> I'm asking for an explanation that goes beyond "they make money, and I don't understand how, they must be ripping people off!"
I didn't say that anyone was ripped off. There's nothing inherently wrong with being a middle-man in a transaction. I just don't see that HFTs are adding any real value.
> What's missing from your explanation is time.
You're pretending that Alice and Bob placed their orders 20 minutes apart. That's not the game HFTs play. HFTs are playing games of milliseconds. It's not 12:20 and 12:40. It's 12:20:00.200 and 12:20:00.450. If Eve had taken the day off, Alice would have traded with Bob, and it would have looked just as immediate to both of them. And if there were a high risk that the market would tank immediately after Alice's sell order were placed, then Eve wouldn't have left her buy order on the book anyway.
If your 20-minute wait scenario were realistic, then sure, HFT would be adding meaningful liquidity. But then, it wouldn't be called high-frequency trading, and you wouldn't have written about how "speed matters".
If Eve had taken the day off, Alice would have traded with Bob, and it would have looked just as immediate to both of them.
This comment makes sense only in the context of a message board hypothetical, because it presumes foreknowledge on Alice and Bob's part. Here, Bob showed up. Eve looks like a genius. But it was equally likely that he wasn't going to show up.
A lot of the discussions about liquidity and HFT here seem a little innumerate. They appear to work from a scale where the hypothetical Alice's ask price is "absolute zero". That's not the real scale. Obviously, instead of Bob showing up at $10.05, you're equally likely to end up with Chuck at $9.95.
If you're not equally likely to get Chuck instead of Bob, why are you selling?
> This comment makes sense only in the context of a message board hypothetical, because it presumes foreknowledge on Alice and Bob's part. Here, Bob showed up. Eve looks like a genius. But it was equally likely that he wasn't going to show up.
Equally likely? So HFTs are flipping coins blindly and just happen to make a lot of money because they can flip quickly?
> If you're not equally likely to get Chuck instead of Bob, why are you selling?
I don't understand this question at all. I'm selling because I want to sell my stock. Maybe I'm liquidating assets to buy a house. Maybe I'm speculating that the market is going to tank. Maybe I'm just adjusting my asset allocation. I could be selling for any number of reasons, and I don't care about Bob or Chuck. I just want to sell and get the market price.
If you need liquidity but want to retain your upside exposure, there's a whole class of tradable instruments that does that for you.
If you need liquidity and aren't confident enough in your upside to want to be exposed to the downside, you're happy to have Eve.
Note well: your hypothesis is that Alice should get something for nothing. Alice wants liquidity (ie: no downside exposure) and immediate access to the next significantly better price to hit the market. It must be nice to be Alice! :)
As for your first question: HFTs do not have crystal balls. If they did, Chris Stucchio would be a billionaire.
For sure, HFTs don't have crystal balls. They certainly are able to leverage their market access to give them an advantage, though.
I feel like I need to reiterate that I don't think HFT is evil. I'm just not sure that HFTs really add that much liquidity to the market, and there is evidence that they contribute to volatility (such as the flash crash).
The "Flash Crash" was caused by a single, manually-initiated large block trade:
At 2:32 p.m., against this backdrop of unusually high volatility and thinning liquidity, a large fundamental trader (a mutual fund complex) initiated a sell program to sell a total of 75,000 EMini contracts (valued at approximately $4.1 billion) as a hedge to an existing equity position.
(From the SEC link Chris posted earlier).
I don't know whether I believe Chris that HFTs caused the market to correct much faster, but it seems clear that HFT didn't cause the crash.
The SEC seems to disagree, and says that HFTs added to the drop. HFTs also apparently burned through about half of the trading volume just trading with each other.
> The combined selling pressure from the Sell Algorithm, HFTs and other traders drove the price of the E-Mini S&P 500 down approximately 3% in just four minutes from the beginning of 2:41 pm through the end of 2:44 pm. During this same time cross-market arbitrageurs who did buy the E-Mini S&P 500, simultaneously sold equivalent amounts in the equities markets, driving the price of SPY (an exchange-traded fund which represents the S&P 500 index) also down approximately 3%.
> Still lacking sufficient demand from fundamental buyers or cross-market arbitrageurs, HFTs began to quickly buy and then resell contracts to each other – generating a “hot-potato” volume effect as the same positions were rapidly passed back and forth. Between 2:45:13 and 2:45:27, HFTs traded over 27,000 contracts, which accounted for about 49 percent of the total trading volume, while buying only about 200 additional contracts net.[9]
HFT didn't cause the flash crash, but neither did that mutual fund manager.
The primary cause was a delay in when incoming orders were time-stamped by the NYSE. Instead of stamping the orders when they arrived at the queue just before entering the market, the NYSE servers time-stamped them when they _left_ the queue and were placed in the book.
Since the queue was delayed by extreme volume (NYSE has always lagged on technology), stale prices were posted to the NYSE feed. However, it was impossible to tell that they were stale from the timestamps.
Since the market was falling rapidly, this resulted in the NYSE quoting higher prices than every other market.
Since the NYSE was quoting higher prices than every other market, arbitrageurs massively sold at the NYSE and bought on other exchanges.
Since the queue was delayed, however, the sell orders at the NYSE took a while to actually show up in the book. Meanwhile, more sell orders were placed.
HFTs are playing games of milliseconds. It's not 12:20 and 12:40. It's 12:20:00.200 and 12:20:00.450.
Or it could be 12:20:00.200 and never. You are assuming Bob will show up, but at 12:20:00.200, neither Alice nor Eve know if he will or not.
If Bob shows up, Eve makes $0.05. If Bob never shows up and the price drops to $9.50, Eve loses money. Alice paid Eve $0.05 to take that risk because she felt it was worthwhile.
If Alice didn't feel this risk was worthwhile, she would have placed an order at $10.05.
But then, it wouldn't be called high-frequency trading, and you wouldn't have written about how "speed matters".
Please go reread the section on why speed matters. As I said, speed matters to Eve and Eddie (both HFT's) - because Eve placed her order at 12:20:00.000, and Eddie placed his at 12:20:00.030, Eve trades before Eddie. Alice's timing is irrelevant in this part of the game.
> Or it could be 12:20:00.200 and never. You are assuming Bob will show up, but at 12:20:00.200, neither Alice nor Eve know if he will or not.
Sure. It could be never. But it's not 50/50 or Eve wouldn't be playing. Eve buys from Alice because she expects to immediately sell at a higher price.
> Please go reread the section on why speed matters. As I said, speed matters to Eve and Eddie (both HFT's) - because Eve placed her order at 12:20:00.000, and Eddie placed his at 12:20:00.030, Eve trades before Eddie. Alice's timing is irrelevant in this part of the game.
It's not irrelevant. A price-increasing event occurs and Eve jumps on Alice's sell order before Bob's buy comes into the system. Bob pays the same, Alice gets her asking price, and Eve pockets the difference. This is just exploiting unequal market access.
Of course it's not. Alice has a lower appetite for liquidity risk - that's why Alice chooses to pay Eve to take on this risk.
A price-increasing event occurs and Eve jumps on Alice's sell order...
First of all, there was probably no event. It's most likely that Eve had passive orders - buy at $10.00, sell at $10.05 out in the market (HFT's usually don't take liquidity, that costs too much money). Alice came along and chose to fill Eve's order.
Ignoring that, you also haven't explained how Eve's "unequal market access" plays any role in this. Why does Eve have to be a machine in this process? While being a machine helps Eve beat Eddie (another machine), if no machines were in the game then Eve could easily be a human. In fact, Eve was a human until fairly recently.
From what I can see, the "best price" rule basically becomes meaningless in the face of HFT. Alice is pretty much always going to get her min only, right? This prevents Alice from setting her min lower to manage risk. e.g. In a world where matches are executed immediately, but market makers are competing without an advantage, Alice could set her min at $9.50. If Bob comes along and buys at $10.05, great. If Chuck comes along at $9.55, not as great, but okay. But in a world where HFT will pop up and buy at the lowest possible price, setting a low min stops being a reasonable option, because you're basically capping your sales price at that point. So maybe HFT helps Alice get $10 instead of risking $9.55, but it also stops her from getting $10.05.
I know that market making could theoretically do this anyway, but it's a different situation when market makers have such a speed advantage. If you've got to sit on your position as long as the typical eTrade user, leaving a passive buy for $0.10 under market price picks up more risk, because you might not be able to cancel if the market shifts downward by $0.30.
You're using terms like "best price rule" but asking questions like "if Alice sets her 'min' at 9.50 she can sell to Bob at 10.05". This doesn't make sense. Alice has a limit order on the book that says she's prepared to sell at 10.00. When Bob comes along saying he'll buy at 10.05, the market fills the order at 10.00.
There are some things I'm not entirely clear about here. I'm not sure how the best execution rule (best price rule is apparently a bit different) plays out when there's a spread. When someone bids 10.10 and someone else asks 10.00, how should that be resolved. Either someone takes the whole spread or it's split between them, and I'm not sure what the SEC says should happen. A "minimum" price doesn't make any sense if it's the only price, but then neither does a "maximum" price.
In any case, though, the spread would theoretically go to the existing participants, rather that an HFT. The "market making" of the HFT still results in extracting money from the market. This could be a beneficial thing in illiquid markets, but I'm not sure it's beneficial in markets that already have high liquidity.
You're not clear on how order books work, which, respectfully, suggests that your reasoning on this stuff is a bit suspect. The standing limit order prices the trade.
I can understand how upsetting HFT must have sounded to you (although to be fair, we're still shifting the good outcome from Bob to Alice in your best case) given that misunderstanding, but, no: to capture the 5 cents (more likely: 1 cent) between Alice and Bob, the HFT had to accept Alice's downside risk exposure. There was no (simple) outcome where Alice could have it both ways, scalping Bob for 5 cents in the best case but getting out at 10 cents in the worst.
I came to my understanding of this topic in a weird way (see downthread) but one resource I found extremely helpful was Larry Harris' _Trading And Exchanges: Market Microstructure For Practitioners_. It is the TCP/IP Illustrated of markets. Very well written, and well written in a way easily appreciated by programmers. Highly recommended. When I first started reading it, I literally didn't want to put the book down.
Respectfully, I never claimed to be an expert of any sort, and I said so earlier. A large part of why I participate in these kinds of discussions is so I can learn.
I still get the feeling that you think I'm attacking HFT. It's not "upsetting" to me. The only questions for me are whether there's more value in HFT than cost, and whether the same value could be had with lower cost. It's good to know that my Alice scenario is invalid, though. That means HFT isn't breaking what I thought was a useful scenario for sellers.
Thanks for the book recommendation. I've added it to my list.
I didn't say that anyone was ripped off. There's nothing inherently wrong with being a middle-man in a transaction. I just don't see that HFTs are adding any real value.
> What's missing from your explanation is time.
You're pretending that Alice and Bob placed their orders 20 minutes apart. That's not the game HFTs play. HFTs are playing games of milliseconds. It's not 12:20 and 12:40. It's 12:20:00.200 and 12:20:00.450. If Eve had taken the day off, Alice would have traded with Bob, and it would have looked just as immediate to both of them. And if there were a high risk that the market would tank immediately after Alice's sell order were placed, then Eve wouldn't have left her buy order on the book anyway.
If your 20-minute wait scenario were realistic, then sure, HFT would be adding meaningful liquidity. But then, it wouldn't be called high-frequency trading, and you wouldn't have written about how "speed matters".