An intersting take on the recent violent move in Rambus stock, which may be explainabe by quirks in the HFT matrix, from Dennis Dick of Bright Trading.
HFT Market Making May Lead to a Crash
Rambus (RMBS) fell 30% today in a
matter of five minutes. It immediately
bounced back. The cause for this move
was speculated as a trader with a “fat finger”.
A trader simply messed up and sold too much stock accidentally, causing
a swift and violent sell-off.
The trades were later deemed erroneous and busted by the
But what if the real cause wasn’t just a trader with a “fat
finger”, accidentally selling too much stock? What if it was something more
serious? I believe it is. I believe the
real cause for this move is a major concern for our markets. The real cause may
have been high frequency market making gone bad. Let me explain.
Market making is the practice of quoting both bids and
offers on the same security, in hopes of capturing the spread. Market making
has existed in our markets since the beginning.
Traditionally it was done by floor brokers, floor traders and
specialists. With the rise of the
internet in the last 1990s, new players emerged in the market making
practice. Proprietary traders,
and E-traders began to play the game.
This led to increased competition and tighter spreads. But in the past five years a new player has
emerged, and this player has become dominant, knocking many of the competitors
out of the game. This new player is the
high frequency algorithmic trader, and it’s not a person, it’s a computer. 70% of our daily volume is now done by
algorithmic computer systems. Much of
this volume is market making. Why has
the HFT computer become such a dominant player?
It has to do with their edge.
High frequency algorithmic systems have been programmed to
step inside the NBBO (National Best Bid and Offer), and be the best bid and
best offer. This puts the computer
system at the front of the line to be first for execution, and gives the
computer the best chance to capture the spread.
Unfortunately, this practice is dominated by a few large firms, and they
have driven traditional market makers out of the market. If a traditional market maker places a bid,
the computer automatically steps in front.
In some cases, it steps in front by as little as 1/100th of a
penny (a practice called sub-pennying, which is
discussed on my website http://www.defendtrading.com).
These programs are very predatory and step in front of the
NBBO on a constant basis. This has
driven liquidity providers out of the market.
Our proprietary trading firm, Bright Trading LLC, in the early 2000s,
used to account for 2% of the volume on the NYSE. Now we account for just a fraction of
that. Our 400 traders used to provide a
substantial amount of liquidity to the market.
But due to predatory HFT market making practices, we now provide very
little liquidity. We are now liquidity
takers. The rational is simple, if we
place a passive limit order (providing liquidity), the
HFT algorithmic programs simply step in front of us. If we do get filled on a passive order, it is
almost always because we are wrong. You
are sub-pennied when you’re right, filled when you’re
wrong. Hence, there is no point to us
providing liquidity. Other proprietary
trading firms, floor traders, and specialists are in the same boat. There is no way for them to compete with the
algorithmic programs, so they don’t place passive orders.
Without traditional market makers, willing to step up and be
the buyer of last resort, we risk having more incidents, like the Rambus incident.
Computerized algorithmic market making works in any type of
oscillating market, as the computer can keep flipping out of it’s
longs, and covering it’s shorts. It
works in a trending market, as long as there is some type of choppy trade. The problem lies, when the computer system
can’t flip out of the position. Most algorithmic systems are programmed with
some type of risk parameter. If this
risk parameter is breached, the computer will dump it’s
position and cut it’s losses. This is
what may have happened in RMBS today. An
algorithmic system making markets on the long side, got too long, and was
unable to wiggle out of the position because of the follow-through in selling
pressure. Once it was down so much in
the position (the risk parameter was breached), it dumped. This simply added fuel to the fire. That is why the sudden plunge to $16 happened. If you check the chart, you will not see
this, because Nasdaq busted
all trades under $22. But don’t kid
yourself, these trades happened, and we should be very alarmed, because it will
happen again, and it may happen to the entire stock market.
High frequency traders make markets on ALL stocks. As they continue to take dominance, and as
more and more liquidity providers are driven out of the market by these HFT
predatory algorithms, the likelihood of a crash continues to climb. All it takes is a little bad news, and a
breach in the HFT’s algorithmic system’s risk
parameters, and we’re in a lot of trouble.
This has happened before, it WILL happen again.
Rambus was ONE stock today. Imagine
if it was the entire market.
Dennis Dick, CFA
Bright Trading LLC