October 24, 2014

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How To Make A Million Dollars An Hour, Step 9: Bet on the Race After You Know Who Wins

With powerful computers scooping up data from other firms, high frequency traders make money from “seeing” the future.

Les_leupold

by Les Leopold

In The Trading Room

On the first day of autumn 2011, I’m driving to leafy Chatham, New Jersey, to get my first live look at a trading room. Located in a bright new office townhouse complex, it’s exactly like what you see in the movies, only smaller. Eight casually dressed traders speak in hushed tones to one another and to clients on the phone, each monitoring multiple screens. One desk holds five screens, including two Bloomberg terminals and another streaming Twitter.

Yet beneath this modest, ordinary trading room, powerful forces lurk in dark pools.

At this very moment, the traders are struggling to protect their clients from invisible sharks that can gobble up foes at the speed of light. They are doing battle with strange predators who shun the sunshine and others whose mysterious movements will entrap you without your ever realizing it. If this is a movie set, it’s for the Twilight Zone, not for Wall Street.

My guide into this netherworld is Joe Saluzzi, the cofounder of Themis Trading, LLC. Joe and his partner, Sal Arnuk, run this small firm, which navigates the shoals of electronic trading for its 35 or so institutional clients. They seem as if they’re doing all right, but they don’t make a million dollars an hour.

They don’t trade any of their own money. Instead, their focus is helping their clients trade stocks, while protecting them from the predators that now stalk electronic markets.

A Crash Course on How Financial Markets Work

Joe, a slim, athletic Brooklyn native, fills the room with his energy and friendliness. A born storyteller, he makes me feel right at home in this foreign world as he bubbles with ideas and insights.  Joe obviously loves what he’s doing. In fact, he’s on a mission, an urgent one that gets him talking faster trading roomas he warms to his subject. He is on a crusade to expose the dangers of high-frequency trading and the perils of a fragmented electronic financial market.

Joe starts by giving me a crash course on how our modern financial markets work. Until a decade ago, a few stock exchanges had a three-hundred-year-old market monopoly on trading. Then it all broke apart. “The market” turned into an arena for rapid electronic trading, and new competitors flocked to the scene.

There are now 13 electronic exchanges in the United States on which you can buy the same financial instruments. “They are the same shoe store,” Joe says. “There are 13 shoe stores selling exactly the same item.”

Lit Screens and Dark Pools

Yet, buying and selling on these exchanges without getting fleeced is a lot harder than going to your local shoe store for a pair of Keds. “That’s where it gets really tricky,” says Joe. “Because sometimes there are the invisible shoe stores called dark pools, which are basically exchanges that are not lit up.”

He explains:

“Each of the 13 exchanges is a lit venue, something I can see on my machine. I can see their quotes. And then there are dark pools that are inside these quotes. So they sell shoes, but you also don’t know what shoes they are selling because no one sees them. But you can still buy them if you want."

Naturally, this all makes perfect sense to Joe, who’s been navigating these dark pools for years. Yet I’m still wondering how you buy shoes in an unlit shoe store, and how quotes can harbor dark pools. Joe tries to help me out: 

“You go in there, and you’re just guessing. You’re hoping there is something in there. Other traders will hide in the dark. They will say, ‘Okay, I’m willing to sell something at $12.16 when the [lit] quote was offered at $12.19.’

Then I come along to see if anyone is hiding in the dark, and I buy it at $12.16. Boom, we’ve got a match. Nice trade. Theoretically, that’s how it’s supposed to work.”

So Joe saves some money for his client by hooking up directly with a seller who was hiding in the dark pool. The lit shoe price on his screen was $12.19, but Joe got it in the dark for $12.16, for a savings of three cents per share, which adds up if you are buying a lot of shoes.

All in all, Joe says that beyond the 13 “lit” shoe stores, we can shop in 40 to 60 dark pools that also shoessell the same shoes. The downside of pool shopping, though, is that we don’t know which shoes and what sizes until we wade in.

On the upside, however, at least with all of those lit shoe stores and dark pools, we have many venues for buying and selling shoes. All of that competition should ensure that we’ll get good prices and low transaction costs wherever we go. Yes?

HFT’s At Hedge Funds, Investment Banks Prey On The Little Guy 

No, says Joe.

Because lurking in all of these markets, whether sunny or shady, are high-frequency traders (HFTs) — mostly hedge funds and investment banks. With their super-computers (and super-programmers, mathematicians, and computer scientists), these guys can complete trades in nanoseconds. They trade so often during the day that they now account for up to 50 to 80 percent of all of the volume we see on the stock exchanges.

This is a very big deal: HFTs are estimated to rake in from $8 billion to $20 billion in profit per year. Now, this is the business you want to get into. 

The problem, says Joe, is that many HFTs — though not all — are predators. They lurk in the dark pools waiting to ambush you. So as Joe wades into a dark pool to buy or sell a certain stock, he has to protect himself from predator HFTs.

You have to find the [stocks] before someone realizes that you’re looking to buy them. If they realize that you’re doing it, they’re going to buy them ahead of you and sell them back to you later [for a higher price]. That’s a predatory hit.

When Joe wants to place a large order for a client, he often has to scour all 13 markets and many high frequency tradingdark pools to find enough reasonably priced stocks to buy. He has no choice but to venture into dark pools from time to time. If he’s not very, very careful, though, a high-frequency trading computer owned by a hedge fund or a large investment bank will sniff him out and front-run his trade, squeezing money out of Joe’s clients.

To understand how this works, let ’s follow Joe deeper into his Twilight Zone.

High Frequency Traders Scoop The Future

Joe wants us to understand that the stock quote we see on our computers is not reality. It’s a picture of reality that is slightly delayed. When high-frequency traders look at their screens, they see something different. In fact, they see the future. It’s as if they occupied a parallel universe that runs on an accelerated clock. We’re not talking about minutes here. Not even seconds. According to Joe:

“They can see in microseconds, which is a millionth of a second. They can see in nanoseconds, which is a billionth of a second. They are approaching the speed of light. So they can see inside the quote. It’s getting really crazy.”

And it gets even crazier. HFTs buy data feeds from the electronic exchanges that contain a trove of information about who is doing what on the exchanges. Joe explains that “every nugget, every little key stroke that I enter is being tracked by some exchange and is in the feed.” That includes “What time did you enter your order? How long was the order in? Did you cancel the order? What time was the order canceled? Did you reenter the order? What price did you adjust it to?”

HFTs use that information to develop models for figuring out exactly how orders are flowing. “That’s how they make their predatory assessments,” says Joe.

It all happens at a warp speed the rest of us can’t even see. To ensure that they can move at close to the speed of light, HFTs “co-locate” their machines right next to one or more of the electronic exchanges. That’s extremely expensive, but it cuts down on the distance their data have to travel and therefore reduces the time. The aim: to predict the quotes before they are posted. An HFT, says Joe, “can build a quote faster than what the public sees. You can see the future.” And if you, the HFT, are seeing the future, he adds, “You can pretty much make money guaranteed every time.”

So next time you see that cute baby on the E-trade commercial buying and selling his stocks, remember that between the time he hits the trade button and the time the trade goes through, he's being fleeced by a high frequency trader.

It's like taking candy from a baby.

_______________________

Step 8: Have the Right People Whispering in Your Ear

Step 7: Don’t Say Anything Remotely Truthful

Step 6: Rig Your Bets

Step 5: Betting Is For Chumps

Step 4: Use Other People's Money

Step 3: Rip off Entire Countries Because That's Where The Money Is

Step 2: Take, Don't Make

Step 1: How To Make A Million Dollars An Hour In Twelve Easy Steps

The opinions, beliefs and viewpoints expressed by CSRwire contributors do not necessarily reflect the opinions, beliefs and viewpoints of CSRwire.

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