Friday, July 24, 2009

Fancy Tradin'!

AlphaNinja - The NYTimes, late to the party, has a great article this morning on HFT, or High Frequency Trading. The stuff is complex and of little use to most investors, but it's a huge part of the market's daily swings, so worth passing along...People are worried that without HFT and PT (Program Trading), the market would be seriously lacking in liquidity.

Some of the trading involves front-running other investors, and benefiting from their purchases. But there are literally thousands of strategies being employed that make up for a massive about of the daily stock market volume.

"For most of Wall Street’s history, stock trading was fairly straightforward: buyers and sellers gathered on exchange floors and dickered until they struck a deal. Then, in 1998, the Securities and Exchange Commission authorized electronic exchanges to compete with marketplaces like the New York Stock Exchange. The intent was to open markets to anyone with a desktop computer and a fresh idea.

But as new marketplaces have emerged, PCs have been unable to compete with Wall Street’s computers. Powerful algorithms — “algos,” in industry parlance — execute millions of orders a second and scan dozens of public and private marketplaces simultaneously. They can spot trends before other investors can blink, changing orders and strategies within milliseconds.

High-frequency traders often confound other investors by issuing and then canceling orders almost simultaneously. Loopholes in market rules give high-speed investors an early glance at how others are trading. And their computers can essentially bully slower investors into giving up profits — and then disappear before anyone even knows they were there."

Getting a "peek" at orders before the order is shown to everyone? Not fair. I'd expect some uproar over this practice.

More straightforward are the thousands of computers hunting for arbitrage situations all day long, and "pairs trading" opportunities like the one example I put together below.

The relationship of INTC and SPY shares changes each day, but over the last year the average has been .2 (.2 times the SPY share price = the INTC stock price)-->> Short INTC and buy SPY when that ratio rises, and you capture the spread as it (hopefully)reverses. The further the spread goes from the average, the larger the profit opportunity. Now picture hundreds of funds doing thousands of these trades daily, sometimes watching for MUCH smaller spreads that can reverse in seconds....Some people are speculating that such trading accounted for almost ALL of Goldman Sachs' recent quarterly profit -YAY CAPITALISM!

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