This podcast episode and article answers the following questions:

  • What is High Frequency Trading?
  • How does High Frequency Trading work?
  • How will High Frequency Trading affect me as an investor?
  • Ask the Investors: Should I use technical analysis along with value investing principles?

This article provides an overview of the book, Flashboys, which is an account of how the stock market is rigged by the rise of high frequency trading. If you want to read our executive summary of, Flash Boys, view this page instead. If you would like to download all of our book summaries, click here.

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What is High Frequency Trading?

The stock market is no longer what is used to be. Previously, it was a place where human buyers and sellers used to agree on the price of stocks. Now 73% of the trading in the United States is conducted by high frequency computers that are programmed to trade stocks literally faster than the blink of an eye. What is just as absurd is that these companies only represent 2% of the firms operating today.

We’re talking billions of trades where the goal is to make just a few or even fractions of cents per trade, but where big profits can be reaped due to the sheer number of trades. Don’t be fooled into thinking that these are investments in American businesses. Simply put, it’s a game of mind-boggling speed and information, where stocks are bought and sold in less than a second. However, it’s also a game where only high frequency traders know the rules, and have the ability to play with concealed cards, whereas investors play with their cards face up.

How fast is HFT? Well, the blink of an eye is between 300 to 400 milliseconds. Through this book, you’ll discover how millions and millions of dollars are spent by HFT companies to save just a few milliseconds. All bets are off when it comes to speed. ‘Flash Boys’ starts out describing the new, mega construction of Spread Networks’ secretive 827-mile cable running through mountains and under rivers from Chicago to New Jersey that would reduce the journey of data from 17 to 13 milliseconds.

How does High Frequency Trading Work?

High frequency trading (HFT) is very complex and is ever changing, which means it is both hard to stop and quantify. The general principle, though, is straight forward. Valuable information is asymmetric in the stock market, and HFT Companies capitalize on this asymmetry on the expense of the investors. The following examples are simplified, but show a few of the underlying principles behind HFT.

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Let’s consider an example of one share of Chevron. Let’s say that the bid price is $99.98, which means that someone is willing to pay $99.98 for one share of Chevron, while the ask price is $100.00. In other words, the ‘ask price’ is what someone’s willing to sell a share of Chevron for. Let’s assume that you want to buy 50 shares of Chevron at the best possible price ($100.00), but after you type in your market order, you realize that the best offered price, and the price you settled at was $100.01. Ring any bells? How did that happen? The answer is “High Frequency Trading”.

Although the latency, or the time period between the placement of an order and its execution was less than a second, a lot of things happened in between. First off, the stock broker has sold the information of your order to a high frequency trading company. Knowing that you wanted to buy 50 shares at $100.00, the HFT Company quickly (measures in 1,000th of a second) buys 50 shares at $100.00 before you, and places a sales order at $100.01, which was the price you bought at. In other words you paid 50*$0.01 = $0.50 more than you were supposed to, and the HFT company grabbed that profit without any risk.

This might both seem outrageous and wrong (and it is!). Nevertheless, it is legal and is just one of the many possible ways HFT companies use to exploit the stock market on a daily basis.

Let’s study another instance of how HFT companies exploit stock market investors. In this example, the investor needs a large chunk of shares, say 100,000, and is therefore willing to pay a price higher than the current ask price of $100.00 per share of Chevron, since he knows he will move the market with his large order. He therefore decides that he will not pay more than $100.10 for any share. The moment after he places his order, he finds that he paid $100.10 for all of his $100,000 shares. How did that happen?

The HFT Company has written an algorithm that removes the sales side as soon as the buying order is placed. In other words the investor can no longer buy the stock for $100.00. After removing all sales orders, the HFT Company is “testing the buyer”, which means that it sends out new sales orders to find the maximum price the investor is willing to pay. First it may try to sell at $100.50, since there will be no response (remember that the maximum buying price was $100.10), it will gradually lower the sales price until the computers finds the maximum price of $100.10. In this example, the investor paid 100,000*$0.1 = $10,000 more than the original sales order of $100.00 per share.

How will High Frequency Trading affect you as an investor?

If you’re thinking that you can’t trust the stock market anymore you are not alone. I truly resonate with that! HFT can make investing appear like you’re placing bets with a bookmarker who already knows the score of the game played! A common denominator for these two strategies mentioned above and for the many more HFT strategies is that contrary to the stock investor, the HFT Companies have no position when the stock market closes and is therefore neither playing the same game, or is exposed to the same kind of risk. It’s all buying and selling at the expense of investors.

One thing to remember though is that HFT companies compete with each other, and not with the long-term investor. The very essence of a stock market has always been in buying a piece of a real business, and that fact has not changed with the rise of HFT. As an investor, there will be times where you will be paying marginally more, or getting marginally less for your stocks, but it won’t affect the overall performance of your portfolio very much. On the other hand, you should be concerned of the general instability of the financial markets, and be frustrated about financing a party thrown by an HFT Company where they aren’t invited.

It is hard to speculate about the future of HFT. Recently we have seen dramatic declines in the estimates from HFT profits. Accordingly to Frederi Viens of Purdue University, profits from HFT in the U.S. have been declining from an estimated peak of $5bn in 2009, to about $1.25bn in 2012. Preston and Stig are under the firm impression that companies not adding value to the society will slowly make themselves obsolete. HFT certainly falls under that category.

Ask the Investors: Should I use technical analysis along with value investing principles?

To the best of the investors’ knowledge, there are no billionaires that have solely used technical analysis. What can be said is that HFT Companies are using some of these techniques in their algorithms. The problem about competing with them as a private investor is that you don’t have the same resources in terms of speed and information as they have. Another fundamental difference is that private investors spend between $5 and $10 on each stock trade, requiring them to predict the market extremely well over time. HFT companies on the other hand are structured so that they can be highly profitable by selling and buying at fractions of a cent or even at the very same price.

BOOKS AND RESOURCES

Michael Lewis’ book, Flash BoysRead reviews of this book.

Michael Lewis’ book, The Big Shortad reviews of this book.

Charles Koch’s book, The Science of Success Read reviews of this book.

The Public HFT Company, Knight Capital Group (KCG)

Billionaire Vincent Viola’s HFT Company (soon to go public), Virtu Financial

Brad Katsuyama’s, Investor’s Exchange
Mark Cuban’s Blog, BlogMaverick.com

VIDEOS THAT SUPPORT THIS PODCAST

OUR SUMMARY OF HIGH FREQUENCY TRADING WORKS

If you would like to download the below summary of How High Frequency Trading Works in .pdf format, follow the link.

Chapter 1: Hidden in Plain Sight

During the summer of 2009, 205 crews that consisted of 8 workers each were assigned to dig trenches and holes through mountains and riverbeds to build a line that was supposed to lessen a few milliseconds in the trading network. Dan Spivey, the man behind this collective effort had come up with this insane idea of digging a line that could produce billions of dollars to firms who were crazy about speed. He was backed by millionaire Jim Barskdale, and they named their company ‘Spread Networks’. The difference in these milliseconds allowed the traders to discover discrepancies in the prices between New York and Chicago and Dan Spivey saw this as an incredible opportunity to make money.

Most Wall Street firms, including Goldman Sachs were mighty interested to foot the bill ($10.6 million if it was paid up front and $20 million if paid in installments) and lay their hands on this new invention that reduced travelling time from 17 to 13 milliseconds! It was noted as one of the biggest moments in the history of Wall Street and everybody who was in awe of this incredible success wanted a piece of it.

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Chapter 2: Brad’s Problem

Brad Katsuyama, a man working for the Royal Bank of Canada (RBC), was sent by the bank to New York as part of a big push – an incident that went unnoticed although RBC was the 9th biggest bank in the world. Brad, who realized that there were major difference between Canada and the USA, had a hard time adjusting with the traders he met in New York. However, as a man who was naturally meant to trade, he was confident that his analytical abilities would be rewarded. After a few years of trading, he began to make major headway and was also known as the ‘Golden Child’ – a man who could end up running the bank himself. Totally comfortable in his shoes by then, Brad liked and trusted the system; however, he was in for a rude shock when the system didn’t return the same favor.

Brad’s troubles began when RBC bought a trading firm named Carlin Financial for $100 million in 2006. Jeremy Frommer, Carlin’s CEO, was totally opposite the culture at RBC – a company that gained a reputation of being a ‘nice’ company. It became increasingly difficult for Brad and his colleagues to adjust with the high and mighty attitude of Carlin’s employees and at that moment in time, Brad also noticed that the market was behaving oddly. In addition, Brad realized that he could no longer trust his own screen since there was something odd going on. For instance, when Brad’s company wanted to buy 100,000 shares at $20 per share, and the information on his terminal said, 100,000 shares were available for purchase at that price, they would typically be able to process this request easily.

But for some reason, things were behaving differently.  Now, only a small portion of the order would be processed, for instance, maybe only 20,000 shares would get purchased at $20, and the other 80,000 shares moved higher.  It was almost like someone was reading his mind, and changing their position as soon as he would hit a button! After thorough research, he realized that there was something sinister occurring below the surface and that the system was rigged.  Since large market orders are rarely exercised in just one exchange (like the New York Stock Exchange), trades are typically sent to other markets to complete the total volume of the order.  As a result, HFT companies would recognize the initial order, let’s say at the NYSE, and they would front run the remaining orders at the other exchanges.  This way, they could buy up the inventory of stock that was for sale, and then resell it at a higher price – In a matter of milliseconds.

With the help of Allen and Rob Park, computer programmers at RBC, Brad came up with a tool known as ‘Thor’.  This was a program designed to counteract the power of the HFT companies by placing time delays into the orders so the purchase requests would arrive at all exchanges at the same exact time.  This rendered the HFTs helpless.

Chapter 3: Ronan’s Problem

Ronan Ryan, a man who had travelled from Ireland to America with his father when he was very young, was determined to work in a Wall Street firm. Thanks to his accomplishments in increasing trading speed, he was hired by RBC and he took up the job because he wanted to work in a Wall Street firm.

High Frequency Trading is unbelievably unfair for the investor since he had no clue about the sinister incidents that occurred every day. The broker would be paid by the investor to buy some shares, but HFT companies would also pay the brokers so the information could be exploited. However, after the flash crash occurred, investors were more than willing to share secretive information gleaned from brokers to help Brad understand even more about the murky waters of Wall Street.

As things became clearer, Brad realized that the more he understood about the dealings of the stock market, the better he could help investors, thereby forcing the system to be fair and transparent.

Chapter 4: Tracking the Predator

As time progressed, Wall Street looked like it was in the midst of chaos and turmoil that helped Brad employ people who previously would have never even considered working for RBC. After interviewing several candidates, he hired John Schwall who had lost his faith in the system due to his employer. When they tried to understand how it was even legal for these firms to steal from the investors, they realized that there were no rules against HFT traders setting and building faster computers in their exchanges.

At that point in time, where prices would move crazily for anyone who cared to notice, a team of several researches from the University of California in Berkley published a paper. The paper clearly showed discrepancies in Apple’s stock price where the prices shown by the typical market processor and the ones shown in faster trading channels differed by 55,000 times a day!

Brad was jubilant when RBC asked him to present a report at the SEC because he had a lot to say that would expose the system, but as RBC, being the ‘nice’ bank didn’t want to ruffle any feathers, he wasn’t encouraged to present all his findings. During the SEC report, Brad had people challenging him while they leaned in favor of HFT companies, thus making it clear that the problem was deeper than it appeared. Their illogical argument about liquidity as the reason to allow HFT companies on the exchange proved that it wasn’t easy to change the nefarious system. (As a side note, the liquidity argument that many HFT companies make, with respect to the value they create, is false.  Since HFT companies don’t actually execute a majority of the buy and sell orders they place, – they simply use them as bait – liquidity is only a guise for their company homepages)

Chapter 5: Putting a face on HFT

Sergey Aleynikov, a man who migrated from Russia to America, had changed several jobs until he was hired by Goldman Sachs once the firm realized that they had to focus on speed. Sergey’s job was to build a system to help Goldman’s proprietary traders place orders in the stock market faster than anyone else. As he progressed with his job, he became aware that the people in Goldman didn’t really understand the deep causes of what he did.

Once he became well known on Wall-Street for his brilliant methods of increasing speed, he began receiving many offers and though he rejected several of them, he accepted a position in Misha Malyshev, a company that wanted him to create a new trading platform afresh. Plus, he was offered a whopping $1 million dollars a year! Sergey stayed back in Goldman Sachs for 6 weeks to teach his replacements what they needed to know. As a common practice, he mailed himself the codes he worked on; code that was open source information.

On the last day of his job at Goldman, he sent the files to a repository and deleted the bash history – something he used to do ever since he started programming. However, this act changed his life as he was arrested as soon as he landed in Chicago. After a series of events that were bewildering to him, he was accused of stealing lines of code from Goldman Sachs. He was sentenced to 8 years in a federal prison for something that made no sense.

Chapter 6: How to take Billions from Wall Street

Frustrated with the dealings of a shady, rigged market, Brad quit his $2 million dollar salary job at RBC much to everyone’s shock, and decided to open his own stock exchange that claimed to be a fair and transparent stock market. Though he faced issues related to funding the enormous endeavor, many of his former colleagues followed him to the start-up.  Brad was able to collect $15 million in start-up capital to create his new stock market. By 2013, he put all his savings on the line and set out to hire people who had a deep understanding of the stock market and HFT.

He hired Don Bollerman and Francis, a man who had won the National Puzzle competition. Francis was obsessed with making the system extremely simple to avoid manipulation. The new exchange, named The Investor’s Exchange and later shortened to IEX, had a strategy of creating a fair system that wouldn’t pay any kickbacks to banks or brokers. Instead, they would charge both sides the same amount and deal with just 3 order types – limit, market and Mid-point Peg.  In the other exchanges, HFT companies were taking advantage of an ever-growing number of market orders that made the transaction so confusing that it was hard to understand and combat.

Chapter 7: An Army of One

Zoran Perkov, was a person who had moved to USA with his folks when he was a child. He worked for NASDAQ and handled several of their exchanges as the ‘Head of Global operations’. He had realized very early that he was a person who could handle extreme circumstances.  For example, he emerged as a leader when the World Trade Center’s collapse.

During the time he was hired by IEX, there was a severe crisis in the market with several companies masking their mistakes as ‘technical glitches’. While NASDAQ bungled the IPO of Facebook Inc’s shares, the NYSE treaded in dark waters when they were forced to stop trading in about 216 stocks. In addition, it seemed like several Wall Street banks were uniting together by spreading rumors against IEX so that nobody would participate in their venue. IEX opened in 2013. However, it quickly became apparent that the banks weren’t even abiding by their customers’ orders to send orders to IEX, stating that their service was too slow.

To cover their costs, IEX had to trade at least 50 million shares every day and it was obvious that they wouldn’t last once they ran out of money. Then, out of nowhere, Goldman Sachs and a few other big banks tried to send HFT orders to the IEX. On December 18, they managed to trade 11,827,232 shares and the next day, Goldman Sachs began sending honest orders that rose up to 30 million. Allegedly, Goldman suddenly felt that the stock market needed to change, which was the reason for the honest orders.  However, the truth was rather, they couldn’t compete with the smaller HFT companies.  In any case IEX had proved a point, the market didn’t need to be complicated and rigged to make money.

Chapter 8: The Spider and the Fly

Sergey Aleynikov’s trial confused people since they just couldn’t grasp the concept of HFT. It was Sergey’s battle against the bigwigs from Goldman who made it impossible for people to understand HFT, but Malyshev testified as a witness stating that Goldman’s code was useless to them since it was built in a different language. An important point raised during the trial proved that if Sergey wanted to steal the code, he would have done so long ago without anyone noticing because he was granted the ‘Super-user’ status in Goldman. Also if the code was so important, why haven’t he even bothered to open the files? However, even this point failed to convince the jury although they all agreed that Sergey’s actions weren’t suspicious.

The jurors were also mystified about why Goldman had chosen to batter this man by calling the FBI. In effect, Goldman was exploiting the ignorance of the legal system as well as the people who had no clue about HFT. Ultimately, Sergey was sent to prison.

The Second Circuit of Appeals heard Sergey’s appeal about a year after he was sentenced to prison and they dispensed swift judgment in favor of Sergey. On February 17, 2012, Sergey’s lawyer, Marino, emailed him to say that he was going to be freed. Though one might think that his trial and his hopelessness could have destroyed him, Sergey chose to think positive and also wrote a memoir that explained what really had transpired.

Chapter 9: Riding the Wall Street Trail

When the people in Goldman Sachs were questioned as to why they chose to accuse Sergey of stealing code and on the other hand help IEX with its new agenda of creating a fair market, they replied that they were in a state of ‘transition’. In fact, their code would be obviously useless if they supported Brad who was against HFT. Simply put, Goldman’s actions can be understood if you saw the connection between Sergey and Goldman’s supportive behavior towards IEX. A lot of people had begun to question the activities of HFT trading and Goldman was continuously in the spotlight. They too, had to finally grasp the fact that they couldn’t compete with other companies when it came to speed. In other words, the people in Goldman realized that Sergey hadn’t stolen anything; the speed was the secret sauce.

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