The beauty and insanity of HFT

May 10th, 2013 (updated May 14th 2013)

What has become of our markets? Nanex, the market analysis firm, has animated a half second of trading activity in Johnson & Johnson stock. The animation is both intoxicating and mindblowing, not only because of the sheer quantity of trades, each of which is made by computer algorithms (i.e. without human intervention) in such a miniscule timespan, but also because of the tremendous scope that high-frequency trading creates for what Nanex calls “abusive behaviour” — including arbitrate and market manipulation — and systemic risk.

The video illustrates an actual half second of trading in J&J stock from May 2nd, 2013, slowed down so it takes five minutes to watch. In the video each box represents a stock exchange. As Time magazine explained in an article last year (“Wall Street’s Doomsday Machine“) high frequency trading has nothing to do with the efficient allocation of capital, and everything to do with socially-useless proprietary trading that runs counter to the interests of long-term investors:-

High frequency trading is a catch-all term that describes the practice of firms using high-powered computers to execute trades at very fast speeds – sometimes thousands or millions of trades per second. These systems have developed over the past ten years, and began to really dominate Wall Street over the last five. For example, a high-frequency trader might try to take advantage of miniscule differences in prices between securities offered on different exchanges: ABC stock could be offered for one price in New York and for a slightly higher price in London. With a high-powered computer and an “algorithm,” a trader could buy the cheap stock and sell the expensive one almost simultaneously, making an almost risk-free profit for himself…

Nanex created the animation in order to try and explain how today’s equity markets work to head-in-the-sand US regulators, including the Securities & Exchange Commision and the Commodities Futures Trade Commission (CFTC). Here’s what Nanex said about the animation and its significance:-

We got the idea after realizing, in face to face meetings with them, they didn’t understand market structure or the importance of latency and the consolidated feed. That was several years ago. We still aren’t sure if they get it, or are just playing dumb. The bottom box (SIP) shows the National Best Bid and Offer. Watch how much it changes in the blink of an eye. Watch High-Frequency Traders (HFT) at the millisecond level jam thousands of quotes in the stock of Johnson and Johnson (JNJ) through our financial networks on May 2, 2013. Video shows 1/2 second of time. If any of the connections are not running perfectly, High Frequency Traders can profit from the price discrepancies that result. There is no economic justification for this abusive behavior. Each box represents one exchange. The SIP (CQS in this case) is the box at 6 o’clock. It shows the National Best Bid/Offer. Watch how much it changes in a fraction of a second. The shapes represent quote changes which are the result of a change to the top of the book at each exchange. The time at the bottom of the screen is Eastern Time HH:MM:SS:mmm (mmm = millisecond). We slow time down so you can see what goes on at the millisecond level. A millisecond (ms) is 1/1000th of a second. Note how every exchange must process every quote from the others — for proper trade through price protection. This complex web of technology must run flawlessly every millisecond of the trading day, or arbitrage (HFT profit) opportunities will appear. It is easy for HFTs to cause delays in one or more of the connections between each exchange. Set to lowest resolution for an “artistic rendering”, or highest resolution for science.

Here is another explanation from Nanex (added 14 May 2014)

Each colored box represents one unique exchange. The white box at the bottom of the screens shows the National Best Bid/Offer, which often drastically changes in a fraction of a second. The moving shapes represent quote changes which are the result of a change to the top of the book at each exchange. The time at the bottom of the screen is Eastern Time HH:MM:SS:mmm, which is slowed down to be able to better observe what goes on at the millisecond level (1/1000th of a second). In the movie, one can observe how High Frequency Traders (HFT) jam thousands of quotes at the millisecond level, and how every exchange must process every quote from the others for proper trade through price protection. This complex web of technology must run flawlessly every millisecond of the trading day, or arbitrage (HFT profit) opportunities will appear. However, it is easy for HFTs to cause delays in one or more of the connections between each exchange. Yet if any of the connections are not running perfectly, High Frequency Traders tend to profit from the price discrepancies that result.

h/t Izabella Kaminska