Dennis Dick
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
High Frequency Trading – The Good, the Bad, and the Ugly
January 11, 2013 - 2:41 pm
In the latest edition of CFA magazine, we take a look at various high frequency trading strategies and their impact on the overall market. You can read the article here:
High Frequency Trading – the Good, the Bad, and the Ugly
Copyright (2013), CFA Institute. Reproduced and republished from CFA Magazine with permission from CFA Institute. All rights reserved.
Market Fragmentation Flash Crash
December 13, 2012 - 2:03 pm
Today a number of stocks had a mini flash crash exactly one second before the market opened. The affected issues: C, HPQ, T, WU, HES, WFC, KR, VTR, GS, S, RAI, WMB, CRM, IBM, LUK, & TAP
HPQ traded as low as $3.06 as you can see on the tape:
Today’s flash crash in these issues was caused by market fragmentation and inefficient order routing. These sudden market moves were caused when an order was routed “direct” to the Nasdaq (NSDQ), bypassing liquidity on the other exchanges. SEC rule 611, the order protection rule, is designed to prevent “trade-throughs”, which are trades being executed at prices inferior to the best-priced quotations. But this rule only protects the top of the order book, and the rule does not cover the pre-market trading session.
To better understand SEC rule 611, consider the following example:
Security ABC order book on Ask:
Size Price Exchange
300 25.00 BATS
300 25.02 BATS
300 25.03 NSDQ
NSDQ receives a market order to buy 600 shares of security ABC. The best available offer is on the BATS exchange at $25.00. NSDQ must route the first 300 shares to BATS because this order is at the top of the order book and is a “protected quotation” under SEC rule 611.
But here is where it gets interesting. Having satisfied the order protection rule by routing the first 300 shares to BATS, the remaining 300 shares is now routed back to NSDQ and executes against the NSDQ’s $25.03 quotation. The $25.02 offer on BATS remains unfilled. In other words, the second BATS order is traded through.
The participant sending the order actually gets an inferior price being filled at $25.03 on NSDQ when they could have been filled at $25.02 on BATS, but the $25.02 BATS quote (because it was not at the top of the book), is not a protected quotation and not covered by SEC rule 611.
In today’s example, the trades occurred during the pre-market session, so even the top of the book is not protected. With market liquidity being fragmented across multiple exchanges, order depth on one specific exchange can in some instances be pretty sparse, especially during the pre-market session. Sometimes directed orders are large enough that they can sweep through multiple levels on the exchange, causing the stock to have a sudden fall in price on that specific exchange.
This is what happened today on these 16 symbols. As you can see, it is very important to route your orders carefully in this fragmented market structure.
Note – Nanex has done an excellent job at analyzing the details of today’s flash crash event. You can view it here:
A Five Minute Example of HFT Shenanigans
December 11, 2012 - 11:03 am
I was trying to buy 500 shares of a preferred stock this morning, Principal Financial Group Inc. series B (NYSE:PFG-B). It is such a challenge to trade any type of illiquid issue as the execution of orders is nearly impossible in this HFT world. Here is the sequence of events.
At 09:39:08, the stock is offered on EDGX at $26.29.
I place an order to lift the offer. The shares trade but I get filled on zero shares. Knowing that my bid will cause a bunch of HFT programs to penny-jump me (step ahead of my order by a penny - which they immediately do), I cancel the order. The HFT penny jumper cancels their order as well.
At 09:39:29, the stock is offered on EDGX again at $26.32. I place an order to lift the offer. The stock trades at the exact same second. Again, I get filled on zero shares. I cancel the order.
At 09:39:41, the stock is offered on PCSE at $26.29. I place an order to lift the offer. The stock trades at the exact same second again, but I get filled on zero shares. I cancel the order.
At 09:39:50, I place a hidden order to buy the stock at $26.32. Five second later the stock prints in front of me at $26.33 (Obviously these hidden orders aren’t as hidden as they should be). I leave the hidden order to buy at $26.32.
At 09:40:05, the stock prints right through my hidden order on another exchange at $26.30. So despite my bid being higher at $26.32, thanks to the fragmentation in the market, I get filled on zero shares again (and the seller gets a worse price!)
At 09:40:20, the stock prints through my hidden order again at $26.30. Again, no execution for me. Frustrated, I cancel my order.
A few seconds later, at 09:40:36 a couple of HFT programs battle out for the top of the order queue, and the bid changes rapidly, as you can see below:
At 09:40:40, the HFT programs go to battle again fighting for the best bid.
This battle continues for the next few minutes. In fact, during one period of time from 09:44:53 – 09:46:35 (a total of just over a minute and a half), the best bid changes over 800 times, as these two HFT algorithms battle to be at the top of the queue.
At 10:07:14, I finally lift an offer and pay up to $26.35. The HFT firm scalps their few cents from me, and all the games are over.
Some serious issues are highlighted in these few minutes of activity:
1) Inability for market participants to access a quote.
2) Excessive quote pollution as HFT algorithms battle each other.
3) Market fragmentation can lead to inferior execution.
4) HFT penny jumping can discourage market liquidity.
The bottom line is that all of these issues discourage participants from trading illiquid securities – making these securities even more illiquid.
* Update – Click here for charts of the liquidity and trading activity provided courtesy of Nanex.
The Dogs are Barking
November 26, 2012 - 7:08 pm
RIMM up 50% this month. HPQ up 10% since gapping down after the Autonomy debacle. BBY up 6.6% today.
What is powering the sudden surges in these perennial underperformers? Are these companies turning it around? Are these companies fundamentally better than they were a week ago?
Josh Brown at the Reformed Broker just answered this question in his blog post, “Here is an incontrovertible fact“, in which he discusses the real reason behind the sudden resurgence in these stocks. The answer is market sentiment.
Stocks move on short term supply and demand. When the majority of short-term market participants are on the same side of the trade, the price will almost always move in the opposite direction. The herd is always wrong. Too many participants have thrown these dogs out, and some real Johnny-come-latelies were recently shorting them. But sorry to break it to you Johnny, nothing goes straight to zero. There are always short covering squeezes, glimmers of hope, and market sentiment shifts. And the market sentiment has shifted for all of these issues. These dogs are barking.
You know what happens when one dog starts barking in the neighborhood, all the other dogs start barking as well. So don’t be surprised if some of these other dogs start gathering some short-term interest.
RadioShack (RSH)
Advanced Micro Devices (AMD)
Alcoa Inc. (AA)
Alcatel-Lucent (ALU)
ITT Educational Services (ESI)
Apollo Group (APOL)
Zynga (ZNGA)
Supervalu (SVU)
J.C. Penney (JCP)
The bottom line is that there may be some short-term upside in some of these issues, but don’t get married to any of them. Just because the dogs are barking, doesn’t mean they don’t all have fleas.
DRIPS – A Scary Tool For Investing
November 20, 2012 - 11:43 am
Many investment advisors advocate for the use of dividend reinvestment programs (DRIPS) in their client’s portfolios. Some brokerage accounts actually have the setting defaulted to automatically reinvest dividends into the underlying companies when a customer opens a new account. I believe this is a big mistake.
Take a look at the share prices of Best Buy (BBY) and Hewlett Packard (HPQ) today. They are making new 10 year lows. The business model of both of these companies is broken. However, both companies have had a history of paying a nice dividend. If an investor had been banking those dividends for the past decade, they may still be down in both positions, but they would have had a substantial amount of their initial investment recouped, just from the dividend checks.
The story is quite different if they participated in a dividend reinvestment program, as the majority of those dividend payments over the past decade would have been reinvested in the companies at much higher prices, eroding the value of all of those dividend payments.
The underlying problem with DRIPS is that very few businesses stand the test of time. Industries change, technology changes, consumer tastes change, and companies have to keep reinventing themselves if they are going to survive. In many cases this simply does not happen.
Just ask the shareholders of Eastman Kodak. It paid a healthy dividend for the past 50 years. If you had invested in the company 50 years ago, and had been banking those dividend checks, your initial investment in the company would have been worth a small fortune just from all the quarterly dividend payments you had received.
But if you had been participating in a DRIP, all of those dividend payments, and all of that cash would have been gone when Eastman Kodak filed for bankruptcy earlier this year. You would have lost it all.
DRIPS work great in companies that continue to grow and stand the test of time. But most companies do not. Placing all your bets that the companies in your investment portfolio will be there when you retire is simply a very scary bet to place. The best way to continue to build your portfolio is to bank those dividend checks and invest them in other stocks and other sectors. Those dividend checks are the natural way to diversify out of core holdings, because very few companies last forever.
