Trading in an HFT World
Presented to you by:
Dennis Dick, CFA
Bright Trading LLC
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presentation is for information purposes only.
The material in this presentation does not constitute advice and you should not rely on any
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DAMAGES, ARISING OUT OF OR IN CONNECTION WITH THE USE OF THE STRATEGIES AND
INFORMATION DISCUSSED IN THIS PRESENTATION.
Trading in an HFT World
Topics:
- Clear up the confusion: High frequency trading,
internalization, sub-pennying, flash trading
- Quick update on internalization, flash trading
- Trading Against the HERD
- Tape-reading examples – Identifying the herd
- Large size orders and the HFT tractor beam
HFT vs Internalizers
High Frequency Trading vs Internalizers
The majority of HFT firms are NOT internalizers.
 They are not responsible for the majority of sub-pennying.
 HFT firms typically trade on the exchanges. Sub-pennying is done
OFF-EXCHANGE.
 Important not to villainize the wrong participant
Internalizers operating on a high frequency level, are the real villain here.
 Approx 200 broker-dealers that internalize flow.
 Report trades to FINRA TRF.
Broker-Dealer Internalization
What is Broker-dealer Internalization?


When a brokerage firm acts as a dealer and internally executes
against its customer’s order (taking the other side of trade)
Alternatively the b/d may routes its customer’s order to an
internalization pool where other market participants will execute
against the order
- done off exchange – reported to a TRF – Trade Reporting
Facility
Reasons for internalizing:
1.
To avoid paying take fees.
2.
To receive payment for order flow, from internalizing participant.
3.
So internalizer can jump the displayed order queue.
Profit by queue jumping
Consider the following example:
Ticker: C
Bid
4.18
Size
30287
Ask
4.19
Size
48298
An internalizer can take the opposite side of their customer’s
market buy order and sell the stock at 4.19, jumping ahead
of the 4.8M shares offered there.
Similarly, take opposite side of marketable sell orders and
buy at 4.18 ahead of queue.
Sub-Pennying
Sub-pennying to improve 605 stats:
The SEC keeps track of price improvement stats in their rule 605 reports:
Internalizers will offer a few sub-pennies of price improvement to improve
their 605 stats, and give them justification for jumping the queue (price
improvement, and saving taker fee).
Eg. Sell C at 4.1899 or buy at 4.1801 in front of displayed NBBO.
Flash Trading
Flash Trading
HFT firm gets a ‘sneak peak’ at an incoming order.
 Done at exchange level
 Allows HFT firm to match or beat NBBO, which can lead to sub



pennying.
SEC has proposed a ban on flash trading, but is still seeking comment.
Most exchanges have voluntarily ceased the practice.
Exchanges that still offer flash trading – Direct Edge on equities, CBOE
on options.
Bottom line - some sub-pennying done through flash trading, but vast
majority of sub-pennying done by internalizers.
Quick Update - Internalization
Update – Internalization / Sub-pennying issues
 Number of firms discussing concerns with Internalization
 NYSE – discussed concerns in their Equity Market structure comments, and





support for Trade-at rule. Recently discussed concerns with flash trading in
letter to SEC.
Nasdaq – discussed concerns with internalization, and indirect support for
trade-at rule.
CFA Institute – two letters to SEC discussing concerns of NBBO being
compromised by sub-penny trades
Interactive Brokers – Thomas Peterffy publicly attacked internalization at
the General Assembly of World Federation of Exchanges.
Ewing Marion Kauffman Foundation – In an 88 page report, attacked
ETFs and internalization.
These reports can be viewed on http://www.defendtrading.com
Trading Against the Herd
Presented to you by:
Dennis Dick, CFA
What is the Herd?
The Herd of Traders





The vast majority of trading population.
Chase moves.
Copy strategies.
Last to get in the trade.
When the herd is in….you need to get out.
Why?
Because once the herd has entered the trade, there is no one
left to continue the buying or selling.
Retail traders - the Herd
Vast majority of HERD, is retail traders, and longer
term players (cause they don’t care about paying
an extra nickel to get in/out).
But their orders are now internalized. So you can’t
trade against them.
Regulation could help but in the meantime….let’s
stay profitable.
For most part on exchanges, it’s professionals
trading with other professionals now.
So we need to find the herd on the exchanges to
trade against.
Profiting from the Herd
How do I profit from the Herd?
Figure out which side the short-term herd is on, and
trade against them.
How do I figure out which side the herd is on?
Number of predictable spots to find the herd, but first we must
understand the strategy life cycle.
Strategy Life Cycle
Life cycle of a successful strategy:
1. Research and Development
- Finding the ‘Edge’ and back testing it.
2. Implementation and Production
- implementing it, and profiting from it.
3. Herd joins in
- other traders notice the edge, and exploit it.
4. Over-saturation and eventual unprofitability
- too many traders on same side of strategy.
5. Traders cease strategy (herd backs off), and strategy
may start working again (not always though).
Why do strategies stop working?
Why don’t successful strategies work forever?
 Because they get over-subscribed to.
 If a specific strategy is making money consistently, it
attracts more participants. As more and more participants
participate in that specific strategy (the HERD), it becomes
over-subscribed to and stops working.
 Eg. OPG strategy
 If a few traders doing it….no problems.
 Hundreds of traders doing it…..there won’t be enough fundamental
traders to bring the stock back up to fair value (in short-term).
OPG Strategy example
Example of Strategy Life Cycle – OPG Strategy
 Edge – Opening print too high or too low relative to fair




value.
Implementation – Surrounding Fair value by placing sell
short orders above, and buy orders below.
Why does this strategy work? Fundamental traders, index
arbitrageurs, pair traders bring price back in line.
Herd comes in – OPG traders begin to outnumber
fundamental traders, pair traders. Strategy is now
oversubscribed to.
Not enough fundamental traders to offset OPG traders,
OPG trades continue in direction of gap and becomes
unprofitable.
OPG Strategy example
Consider KO example:
Closing price = $60.00
S&P futures = down 1%
Fair value KO = $59.40
Opening price = $59.20, OPGers filled long on opening print.
If there’s only a few OPG players, fundamental traders, pair
traders, will press price back to fair value.
But if strategy is oversubscribed to, there will be vicious
shake-out as OPG players scramble for liquidity.
Often a play to get in after opening print, when OPG players
shake-out.
Option expiration
Why does this strategy work better on option
expiration?
More fundamental traders, option traders participating in market on
opening. They can often still outnumber OPG traders, even if there is
mass participation in the strategy.
So should I just do the OPG strategy on option expiration?
 I would say No…..I never cease doing a strategy completely, because
what is oversubscribed to, can become under-subscribed to quickly,
and can start working again. I reduce size when strategy is not
working, to limit losses.
What does this have to do with
HFT?
What does this have to do with HFT?
One HFT player can saturate a strategy.
 10 years ago, successful strategies lasted a while, as it took time before
traders over-exploited them.
 One HFT computer can process thousands of orders per second
 Kind of like 100 traders participating
 Dramatically reduces the life cycle of profitable strategies.
Tips:
 Protect profitable strategies.
 Continue to research and develop new strategies.
 Re-visit previously unprofitable strategies.
Identifying the Herd – Tape
Reading
Identifying the Herd by Reading the Tape
 Kind of a war going on – HFT vs Internalizers
 Internalizers have a strong upper-hand
 Internalizers will often trap HFT players in stocks
Lets consider the following example:
Consolidated Tape of AWR
• Notice all the sub-penny trades
- trading in front of ask
• No sub-penny trades printing in
front of bid
• What do you think happens next?
December 2, 2010
Time & Sales
Time
14:09:34
14:09:50
14:09:54
14:10:12
14:10:14
14:10:34
14:10:46
14:10:46
14:10:54
14:11:10
14:11:10
14:11:14
14:11:29
14:12:05
14:12:09
14:12:10
14:12:27
14:12:30
14:12:47
14:12:50
14:13:30
14:13:45
14:13:45
14:13:45
14:13:45
14:13:45
Ticker: AWR
Last
34.66
34.7191
34.66
34.7197
34.66
34.66
34.71
34.71
34.66
34.66
34.65
34.65
34.65
34.6899
34.65
34.64
34.68
34.64
34.65
34.62
34.56
34.625
34.6249
34.625
34.6249
34.6249
Share (100 lots)
1
3
1
5
1
1
1
1
1
1
1
1
1
5
1
1
1
1
1
1
2
3
3
1
1
1
Exchange
NYSE
FINRA TRF
NYSE
FINRA TRF
NYSE
NYSE
NSDQ
PCSE
NYSE
NYSE
EDGX
NYSE
NYSE
FINRA TRF
PCSE
NYSE
FINRA TRF
NYSE
NYSE
NYSE
NYSE
EDGX
FINRA TRF
EDGX
FINRA TRF
FINRA TRF
AWR Continues Down
• Continues downward move, as
traders can’t get out on offer (due to
internalizers, sub-pennying ask
price.
• Traders (the HERD) are trapped
long, unless they pay spread.
December 2, 2010
Time & Sales
Time
14:41:20
14:41:20
14:41:37
14:41:50
14:42:26
14:42:34
14:42:47
14:42:47
14:43:06
14:43:10
Last
34.49
34.49
34.44
34.45
34.43
34.43
34.42
34.42
34.39
34.38
15:59:53
15:59:57
15:59:59
15:59:59
15:59:59
15:59:59
15:59:59
15:59:59
16:00:00
16:00:00
16:00:43
16:01:33
16:03:43
34.10
34.09
34.10
34.10
34.09
34.12
34.13
34.10
34.10
34.10
34.09
34.10
34.07
Ticker: AWR
Share (100 lots)
1
1
1
1
1
1
5
5
4
5
1
1
5
3
2
1
1
1
1
1
8
2
60
Exchange
NSDQ
EDGX
BATS
EDGX
FINRA TRF
NSDQ
NYSE
BATS
FINRA TRF
NYSE
PCSE
NYSE
NYSE
NYSE
NYSE
NYSE
NYSE
PCSE
PCSE
NSDQ
FINRA TRF
FINRA TRF
NYSE
Trapped Short-term Traders
AWR – 2 day chart
The HFT “Tractor Beam”
What is a “Tractor Beam”?
 Defined – a device that attracts an object from a distance
 Remember Star Wars – the Millenium Falcon would get
caught in the Death Star’s Tractor Beam
- Once it was in the Tractor Beam, there was no escape.
- The falcon would be pulled into the Death Star.
Large size on a stock, can act like a tractor beam,
pulling the stock towards the size. We’ll explain this in
a minute, but first, we have to understand Rebate Trading
and the concept of providing and taking liquidity.
Providing Versus Taking Liquidity
Liquidity providing versus Liquidity taking:
Providing Liquidity: If you place a passive bid, or passive offer, you
are a liquidity provider. You have added a bid or offer to the market.
Typically, if your execution is not immediate (for orders placed
during market hours), you are providing liquidity.
Taking Liquidity: If you take an offer or hit a bid, you are a liquidity
taker. You have removed a bid or offer from the market. Typically, if
your execution is immediate (for orders placed during market
hours), you are taking liquidity. ALL market orders take liquidity.
Rebate Trading
What is Rebate Trading?
 Defined – The practice of buying and selling stocks to
capture the liquidity rebates given by the exchange.
- Liquidity rebates are given by the exchanges to
encourage the practice of displaying liquidity, and adding
depth to the market.
High Frequency Traders with a low commission structure, can
profit on trades that are scratched, by providing liquidity and
capturing the exchange given rebates.
Leaning on Size
HFT players lean on Size:
 Rebate trading is a low return game, so therefore need to




have low risk to remain profitable.
HFT rebate traders trade thicker stocks like C, Q, S.
But they’ll also trade thinner stocks if they have some size
to lean on.
The size is like their insurance.
Alternatively, internalizers (because they have early access
to order flow) can lean on any order, so they really don’t
need the size.
What is a big offer?
What do you consider a big offer?
 It’s all relative to the stock’s volume
 If a stock trades 100K shares a day, a 5K share offer may
be considered large
 If the stock trade 2M shares a day, 5K share offer is
meaningless
 Don’t be confused with the envelope traders, those are not
real bids/offers - orders are pegged to NBBO
The HFT Tractor Beam captures
the Stock
Think of the Millenium falcon as the current price of the stock. Think of the Death Star as
the Big bid or Big offer.
If the Falcon flies outside the reach of the tractor beam, it will not be affected by it. But if it
gets too close, it will get captured by the beam, and pulled towards the Death Star.
Same thing for the current price of the stock, if it gets too close to the big size, Rebate
traders will jump in, and “capture” the stock price pulling it closer and closer to the big
size.
Mechanics of the “Tractor Beam”
Mechanics behind the Tractor Beam
 HFT rebate traders see the large offer, and place sell short orders in
front of it.
 As they get filled on their shorts, they immediately bid the stock, adding
support. As more and more rebate traders get filled on their shorts,
they place more and more bids.
 It takes a lot more selling pressure for the stock to go down because of
the added bids. Therefore the path of least resistance is towards the
size, pulling the price of the stock towards it.
 As time passes, and the stock price gets closer to the larger offer, the
rebate traders get nervous about missing the offer and getting caught,
they then cover on the size.
Tractor Beam is Gone, how fast?
Tractor Beam is getting taken out, what now?
Two Scenarios:
1. Size goes quickly (often in one or two large
prints).
- HFT rebate traders are caught.
- This will cause the stock to spike quickly, as rebate traders
panic, and drive the price higher, out-bidding each other.
2. Size goes slowly (large number of small prints).
- HFT rebate traders get covered, and the HERD actually has time
to get long for breakout
- If they are not caught, stock may have a vicious shake-out as
there is no longer the rebate trader bids to support the price,
and there is added selling pressure from the traders who just
speculated on a breakout. When stock doesn’t breakout, HERD
stumbles over each other trying to get out, driving the price lower.
Summary
Summary of trading tactics in HFT world
 Take liquidity, because internalizers will sub-penny your




passive orders
Be conscious of the HERD, if everyone is on same side,
trade is bound to go the other way.
Research and Develop new strategies, as HFT has
dramatically reduced the life of successful trading strategies
Read the Tape, follow the sub-penny prints and FINRA TRF
to see what side the internalizers are on.
Sizeable orders tend to get printed, so leaning on size
game is over for manual traders.