Independent, Fee-Only Financial Advisor

Independent, Fee-Only Financial Advisor

Tuesday, August 14, 2012

high frequency trading and price improvement

High frequency trading - done by superfast computers located really really close to the exchanges - often gets a bad rap. Proponents of HFT (generally, the traders and the exchanges they patronize) typically argue that adding the massive volume of trades to the exchanges increases liquidity and tightens spreads. Increasing liquidity means it is easier to find a buyer or a seller when you need one. Greater competition tightens the spread between the price you can buy or sell at. Opponents argue that HFT gives the impression that the game is rigged. The computers can see orders coming in and step in front of them, denying a trade to someone.

This is not exactly true. While it is possible to step in front of an order, it is actually a good thing! If person A announces they are willing to sell something for $100 (i.e. put in a Limit Sell order for $100 or better) person B can step ahead of person A by announcing that they are willing to sell that same thing for $99. When a buyer comes to the marketplace, they exchange will match them up with the best price - person B's $99. If you do not offer a competitive price, you will not buy or sell what you want, obviously.

It is possible to see the benefits of this in your trading. It is not possible for a retail customer (at most brokers, at least) to put in an order price in sub-penny increments. HFTs and exchange members can, however. While this may seem unfair, it is literally less than a penny per share, which is a rather small amount. HFTs allow some price improvement for retail customers in this case. If you put in a limit buy, your broker will not fill it at a higher price, but may fill at a lower price if someone offers it. I put in a limit $27.17 buy order that was filled for $27.1589 once. Thats price improvement!

So, thank you HFTs. Competition breeds excellence.