Dennis Dick, CFA, is a proprietary trader, and market structure consultant with Bright Trading LLC. He has twelve years of proprietary trading experience specializing in pair trading, crutch trading, momentum, contrarian, technical, and algorithmic trading. His insights into equity market structure have been cited in a number of financial publications including the Wall Street Journal, Reuters, Dow Jones, and Forbes. Dennis is a regular contributor at CFA magazine, and a member of the Capital Markets Policy Council at the CFA Institute. He holds his Business Degree from the University of Windsor with a concentration in Finance and Economics.
Posts by Dennis Dick
Harris Corp reported preliminary earnings tonight. They cut their 2013 outlook and announced job cuts, which is obviously not good for the stock. HFT news algorithms specialize in trading off these headlines and picking off limit orders that are out to lunch.
Check out the tape:
The news was reported at 16:20:00. Notice the time it took the HFT news algorithm to respond to the news – instantaneously.
It is a very dangerous game to make markets after hours in this HFT world, and the traders that bought this stock between $45 and $46 just learned the hard way, as the stock is now trading at $43.50.
They were sitting ducks.
Doug Clark, managing director of liquidity research for ITG Canada, was recently interviewed on TabbFORUM in a post called “Dark Pools & Private Schools”. In his interview, Clark questions Canadian regulators for their recent regulation of dark pools. He compares the restrictions placed on dark pools to prohibiting parents from sending their kids to private school.
But his analogy is flawed.
In his analogy, the parents are the ones choosing to take their kids out of the public school sector, to place them into the private school sector. But in many cases the retail investor is NOT the one choosing to send their orders to a dark pool. In some cases, they don’t even have a choice. It is often the broker/dealer controlling the routing, and making that choice for them (usually based on the payments they receive from routing their orders to a specific OTC market maker or dark pool). Following Mr. Clark’s analogy, this would be equivalent to the education authority taking kids out of public schools and placing them into private schools without the parent having any say, and getting paid to do it!
Secondly, the reason the parent would move their child from a public school system to a private school system is to receive some sort of benefit – better food, better teacher to student ratio, better security, better programs, as Mr. Clark mentions in his interview. But what is the benefit that the customer is receiving by having their order routed away from the public exchange? The chance to receive sub-penny price improvement on their order? These fractions of a cent give little nominal value to the customer, but have a significant effect on deterring displayed liquidity, especially in thinly traded issues.
Consider the following example.
Assume stock XYZ has NBBO:
Bid Size Ask Size
25.50 500 25.70 500
A retail investor places a market order to buy 500 shares of the stock. The order is routed to an OTC market maker who gives sub-penny price improvement to the order, and executes the buy order at 25.6999.
Instead of paying $12,850 for the stock, the retail investor pays $12,849.95 for the stock, saving a whopping nickel.
But the participant who placed the 25.70 limit order on the exchange, the displayed liquidity provider, is left unfilled.
Imagine if you were that participant that should have received an execution, but did not because your order was stepped in front of at the moment it was about to be executed. This leaves you with an unquantifiable loss, the loss of the missed trading opportunity.
Now imagine a different scenario:
Assume the same NBBO:
Bid Size Ask Size
25.50 500 25.70 500
A retail investor places a market order to buy 5000 shares of the stock. The OTC market maker, knowing this order will impact the price significantly, does NOT step in front of the 25.70 order, and allows the market order to route to the displayed market, taking out the 25.70 seller, and trading all the way up to 26.00 to fill the balance of the order.
The 25.70 limit order trader is immediately down 30 cents on the trade.
The routing of retail order flow away from the displayed market has distorted the risk-return matrix of displayed market makers, and they are hesitant to make markets in smaller stocks as a result of the increased adverse selection risk.
In fact, the matrix has become so distorted that our firm, Bright Trading LLC, recommended to our traders that they stop providing liquidity in small and mid cap stocks entirely. The rationale is simple, if you get filled on your limit order, it is usually because you are on the wrong side of the trade, and the price often blows right through you.
Therefore, there is little point to displaying liquidity in these issues, as the return no longer justifies the risk. Our traders have learned this the hard way. The OTC market maker steps in front of your order when it is on the right side of the trade, and allows your order to be filled when it is on the wrong side of the trade.
We believe that the distortion of the risk-return matrix of displayed market makers due to internalization, is the main reason that we have liquidity problems in the small and mid cap space. It is apparent that the Canadian regulator (and now ASIC) have similar concerns.
To rectify the situation, the Canadian and Australian regulator have mandated that orders routed away from the public exchanges receive meaningful price improvement over the NBBO. That way at least there is some benefit to the end customer from the routing of their orders away from the public exchange. It should also help to deter OTC market makers from stepping in front of limit orders, as they now have to assume increased risk (by giving meaningful price improvement) when internalizing a retail market order.
But ASIC may go further. In their recent report on dark liquidity, not only are they mandating meaningful price improvement, but they are also proposing a trigger to implement a minimum dark order threshold, to apply to securities where there is evidence that dark liquidity has caused degradation in market quality.
These actions by the Canadian and Australian regulator should be applauded as opposed to questioned. Displayed limit orders are the building blocks of price discovery. It is imperative that we protect these orders. The new policy decisions of the Canadian and Australian regulator should help to improve the risk-return matrix of displayed market makers and encourage market participants to display limit orders more aggressively, which should improve market quality in these countries.
Every once in a while a key technical level becomes so relevant, that every time the stock moves away from that level, it gets pulled back towards it. I call these types of levels “magnets”.
Take for example the 55 level on LLY. For the past 8 trading sessions, LLY has found incredible support at this level. In fact, it has bottomed near the 55 level in each of the past 8 trading sessions. Every time the stock starts to pop, it gets pulled back by the force of the 55 magnet.
Technically, the magnet continues to hold for a number of possible reasons:
1) Traders have identified this area as support and continue to buy the stock in this area. As the stock rallies, those same short-term traders scalp out of their longs which doesn’t allow the stock to gain any significant upside momentum. Eventually the stock just collapses back.
2) Short-term traders have identified the relevance of the 55 level and continue to short the stock when it pops. Again the stock cannot gather any upside momentum to break the force of the magnet.
Regardless of the cause, if a trader can identify these magnet levels early on, there can be some significant opportunity to profit from these “Magnet Trades”, by simply fading the moves away from the level of significance.
Some market participant is running a very aggressive news algorithm. At 16:10:10, Procter & Gamble (PG) lowered their 2013 guidance down slightly, citing devaluation of Venezuelan currency. The news algorithm went to work, responding instantaneously to the news. Here is the tape:
(Note the ticker tape reads from the bottom-up)
As you can see from the tape, the news algorithm sold the stock down to a price of $74.10. The stock a few seconds later jumped back up to $76. This algorithm just threw away a huge chunk of change as nearly 10K shares were sold at the bottom.
These trading overshoots have been happening a lot lately, especially in the most recent earnings season. I wonder if the participant that is running this algorithm will eventually stop running it so aggressively as it appears to be burnings some serious cash.
Two HFT algorithms battled it out for 12 minutes today in preferred stock FNFG.PRB. Both of these algorithms wanted to be the best bid. One algo bids $29.45, the other penny jumps and bids $29.46. Then the other penny jumps back and bids $29.47, the other algo follows and bids $29.48. They battle up to a bid of $29.62 at which point the one algo cancels and moves its bid back to 29.45, and then the cycle repeats itself. This battle continues for the next 12 minutes with the bid price changing more than 6000 times. Total shares transacted on the exchange during this period is zero.
Take a look at the video to get a feel for how quickly the quote was changing:
Note: Video shows entire 12 minute period of algo loop that repeats itself every two seconds.
Yesterday, the SEC held a roundtable discussion on decimalization. Some participants suggested a pilot program which would change the minimum quoting increment in the mega-caps to tenths of a penny from the current penny. Could you imagine the quote traffic when algos battle for the top of the book in sub-pennies? At least Nanex will have fun analyzing all the quote pollution.