Algo trading has been around longer than HFT. It was invented to protect the information that that a big order was being executed. This avoided the risk of front running by handing the order to humans or scaring liquidity providers by executing it all at once.

HFT came about when computerized exchanges began to compete with each other for business. Nowadays you go hunting for liquidity. Speed differentials are more important.

I think the OP is likely to agree up until here.

Today HFT in its worst form amounts to high speed computerized rumor mongering. You game the market by bluffing orders and trading faster than your customers. The regulators will never catch on and try to fix it even thought the remedies are many and simple. Moreover our attitudes about who owns information make it very difficult for us to even consider these simple solutions.

Though I do get a chuckle out of the extremely bombastic stories ("MAN OBSOLETE? COMPUTERS TAKING OVER!!!"), it's nice to see the record set straight. Sadly this will get 1/10000th of the page views of the garbage articles it dissects.

HFT is a subset of algorithmic trading. It's as simple as that. Not all algorithmic trading is HFT. But all HFT is algorithmic trading.

Algorithmic trading is any type of trading done based on an algorithm, and not based on "traditional investing principles". For example, "buy when the 10-day moving average crosses over the 20-day MA, and sell when the 10-day it crosses below 20-day". One of the most famous types of this is Richard Dennis and the Turtle Traders, where a successful commodities trader took a bunch of ordinary people and tried to turn them into traders using this method.

I'm also an algorithmic trader. Not a wildly successful algorithmic trader yet, but I'm still learning and growing, and I love it more than any programming venture I've ever been involved with. And I haven't taken a catastrophic loss yet, so that's good. I trade on 3 separate markets using different algorithms, and for the most part it is fully automated. I'll hold futures contracts anywhere from 1 seconds to 20 mins.

HFT is several orders of magnitude more intense. For the most part, they are types of arbitrage, where they can arbitrage a few cents worth of difference in stock prices between different markets, and make a few pennies per 1000 shares. Or they will arbitrage between the price of an ETF or futures contract and the underlying basket of stocks that it represents. These are the ones that need colocation and trade on the millisecond. The more nefarious ones are the ones that game the system, by "quote stuffing", by frontrunning large orders by institutions, or by creating volatility through momentum-trading.

Is there a downside to algorithmic trading? Sure. Algorithmic trading is what has turned the stock market from a predictive market of future earnings, into essentially a casino, where the predictive nature of the markets is completely dead. Instead, it's about thousands of computers running random number generators and picking up nickels every 10 ms. This is why I believe there will be market crashes every 7-10 years, and long term investing is dead.

But unfortunately, this is the reality of the system that we live in, and we have to adapt or die. Or you can just buy bonds and get a stable 3-5% return every year, which is nothing to shake a stick at.

In which case is this not a rather thin hair to split?

Doing this type of trading doesn't require millions of dollars and teams of PhDs. You don't have to know the right people and you don't have to know any secret handshakes.

Critics of high frequency trading are almost always misinformed. Some of the most informed critiques I have read about this stuff are the following books:

"A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation" by Bookstaber

"Traders, Guns and Money: Knowns and unknowns in the dazzling world of derivatives" by Das

And Nasim Taleb's work.

------- More to the point, the author is explaining something very basic (which journalists don't seem to understand): -Algorithmic trading is NOT a general term for all trading done with algorithms/computers. It refers to telling a computer to EXECUTE a specific trade. In other words, when your retirement fund decides to buy A LOT of AAPL, they naturally need to spread that trade over the whole day (or even several days). In the old days, human traders used to do it. Now it is mostly done by computer programs.

This is different from the kind of trading where a computer decides WHAT to trade (NOT HOW to trade). This kind of trading involves so many different strategies that it is silly to lump them together.

There seem to be other misconceptions: -The best and the brightest are working in Finance, instead of doing things more beneficial to society.

A quant colleague of mine, who has a PhD in Physics from an Ivy League school told me that he, and many of his friends, left academia because there were simply no positions for them.

-75% of trading is now automated, it is just computers trading with each other.

I hope someone will correct me if I'm wrong but I have never figured out if this 75% includes algo trading. If it does include algo trading (my guess is that it does), then I'm surprised it is not 100%. That is like saying 95% of TV channels are controlled by remote-control devices.

-People seem to think that wall-street traders make their money by "trading ahead" of mom & pop investors: your Dad buys 1000 shares of microsoft, a wily trader puts your dad's order on hold, buys it for himself, raises the price, sells his shares to your dad at a higher price...thereby making money off your dad.

Your broker is not allowed to 'trade-ahead' of you. At least in the places where I have worked, this is taken very seriously. Interestingly, high frequency traders (who are most frequently accused of this) don't actually have access to customer order-flow. High frequency trading hedge funds don't generally have any client orders. Places where the two co-exist are forced to have seperation. Traders from one department cannot share information with the other. As more and more client facing firms (sell-side) become automated, the chance of them actually coding up such cheats is even dumber.

Flash trading is often given as an example of people, in cahoots with exchanges, trading on others' order information. As far as I know, "flash" functionality exists to help clients trade more effectively. Large traders are VERY concerned about letting the whole market know that they are interested in some stock. Some exchanges offered the following functionality: if you are interested in buying a stock, you have the OPTION of giving other members of the exchange a chance to trade with you. If no one takes you up on the offer, then the order goes to the wider market.

I have to admit that a laywer friend told me that he opposes this functionality at his firm. If someone _really_ needs to know more, I suppose I could ask him to explain.

-High frequency traders trade so fast that mom & pop simply can't compete with them. Their computers/networks are just too fast and they can get closer to the exchanges than anyone else.

High frequency traders are not competing with mom & pop, they are competing with market makers. If two people hear a news item, the one closer to the exchange will naturally get the trade done faster (presumably at a better price). The same is (generally) true of people on the East Coast vs rest of the country (let's assume US financial system). The same is true of people who can click their mouse faster. Besides, there is no moral reason your Mom should be able to dump her Enron stock faster than Joe Trader.

etc., etc., etc. -------------

I should add that I am actually not at all comfortable with the role finance plays in world economy. I can't call myself a critic since being critical requires more complete understanding.

I am specifically opposed to things like direct market access. This is where any Joe Blow can use an API to setup his trading system. If he accidently leaves an infinite loop in his code, he can cause real problem. I remember sweating bullets (and almost trembling) when my boss asked me to flip the switch on the trading system I wrote. In reality, there are at least some protections built in to keep this from happening. However, I would like to see more uniform, consistent and better advertised rules.

I am also against the ability to trade by borrwing money from brokers (margin trading or leveraged trading). If an individual trader screws up, they wipe themselves out. If they borrowed money, then the consequences of their bad trades starts to seep out to others. If more than a handful of traders, trading on margin, go belly up, the lender could be in trouble as well...you can see how this could ripple across a system.

Closely related to allowing trading on margin is reliance on models. Say you have calculated that two stocks always move together. You _and your lender_ are so sure of this correlation that they think of it as the truth. What if your calculations or your assumptions were wrong? The consequences of this mistake may not be linearly related to the risk you thought you took. Read Nasim Taleb's work on this for more.

Finally, those who smell something fishy should broaden their concern beyond just modern trading system or even complex derivatives. I can see no principal, within the framework of free markets and individualism, which leads to condemnation of ever more automated and faster trading, more complex instruments and more dependence of finance. The best moral principal, I can think of, which opposes the current state of affairs, is the one uttered by Martin Sheen's character in the movie Wallstreet: "Create, instead of living off the buying and selling of others."

Wallstreet 2 was a piece of shit.

you can do both algorithmically, or manually, or a mix.

Here is a video of an extremely interesting talk, entitled "Human Traders are an Endangered Species!", by Dave Cliff who's involved with the Foresight project:

http://trading-gurus.com/human-traders-are-an-endangered-spe...

and more information on the Foresight project itself:

http://www.bis.gov.uk/foresight/our-work/projects/current-pr...

The big problem when you place a huge buy or sell order is that it shifts the price in a direction you don't want it to go. For a large sell order, the price goes down, as the market becomes skittish about the security. For a large buy order, the price goes up, as the market becomes bullish and arbitrageurs quickly buy up securities to resell to you. So, many traders use algorithms to hide their trades. The purpose of these algorithms is to avoid volatility, so they shouldn't be dangerous to the market, as long as they're designed correctly.

(Although, to be fair, algorithms may automatically stop trading when the market becomes too volatile, which contributes to flash crashes by reducing liquidity.)

Algos are about getting a trade done at the least cost. You want to buy 100M shares for fund XYZ or sell 10M shares for fund ABC. Algos are run by brokers on behalf of their buy-side clients. A simple algo is something like TWAP, the time weighted average price, which attempts to buy a large position over the course of the day gradually. The purpose of this algo is to avoid moving the market. This is suitable for the "build up a large position because I'm bullish on this industry" type of trade.

Another algo might be IQx, a package offered by CovergEx which tries to quickly execute the trade by sending it out to multiple dark pools and the major exchanges at gradually worse prices until the whole order fills. (Or at least that's my reading of the marketing material.)

Let's say an institution wants to buy 10K shares of a thinly traded stock (lets say, 100K shares per day). Placing a single order for 10K shares will send a signal to the market that someone wants to buy, and other traders will see it.

There are special algorithms designed to purchase the specified number of shares without making too much of a market impact. For example, in this case, the strategy would send 100 share orders rather than presenting the full 10K interest at once.

for the googlers: there are all kinds of technical terms like implementation shortfall to give more info

A big part of the problem is systemic. The researcher that discovers new technology gets a nice $30k bonus. The owners of the capital get the millions of dollars resulting from that invention. So if you're a bright physics student in the US, why on earth would you pursue R&D? It is far more remunerative to work for those who own the capital figuring out new ways to move money around.

I hope someone will correct me if I'm wrong but I have never figured out if this 75% includes algo trading. If it does include algo trading (my guess is that it does), then I'm surprised it is not 100%. That is like saying 95% of TV channels are controlled by remote-control devices."

From the Foresight project homepage (http://www.bis.gov.uk/foresight/our-work/projects/current-pr...): "For example, today, over one third of United Kingdom equity trading volume is generated through high frequency automated computer trading while in the US this figure is closer to three-quarters."

Then why not work in any other industry? Going from the worst paid to the best paid occupation is not really something you have to push most people to.

The biggest problem with HFT provided liquidity is that it is far from a sure thing as the Flash crash proved. The liquidity dried up so fast, because most players algorithms "said" the situation was too unpredictable so the easiest thing to do was to close up shop temporarily.

In older days, market makers on the floor were allowed to make the money from the spread with the understanding that if the things got rough they would HAVE TO stay in the game. Some got rich, some died broke, some jumped out of windows, but overall the game continued.

Increasingly, the role of a market maker has been delegated to HFT firms, but without any obligations placed on them.

Who is to blame for such state of affairs is a question someone else can answer better than me.

In theory, shouldn't those giving the loans account for the risk and thus be protected from wiping out themselves?

Also, what IS algo trading?

Is a margin call algo trading? Is a stop loss algo trading? What about technical analysis?

(Flash) crashes should be expected anytime you over leverage your entire economy.

See: George Soros and the pound.

Imagine everyone you know has widgets, and you realize that most people like to keep their widgets in a warehouse. You setup a warehouse that stores widgets and people pay you to store their widgets. Everyone loves it, no more widgets around the house cluttering things up.

Now since the widgets are identical and interchangeable you stop tracking whose widgets belong to who and throw them all into a big pile, and when someone asks for their 20 widgets you give them a random 20 widgets.

Now you realize that keeping all these widgets around is a massive waste of time and money since only about 1% of widgets are actually in use before being returned to the warehouse. So you tell your customers, "hey, I'm not going to bother actually keeping all the widgets, and I'm going to stop charging you to store your widget and instead I'll pay you to keep your widgets, if you store your widgets for a year I'll give you an coupon you can bring back to me at the end of the year and I'll give you all your widgets back plus 10% more".

This system works great and everyone is happy, after a few decades the coupons for the widgets outnumber the widgets by a factor of 10,000.

Now some asshole with a basic grasp of mathematics invents a computer program to manage widget coupons and it realizes that if it buys 1/10000th of the widget coupons and redeems them for widgets that no one else can actually redeem any other coupons. So your computer takes delivery of all the widgets in the world and then redeems one more widget coupon and everyone loses faith because the coupons for widgets no longer get you widgets and suddenly widget coupons are only worth 1/10000th of a widget. Suddenly everyone is mad at the guy with the computer and basic grasp of mathematics because their widget coupons only buy 1/10000th of a widget, and he's making bank selling everyone their widgets back.

Is the cause of the devaluation of widget coupons the fault of the algorithm, or the fault of the system that allowed more coupons than there are widgets?

It was shown that one, some, or many HFTs were involved in "quote stuffing" which is bidding for stock and then pulling the order, something like 100k times per second. This gave the appearance of liquidity and demand, but it was fake, because as soon as someone would bid for the stock, they would pull their order. But another use of this was to essentially slow down the "ticker tape" of the NYSE. What was happening was that the "ticker tape" that showed the current bids and asks was slowing down, and by doing this, some HFTs could make use of the latency arbitrage. Colocated HFTs got their quotes for the best bids and asks directly from the exchanges, but other people were getting their quotes from the NYSE, so they were behind. I believe they were something like 30 seconds behind, so what would happen is that the HFTs had full reign to take advantage of others being blinded like this.

Of course, the side effect of this was that they "broke" the markets. Because of this latency, the NYSE suspended the markets temporarily, which then had the unintended consequence of forcing all the bids and asks to flow into the smaller exchanges, which didn't have the liquidity to handle the orders. There were so many sell orders, that basically all the buy orders for some stocks got taken out, causing the prices to plummet down to 1 cent or something like that.

I'm expecting another flash crash to occur at some point, so whenever I see heated market action, I place a bunch of trades around 25% below the current stock price, which I believe is just above the limits that the exchanges would use to roll back bad trades. (Un)fortunately, it hasn't happened yet, but I'm sure at some point it will.

http://www.nanex.net/FlashCrashFinal/FlashCrashAnalysis_Theo...