Rogue Algorithms And Other Mutually Assured Destruction Program Trading Alternatives

Tyler Durden's picture
Submitted By Joe Saluzzi Of Themis Trading
Why Institutional Investors Should Be Concerned About High Frequency Traders
A Themis Trading LLC Mini White Paper
It is now generally understood that high frequency traders (HFTs) are dominating the equity market, generating as much as 70% of the volume.
HFTs are computerized trading programs that make money two ways, in general.  They offer bids in such a way so as to make tiny amounts of money from per share liquidity rebates provided by the exchanges.  Or they make tiny per share long or short profits.  While this might sound like small change, HFTs collectively execute billions of shares a day, making it an extremely profitable business.
Why should institutional or retail investors care?  After all, aren’t HFTs adding liquidity?  That’s what they and the exchanges, who court their business, say.
There’s a lot to worry about.
1.  HFTs provide low quality liquidity.
In the old days, when NYSE specialists or NASDAQ market makers added liquidity, they were required to maintain a fair and orderly market, and to post a quote that was part of the National Best Bid and Offer a minimum percentage of time.  HFTs have no such requirements.  They have no minimum shares to provide nor do they have a minimum quote time.  And they could turn off their liquidity at any time.  When an HFT computer spots a real order, the HFT is not likely to go against it and take the other side.  The institution is then faced with a very tough stock to trade.
2.  HFT volume can generate false trading signals.
This can cause other investors to buy at a higher price, or sell at a lower price, than they would otherwise.  A spike in HFT volume can cause an institutional algorithm order based on a percentage of volume to be too aggressive. A spike can attract momentum investors, further exaggerating price moves.  Seeing such a spike, options traders can start to build positions, which, in turn, can attract risk arbitrage traders who believe there’s potential news that could affect the stock.
3.  HFT computer servers are faster than other trading systems.
Because most HFT servers are co-located at exchanges, they can beat out institutional or retail orders, causing them to pay more or sell for less than they should have for a stock.
Then there are the “what if” problems that could be created by HFTs.
1.  What if a regulation like the uptick rule were enacted?
Volumes could implode and stocks that appeared highly liquid could become extremely difficult to trade with wide spreads and no depth in the quote.
2.  What if a “rogue” algorithm entered the market?
Many HFTs are hedge funds that enter their orders into the market through a “sponsored access” arrangement with a broker.  Many of these arrangements do not have any pre-trade risk controls since these clients demand the fastest speed.  Due to the fully electronic nature of the equity markets today, one keypunch error could wreak havoc.  Nothing would be able to stop a market destroying order once the button was pressed.
Gives new meaning to the term “mutually assured destruction?”


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ghostfaceinvestah's picture

Nice educational piece.

Regarding point #3, wouldn't limit orders take care of this problem for retail investors?


I don't worry about most retail investors who invest in individual stocks, most are relatively experienced from what I have seen.   I worry more about retail investors putting money into mutual funds, or contribute (sometimes indirectly) to defined benefit pension plans.  Those stupid buggers could care less if they overpay (or undersell) a stock, they get paid either way.  that is how the retail investor really gets ripped off.


Anal_yst's picture

You serious dude?  Most retail investors that invest in single-names are experienced?



ghostfaceinvestah's picture

Experienced in getting good execution?  Yes, most aren't stupid enough to enter market orders.

Experienced in that they understand what they are investing in?  Not in most cases.

the point is, the real victims are the sheeple giving their money to professional money managers, who could care less if they get good execution.  these were the fuckers who allowed hedge funds to late trade, after all.  how quickly that whole scandal was forgotten.

BTW, that was another scandal where the useless SEC was asleep at the wheel; Spitzer handed them that one.

Arco's picture

Hahaha. that is a pretty absurd comment. I'm just picturing my idiot roommate who day trades his E-Trade account... hahaha

ghostfaceinvestah's picture

When I said "know what they are doing" I meant "know what they are getting into", not necessarily that they have any skill as traders.

it is hard to argue that your idiot roommate is getting ripped off on execution, he can choose to use limit orders if he wants, that way he only pays the price he wants.

whether or not that price makes any sense is his problem, and has nothing to do with HFT.

Anonymous's picture

Limit orders are a poor choice for most stock trades. You lose far more in opportunity cost of the non-fills than you pay in spreads. The option you grant to the market has value.

Limit orders do make sense if the spreads are wide & you can step ahead one tick and provide liquidity. You will again mostly get beat by the opposition

lettuce's picture

limit order only offers 1-sided protection based on whether it is buy or sell. the market may move after your order is submitted in such a way that you may not be receiving the cheapest buy (below your limit) or highest-value sale (above your limit) from the counterparty. the idea here is to not have to put a limit order on, necessarily, e.g. that liquidity is so high and trading so instantaneous that a market-order is truly what you see on the nat'l best bid/offer books...


naturally this isnt realistic...and it's what we're struggling against, while the SLPs reap benefits from rebates.


the article is wrong in what it says about not having minimum %'s of trading-day time to list best bid/offer for these rebate-incentivized participants... i'm sure in the past few days, many of us (if not most) have read, re-read and re-re-read the NYSE SLP and DMM rules....

Woodshedder's picture



Not trying to be a pain.

Anonymous's picture

Mutually Assured Desturction?

It was the best of times, it was the BLURST of times?!?

Anonymous's picture

Nothing like being nickel and dimed to death.
Another tax to pay for someones beach house in the Hamptons

aldousd's picture

Tyler = Joe Saluzzi?


Just a big fan?


The world may never know.

Anonymous's picture

notice in the article he says that momo traders may see the momentum and pile on. Why are those momo traders any better than the super fast guys? How is a mutual fund any better who gets paid regardless of performance? At least the high frequency guys get paid based on pnl, rather than a guaranteed and unethical drain of .5 - 3% of an investors money regardless of performance. Take last year...oops, lost 40% of your money, now give me 1% more in fees?

High frequency traders are no different than used car lots when you boil it down. Does it make you made they make so much money? Then go compete against them.

If you dont think high frequency players produce anything (I disagree and will say without them spreads and liquidity issues would cost the average investor WAY more), then I will argue that writers dont produce anything either. They just disseminate information more quickly (= liquidity of info).....and they are not actually producing anything....rather just rehashing the news.

There are a ton of jobs in America that dont produce a tangible product, but before you get all pissed about trading, remember that authors and car dealerships are just liquidity adders too.....

Anonymous's picture

The sheeple clamor for more "regulation". Well, then shut down the HFT. It is clear and obvious this is a ticking time-bomb. Let the SEC terminate its usage. They wont.It is ridiculous. Its te next cdo/mbs/aig scenario. Thy are fighting the last war when they should be ending HFT non-sense. Proprietary trading algorithms considered a goldman/national security risk? they have the story/concept backwards. Employing all these genius maths andphysics PhD's in paper shuffling violates the national interest. Get them involved in making a flying car or endless swimming pool. Or personalized nuclear power plant,etc. but nooo, the FBI has to protect the paper shufflers/monies changers!!! Do you see the irony?

Anonymous's picture

Shut down the HFTs. They are the tools of economic vampires.

Anonymous's picture

If you dont like the way the market is traded, dont trade. Dont invest in stocks. If something is wrong, or bad for you, why would you play? Do you guys need someone protecting you from everything? Are you too dumb to protect yourself? Is someone is dumb enough to buy a $25 burger, should the government come in and regulate burger prices so that poor consumer doesnt get hurt? where does it all end people?
The beauty of being free is to be able to walk away and put your money in real estate, foreign markets, checking account - - go figure it out but stop asking regulators to hold your hand through everything.

I gotta go, someone in my city just got hit crossing the street....I DEMAND cops holding our hands across the street to protect me!!!!

Anonymous's picture

So where do I put my money. In my 401(k) my only option is these markets. Real estate is too illiquid, and requires too much principal for the average joe to properly diversify beyonbd his residence. Foreign markets will only behave just like ours at some point. And I lose money over time in my checking account. (inflation, and my wife spends it!)

I agree with some of your statements that handholding isn't the answer, but the point is that a blind person does need his hand held when crossing the street. And most people are blind to the effects this kind of thing has on the markets. Who is talking about trading...what about Joe the plumber who is simply holding long term. I agree people have to look out for themselves, but when their widely held assumptions about the how the market works are wrong, how are they able to?

Anonymous's picture

You can invest in REITs and thereby invest in real estate. You have a fatalistic attitude that suggests you want everything for nothing. Be realistic. Foreign markets act, in some ways, like the US market, but experiences different forces so they have generally lower correlations to the S&P.

The way the market works isn't "wrong." You are witnessing the "any investment carries with it risks of financial loss" part of the disclaimer.

Look back in history. There's a lot of times when the markets lost more than this. The world went on, investing went on, and life went on. 1970 to 2008. Taking into accoutn the worst markets in the early 70s, early 80s, 1987, early 90s, early 2000s, and even the tumble of 208. Markets TOTAL return using a well diversified portfolio is 10.8%.

Can you live with that?

If you want security, and I don't care what the gold salesmen on this site say, stick with intermediate term treasurys.

If you want returns, diversify. It's not as hopeless as you make it sound.

Anonymous's picture

50% in Vanguard's total stock fund, 50% in Vanguard's total bond fund. Rebalance your allocation every year.

Steak's picture

<If something is wrong, or bad for you, why would you play?>

That is perhaps the most ignorant statement I've ever read.  If as our dear leaders tell us, functioning capital markets are essential for the survival of our economic structure, then clearly there must be some sort of organized rules to the game. Your hamburger example is valid only because someone can easily choose no hamburger.  Can any of us professionals choose no capital markets?

Do you make the same asinine comments when rules are tweaked in football to protect the players?  Ohh the babies can't handle being horse collar tackled, how can they let their freedom be taken like that.

By your logic I should have access to enriched uranium if I want.  Since, you know, setting rules for things is for commies.  There is a middle ground beetween FREEDOM as you describe it and having the hot breath of an SEC officer on my neck at all times.  And I would say that setting rules to limit how much power an algorithm can have over capital markets fits within that middle ground.

Anonymous's picture

"your hamburger comment is valid only because someone can easily choose no hamburger. Can any of us professionals choose no capital markets"

Yes, you have a choice.... those of us in cash for the last two years lost nothing, and actually have way more buying power.

The point is that the markets are fine and in fact have never been more efficient or fair when it comes to trading. Sure, there are manipulators and bad firms out there, but that has always been the case.

You want more regulation from the exact guys who caused all this by relaxing lending rules for minorities and increasing leverage allowances? If youre in the business, you know its regulated as much or more than any other business in the world aready. What we need is a new overhaul in the sec/nasd....not more rules and regulation. Enforcement of current laws is what we need.

Anonymous's picture

Aren't you sort of blindsiding the posters above. I'm fairly certain that the above posters would be just as happy with enforcing current laws as they would be with more regulation. I mean isn't enforcement of current laws essentially the equivalent of more regulation? It would seem so to me. And by your logic cap and trade should be ok as even though the GS's of the world will profit handsomely by injecting themselves as the middlemen in the trade that is afterall free market capitalism

Anonymous's picture

And rope.

ghostfaceinvestah's picture

the problem with your argument is that these guys are not scalping you and me, who invest in indivdual stocks and ETFs and can decide to exit the market entirely, like many have done during this runup.  Our only cost is "opportunity cost".  the real victims are the sheeple who invest part of their paycheck week after week into their 401k, which has as choices 8 large cap mutual funds and 1 bond fund.


the same companies who are practicing HFT are pushing the sheeple to continue to pump money blindly into 401k accounts, to help feed their machines.  they exploit a known weakness in the system, while suppoting the continuation of that weakness.

Anonymous's picture

commissions for active traders is around 1 tenth of a penny a share. That is down from 5 - 10cps just 10 years ago. Spreads are down from .123 to .01. HFT do add liquidity as the article states, and I disagree regarding the quality. Liquidity is liquidity and adding it is good.

All in, the retail investor is way better off today than 10 years ago, and his returns bleed to the street at a much lower rate.

Your 401k comment is accurate....investing in stocks long term via funds has many pitfalls and the public has been rope a doped into many false ideas about returns and fees.

Anonymous's picture

The retail investor was better off when we traded in eights. A smaller increment does not mean a better price. To say there is a great advantage to the smaller spread ignores the effect of parasitic siphoning off of pennies on high volume . Smaller increments facilitated programmed trading. The opportunity to shave these pennies is lower for 1/8 pricing increment. Program is not beneficial to the market. Mechanized bets executed by high speed computers suck capital out of the system, causing a net loss. Sucking capital out of the market while producing nothing of value damages society in general.

This argument of penny vs eights is like saying an accountant that embezzles a penny of each transaction costs the business less than one who take a buck from the till every so often.

I would argue that high volume damages share value by the amount profited by the high speed trading if not more.

joann's picture

Ok ... I'll "stop asking regulators to hold your[my] hand through everything".  


If they stop asking taxpayers to pay for their losses.

aldousd's picture

While I dont know if I'd agree with you, based on your first statement, I do agree on the second one.  


Personally I'm all for regulation against fraud and misrepresentation, but tyring to prevent people from being stupid, i.e. making rules that lessen the requirement for people to be stupid, well you're asking for stupid people to start investing money then.  This would give, by default, new guys on the scene who will cut and run with clients money, equal footing with those who have honestly worked hard and built reputations.  Now reputations don't matter, since people are equally suspicious of all wall streeters. I feel so protected.

joann's picture

#1 Was rhetorical, howeverGlass-Steagall Act reinstated would be advantageous.


#2  Is a no brainer, banks and financial institutions take their own losses since they caused it.

Anonymous's picture

Is there anyone on the scene with a reputation other than ill repute?

aldousd's picture

That was my point.

Anonymous's picture

"Maiden Lane" meant a street of ill repute. A maiden kind of ill repute.

Anonymous's picture

Sorry, more explanation:

Anonymous's picture

"The beauty of being free is to be able to walk away and put your money in real estate, foreign markets, checking account"

...precious metals, mattresses, seeds...

nice point.

if u walk away, they can't play no mo
what a beautiful vision that would be

1 3/4

Anonymous's picture

Rogue Algorythm? Nice idea, no need in nitroglycerine to blow everything up. Project Mayhem can be executed electronically.

Anonymous's picture

Re #3 - your complaining because someone is faster? Please, the barriers to entry at these speed levels has never been lower. What, we want to regulate the speed of competition now?

Re the rouge algo - - the markets are littered with fat finger trades through the years. Algos are less likely to spin out of control than a manual trader. But, what would protect against anything unusual would be the return of the specialist, but all you people hated the specialist because of the fees and games he plays. There is no perfect system. Think before you jump on the bandwagon

Anonymous's picture

Laughing at the title of this article "Why Institutional Investors Should Be Concerned About High Frequency Traders "

It should be called: be paranoid and annoyed at any and all competitors. Or "Its not fair that people are competing against me"
Or, how about "Booooo the competition is faster and smarter than me because they learned to make money based on pnl rather than guaranteed fees which leads to laziness and poor risk and cost control"

Anonymous's picture

#5970 - 100% agreed. Let them trade with themselves if it's that bad. Or at least let

Veteran's picture

So were comments #5968, 5970, 5973, and 5974 all written by the same Anon?  They all seem to be a thinly veiled defense of the status quo. You know, the same asshole status quo that knee capped this country and got disgustingly rich, (and richer by the day), in the process.



ghostfaceinvestah's picture

to that point, that is one drawback so far to the new site - anyone not registered shows up as Anonymous.  confusing.

Anonymous's picture

congress set up the if anyones to blame its them. If you play by the rule of the law and with some ethical standard and win, then why are you a bad guy?

Veteran's picture

Blame whoever you want.  Doesn't change the fact that overall the system as it stands today is fucked for the majority

Anonymous's picture

That is complete BS. First, there is no ethical standard. Ethics never enters the picture. Second, when you have a revolving door btn lawmakers and your organization it becomes up to you to set your own laws (almost entirely to favor your). You're a corporate hack.

Veteran's picture

Corporate hack, liberally sprinkled with horseshit.  I stand by what I said earlier, thinly veiled defense. . .

Anonymous's picture

Thinly veiled defense. Perfect description.

I have to wonder if these people are GS employees...

Anonymous's picture

I love that greed has crushed people. Sure, GS is greedy and there are lots of figures pointed at them right now. But, I dont know if they are any worse than the greedy masses who thought it was ok to buy a 400k house and two 30k cars on a a 60k income. Thats just greed too. Taste the pain you greedy mofos. Live simply, within your means, and dont risk more than you are willing to or can lose. The lessons people teach their 14 year old have held true through all this, and if you simply lived within those rules you should be ok.
Goldman is no better or worse than Congress or the overall greedy people trying to keep up with the Jones

Anonymous's picture

And what of those who did live within their means and are still underwater on their mortgage or out of a job or both. What of those who lost 20yrs of equity in their homes. The last two standing (unscathed)I blame entirely. What a corn hole.

curbyourrisk's picture

have not traded in years, but I remember when we were acting as liquidity for the markets, and i mean proprietary traders.  I only traded the NYSE and just when trading was getting good for us....actually beating the specialists at their own games- they started changing all the rules...  went to pennies, went to open book, took away married puts.  When the rules changed, the game changed.  I left, the old firm disappeared and has been relaced by computers.  The human element knew fear and kept us in check.  The computers know no fear, nothing to keep them in check.

Anonymous's picture

I, like many who were surprised by and don't believe in the post-March 2009 rally, am still trying to figure out what is holding up the market. I think everyone understands it is government intervention, the more pressing question is how the government is acting on the market. ZH seems to be pointing at HFT and program trading as a primary mechanism, which seems reasonable given how well correlated the relative dominance of program trading and the recent run-up. But then again, blaming "robot" trading has a certain Space Odyssey appeal to it and may have nothing to do with the market insanity.

Can anyone actually show that program trading, in and of itself, can cause a market to remain elevated? Is the supposed mechanism solely that program trading manipulates signals and prevents selling cascades, reduces volatility, etc.? Or is HFT supposed to be a front for concealing coordinated, net buying by GS, JPM, et al.? Is there anything to show that there been a large net-increase in the daily prop holdings of GS, JPM, et al. in the past 3 months?

More substance, less speculation please.

Anonymous's picture

The weekly prop trading reports are publicly available from the NYSE. Program trading has gone from about 20% of all volume, to about 40%, and even as high as 50%.

The previous (revised) report claims GS's program traded something like 2 billion shares. That's just in one week!!

I think it's safe to say, that computers controlling greater than one-third of all NYSE volume would make market intervention very achievable.

Anonymous's picture

Prop trading does not equal program trading does not equal high frequency trading. FAIL.