[Infowarrior] - Traders Profit With Computers Set at High Speed

[Richard Forno]

  Traders Profit With Computers Set at High Speed
By CHARLES DUHIGG
Published: July 23, 2009
http://www.nytimes.com/2009/07/24/business/24trading.html?_r=1&hp

It is the hot new thing on Wall Street, a way for a handful of traders  
to master the stock market, peek at investors’ orders and, critics  
say, even subtly manipulate share prices.

It is called high-frequency trading — and it is suddenly one of the  
most talked-about and mysterious forces in the markets.

Powerful computers, some housed right next to the machines that drive  
marketplaces like the New York Stock Exchange, enable high-frequency  
traders to transmit millions of orders at lightning speed and, their  
detractors contend, reap billions at everyone else’s expense.

These systems are so fast they can outsmart or outrun other investors,  
humans and computers alike. And after growing in the shadows for  
years, they are generating lots of talk.

Nearly everyone on Wall Street is wondering how hedge funds and large  
banks like Goldman Sachs are making so much money so soon after the  
financial system nearly collapsed. High-frequency trading is one answer.

And when a former Goldman Sachs programmer was accused this month of  
stealing secret computer codes — software that a federal prosecutor  
said could “manipulate markets in unfair ways” — it only added to the  
mystery. Goldman acknowledges that it profits from high-frequency  
trading, but disputes that it has an unfair advantage.

Yet high-frequency specialists clearly have an edge over typical  
traders, let alone ordinary investors. The Securities and Exchange  
Commission says it is examining certain aspects of the strategy.

“This is where all the money is getting made,” said William H.  
Donaldson, former chairman and chief executive of the New York Stock  
Exchange and today an adviser to a big hedge fund. “If an individual  
investor doesn’t have the means to keep up, they’re at a huge  
disadvantage.”

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.

High-frequency traders also benefit from competition among the various  
exchanges, which pay small fees that are often collected by the  
biggest and most active traders — typically a quarter of a cent per  
share to whoever arrives first. Those small payments, spread over  
millions of shares, help high-speed investors profit simply by trading  
enormous numbers of shares, even if they buy or sell at a modest loss.

“It’s become a technological arms race, and what separates winners and  
losers is how fast they can move,” said Joseph M. Mecane of NYSE  
Euronext, which operates the New York Stock Exchange. “Markets need  
liquidity, and high-frequency traders provide opportunities for other  
investors to buy and sell.”

The rise of high-frequency trading helps explain why activity on the  
nation’s stock exchanges has exploded. Average daily volume has soared  
by 164 percent since 2005, according to data from NYSE. Although  
precise figures are elusive, stock exchanges say that a handful of  
high-frequency traders now account for a more than half of all trades.  
To understand this high-speed world, consider what happened when slow- 
moving traders went up against high-frequency robots earlier this  
month, and ended up handing spoils to lightning-fast computers.

It was July 15, and Intel, the computer chip giant, had reporting  
robust earnings the night before. Some investors, smelling  
opportunity, set out to buy shares in the semiconductor company  
Broadcom. (Their activities were described by an investor at a major  
Wall Street firm who spoke on the condition of anonymity to protect  
his job.) The slower traders faced a quandary: If they sought to buy a  
large number of shares at once, they would tip their hand and risk  
driving up Broadcom’s price. So, as is often the case on Wall Street,  
they divided their orders into dozens of small batches, hoping to  
cover their tracks. One second after the market opened, shares of  
Broadcom started changing hands at $26.20.

The slower traders began issuing buy orders. But rather than being  
shown to all potential sellers at the same time, some of those orders  
were most likely routed to a collection of high-frequency traders for  
just 30 milliseconds — 0.03 seconds — in what are known as flash  
orders. While markets are supposed to ensure transparency by showing  
orders to everyone simultaneously, a loophole in regulations allows  
marketplaces like Nasdaq to show traders some orders ahead of everyone  
else in exchange for a fee.

In less than half a second, high-frequency traders gained a valuable  
insight: the hunger for Broadcom was growing. Their computers began  
buying up Broadcom shares and then reselling them to the slower  
investors at higher prices. The overall price of Broadcom began to rise.

Soon, thousands of orders began flooding the markets as high-frequency  
software went into high gear. Automatic programs began issuing and  
canceling tiny orders within milliseconds to determine how much the  
slower traders were willing to pay. The high-frequency computers  
quickly determined that some investors’ upper limit was $26.40. The  
price shot to $26.39, and high-frequency programs began offering to  
sell hundreds of thousands of shares.

The result is that the slower-moving investors paid $1.4 million for  
about 56,000 shares, or $7,800 more than if they had been able to move  
as quickly as the high-frequency traders.

Multiply such trades across thousands of stocks a day, and the profits  
are substantial. High-frequency traders generated about $21 billion in  
profits last year, the Tabb Group, a research firm, estimates.

“You want to encourage innovation, and you want to reward companies  
that have invested in technology and ideas that make the markets more  
efficient,” said Andrew M. Brooks, head of United States equity  
trading at T. Rowe Price, a mutual fund and investment company that  
often competes with and uses high-frequency techniques. “But we’re  
moving toward a two-tiered marketplace of the high-frequency arbitrage  
guys, and everyone else. People want to know they have a legitimate  
shot at getting a fair deal. Otherwise, the markets lose their  
integrity.”