Tradeworx and other high frequency hedge funds using powerful computers have replaced humans on the trading floor for two thirds of all stock market transactions. Flickr photo.

Companies like the Tradeworx hedge fund are where the action is on Wall Street these days, although Tradeworx isn’t on Wall Street. It’s not even in New York. Tradeworx is in New Jersey.  High-frequency trading companies like Tradeworx are little more than rooms full of computers in obscure locations across the country.

High frequency trading dominates stock market

The traditional image of a frantic traders shouting and gesturing at the New York Stock Exchange is all for show now. Super-powerful computers at high-frequency trading firms can buy and sell 10 million shares an hour. The Tradeworx hedge fund is one of a growing number of high-frequency hedge funds. A few years ago there were none. Today, high frequency trading makes up two-thirds of all U.S. stock trades.

High speed trading selloff

Tradeworx went from obscurity to the front page after the Flash Crash when the Dow Jones industrial Average plunged nearly 1,000 points in a few hours earlier this month. Regulators trying to figure out what triggered the massive selloff have high-speed trading in their crosshairs. The theory goes that high-frequency traders didn’t trigger the market slide with huge volumes of trading. They actually caused the problem by not trading at all — for a few seconds.

Trading billions of shares a day

Tradeworx and the other 100 or so high-speed traders account for 60 percent of all trading on every stock market in the country. Some of the biggest trade more than a billion shares a day as though they were same day cash loans. The New York Times reports that the founder of high frequency hedge fund Tradebot, in Kansas City, Mo., said his firm typically held stocks for 11 seconds. On the afternoon of May 6, as the stock market began to plunge due to fears of a European debt crisis, high-speed trading computers were commanded to sell everything and shut down. In a nanosecond the most powerful players in the stock market went dark. The result rocked the financial world.

How does high speed trading work?

Tradeworx and Tradebot use computers programmed with complex mathematical formulas to comb markets for securities priced too high or too low, the Associated Press reports, because human traders haven’t yet reacted to the latest data. The computers then buy or sell in a split second, locking in a profit, often a penny or less. The pennies add up to a lot of money at a billion trades a day. Tradeworx, Tradebot and other high-frequency hedge funds make money by buying or selling in 15 millionths of a second. If a stock’s price rises, the high-speed trading computer buys it at the lower price before the index fund that includes it can adjust. After the index fund adjusts — a fraction of a second later — the computer sells them again at the higher price.

Is high speed trading ethical?

Many institutional money managers are uneasy about how the high-frequency trading computers anticipate their transactions. Reuters reports that asset managers worry there might be information leakage about their trading intentions — a critical issue.

“High-frequency trading, fundamentally, when you look at what their algorithms are finding, they’re almost a structured way of trying to front-run,” said Jim McCaughan, chief executive of the asset management arm of Principal Financial Group, where he oversees about $215 billion in assets. “That just seems to me ultimately as doing it at the expense of other investors.”

High frequency market confidence?

Whether high speed trading by Tradeworx, Tradebot and other high frequency hedge funds directly contributed to the May 6 Flash Crash hasn’t been determined. In fact, financetech.com reports that many experts credit high-frequency traders for helping with the sudden recovery on May 6. They say that as automated trading systems recognized good buys, they pounced and the markets recovered as liquidity quickly returned. The New York Times reports that high-frequency traders believe this liquidity they provide to the market enables investors to trade more easily. When investors can buy a security knowing they can resell it at anytime, confidence in the market is maintained.

(Photo: donkelphant.com)

Ask any investor what the last thing Wall Street needs is these days. There will be some variety in the answers you receive, but most anyone will agree that a stock market crash (always a bad thing) would be horrible right now. Particularly since America is barely beginning to claw its way back up out of the recession.

What could cause a stock market crash? There are a number of complicated ways to answer that, but for the purposes of this article, let’s examine something called flash trading, which the SEC is seriously considering banning. Not just because it gives certain high-powered investors a possible advantage, but because the same technology that makes flash trading (also known as high frequency trading) possible could create a feedback loop that grinds the market to a halt. At that point, payday loans and no fax payday loans won’t be enough to put Humpty Dumpty back together again.

We don’t need more shenanigans

Sarah Lynch reports for The Wall Street Journal that the Securities and Exchange Commission is considering stopping the flash trading practice that critics claim “gives an unfair advantage to some traders by giving them an early look at buy and sell orders.”

How does this happen? Well, apparently flash trading gives people with the technology a glimpse at stock trades before they reach exchanges for filing. From a technological standpoint, it is collocation of the servers flash traders use that makes the whole process much faster. They can avoid the data latency that other traders would encounter. In a nutshell, this technology gives flash traders a window in which to act that other traders simply don’t have, and while it’s currently legal, the SEC would perhaps like to change that. For more detailed info on this practice, check out this article at Wall Street and Tech.

Cut it out, right now

SEC Chair Mary Schapiro has decreed that SEC staff “explore an approach that can be quickly implemented to eliminate the inequity that results from flash orders.” The majority of U.S. stock exchanges have said they would not object to curbing the flash trading practice.

“We salute the SEC for moving forward with this ban that will restore integrity to the markets. The agency is absolutely making the right call by stepping up and ending this unfair practice,” Sen. Charles Schumer said. “It is also important to make sure flash orders aren’t just the tip of an iceberg lurking in the dark reaches of the market.”

“The dark reaches?”

Yes, I did say that there’s more to this than just giving some investors an unfair advantage with flash trading. Joe Weisenthal of BusinessInsider.com writes that

Of course, there are a lot of folks who rail against financial innovation and they have what seems like a good reason: it can cause epic blowups. We’re still not convinced that this last crisis was actually caused by innovations, but it’s an acceptable argument, and in the world of HFT (high-frequency trading), we could imagine, possibly, some computer going buck wild and screwing up the whole market, creating some crash-making feedback loop.

That would be a bad. Very bad.

Here’s hoping that the SEC gets this off the boards quickly. If flash trading and other HFT elements present the risk Weisenthal suggests, America hasn’t got time for the pain. Not anymore. We’re recovering. We use payday loans and no fax payday loans on occasion when needed, but we don’t want to have to face the complete collapse we feared would come from our current recession.

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