« Breaking Down – Premarket Stock Talk
Quadruple Witch – Premarket Stock Talk »
Stealing Executions
One certainly cannot argue with Jim Chanos’ track record, and his market calls have been extremely impressive. His calls on the slowdown in China, and the unsustainability of the solar industry have been spot on. However, we disagree with some of his comments on CNBC this morning regarding high frequency trading (HFT).
Jim Chanos explained that HFT does not really affect his trading because he has a very low portfolio turnover, and uses limit orders. While we agree with Jim that HFT has less of an effect on traders with longer time horizons, we fundamentally disagree with his analysis that traders who use limit orders need not worry about high frequency trading.
Limit orders, in our opinion, are the most abused order type in the market today. High frequency traders have the ability to jump the limit book order queue by intercepting retail market orders BEFORE they get to the exchange, leaving limit orders unexecuted.
When an investor places a passive limit buy order onto an exchange, the order sits there resting until a contra-side sell order executes against it. Let’s assume that the investor’s buy order is the best bid on the exchange. A retail investor sending a market sell order to the exchange should normally interact with this passive buy order. This is the basic fundamental principle to a public market, buyer meets seller.
However, in this HFT world, we have an HFT middleman that intercepts the market sell order and they trade directly against that market order which should have interacted with the best bid, leaving the investor’s bid unfilled.
In plain english, they STEAL THE EXECUTION.
How do they do this?
Privileged HFT participants buy order flow from retail brokers and trade directly against retail market orders BEFORE they get to the exchange. Shocking, isn’t it? Your broker sells your order to an HFT firm, who in turn trade directly against it. This practice is known in the industry as internalization. The payment your broker receives is referred to as payment for order flow.
How often does this occur?
It is estimated by the SEC that nearly 100% of retail market orders are routed to HFT internalizers.
What is the cost to the limit order traders?
Statistics from Nanex show that these losses add up to billions of dollars per year for limit order traders.
The scary thing is that the Nanex estimates are conservative, because they only track those executions where the HFT internalizer actually give price improvement to the retail market order. In many instances the HFT internalizer gives nothing to the retail market order. They simply steal the execution, giving no benefit to any investor whatsoever.
The bottom line is that limit order traders are substantially disadvantaged by these HFT internalization practices, and the costs to these limit order traders is in the billions of dollars per year. So if you think limit orders will save you from HFT abuses, your portfolio is likely part of those billions of dollars in losses suffered by the investing public.
This entry was posted by Dennis Dick on September 20, 2012 at 2:16 pm, and is filed under High Frequency Trading. Follow any responses to this post through RSS 2.0. You can skip to the end and leave a response. Pinging is currently not allowed.
I agree with you on the general “badness” of private payment for order flow because it undermines price-time priority in lit markets, but I think that two important clarifications are in order:
First, there are plenty of HFT algorithms that don’t purchase order flow. Even firms who purchase order flow are expected to have a Chinese wall in between their retail operations and proprietary operations (though obviously there is a moral hazard). Your article is painting with a rather large brush-stroke, demonizing HFT as a whole when payment for order flow is the real issue here.
Second, while I agree that the “stolen execution” is a problem, I think it has very little impact on retail traders. If the retail limit order is at the top of the book, then the only way that it will fail to execute is if that price level doesn’t trade through at for the rest of the day. Effectively this means that the retail trader has lost the opportunity to buy at the lowest daily price, or sell at the highest daily price; but no opportunity is lost in between.
Hi Wink, thanks for the feedback.
On your first point, I agree. The media paints a very bad picture of HFT, where many HFT strategies do add value such as stat arb. Not my intent here to villainize the entire industry. But more and more HFT firms are participating in internalization and buying order flow, and that is the area that I am concerned about in this article. Completely agree that payment for order flow is the real issue here.
On your second point, I disagree with your synopsis that no opportunity is being lost between the low of the day and the high of the day. Many retail traders used to scalp during the day, and these “intraday” profits are being lost to HFT internalizers. For example, if a retail trader places an order to buy stock XYZ at 25.00, and the stock trades to that limit, then takes off and trades up to 25.20, then back down to 25 and through, that trader (while they were filled on their order at 25 on the second time through), has missed the opportunity to participate in the first 20 cent move up. Your synopsis does not account for these lost “intraday” profits. In a stock like BAC, internalizers can trade between the same bid and same ask for sometimes hours, while the same participants sit unexecuted on the bid and the ask. These intraday lost executions can add up to meaningful opportunity costs for retail intraday traders.