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Stock Traders Find Speed Pays, in Milliseconds

2010-06-25 04:08:16

By CHARLES DUHIGG

Published: July 23, 2009

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.