The flatness of being a high-frequency trader

September 16, 2009

A common claim made by the high-frequency trading crowd is that their funds end the day flat–with little overnight exposure to a given stock.

In other words, high-frequency traders argue they always manage to find some other sucker–I mean trader–to layoff their positions on before shutting down their algorithims for the night.

It’s a claim that sort of defies logic when you consider that most high-frequency traders compare themselves to good old-fashioned market makers–firms that put their own capital at risk to make markets in stocks. Based on that logic, it would seem high-frequency traders would need to go home at night with a sizeable exposure in certain stocks based on trades they did with other parties.

But a story in The Wall Street Journal helps explain how high-frequency traders can make this claim and why these rapid-fire, computer driven traders really aren’t classic market makers. The WSJ story points out that most rapid-fire algorthimic trading is in highly-liquid big-cap stocks–not less liquid small-cap stocks.

And, when you think about it, it makes sense that high-frequency traders generally shun small-cap stocks in favor of bigger names. That’s becuase it’s far easier to trade in and out of stock with lots of shares outstanding–and to do that trading in milliseconds. In a big-cap name, there’s not only more shares available for trading, but more potential buyers.

Of course, it’s the complete opposite with a small-cap stock–some of which may only trade a few thousands a shares a day in a handful of transactions.

The other problem with small-caps is the potential to get stuck with a big position at the end of the day. The slim trading in these stocks raises the possiblity that a high-frequency trading firm could end the day with a lot more exposure than it wants.

And overnight exposure is something a high-frequency trader tries to minimize–otherwise precious capital would be at risk.

In my mind this isn’t market making. It’s simply adding liquidity for liquidity sake in big-cap names and reaping a profit from those super-fast trades.

Is this bad? I’m still not sure but it sounds a lot like churning. And it’s not clear it’s adding anything of benefit to the market other than fattening the pockets of the high-frequency trading crowd.


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[...] High frequency trading is not market making.   (Matthew Goldstein) [...]

Yes, HFT are different than old-fashioned market makers.

Old-fashioned market makers officially keep the order book so they are the first to see incoming orders and have the exclusive opportunity to legally trade ahead of these orders when they see the market is going a certain way. They also have the ability to constantly make money on the spread (which used to be relatively huge). In return for these valuable privileges they are kind-of, sort-of required to put their capital at risk to maintain an orderly market (except when things get really hairy and they don’t live up to these obligations).

This used to be an extraordinarily profitable business when spreads were 12-25 cents because they had no competition. Now that they have competition spreads are pennies.

Another exclusive benefit market makers enjoy is to legally naked short stock. (BTW, it makes sense for them, and them alone, to have this privilege).

You note that HFT players aim to have little overnight exposure to stock. This is actually a similarity to market makers who also aim to have a low inventory at all times. If they have used up all their capital they would become useless at providing additional liquidity – so staying close to zero keeps their powder dry.

Posted by Steve | Report as abusive

I agree, almost entirely, with Steve’s remarks. His final paragraph is especially telling. (I thank him for saving me some typing.) I do differ with his opening remark – that HFT is different. Steve makes ample demonstration that, au contraire, the two marketing functions are the same, or at least similar.

Posted by Fitz | Report as abusive

Thanks Fitz.

As you can probably tell, my point about MMs being different was meant to highlight the exclusive benefits MMs get that HFT does not get. A deal was struck whereby MMs agreed to put capital at risk to maintain liquidity and orderly markets in exchange for those valuable, exclusive benefits. That’s why I am constantly annoyed to hear HFT dinged for not being *required* to maintain liquidity. HFT didn’t make the deal for the exclusive MM benefits so they aren’t getting away with anything.

The rich irony of it all is that many MMs abandoned their posts during the 87 crash – they made huge guaranteed profits for years but didn’t fulfill their end of the bargain when called upon. Meanwhile in our most recent crisis HFT continued to provide liquidity even though they weren’t obliged to.

And to amplify on the issue of HFT ending the day flat: I’ll bet that this is overstated. Like market makers HFT traders will, throughout the day, strive to be as close to zero as possible but will commit capital to long or short positions as opportunities present themselves. Any well run shop would strive to be diversified, beta-neutral and maybe even industry-neutral at all times, intra-day or overnight. The more names that are being traded the easier this is to accomplish without making extra hedging trades. My point is that if you are always diversified and roughly beta-neutral during the day, there’s no undo risk associated with keeping the positions overnight. And in fact, if you forced trades near the end of the day to close any open positions, you’d get slippage, probably to another enterprising HFT trader more willing than you to hold the position overnight.

Posted by Steve | Report as abusive

Market making is providing liquidity. But providing liquidity is not necessarily market making.

Posted by VM | Report as abusive