Algorithmic & High-Frequency Trading

Algorithmic & High-Frequency TradingComplexity arising from centralization

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Electronic TradingOpen Outcry to Computer-based ExecutionReduced CostsGreater LiquidityTighter SpreadsIncreased CompetitionMore Transparency

Transition gained velocity in the early 2000s

Reduced Costs reduced costs for trade execution. Depending on trading volume, traders can pay pennies on the share.Increased Competition trades can be executed by the click of a mouse without needing to go through someone on the floorGreater Liquidity greater efficiency allows for firms to participate regardless of location. Tighter Spreads created by increased liquidityMore Transparency information about security, prices, and historical prices is readily available to anyone who seeks it.

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SEC Regulation NMS (National Market System)Order Protection Rule receive best price when executing an order.Access Rule improve access to quotes from exchanges in the NMS by required linkages and reduced access fees.Sub-Penny Rule quotation increment for all stocks over $1.00/share to at least $0.01Market Data Rule revenue allocated to organizations that promote and improve market data access.

Aimed at improving fairness in price execution, displayed quote data, and access to market data.Prices are posted on all (most) exchanges simultaneously improving chances for investors to ascertain the best price.

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Centralizing the MarketsSIP Securities Information ProcessorLinks US markets by consolidating all protected bid/ask quotes and trades from every trading venue into a single data feed.NBBO National Best Bid and OfferThe best price (lowest available ask price / highest available bid price)The typical bid/ask the average person sees.LULD limit up limit down price bandsRegulatory Halts & Short Sale RestrictionsUTP Unlisted Trading PrivelegesRegulation the gives exchanges the right to trade securities without meeting the minimum requirements (security not listed or registered on the exchange)

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Dark PoolsNo Swimming AllowedMarkets/exchanges where liquidity is deliberately hiddenReport trades to the SIP and trades recorded to the national consolidated tape but with as much delay as possible (to reduce market impact) and recorded as OTC transactions (detailed volume and transaction type data is not reported)Market ImpactAllow large blocks of shares to be traded while reducing the effect of such size orders would have on the market priceLiquidity seen by a trader in the book may not be an accurate reflection of the true liquidity available.

Arbitrage StrategiesIndex and ETF ArbitrageTaking advantage of mispricing between indices and associated ETFsStatistical ArbitrageDoes contribute to increased liquidity.Latency ArbitrageIncreases liquidity at the expense of other investors/traders.Large order enters the market, HFT traders are able to buy shares from other exchanges (often a penny or so cheaper) before the order hits the other exchanges.Market participants both receive a slightly less than best possible price had the middle man not been present.Rebate ArbitrageExchanges offer rebates or fees for making and taking liquidityFees differ from between exchangesWould a broker route an order to an exchange that offers a rebate rather than charges a fee resulting in an execution that may not give the best possible price to the client?

Does contribute to increased liquidity. Mainly due to HFT having access to hidden liquidity that most traders do not. Also with options contracts, one can usually find a buyer for contracts if they are willing to sell for below par value. HFT can buy, exercise, and sell the shares within a few milliseconds.

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HFT Visualized

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One Half of One Second of Trades in One Stock Around the World

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Slowed Down to the Millisecond

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Footprints of the Middle Man

No Shortage of Examples

The Bigger Picture Trumps All

These images are from October 30, 2014. At 13:17, a massive surge in /ES futures volume resulting from a major overhead resistance being broken cause a system wide error that resulted in trades being executed in a greater than 50cent range as indicated by the extremely long tails on the 1m and 133tick candles.12

August 24th, 2015LULD bands prevented a much more catastrophic event.Stocks such as AAPL traded in