Traders Profit With Computers Set at High Speed - NYTimes.com
Riaz K Tayob
Stock Traders Find Speed Pays, in Milliseconds
By CHARLES DUHIGG
It is the hot new thing on Wall Street, a way for a handful of traders
to master the stock market, peek at investors' orders and, critics say,
even subtly manipulate share prices.
It is called high-frequency trading — and it is suddenly one of the most
talked-about and mysterious forces in the markets.
Powerful computers, some housed right next to the machines that drive
marketplaces like the New York Stock Exchange, enable high-frequency
traders to transmit millions of orders at lightning speed and, their
detractors contend, reap billions at everyone else's expense.
These systems are so fast they can outsmart or outrun other investors,
humans and computers alike. And after growing in the shadows for years,
they are generating lots of talk.
Nearly everyone on Wall Street is wondering how hedge funds and large
banks like Goldman Sachs are making so much money so soon after the
financial system nearly collapsed. High-frequency trading is one answer.
And when a former Goldman Sachs programmer was accused this month of
stealing secret computer codes — software that a federal prosecutor said
could "manipulate markets in unfair ways" — it only added to the
mystery. Goldman acknowledges that it profits from high-frequency
trading, but disputes that it has an unfair advantage.
Yet high-frequency specialists clearly have an edge over typical
traders, let alone ordinary investors. The Securities and Exchange
Commission says it is examining certain aspects of the strategy.
"This is where all the money is getting made," said William H.
Donaldson, former chairman and chief executive of the New York Stock
Exchange and today an adviser to a big hedge fund. "If an individual
investor doesn't have the means to keep up, they're at a huge disadvantage."
For most of Wall Street's history, stock trading was fairly
straightforward: buyers and sellers gathered on exchange floors and
dickered until they struck a deal. Then, in 1998, the Securities and
Exchange Commission authorized electronic exchanges to compete with
marketplaces like the New York Stock Exchange. The intent was to open
markets to anyone with a desktop computer and a fresh idea.
But as new marketplaces have emerged, PCs have been unable to compete
with Wall Street's computers. Powerful algorithms — "algos," in industry
parlance — execute millions of orders a second and scan dozens of public
and private marketplaces simultaneously. They can spot trends before
other investors can blink, changing orders and strategies within
milliseconds.
High-frequency traders often confound other investors by issuing and
then canceling orders almost simultaneously. Loopholes in market rules
give high-speed investors an early glance at how others are trading. And
their computers can essentially bully slower investors into giving up
profits — and then disappear before anyone even knows they were there.
High-frequency traders also benefit from competition among the various
exchanges, which pay small fees that are often collected by the biggest
and most active traders — typically a quarter of a cent per share to
whoever arrives first. Those small payments, spread over millions of
shares, help high-speed investors profit simply by trading enormous
numbers of shares, even if they buy or sell at a modest loss.
"It's become a technological arms race, and what separates winners and
losers is how fast they can move," said Joseph M. Mecane of NYSE
Euronext, which operates the New York Stock Exchange. "Markets need
liquidity, and high-frequency traders provide opportunities for other
investors to buy and sell."
The rise of high-frequency trading helps explain why activity on the
nation's stock exchanges has exploded. Average daily volume has soared
by 164 percent since 2005, according to data from NYSE. Although precise
figures are elusive, stock exchanges say that a handful of
high-frequency traders now account for a more than half of all trades.
To understand this high-speed world, consider what happened when
slow-moving traders went up against high-frequency robots earlier this
month, and ended up handing spoils to lightning-fast computers.
It was July 15, and Intel, the computer chip giant, had reporting robust
earnings the night before. Some investors, smelling opportunity, set out
to buy shares in the semiconductor company Broadcom. (Their activities
were described by an investor at a major Wall Street firm who spoke on
the condition of anonymity to protect his job.) The slower traders faced
a quandary: If they sought to buy a large number of shares at once, they
would tip their hand and risk driving up Broadcom's price. So, as is
often the case on Wall Street, they divided their orders into dozens of
small batches, hoping to cover their tracks. One second after the market
opened, shares of Broadcom started changing hands at $26.20.
The slower traders began issuing buy orders. But rather than being shown
to all potential sellers at the same time, some of those orders were
most likely routed to a collection of high-frequency traders for just 30
milliseconds — 0.03 seconds — in what are known as flash orders. While
markets are supposed to ensure transparency by showing orders to
everyone simultaneously, a loophole in regulations allows marketplaces
like Nasdaq to show traders some orders ahead of everyone else in
exchange for a fee.
In less than half a second, high-frequency traders gained a valuable
insight: the hunger for Broadcom was growing. Their computers began
buying up Broadcom shares and then reselling them to the slower
investors at higher prices. The overall price of Broadcom began to rise.
Soon, thousands of orders began flooding the markets as high-frequency
software went into high gear. Automatic programs began issuing and
canceling tiny orders within milliseconds to determine how much the
slower traders were willing to pay. The high-frequency computers quickly
determined that some investors' upper limit was $26.40. The price shot
to $26.39, and high-frequency programs began offering to sell hundreds
of thousands of shares.
The result is that the slower-moving investors paid $1.4 million for
about 56,000 shares, or $7,800 more than if they had been able to move
as quickly as the high-frequency traders.
Multiply such trades across thousands of stocks a day, and the profits
are substantial. High-frequency traders generated about $21 billion in
profits last year, the Tabb Group, a research firm, estimates.
"You want to encourage innovation, and you want to reward companies that
have invested in technology and ideas that make the markets more
efficient," said Andrew M. Brooks, head of United States equity trading
at T. Rowe Price, a mutual fund and investment company that often
competes with and uses high-frequency techniques. "But we're moving
toward a two-tiered marketplace of the high-frequency arbitrage guys,
and everyone else. People want to know they have a legitimate shot at
getting a fair deal. Otherwise, the markets lose their integrity."
Copyright 2009 The New York Times Company
Traders Profit With Computers Set at High Speed - NYTimes.com (25 July 2009)
http://www.nytimes.com/2009/07/24/business/24trading.html?_r=1&partner=rss&emc=rss&pagewanted=print