High-Frequency Traders Say Speed Works to Everyone’s Advantage

By Edgar Ortega, Jeff Kearns and Eric Martin

July 28 (Bloomberg) -- Frank Troise, the head of electronic equity trading products at Barclays Plc, says using computers to execute orders in milliseconds is no different than brokers jockeying for position years ago on the floor of the New York Stock Exchange.

“This has been going on for quite awhile, and it’s now at a fever pitch,” says Troise, 43, who is based in New York. “There’s always been an advantage to executing with speed.”

Policymakers are asking whether that advantage has become too great for so-called high-frequency traders, whose programs buy and sell shares up to 1,000 times faster than the blink of an eye. Defenders say the competition for profits that gave rise to today’s rapid-fire execution has roots that span decades and has helped reduce costs for investors.

About 46 percent of daily volume is handled through high- frequency strategies, according to estimates by NYSE Euronext, the world’s largest owner of stock exchanges. The transactions are made by about 400 of the 20,000 firms trading stocks in the U.S., according to Tabb Group LLC, a New York-based financial services consultant. Each makes bets in hundredths of a second to exploit tiny price swings in equities and discrepancies in futures, options and exchange-traded funds.

The firms compete for $21.8 billion in annual profits, according to Tabb. Among the largest are hedge funds Citadel Investment Group LLC, D.E. Shaw & Co. and Renaissance Technologies Corp., as well as the automated brokerages Getco LLC, Hudson River Trading LLC and Wolverine Trading LLC. Rapid- fire strategies helped equity volume more than double in the U.S. since 2006 to a record 10.8 billion shares a day last year, Nasdaq OMX Group Inc. data show.

Market Patterns

High-frequency programs look for patterns in securities markets. A typical strategy is based on the likelihood that a stock that rose over the past 20 hours will pare its gain, said Irene Aldridge, managing partner at Toronto-based Able Alpha Trading Ltd., a high-speed proprietary trading firm. Others sift through thousands of quotes to calculate the probability of a shift in the market.

“There’s a lot of brainpower involved in this,” said Aldridge, whose book “High-Frequency Trading: A Practical Guide to Algorithmic Strategies and Trading Systems” is scheduled for publication in January 2010. “It’s profitable if you can capture a few basis points and do it a few times a day, and markets have evolved to support this.”

Penny Increments

U.S. equity exchanges have catered to such clients since at least 1997, when the NYSE ended its century-old practice of quoting stocks in eighths of a dollar. It shifted to penny increments in 2000. That eroded earnings for NYSE and Nasdaq market makers, who profit from the difference between bids and offers. For investors, it helped reduce trading costs.

The exchanges sought to compensate for the lost business by paying rebates to high-frequency brokerages that buy shares at the best public prices. Exchanges have also overhauled their trading systems to cut transactions times and rent space in data centers so it takes less time to transmit information to buyers and sellers. Bats Global Markets processes orders in less than 400 microseconds, or 0.0004 second, which is about 1,000 times faster than humans blink their eyes.

As the strategies increased in speed, it became impossible for investors without advanced computer systems to get fair prices, according to some market participants. Firms handling large trades complained that brokers using complex algorithms fire off hundreds of orders and immediately cancel them in an effort to trick them into revealing plans to buy or sell.

Higher Volatility

“If you’re trying to buy a big block of stock, the algorithms notice,” said Bart Barnett, head of equity trading at Morgan Keegan & Co. in Memphis, Tennessee. “It increases volatility and has an adverse effect on the prices customers get on stocks.”

New York’s Charles Schumer, the third-ranking Senate Democrat, asked the Securities and Exchange Commission on July 24 to ban a practice in which some exchanges hold orders for a split-second before publishing them on competing platforms. Schumer said so-called flash orders are used by “sophisticated high-frequency traders” to get an edge.

At Bats, the third-largest U.S. stock exchange, about half of its customers use flash orders, Chief Executive Officer Joe Ratterman said in an interview yesterday. The system is open to everyone and allows brokers to submit prices that are more competitive because the delay gives them a way to anticipate moves in the market, he said.

Waiting for Orders

Ratterman said the danger of flash trades is that brokers may grow reluctant to post publicly accessible quotes, opting instead to wait for flashed orders. That doesn’t mean the deck is stacked against small investors, he said.

“The idea of haves and have-nots is just crazy to me,” Ratterman said. “Every firm in the U.S. has the ability to invest in the same way that every successful trading firm has done. Trading by definition is a competitive business.”

Ben Townson of New York-based BlackBox Group, which uses high-frequency strategies and specializes in algorithmic trading, says “natural abilities and skills” determine who makes money, not computers.

“You can throw a lot of money at technology, but if you don’t take the time to study your trades, it doesn’t matter,” Townson said. “We’ve built a racecar that is optimized for driving fast. Is that an advantage? Yes. Is it an unfair advantage? No.”

To contact the reporters on this story: Edgar Ortega in New York at ebarrales@bloomberg.net; Jeff Kearns in New York at jkearns3@bloomberg.net; Eric Martin in New York at emartin21@bloomberg.net.