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Actually, HFTs Take on a Lot of Risk

Jason Carroll of Hudson River Trading, a member of the Modern Markets Initiative (MMI), has framed out some thoughts explaining how professional high frequency trading firms do in fact take on and manage risk in today’s modern markets:

One of the frequent criticisms of HFT is that HFT firms don’t take any risk.  The most frequently cited example is Virtu’s statement that in 1,238 trading days it was profitable in all but one. I’d like to explain why this isn’t as preposterous as it sounds.

A traditional trader or market maker from a decade ago was not automated. He or she traded by walking into a pit or up to a trading post or possibly by clicking a key by hand as he sat at a NASDAQ Workstation waiting for someone to try to trade with him. Frequently he traded a few products or symbols. The number of trades he made in a day probably measured in the range of 10-100, and his success rate on those trades was probably 60-70%.

He probably worked for a firm that, in aggregate, employed dozens to hundreds of traders covering a broader array of products.  In addition to covering many more products, these traders also probably covered an array of trading ideas — from shorter-term market making activity to longer-term inter-product arbitrage strategies.  Any individual trader’s daily Profit or Loss (“PNL”) was probably far more volatile than the firm’s aggregate PNL, because when you sum diverse and independent sources of PNL, you end up with a smoother aggregate total.

Many automated trading firms (or HFTs) conduct very similar activity, except they do more of it, for smaller rewards, using computers. An HFT firm may manage to trade 100s to 1000s of times a day in 1000s of products and symbols in different asset classes and markets around the world. Our success rate is closer to 51-52% than 60-70%, and the amount we stand to make or lose in any single trade is also smaller than what a manual trader faced.

Consider these two contrived companies:

Firm 1 employs 10 human traders, and each human trades 10 times a day.  Each trader is right 60% of the time, and each trade makes or loses $500.  Given that data, Firm 1 will trade on average 100 times a day, and make $10,000 per day.

Firm 2 employs 10 people who develop automated trading strategies, and each employee is responsible for 10,000 trades a day made by those strategies.  The strategies are right only 50.5% of the time, and they stand to make or lose $10 per trade.  Firm 2 will trade on average 100,000 times a day, but will still only make $10,000 per day.

For an individual human trader described at Firm 1 to lose money, he’d have to be wrong in more trades he was right. So he’d have to be wrong in 6 trades and right in 4 trades.  Statistics tells us the chance of losing at least 6 trades out of 10 when your win percentage is 60% is only 16%. So about 1 in every 6 days, each human trader will lose money.

Here’s a calculator that you can use to check my math:  For a deeper explanation of the statistics behind the math, I’d recommend reading some of the links on that page.1

For Firm 1 overall to lose money on a given day, it would have to be wrong in at least 51 trades.  The chance of losing in 51 trades out of 100 when you’re right 60% of the time is even lower than 16% — it’s 1.7%.  That means Firm 1 will lose money about 1 in every 60 days, or about 4 losing days a year assuming the firm doesn’t trade on weekends and holidays.

For Firm 2 to lose money on a given day, it would have to be wrong in at least 50,001 trades.  The chance of being wrong in 50,001 trades or more out of 100,000 trades, when you expect to be right 50.5% of the time, is very, very small — it’s .077% or approximately 1 in 1292.  So that means that this firm will lose money in one day every 5 years.

Is Firm 2 taking risk?  On any given trade it’s taking on a lot of risk.  It has a far smaller chance of success on each trade than the human traders do.  But because Firm 2 makes so many trades, it achieves a much more stable PNL profile than the human trader.

In general, investors should appreciate that automation has allowed firms to compete more aggressively to participate as market intermediaries. After all, the better such firms are able to manage risk, the smaller the reward is they need to capture in order to viably provide short-term liquidity.


[1] For the stats geeks among you, I acknowledge that this analysis relies on the assumption that the outcome of all of the trades is determined independently.  That’s probably not the case either at Firm 1 or Firm 2.  Weakening that assumption may change the scale of the comparison, the effect I demonstrate from making a much larger # of trades still exists.

For more information on this topic, please also read a previous post from the MMI entitled “No Trading is Without Risk.”


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FACT CHECK: "Average Joe" Investors and the Benefits of HFT

A recent commentary piece in The Guardian about the “Average Joe” investor contained a number of inaccuracies regarding high frequency trading and electronic markets.

MMI senior advisor Peter Nabicht reviewed the commentary and set the facts straight, giving the piece “the Walmart treatment“:



The Modern Markets Initiative has many resources available to members of the media, regulators, lawmakers and end investors who want to learn more about our electronic markets. Please visit our Investor Benefits page and watch our “What is High Frequency Trading?” video to learn more.


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Mark Spanbroek: “Squeezing the Middlemen”

Following the release of Michael Lewis’ book Flash Boys, the role of “middlemen” in the marketplace has come under scrutiny.

The fact is, our financial markets have always had “middlemen” coordinating trades between market participants. Even 20 years ago, these middlemen were part of an exclusive group of floor traders that closed off access to average investors. However, thanks to investments in technology and high frequency trading practices, in recent years middleman have reduced transactions costs and improved access more than ever before for the average investor.

As FIA EPTA Vice-Chairman Mark Spanbroek explains in a new blog post, middlemen provide an extremely valuable role in today’s market structure, especially for end investors, much like other industries:

“While it is true to say that technology, particularly the internet and digital communication, has radically reshaped the way we all do business (not just in the financial markets), it would be wrong to say that middlemen are no longer needed. Certainly there are fewer middlemen, supply chains have been simplified, and the number of links between the two ends of a purchasing chain have shrunk, to the great benefit of all those concerned at the ends of the chain; yet very rarely can we do away with the middleman completely.

“Similarly, whereas once we had to go to a travel agent to be able to book a holiday, now we can simply go online, looking for the best possible deals for our flights, hotel, car hire etc. There are far more competitors for this business, with individual and aggregated / comparison sites (middlemen), as well as the ability to book directly from the airline or hotel (no middlemen at all), cutting out the need to pay travel agent’s fees. The travel agent still exists, but more and more of their business is to provide a combined version of these services online, or to provide a custom-made holiday plan for a more comprehensive package. 

“The internet has reduced the cost of many day-to-day consumer purchases, by replacing middlemen with cheaper alternatives (often due to greater competition) and in some cases removed them completely, bringing customers into contact with the manufacturer. And while this has changed the way we do business, accepting the new technology as part of our everyday lives brings a lot of benefits and keeps us primed for future innovation.”

Spanbroek rightfully argues that “the rise of algorithmic trading has cut out a lot of middlemen in the markets” thereby “enabling more participants to connect directly to the exchange.” Investors have also benefited from the competition between traders utilizing algorithmic trading strategies, since “those who remain have had to find new, more cost-effective ways to provide their service.”

The advancements in technology in today’s modern markets should be embraced by all market participants and preserved to keep costs low for end investors. Read Spanbroek’s entire blog on FIA EPTA’s website here.

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Keith Ross: Dispelling Myths About Trading

In a new commentary for Traders Magazine, PDQ Enterprises CEO Keith Ross takes on some of the top myths being promulgated about our financial markets following the release of Michael Lewis’ book Flash Boys.

One of the top myths is the claim that high-frequency trading is only successful because of its speed and rebates. However, according to Ross:

Myth #3: High-frequency trading is successful because of its speed and rebates.

Actually, HFT has been successful because it provides a needed service: liquidity. HFT traders are willing to take short-term inventory risk so that they can offer immediate executions to those with a natural demand to buy or desire to sell the asset in question. When high-speed traders are successful it is because their algorithms have excellent risk management capabilities and perfect discipline. The faster they go, the faster they can adjust their risk and make better trades. The rebate issue is simply a function of where high-speed traders are going to be paid for their service of providing liquidity. If regulators eliminate the maker/taker model, the high-speed group would instead make their money through wider spread capture.

Think of it this way: If you go to a restaurant in the U.S., when the bill comes you add the tip, similar to a take fee. If you go to a restaurant in Europe, the service fee, or tip, is automatically included in the bill rather than itemized and collected separately. Without rebates or take fees, the European dining model would prevail. Traders would see net prices, but liquidity providers would still make profits. The existence of the “maker/taker” model doesn’t create the HFT industry any more than the “menu price + tip” model creates the restaurant industry.

After “busting” five myths associated with the markets, Ross states “everyone on Wall Street would agree with [SEC] Chairwoman White that market quality is good,” – and we agree. Today’s modern markets offer more access and lower costs than ever before to the average investor.

This certainly doesn’t mean our markets are perfect. The Modern Markets Initiative supports efforts to engage in a data-driven review that will look to strengthen markets structure for end investors while preserving the many benefits provided by technology.

Read Ross’ entire OpEd on here.

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Maker/Taker Takes Center Stage at Senate PSI Hearing

Yesterday, the Senate Permanent Subcommittee on Investigations held a hearing ostensibly on high frequency trading (HFT) – that’s because much of the pre-hearing attention and the hearing’s title all focused on HFT. However, the actual focus of the hearing was on maker/taker, its potential conflicts of interest and a lack of transparency around dealers getting best execution for their customers. The hearing once again highlighted that the issues that need to be addressed are structural and not caused by HFT.

Defining Maker/Taker

HFT and maker/taker are so often combined in coverage of the markets that a layman might think they are one and the same. They are not. Maker/taker is a fee and rebate system implemented by many US Equities exchanges. Through this system, the resting (passive) order receives a rebate in order to encourage displayed liquidity, while the order that crosses the spread (aggressive) pays a fee. The difference between the fee and the rebate is the net revenue kept by the exchange.  All resting orders, no matter the type of participant that placed them, receive the rebate indiscriminately.

HFT does not rely on maker/taker. In fact, HFT operates in many venues and markets that do not have maker/taker.  Also, HFT powered strategies rest orders in equities venues that have the reverse rebate model – taker/maker – where the resting order pays the fee. You can read a previous MMI piece for more on maker/taker and its relationship to HFT

At the heart of the maker/taker issue, and yesterday’s hearing, is a concern that brokers are routing their customer’s orders in a way that best serves their own financial interest at the expense of the financial interests of their customers.  That brokers may be making decisions to route orders to venues that maximize their own rebates instead of getting the best execution possible for their customers.

If that’s the case, and brokers are not acting in the best interests of their investing clients, they should be stopped. It is worth noting, however, that there is an inherent conflict that will always exist unless every exchange or execution venue charges the broker the exact same price, not only for fees but also for connectivity, membership and other access related fees. This is currently not the case and in a competitive landscape most likely never will be. As a result, this conflict is best governed by the common law fiduciary duty and regulations requiring best execution of customer orders.

Better Data, More Transparency Needed

As some pointed out yesterday, more transparency can go a long way towards solving some of the issues around maker/taker and conflicts of interest. Better data could be made available to third parties to better research the extent of any issues. The best way to approach any issue with the structure of today’s modern markets is to evaluate the problem with data and come up with changes that can be measured. The examination of maker/taker and its impact on investors would very much benefit from further study and better data.

Also, regulators could be clearer in terms of best execution.  As the SEC describes on their website: “Brokers are legally required to seek the best execution reasonably available for their customers’ orders.” This is incredibly subjective.

More detailed best execution requirements might be difficult to craft, but more stringent transparency requirements would not be.  If brokers were required to be more transparent in their reporting of routing decisions we could see three benefits:

  1. Investors would have better data to judge the performance of their broker;
  2. Better information would be available for studying the impact of maker/taker and other liquidity incentives, such as payment for order flow; and
  3. Some bad behavior would naturally end in order to escape the spotlight of transparency.

In concluding the hearing, Senator Carl Levin said, “We’ve got to rid our market of conflicts of interest to the extent that it’s humanly possible if we are going to restore confidence in our markets.”

Level-headed examinations and changes to market structure issues, such as maker/taker and broker conflict of interests, will go a long way towards restoring confidence and ensuring the markets continue to benefit all investors.

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Market Structure Series (Part III): Should HFT Firms Register?

In Part I and Part II of our market structure series analyzing SEC Chair White’s recent speech outlining new proposals to strengthen financial markets, we discussed ways in which lawmakers and regulators could work to prevent market insatiability and promote market fairness.

The majority of market participants agree on the need to eliminate abusive practices no matter the frequency of trading. But one topic that remains an issue of debate is whether firms that employ high frequency trading strategies should be required to register. In Part III of this series, we examine White’s comments on registration and the potential issues associated with such a measure if regulators move forward.

Registration and Firm Oversight

In her speech, Chair White highlighted her request to SEC staff to prepare two recommendations around firm registration:

  1. “A rule to clarify the status of unregistered active proprietary traders to subject them to our rules as dealers;” and
  2. “A rule eliminating an exception from FINRA membership requirements for dealers that trade in off-exchange venues.”

The desire for registration is an easy one to understand: if there is an active market participant it makes sense for the regulators to know who they are. No one should be able to operate under the radar. In fact, many proprietary trading firms are registered already, either as dealers or with the exchanges on which they trade. In this case, there are two questions that the SEC staff is surely asking themselves: is dealer registration the appropriate registration and why does mandatory registration need to apply to more than just proprietary traders?

Further along the lines of oversight, Chair White has asked “staff to prepare recommendations for the Commission to improve firms’ risk management of trading algorithms and to enhance regulatory oversight over their use.”  With algorithms being used by most across the spectrum of market participants, it is understandable that the SEC would want a better handle on understanding and monitoring the algorithms and their risk. But the devil is in the details, especially when it comes to those “poorly designed and operated.”

It will be interesting to see how the SEC proposes to oversee firms’ algorithms. There are many issues that need to be addressed in this proposal. Not the least of which is understanding the algorithms. It is one thing to review an algorithm; it is another to fully understand it. Firms of all stripes invest a great deal of money in talent who can fully understand how algorithms will behave in the market; regulators do not.  The SEC is currently improperly staffed for undertaking such a task. Another important issue will be guaranteeing the protection of intellectual property, which is critical for firms who use algorithms.

Chair White has a tall task but is taking a thoughtful approach. Certainly, there will be more to come on this topic.

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Rishi K. Narang: Today’s Markets “Absolutely Terrific” for Retail Investors

In an interview for, T2AM founder Rishi K. Narang argues that today’s financial markets are better than ever before for retail investors and explains that high frequency trading is a big part of it: You don’t believe the U.S. stock market is rigged, to the detriment of retail investors? Does HFT allow for unfair competition?

Narang: No, and neither does any serious practitioner in the markets. Even the staunchest opponents of HFT would openly admit the retail investor has never, in the history of markets, had it better. It’s an absolutely terrific market for the U.S. retail investor.

HFTs don’t allow for unfair competition. They are a natural byproduct of our market structure. And our market structure isn’t nearly perfect, but it’s extremely egalitarian if you compare it to any market structure we’ve ever had.

Anyone who wants to can “co-locate” their servers at the exchange, and this service costs a fraction of what an exchange membership used to cost—if you could even get one! The old floor-trading model was pretty much an “old boys’ club,” and that was the unfair system.

Narang also explains that high frequency trading isn’t a new phenomenon, in fact its profits are slowing whereas costs for investors continue to lower: HFT today represents about half of all U.S. equity trading. What’s driving the proliferation of high-frequency trading? Is it a very profitable business, or does it equate to lower costs for investors?

Narang: Actually, the proliferation happened some time ago, and what we’re seeing now is very much a consolidation phase in the industry. Many HFTs are going out of business. Others are joining forces to reduce the cost burdens because, in fact, margins—especially in U.S. equity trading—have been severely declining for several years already.

But when you look at the dollar volume of trading, compared to the profitability, it appears HFTs are making well below $0.001 per share for all their efforts. This unequivocally translates to lower costs for investors. This is the cheapest equity market in the world to trade, hands down.

Read the entire interview on here.