High frequency trading
This morning there was an article in the New York Times describing high frequency traders- what they do and how they want people to like them. I’m of the mind that there’s not much to like.
NOTE: Please see update!
High frequency traders are basic, old-fashioned opportunists. They buy somewhere and try to sell somewhere else cheaper. They have expensive technology and colocate next to exchanges to deal with speed-of-light issues to shave off tiny fractions of seconds for their trades. They notice a currency change in Brazil and trade on it in the US before anyone else notices. That kind of thing.
They will tell you that they are useful to the market, because they have set the bid-ask spread smaller than it used to be. Back in the day, there were official “market makers” who would maintain a book of certain instruments, and would be the go-to person for anyone who wanted to buy or sell. In return for the service they would charge a fee, which would be this so-called spread. Moreover, they were required to offer to buy and to sell in all kinds of trading environments (the spreads could get pretty wide of course).
It’s true that those spreads have gotten smaller since high-frequency traders have come to dominate. They have substantially replaced the old-school market makers and claim to be doing a better job. However, it’s also true that high-frequency traders aren’t required to be there. So when the going gets tough they completely vanish. This happens in moments of panic, and it can easily be true that their ability to vanish at will can also create more panics more often (I’d love some evidence to support or deny this theory), since from their perspective, at the first sign of weirdness, they may as well pull out until the dust settles.
The analogy I like to come up with is a little story about chores. Suppose you have someone who comes and helps you with your cleaning, mostly dishes, every day, for a small fee. Since you have kids and a job, the small fee seems to be worth it. After a while someone else comes along and offers to do your dishes every day! for free!! What a deal! You can’t resist. However, it turns out that, if the kitchen actually gets really dirty and needs to be mopped up or seriously cleaned, the free-dishes guy is nowhere to be found and you’re on your own, just when all the kids are sick and there’s a product release at work. Maybe not such a great deal after all.
mathbabe 
I work in the industry, so it often amused me at seeing some posts about it. Most of the information out there is terribly wrong, and me and my co-workers (I’ve been at a few firms) routinely laugh at how incredibly wrong it was, often wishing it was as easy as everybody makes it out be. They think we just turn a computer on and go to the beach all day. You post actually doesn’t propagate many of the false claims you see out there, thankfully.
I saw the update and the other person described how traditional market makers had to obligate to post a narrow two-sided quote, so them being in the market can also me way outside anywhere anybody would want to trade.
However, I’d like to touch on the reason many HFT firms will run and hide when big runs come.
When trades happen way off the previous trade prices, the venue can break the trade after the fact. Let’s say ABC had been trading around $10.00 the last couple days and something happens today (a trader in Japan fat fingers a number for example). ABC runs all the way up to $40.00. Your computer notices a $0.05 mispricing between ABC on NASDAQ and futures for ABC on another exchange. So you buy on the futures exchange and sell on NASDAQ.
Now NASDAQ decides the price was clearly erroneous, and breaks the trade. Where at one time you were hedged, now you have an unhedged position in the equity. In the mean time, the stock has fallen back down to $15 (the fat fingered order was a good order, just for the wrong price or amount).. For staying in the market you just lost $25 a share and still have an open position you now have to cover for probably even more losses.
This is why a lot of HFT people pulled out of the market during the flash crash. The ones that actually stayed in made a lot of money. I think it was with GETCO where I saw that they cleaned up.
It isn’t them being afraid of volatility, on the contrary, most HFT places thrive on volatility. It is the uncertainty that trades will be broken or repriced leaving them holding a potential very ugly and losing position.
I think most in the industry would actually really like trade collars to be standardized and trade break or repricing rules to be laid out. It would make it easier to evaluate risk. However, this is only a very simple situation. As the trading strategy becomes more complex and has more legs, it becomes almost impossible to prevent this situation. Not sure of there is a good solution, but the linking of the markets that HFT provides, like this example, translating the liquidity from the futures market into the cash market, definitely makes the US markets the deepest in the world.
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During the flash crash, HFT’s who stayed in made a boat-load of dinero. I think it’s up to each firm whether they want to risk the volatile markets or not. It has to depend on how they make their money.
Check out Euan Sinclair (filthy)’s reply to the Reverse Kolmogorov-Smirnov jokes here: http://www.nuclearphynance.com/Show%20Post.aspx?PostIDKey=138073&PageIndex=1. Market making is one of the few “sure-thing” ways to make money, other than speed or a new arb.
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