High frequency trading…
One of the most spoken about but unknown parts of financial markets.
Most would say it is terrible for the market, the cause of crashes, and bad for the individual investor.
Here at Stony Brook Securities, we do not look at headlines and just assume they are spot on…
Rather we look at the data and the underlying metrics.
We will do the same here for high frequency trading.
What Market Making?
Let’s slow down a bit…
And go back to the time when the trading floors in Chicago and New York were packed with thousands of people yelling and screaming at each other all day.
There was a concept called a market maker, which would be a company or sometimes an individual who was responsible for quoting the bids and the offers of the stock or the underlying options at all times.
These market makers would know as much as anybody about the security they were making markets in and be the middleman in many transactions.
Let’s give an example.
Market makers are the one keeping the participation (liquidity) going. This way, there is always action for a buyer or a seller.
The more liquidity, the more people gravitate there are they are always able to buy and sell at any price.
How Do Market Makers Make Money?
They make money by knowing all of the true bids and offers at all time.
And are able to take pennies here and there off every trade. Do that a few hundred thousand times a day, you end up making a lot of money.
But nobody seems to be bothered by the fact that these market makers have and always will make a lot of money by providing liquidity and facilitating more transactions.
And why is that?
- Liquidity is king. I want my order to be filled at the price I want it to and as quickly as possible
But these market makers have been there for a long time and used to make a lot more money as the spreads used to be dollars wide compares to the pennies now.
Enter High Frequency Trading
With every year that passed, new technology comes to financial markets. The biggest happening around the time of the Dot Com bubble.
Online brokerages were popping up, allowing investors to participate in markets from in front of their computer. They didn’t have to call their brokers as individuals could make trades for themselves.
All the information was right there for everyone, and because transaction volume went up, competition for those new orders rose as well.
And let me just state this:
Competition for your order if the best thing that ever happened to you.
Because of this competition, you can get filled faster than every from the comfort of your home at a better price than you used to.
Who could say anything bad about that?
Where as back in the day, market makers were human beings, they have now been replaced by machines, known as high frequency traders.
What Is High Frequency Trading
In short, high frequency trading is machine-driven trading that happens faster than any human being can place a trade.
Financial media will say how bad high frequency trading is.
But is it really?
We at Stony Brook Securities do not agree with what financial media says about high frequency trading. The rest of the article will talk about the real pro’s and con’s of high frequency trading through the eyes of someone who has actually placed a trade in their life.
The big stink from Wall Street about high frequency trading is that is front-runs large institutional orders.
First, who cares about big institutions, we care about individual investors.
Second, if a big institution (or anyone for that matter) is entering a market order, they deserve the be ripped off.
Why might you ask?
Well, if high frequency liquidity providers are the new market makers, and the old market makers were responsible for quoting bids and offers, well what do you think these new liquidity providers do?
Yes, you guessed it, the same!
And if some money manager puts in a large order to buy at the market, they deserve to have offers taken away and have to pay a higher price than they thought!
This is the ONLY negative about high frequency liquidity providers and can be 100% avoidable at all times by just simply placing a limit order.
Look how happy that little guy is!
But you should be too!
Because in order to stay away from ANY of the negative side effects of high frequency trading is to place a limit order!
But why are they so good?
It is because competition for your order is the best thing ever.
And what happens when there is more competition for your order?
- You get filled faster
- You get filled at a better price
Can someone please explain to me how any of this can be bad at all.
The reason there is so much competition for your order is because they liquidity providers get a rebate from the exchange for providing the liquidity. And because of this, they fight tooth and nail, spend hundreds of millions of dollars on fiber-optic cable to literally shave off one millisecond of time. and create a win-win scenario for the individual investors.
And if they play between pennies, why do you care?
Well, you will care when you put in a buy order in AAPL at $125 and you get filled at $124.975 🙂
To sum this rant up:
- High frequency traders are just the same as market makers back in the day, they are liquidity providers
- Technology in financial markets have cut the spreads down the pennies and have significantly reduced your commissions
- High frequency traders rip off people who make market orders (so just don’t it’s a terrible idea)
- High frequency traders fill you faster (100% of the time) and at a better price than your limit order (50% of the time)
- High frequency traders do this because they get a rebate from the exchange for providing the liquidity, the more trades they make, the more money they make from the exchanges
Again, here at Stony Brook Securities, we don’t just take what other people say and believe it…
We look at the underlying numbers and what is really going on.
High frequency liquidity providers are one of the best things to happen to you, me, and anyone else who actually trades.