 

EDIT:  Addendum - I sent an email to the author (Scott Patterson) requesting more information on the details of the so-called trade trap.  Will follow-up with amplifying information if he answers.

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Re: Fast Traders' New Edge..."It is a rigged game"
Dogs_In_A_Pile wrote:
saxplayer00o1 wrote:

The trader told the broker not to pay a price higher than the midpoint between what buyers and sellers were offering, which at the time was $70.49.

Several seconds after the dark pool order was placed, the market price didn't change. Then the TFS trader set a trap: he sent a separate order into the broader market to sell Nordson for a price that pushed the midpoint price down to $70.47.

Sax -

Unless there is a lot more to this, what happened is how the market is supposed to work.

Let's see, TFS puts in a buy order (assumed to be a limit order) when the Ask hits $70.49 - (stated above to be the midpoint between the Bid/Ask spread.)

TFS then sets a "trap" by putting in a market order sell???  The sell order had to be at the market in order for the midpoint price to move down.  You can debate the "morality" of the market maker lowering the the Bid, but it is how the market works.  He sees a Buy limit order at one price - $70.49, followed shortly by a Sell order at the market?  So he drops the Bid, fills the Sell order at $70.47, then turns and fills the $70.49 Buy order and pockets $.02?  The market maker is under no obligation to lower the Ask price so the initial Buy limit order at $70.49 won't change when the Sell market order hits the floor.

Dogs, I think there's a little more to it. Your explanation of how its supposed to work "So he drops the Bid, fills the Sell order at $70.47, then turns and fills the $70.49 Buy order and pockets $.02?" is I believe invalid since the broker doesn't actually see this and its all done by his high speed/ high frequency trading computer.

The computer sells at $70.49 and then buys at $70.47. It cannot buy the market ask at $70.47 first because there's a bid of $70.49 that's been in the system for several seconds, an eternity to these computers (although I concede that the machine might be programmed to do a flash buy before sell as you suggest). Without the computer jumping to the gun first the sale would go through at $70.47, both sides to TFS, and being a null trade except for commissions. So basically its unethical if not illegal. Can't traders subsist on commissions alone?

A high speed computer located within the NYSE building can see the $70.47 trade first since the electrons only go 300 metres a millisecond. In essence the two trades will occur within a few 10's of milliseconds depending upon how far away the handshaking computers are.

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Re: Fast Traders' New Edge..."It is a rigged game"
SteveW wrote:
Dogs_In_A_Pile wrote:
saxplayer00o1 wrote:

The trader told the broker not to pay a price higher than the midpoint between what buyers and sellers were offering, which at the time was $70.49.

Several seconds after the dark pool order was placed, the market price didn't change. Then the TFS trader set a trap: he sent a separate order into the broader market to sell Nordson for a price that pushed the midpoint price down to $70.47.

Sax -

Unless there is a lot more to this, what happened is how the market is supposed to work.

Let's see, TFS puts in a buy order (assumed to be a limit order) when the Ask hits $70.49 - (stated above to be the midpoint between the Bid/Ask spread.)

TFS then sets a "trap" by putting in a market order sell???  The sell order had to be at the market in order for the midpoint price to move down.  You can debate the "morality" of the market maker lowering the the Bid, but it is how the market works.  He sees a Buy limit order at one price - $70.49, followed shortly by a Sell order at the market?  So he drops the Bid, fills the Sell order at $70.47, then turns and fills the $70.49 Buy order and pockets $.02?  The market maker is under no obligation to lower the Ask price so the initial Buy limit order at $70.49 won't change when the Sell market order hits the floor.

Dogs, I think there's a little more to it. Your explanation of how its supposed to work "So he drops the Bid, fills the Sell order at $70.47, then turns and fills the $70.49 Buy order and pockets $.02?" is I believe invalid since the broker doesn't actually see this and its all done by his high speed/ high frequency trading computer.

The computer sells at $70.49 and then buys at $70.47. It cannot buy the market ask at $70.47 first because there's a bid of $70.49 that's been in the system for several seconds, an eternity to these computers (although I concede that the machine might be programmed to do a flash buy before sell as you suggest). Without the computer jumping to the gun first the sale would go through at $70.47, both sides to TFS, and being a null trade except for commissions. So basically its unethical if not illegal. Can't traders subsist on commissions alone?

A high speed computer located within the NYSE building can see the $70.47 trade first since the electrons only go 300 metres a millisecond. In essence the two trades will occur within a few 10's of milliseconds depending upon how far away the handshaking computers are.

Steve -

The hitch in your scenario (I think) assumes that the original Buy order is necessarily matched to the Sell order that follows and that rarely if ever happens.  There are several clearinghouses that match Buys and Sells and you really can't draw straight lines between orders within an exchange, much less across exchanges.  Buys and Sells are typically filled in the order received and the market maker/computer matches order sizes and executes once matched.  It sounds to me that in the scenario given, TFS expected the Buy order to be filled by the subsequent Sell order.

All the "computer" initially sees is a limit order Buy with a limit price of $70.49 (the old midpoint).  Then it sees a Sell order - and I assumed this to be a market order since the equity price in the scenario presented in the article dropped to $70.47.  For argument's sake, we'll say the original Buy limit order was for 1000 shares.  When the Sell market order hit, the market maker (computer for a trade this small) is allowed to move the Bid price down.  This is exactly why you NEVER EVER USE MARKET ORDERS TO BUY OR SELL!!!!!  He moved the price down to create a spread between the Sell order he was going to match to the Buy order he had.  All perfectly legal.  The discussion of this practice being ethical or moral would probably be belief driven more so than fact driven.  Let's just say I view the market maker as a bad guy and at the end of the day I want him to jump out of a window when he sees my trade orders hit.  Or at the very least cuss me out while filling my orders at a profit for me and nothing for him past commissions.  Cool

Now if the Sell order had been a limit order that came in with a limit Sell price of $70.49 AND the share size matched the Buy order lot size, the market maker has two options.  Fill both orders and be happy with commissions or do nothing and leave them unfilled until the person who put in the order changes the limit price.

Still haven't heard from Patterson, but each time I read over the article to see if there is a nuance I missed, I am more and more convinced that it is a very poorly written article as far as accurately laying out the technicals of the orders he used in his trade trap scenario.  I can't tell you how many articles I've read about market manipulation of a trade - only to find out that the trade consisted of a combination of limit orders and market orders.  Without intending to insult anyone, IMO if someone uses market orders to trade with, they are putting a flashing sign on their order that says "I DON'T KNOW WHAT I AM DOING.  PLEASE COME TAKE MY MONEY FROM ME."

As far as seeing the $70.47 Sell order first, it doesn't fit the scenario given.  I assumed that TFS waited until they had a confirmation on their Buy order at $70.49 prior to putting in their Sell order that moved to $70.47.  If they had two people typing in the orders separately and just letting them hit the floor whenever, then that's a poison pill argument and completely invalidates the argument they are trying to make.  Hopefully, Patterson will provide some info soon.

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Re: Fast Traders' New Edge..."It is a rigged game"

DIAP,

Thanks for your considered reply. I know that orders don't necessarily match but for the scenario to make sense the buy has to have been placed and not filled within several seconds before the sell order is placed.

Dogs_In_A_Pile wrote:

As far as seeing the $70.47 Sell order first, it doesn't fit the scenario given.

If this relates to my "A high speed computer located within the NYSE building can see the $70.47 trade first since the electrons only go 300 metres a millisecond" I was suggesting that such a machine sees the order before others because of its proximity to the exchange. From prior reading this is what I have seen reported.

Dogs_In_A_Pile wrote:

 I assumed that TFS waited until they had a confirmation on their Buy order at $70.49 prior to putting in their Sell order that moved to $70.47.

If this were true the scenario and their test makes no sense.

Dogs_In_A_Pile wrote:

Hopefully, Patterson will provide some info soon.

That would certainly be helpful. Let us know what you hear.

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Re: Fast Traders' New Edge..."It is a rigged game"

Steve -

I don't think computer proximity matters that much.  I know the computer center for the brokerage firm I use is a long way from New York - it's in Texas.  The article seemed to be implying that the "Buy" computers could "see" the "Sell" orders some amount of milli/micro/nano seconds before other trading house computers saw the orders hit the floor and adjust accordingly.  That might be exploitable for orders with large numbers of shares, but not so much for many, many smaller orders in a volatile day.

For clarification on the order confirmation discussion - I mean confirmation of the Buy order going to the floor, not confirmation of execution of the actual buy.

The more we discuss this, the more we are exposing the data shortcomings of the article.  I may be wrong, but it's not apparent to me that the author has a working understanding of market orders vs. limit orders.  I've had market orders sit in the queue for hours before the price moved enough to trigger it.  Market makers generall won't go after limits that are outside the spread until after he has crushed all the market orders.  I've actually had trades sit and I watched as the market maker tried to lure me in by lowering the ask or raising the bid to within a nickel of my limit price in an attempt to make me take it.  Several years ago I sat on a KSwiss Call option for 4 days with a limit order sell in that was within $.05 of the current Bid.  He just wouldn't take it.  I was watching premarket and saw KSwiss was up a pretty good chunk so I changed my limit order price at 9:29 and raised it $.10.  It opened up enough to drive the real value portion of the option price enough to trigger the limit order and I sold to close at $.15 higher than what the market maker could have taken.  The volume on the option contracts was low enough that execution was all computer driven - by me being able to see premarket price pressure and adjust my limit order price accordingly, I was able to piss off the market maker.  That's one drawback of computer controlled trading - during premarket trading, the computers will adjust the option Bid/Ask as a function of the price of the underlying equity within its algorithm so that if the market opened up right then, heres where the option price would be, but it isn't a thinking machine and it doesn't bounce premarket price adjustments against open limit orders that are close.

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Re: Fast Traders' New Edge..."It is a rigged game"
Dogs_In_A_Pile wrote:

Steve -

I don't think computer proximity matters that much. 

DIAP,

For the record wikinvest (among others) suggests that proximy is important.

http://www.wikinvest.com/wiki/High-Frequency_Trading_(HFT)

"High-frequency trading strategies are highly dependent on ultra-low latency. To realize any real benefit from implementing these strategies, a firm must have a real-time, colocated, high-frequency trading platform where data is collected, and orders are created, routed and executied in sub-millisecond times"

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Re: Fast Traders' New Edge..."It is a rigged game"
SteveW wrote:
Dogs_In_A_Pile wrote:

Steve -

I don't think computer proximity matters that much. 

DIAP,

For the record wikinvest (among others) suggests that proximy is important.

http://www.wikinvest.com/wiki/High-Frequency_Trading_(HFT)

"High-frequency trading strategies are highly dependent on ultra-low latency. To realize any real benefit from implementing these strategies, a firm must have a real-time, colocated, high-frequency trading platform where data is collected, and orders are created, routed and executied in sub-millisecond times"

Let me clarify.  For the trading strategies Cat and I use, proximity absolutely doesn't matter.  So we don't get caught up in electron theory vs.hole flow arguments.

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An answer - of sorts

[Text removed at poster's request. Moderator John]

To summarize the scenario in the article:

1.  TFS put in a limit order Buy to buy the stock at the current midpoint between the Bid/Ask - $70.49.

2.  TFS then put in a Sell order at the market - which was executed in the broader market - causing the Bid price to drop to $70.47

3.  TFS's original Buy order was filled at the limit order Ask price of $70.49.  (Note:  The market maker is under no obligation to move the Ask price down if the Bid drops.  Since the market maker is supposed to create a fluid market by maintaining a spread, he did what he was supposed to do.)

I'm not sure what "it appears that another firm saw that trade, anticipated the lower midpoint and bought in the dark pool before it moved lower."  I struggle with an article's validity when I see words like "it appears".  There's not a whole lot of academic rigor that can stand up to much scrutiny.  But using words like "it appears" allows an author to write a belief based OPED that is very short on facts.

So to summarize the author - TFS bought high and sold low.

There are a host of other inconsistencies in the article -

"The sell order was executed in the broader market, but wasn't filled by TFS itself"  - Okay, then who filled TFS' Sell order?  Or did they execute a naked short sell?  (I digress)

Why in the world would a spooky dark bad guy computer see a sell order execute, anticipate that the price would move lower but buy (in the dark pool) BEFORE it moved lower??????  Is there some kind of dark matter string theory that has negative commission costs if you do this?  (I digress again)

I'll go back to my original assessment that the author doesn't really know what he is talking about.  And that is just my opinion.

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Re: Fast Traders' New Edge..."It is a rigged game"

Actually Steve it's 300,000 meters per millisecond, and probably less if they are propagating through copper. Wink

 

In any event this is a VERY good debate. I am reading it with keen interest. 

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Re: Fast Traders' New Edge..."It is a rigged game"
Morpheus wrote:

Actually Steve it's 300,000 meters per millisecond, and probably less if they are propagating through copper. Wink

Ooops you're quite right. Embarassed 300 kilometres in a millisecond max, still not enough to reach Texas from New York.

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Monsters in the Market

Apparently the most sopisticated algorithmic "Monsters in the Market" are designed to detect and defeat their weaker, less sophisticated, brethren and to improve their strategy by learning.

Quote:

Average daily share volume on the New York Stock Exchange increased by 181 percent between 2005 and 2009, while the time required to execute a trade on its electronic systems dropped to 650 microseconds.

...or 195 km at light speed.

http://www.theatlantic.com/magazine/archive/2010/07/monsters-in-the-market/8122/

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