Who's Afraid of HFT?

Uh oh… The “bots” are at it again.

“A single mysterious computer program that placed orders — and then subsequently canceled them — made up 4% of all quote traffic in the U.S. stock market last week,” CNBC reports.

The market data firm Nanex — which tracks high-frequency trading more closely than anyone else — spotted orders on about 500 stocks, placed in 25-millisecond bursts.

The motive? That’s murky. “The ultimate goal of many of these programs,” CNBC speculates, “is to gum up the system so it slows down the quote feed to others and allows the computer traders (with their co-located servers at the exchanges) to gain a moneymaking arbitrage opportunity.”

“Just goes to show you,” says Nanex chief Eric Hunsader, “how just one person can have such an outsized impact on the market.”

The blogosphere is on fire: “The markets are not for you, nor are they for honest companies,” says one representative post. “They have been stolen by the Wall Street bandits and now are used as a tool to screw you and everyone else.”

We take a back seat to no one in our suspicion of the Street. But in today’s 5, we pause to take a deep breath…

“Most talk about high-frequency trading is media sensationalism,” says Jonas Elmerraji, one of our resident traders and technicians.

“It sounds scary and conspiratorial, but in reality, the vast majority of HF trading algorithms don’t exist to trade against individual investors. They exist to keep the real investors at big mutual funds from blowing up the market when they need to put a big order through.”

Consider, Jonas says, SPY — the S&P 500 ETF. “It’s the biggest ETF in the world. It’s got close to $109 billion in stocks. If it needs to sell a position (say, if a stock is dropped from the index), it could materially impact trading volumes for the day and ruin the prices it gets for its shareholders. So the managers at SPY use HFT algos to ensure that any liquidations happen without hurting themselves.”

Consider also that the mystery algorithm didn’t execute any trades. “That means that by definition,” Jonas explains, “it didn’t impact the market — it never made a print on any of those 500 stocks.

“In fact, it sounds like it was maybe there to fake other HFT bots into making poor trades. If that’s the case, then it means that individual investors probably got better fills than the bots.

“I think for my Halloween costume this year, I’m going to be a trading algorithm. Any of my friends who watch CNBC will be terrified!”

Still, the latest HFT episode spotlights some common-sense advice.

HFT alarmists say when it comes to your own buying and selling, it’s best to avoid the first 15 minutes of the trading day from 9:30-9:45 Eastern Time, and again between 9:55-10:15, when many economic numbers are released.

True, says the other member of our trading and technical team, Greg Guenthner: “The morning bell until 10:30 is usually referred to as ‘amateur hour’ — Everyone is jockeying for position and trying to figure out the mood of the day. Data or news that looked ‘good’ at 8 a.m. might not be seen as good by the collective market once trading begins. Early morning mood swings are common — which is enough reason to avoid buying unless you’re a day trader.”

“I always wait until 10 a.m. to execute a trade,” adds Jonas, “even if something is moving against me. Exceptions include the big names like Apple or GE that have very active premarket trading with narrow bid-ask spreads anyway.”

And avoid market orders. “There’s just no reason to use them,” Jonas says.

Cheers,
Addison Wiggin

The Daily Reckoning