Interesting article on high frequency trading patterns


The Atlantic recently carried a fascinating article on the odd patterns in stock market data caused by mysterious high frequency trading algorithms which post and remove bids and asks on stocks with no intention of ever buying the stock in question. My best personal theory is that these mysterious bids and asks are simply ways of “pinging” the market electronic infrastructure for information about the speed and timing of the hardware running it. High frequency trading has become so fast that firms do their best to but their computers as close as possible to the exchange’s servers.

My guess is these bid patterns are just acting as clocks. To quote one of the experts in the article, the speed of light actually starts to matter. Given that the timing of trades can mean millions in profits for some of these firms, it stands to reason they would try to keep close tabs on the speed of their connection to the exchanges. By sending in a sequence of false bids (bids so far away from the current price and retracted so quickly they will never result in a buy) they can safely figure out how long it takes an order to go from their computer to the exchange’s computer. They use a sequence (ramp) of increases prices simply to keep track of all the different orders and their timing. (If they used the same price repeatedly, they’d have no way of knowing which order was which.)

My next best theory is that they are probing the HFT algorithms of other firms, trying to either reverse engineer other trading programs (which would give them a decided advantage) or search for some way to induce other programs to act in a way that can be exploited, like a big robot battle played with real money. They are trying to see if they can predict what others’ programs will do in a way that doesn’t require them risking any money. Frankly, I don’t see this as too likely, given that it would be very poor programming for anybody to let their HFT algorithm respond to ludicrous bids.

A final, rather crazy possibility, is that these false bids are a way to communicate between market participants over public, non-traceable channels. If encrypted information were embedded in the timing or changes of the bids, it would be a good way for firms to collude in a way that would be nearly impossible to trace: everybody is allowed to post bids, and every is allowed to read them. Unless you knew how to decode the information encoded, you’d have no way of proving information was being exchanged between parties. And what better avenue of communication between financial firms than the stock market’s public quote system?

One thing that is certain is that this frenetic activity, with hundreds of quotes a second being generated and cancelled, is clearly meant for the “benefit” of other computers, either at the same firm or another. It’s a fascinating phenomenon. I’m not sure what it portends for the markets, however. As people leave the market in droves (as evidenced by 13 straight months of mutual fund outflows) I wonder what will happen when the only people left aren’t people.


15 responses to “Interesting article on high frequency trading patterns”

  1. Jon,

    Your last possibility sounds like something Neal Stephenson would have used as a plot device in one of his novels.

    As always, an interesting post. Thanks!

    Alain

  2. I struggle to understand how this can occur with zero risk of having the trade executed. There must, I would think, always be some possibility of having a large move in the direction of the trade.

    I’ve never considered your last possibility – but I agree with Alain that sounds like the stuff of science fiction.

    – Michael (http://www.learntotradestocks.org)

    • Sorry for the delay, Alain. Since there was a link in your comment (which I appreciated, by the way) it got held for approval. I hadn’t seen that. The guy’s comment at the end is scary, about the future of Wall Street being computers battling each other intraday with humans only bothering to check at the end of the day. Scary because one of the guys running Wall Street could say something so dumb. Nobody should want that future. Eventually everybody would converge on algorithms that will simply be unable to beat each other, as the losers quit trading and the winners who stay are all essentially on the same level. Then it would be only a matter of something happening that causes the computers to want to get rid of the hot potato of holding shares, even if for a second, and then we’re going to get the world’s fastest market crash.

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  4. Interesting Jonathan – either those bids and offers could be a way of testing infrastructure speed as you say or may be a “large numbers theory” method to hit any bids or offers that may be in the market for just a split-second, in the off chance of a mistake or similar.

    Or, taking the logic further, that could be a HFT trying to hit bids and offers of some other HFT who may be using the same or a different strategy.

    Hope this makes sense 😉

    Very interesting plot in any case as Alain mentioned…

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  8. This practice is known as “order stuffing.” It has to do with sub-second delays between various ECNs and tripping up what are known as THOR algorithms. Early on HFTs arbitraged sub-penny price differences between various ECNs. This affects orders that cannot be filled by a an offer placed on one ECN. So, the order is routed to multiple ECNs in order to be filled. The problem (and conversly the opportunity for the HFT) is that there are sub-second delays between the order routing. Meaning, an order may post in one ECN fractions of a second before it posts in another. This alerts the HFTs to an order coming through and allows them to take the liquidity from the other ECNs before the other order is routed there. This means that the original order must now pay more for the transaction (on the subpenny level). To combat this, algorithms such as THOR were devised that delayed sending the order to a given ECN, so that it would post in all ECNs at the same time. Enter the HFT order stuffing era. In reaction to THOR, HFTs order stuff ECNs now. It’s essentially a way to artificially create traffic jams for the sole purpose of tripping up the THORS of the cyber world. Now delays in order routing aren’t caused by network access issues, but instead through the order stuffing. This artificially creates arbitrage opportunities for the HFTs.

  9. I’ve always wondered about high frequency trading. I know that it is very closely connected to AI trading where positions are opened and closed within seconds. Surely it this must have a devastating effect on human traders in general.

  10. Very interesting article… i wonder if good old fashioned day trading will be possible in a decade , or so? I mean how are you going to compete with algo’s and AI’s…food for thought.

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