Wall Street Loves High Frequency Trading
Flash Trading with Supercomputers is Very Profitable
Sep 7, 2009
With the budget deficit at an all time high in 2009, some Congressional Democrats are looking for ways to reduce the deficit by taxing the buying and selling of stock transactions. The amount of the tax they suggest is a tenth of a percent (.1 of 1%). This certainly seems small, and one would believe that such a small amount of tax would not meet with much resistance. How does that work? At the heart of this debate is using speed to make stock transactions; high frequency trading is bringing profits back to Wall Street.
Tax On Wall Street Trading
The tax is intended to hit Wall Street transactions where millions of buy and sell orders occur every day. Large brokerage houses like Goldman Sachs would feel the tax almost immediately. The intended effect would be to raise revenue, in the order of 50 to 100 billion dollars per year. The second intended effect is to discourage speculative trading which occurs with the use of high frequency trading. High-frequency trading firms represent approximately 2% of the 20,000 plus trading firms operating in the U.S. markets today, but they account for 73% of all U.S. equity trading volume.
High Frequency Trading – How it works
To employ high frequency trading, first one needs really, really fast computers. One can buy and sell transactions at incredible speeds, say at 500 milliseconds faster than your competition. How can that make a difference? Here is how.
Flash Orders
The NASDAQ rules state that once a trade occurs, the transaction must be posted electronically in no more than one second after the order is taken for the exchange to see.
So suppose an investment company needs to buy 5000 shares for its customer. The customer is willing to pay up to 21.04 per share. The investment company sees that only 1000 shares are available at 21.00, so they buy that amount. Now the rest must go to other exchanges to fulfill the buy order. The BATS exchange has 4000 shares @ 21.03. However, NASDAQ creates a flash order and it will remain in the system for 500 milliseconds before it is posted. It can only stay there for 1 second at most.
The investment company decides to buy 2000 shares at 21.02. Then it purchases the remaining 2000 shares at 21.03. It can now sell the stock to the buyer @21.03, below what the buyer was willing to pay. But here is the point, by shaving even 1 penny from the purchase price, the Investment company made a profit of 50 dollars with the flash transaction, without it the profit would have been 30 dollars. The process works only if the Investment Company has very fast computers that can make the transactions in about 500 milliseconds.
That is high frequency trading. If current estimates are correct that there are over a trillion transactions occurring per day, one can see how a penny here, two pennies there can add up to billions of dollars. That, by the way, is what Goldman-Sachs current projected profits in August 2009 are at; a portion of that came from high frequency trading with flash transactions.
Where the volatility occurs is at “the trading system sees order.” There is no trading system. The investment company ratchets up the price to see if there are any takers. If so, it does it again until it finds a taker that will spend the 21.02 or 21.03. But it doesn’t let the other investor buy the stock, it now knows what the other investor will pay; so it now pays that much. The other investor is out because the first investor was able to find the “hidden” price that the other had in mind to pay, and paid first. This is where Congress is concerned that there is manipulation in the transactions and can be detrimental to investors, and the market as a whole.
With High Frequency trading take that order and multiply it repeatedly with the use of the supercomputers, the investment company can attain a very good profit at almost no risk to itself. By analogy, flash trading is like knowing the opponents hand in poker; one will know when to play a hand or not.
For additional information see:
Traders Magazine, Peter Chapman, "SEC to Reconsider Legality of Flash Orders," http://www.tradersmagazine.com/news/-103830-1.html, 5/2009
Seeking Alpha, Karl Denninger, "Ban Flash Orders," http://seekingalpha.com/article/151562-ban-flash-orders, 7/2009
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