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Sunday, August 5, 2012

Dark Pools: Understanding The World Of High Frequency Trading

I have spent a good amount of time recently studying the topic of high frequency trading. Just as with other areas of finance and economics, as I find and research information on the subject it opens up three or four new doors of a hidden world I had no idea existed.

I am currently listening to the book Dark Pools: High Speed Traders, A.I. Bandits, and The Threat To The Global Financial System. It is told in story form, almost like a movie, starting with characters that exist in the trading world today and then taking you back to the origins of electronic trading.

For anyone that owns or is interested in purchasing a single stock in their lifetime, the book is an absolute must read. The actual stock market that exists today is nothing like people imagine it to be. The level of dominance of high frequency trading in the markets and their impact on everything that takes place daily in the financial world is staggering.

I will give you a simple example of one of the many ways high frequency trading algos operate.

Most people have an allocation in their 401k to certain funds that purchase stocks for them. For some people this is their only form of investing; it is essentially run on autopilot. Every two weeks when they receive their paycheck a portion of the check is sent to a large firm such as Vangard or Fidelity to purchase mutual funds and add them to their portfolio.

When the fund managers receives these funds from investors all over the world they must enter the market and buy stocks for the mutual fund to hold. Because the orders are so large they can easily be detected by algos in the "pools" where funds are purchased.

For example, let's say that a fund manager wants to purchase 20,000 shares of IBM at 200 (its price that day). He pushes the buy button and waits for confirmation. The HFT algo can see this trade coming and it jumps in front of the order to purchase IBM at 200. This pushes the price up to 201, which means by the time the trade is completed the fund (average investors) pays a price that is .5% higher than what they would have.

The HFT trading algo then immediately sells the shares at a profit, essentially stealing the purchasing power from the mutual fund investors.

Most people would look at this simple example and say "who cares?" They do not care if they purchase IBM at 200 vs. 201 because it is just a small amount. Let the trading algo have their tiny profit, right?

The problem is that this occurs for every individual, brokerage, or mutual fund trade that is made every day. Everyone pays a "premium" to play in the stock market, essentially siphoning billions and billions of profits into the pockets of these trading machines daily. Over time and over a large enough amount of trades the numbers add up significantly.

Imagine if you were online purchasing a car. You get to the final page and you are ready to click "submit" to lock in on the order. As you press the confirmation button a message popped up on the screen saying "I'm sorry, another bid has arrived and the cost to purchase the car has moved from $40,000 to $40,400, would you like to proceed?"

The person purchasing the car would be furious, however, this happens to that person every single time they purchase a stock (which they are unaware of).

The danger moves much further beyond this immediate theft. The HFT machines created the now famous "flash crash" and they have been responsible for many of the major dislocations in the market over the past few years. I strongly feel that the flash crash was the warm up for the bigger event that is coming due to these machines. As quickly as they create liquidity in the market, they can take it away.

I will continue to track and monitor this fascinating topic in the months and years ahead. Its importance on the financial markets cannot be understated. In the meantime, if you would like additional reading and listening on the subject (beyond Dark Pools which I again highly recommend) I suggest you listen/read the following two excellent interviews:

The Casey Report: Interview With A High Frequency Trading Expert

Financial Sense Audio Interview: Eric Hunsader Of Nanex - HFT & Knight Capital