Active-Trader - Flash Boys

Welcome back, Active Traders and Wealth Builders.

I'm back from a week of sailing the high seas and had a chance to read Michael Lewis's book Flash Boys.  It was an excellent read and an eye-opener as to how you can be taken advantage of when trading on-line.

Here's a quick overview of what I learned and how you can protect yourself.  There are many types of algorithmic trading going on in the market place. What surprised me is how much of it occurs with little or no risk being assumed by those trading against you.  And it explains why many market-making firms pay the brokers for order flow.  Its because when a trading firm has your order to buy or sell in hand, they have the opportunity to transact elsewhere or at a different price and use your order to offset it.

There are 3 of the most basic type of high-frequency trading HFT trading scenarios:

- Front Running - You place an order to buy 1000 shares of a stock.  The first hundred goes off at close to the spread and the HFT firm goes out immediately (and I mean microseconds) goes out and buys up the available shares on the remaining exchanges driving up the price just to turn around and sell them back to the original buyer at a now higher price.   This gives the HFT firm a small but relatively guaranteed profit.

Front running successful requires physical proximity to the exchange computer since the advantage requires the minimal amount of delay between receipt of the order and execution.  HFT firms pay dearly for this proximity.

- Rebate Aribitrage  - As mentioned above many retail brokers (including the ones I use) receive payment for order flow.  Some exchanges will rebate the firms who send them orders versus charge them which is the standard arrangement.  Rebate Arbitrage occurs when the firm sends your order where they get paid the highest rebate.  BTW the only broker I am aware of which does not accept payment for order flow is Interactive Brokers.

- Slow Market Arbitrage - This method involves monitoring the difference between prices on various exchanges and transacting on one then making offsetting transactions on other exchanges who are slow to update their quotations.

You might think all of this was impossible due to regulation NMS which requires that all transactions be executed at the "NBBO" or National Best Bid or Offer among the available exchanges.   To implement regulation NMS, all of the prices from the various exchanges are aggregated at the SIP - Security Information Processor.   What was unforeseen was that other non-public versions of the SIP data exists on the computers of the high frequency trading firms inside the exchanges which get a first look the data and have a time advantage in terms of how to use the data to their advantage.

Now granted I don't trade that much, so I am not particularly outraged about this arrangement.  Things are still much better now than they were back in the bad old days when a commission of $14.95 for 100 shares was considered a 'Deep Discount Broker'.  Now I can trade the same 100 shares for $1 through TradeStation with a bid-ask spread measured in pennies.

So what's the take away, how to protect yourself and your hard earned money?

1) Use Limit Orders

This one is so obvious and Cramer also preaches this same mantra.  When you put in a market order, you are essentially telling the market maker and HFT firms - here, take my money!  Instead, put in a limit order under the market or in the middle of the spread.  You might still get HFT'd, but at least you got can transact on your terms and not someone else's.

2) Use Market on Close orders.

Large investors avoid these issues by using "Market on Close" orders which is a special match up of buyers and sellers which occurs on the close at the New York Stock exchange.  Why would anyone want to get just an "average" execution?   Just to avoid this entire mess and when you are a large institution with a lot of average investors, average executions work just fine.

3) Transaction with IEXG.

If you have a platform which allows you to route orders to a particular exchange,  send your orders to IEXG.  That is the Market Participant ID (MPID) for the IEX Group which is the exchange formed by Brad Katsuyama who is one of the heroes of the book.  The exchange was created, and at a great personal and professional cost to Mr Katsuyama, to create a fair exchange for buyers and sellers to transact.

4) Start following VIRT

If you can't beat them, join them as the saying goes.  One HFT firm which was identified in the book which is publicly traded is Virtu Financial ticker VIRT.   This company came public back in May of 2015 at about $23 a share and has trade as high as about $24.70 and currently stands about $23.50.  The company is a market maker and liquidity provider.  It's unclear how much of their income comes from market making versus HFT activity, so more research is required.

Thanks again to Michael Lewis for an excellent read.  And have a great week ahead.