The machines have taken control

A lot has been written about high-frequency trading (HFT), especially since the 2010 flash crash, for which HFT is at least partially held responsible. HFT even caught Hilary Clinton’s eye, proposing a plan to tax cancelled trades, thereby hindering HFT’s business.

In my experience as a stock trader, who watches order books all day and follows the workings of HFT’s closely, you see many signs of the subtle workings of HFT’s. We, human traders, often complain about these ‘machines’; especially the more senior traders, who grew up in a time in which trading was something that happened between humans, sometimes get frustrated by the seemingly random price movements caused by the machines.

I want to give you some clues about how HFT has changed the job of a human trader. This might also shed some light on why today there are fewer and fewer human traders. Today, if you buy quite a large sum of stocks, let’s say 50.000 stocks ArcelorMittal or 10.000 stocks Shell, 9 in 10 times you will experience a sudden drop in the stock’s price (+- 1%). That’s right:  a drop, not an increase. This didn’t use to happen a couple of years ago, but from a HFT perspective, the price drop is easily explained.

For suppose you aggressively buy 50.000 stocks, meaning that you buy 50.000 stocks on offer. This implies that a certain HFT is short 50.000 stocks. Assuming the HFT wants to have a net position of zero, this means that it has to buy back 50.000 shares. But it doesn’t want to make a loss: it wants to buy back the shares at a lower price than they were sold for. Being a market maker, hence controlling the order book and therefore the share’s price, the HFT removes successive levels of best bid. Now it waits for other HFT’s to fill up the order book, until it detects an offer of 50.000 stocks at a price lower than the price the HFT sold the stocks for. Now the HFT buys back the shares, hence making a profit. For the human trader, who is on the other side of the trade, this means that he starts his trade with a loss.

Another way in which trading has changed, is in the extremity of price movements. A couple of years ago, human traders would prevent certain extreme price movements from happening – by buying when they deemed a stock oversold, and selling when it was overbought. Machines don’t follow this logic. They go with the flow, and if the flow is selling, they are selling too. Hence you see price movements that either go up or down continuously, without any correction. Furthermore, price movements get accelerated due to the high speed of HFT. This explains the increased volatility; another side effect of HFT.

Another issue that can be extremely frustrating to a trader, is that your orders do change the price of a stock – even if they are not executed. Let’s say you want to sell x number of stocks. If x is larger than a certain size, HFT’s will detect your order as being real, and use it build their order books around. Meaning: if you are best offer for 5.000 stocks at 4.241, a HFT will put an offer in front of yours at 4.240. Before you can blink your eyes, another HFT will lay down an offer at 4.239. Now the next person buying will pay 4.239 instead of your 4.241. Hence, HFT’s prevent your order from being executed, and cause the price of a stock to go down. You can of course sell your stocks at market, hence paying the spread, but always doing so significantly decreases your profits. There is of course nothing wrong with HFT’s offering stocks at a price lower than yours; it is that, when you put down an order, regardless of the price, the dynamics of the price will change in such way that your order will not be executed – no matter whether you are buying or selling. This process is also described in Flash Boys, Micheal Lewis’ book on HFT.

Adding up all such changes, you can imagine why the traditional way of trading has become increasingly difficult for humans, possibly explaining why relatively fewer and fewer humans trade.