High Frequency Trading: The Use of Fake Orders

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Every second the stock market is open millions of fake orders to buy and sell stocks are placed and then canceled by High Frequency Trading (HFT) firms. The activity takes place so fast, you don’t see it on your computer screen.

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This is part four of a four-part series on High Frequency Trading (HFT). In Part I, the use of computers to quickly identify and execute trades was discussed. In Part II, the belief that data is unfairly disseminated was discussed. In Part III, the possible role HFT plays in flash crashes was discussed. Today’s topic is the use of fake orders and how they potentially influence prices

— Jason Leavitt, LeavittBrothers.com

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PRICE DISCOVERY

The price of a stock at any given time is determined by the National Best Bid and Offer, so if all orders placed are legit, the next transaction should rightly take place at the bid or at the offer or somewhere in between.

But if a majority of the orders are fake and are placed with the intention of being deleted, it’s possible HFT firms can push prices up or down without any transactions taking place. Huge buy orders can be placed just below the best bid or buy orders can be flashed above the bid causing real buy orders to be raised and real sell orders to be lifted to higher prices in hopes of getting a better fill. Repeat the process, and you can see why it’s not hard to nudge stocks up or down.

Deep-pocketed traders do this all the time. They place large orders at certain levels in hopes of pushing a stock price up or down by encouraging or intimidating traders so they can either get in a lower price or get out at a higher price. But now the game is played by computers. The orders aren’t real, and they aren’t placed by people any more. Is this an issue?

TRANSACTIONS

There is a buyer and seller for every transaction, and if it’s believed one person is getting shafted, someone else is getting a gift. Let’s say the bid/ask for XYZ is at $50.00 and $50.02. You want to buy, but HFT firms came in and by placing millions of fake orders at several price levels, the bid/ask was raised to $50.04/$50.05. No transactions took place. Just the appearance buying interest was heavy caused sellers to raise their offers, so buyers felt they had to raise their bids. You then bought at $50.05, and when the price quickly dropped back down to $50.00 and you read an article about how HFT can influence prices, you feel you got duped.

It’s a valid argument except nobody forced you to buy. You could have placed a market order at $50.00 and then turned off your computer.

A GAME OF DECEPTION

In high school, I met Doug Collins. He was the first pick in the 1973 NBA draft and the coach of the Chicago Bulls at the time. He told me basketball was a game of deception. You fake one way, you go the other. But if the fake is too fast and the defensive player doesn’t react, it’s a wasted move; you gain nothing by doing it.

When I hear traders complaining about these fake orders, my immediate thought goes back to that conversation with Collins. If a stock is quoted at $75.25/$75.27, and due to millions of fake HFT orders being place and canceled in less than a second, the quote drops to $75.24/$75.26 or moves up to $75.26/$75.28, does it really matter? The fake happened so fast, you didn’t see it, and the market didn’t respond. If Wall Street, like basketball, is a game of deception, you were not deceived because the fake happened too quickly. A move up or down by a couple pennies amounts to a fraction of the entire day’s range. A trader is hardly a victim of anything.

MOCK EFFECTS TEST

Let’s apply an Effects Test-like test to the practice to see who it affects instead of gauging the act itself.

Long term traders like Warren Buffett certainly are not affected. If you buy with the intention of holding for several years for the purpose of collecting dividends and enjoying some price appreciation, whether you are lucky and get to buy a stock a couple pennies below the currently advertised price or unlucky and have to pay up a couple doesn’t matter one iota. There's a reason Warren Buffett got rid of his ticker in the 1970's. I promise you Buffett doesn't sit in front of his computer watching real time quotes flash across his screen.

For the same reason, fake orders don’t affect swing traders - those of us who buy a stock at around $50 and sell three weeks later at $55. It doesn't matter if I get a slightly better or worse fill on my trade. The important thing is being on the right side of the market and grabbing the bulk of a move. Swing traders shouldn’t complain about getting screwed by a couple pennies to open a trade and then not take responsibility when they choose to get out at $54.75 and the stock continues higher or when they give profits back by neglecting to get out when they should.

Day traders are certainly impacted. A slightly worse entry and exit does add up. Since HFT firms are, by definition, day trading firms, day traders are mostly trading against machines. But who cares about day traders? If you are one, you are on your own. You will get no sympathy from anyone in Washington. If you choose to step up to the table and play this game, you accept the risks and conditions and everything else that comes along with it.

FINAL WORD

It’s believed 70% of the market's volume is HFT. If true, and it very likely is, the firms are trading back and forth with each other. There aren’t enough real traders or investors to take the other side of all these trades. It’s as if HFT firms have their own poker table at a casino, and while they might beat each other up, what they do doesn’t influence anyone or anything else.

THE REAL FINAL WORD

If you’re losing money, it’s not because of high frequency trading.

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Read Leavitt's article on Losing Money And Why Warren Buffett Is Wrong here.

Learn more about Leavitt's work here.

[Editor's note: what do you think about high frequency trading? Leave a comment below.]

5 Comments

Join In on this conversation, post a comment below.
Visitor - Adam: Right, so it's a matter of scale? If you think the bid ask is manipulated by only a few pennies, and only for short periods, I think you are being naive.
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JasonLeavitt: I consider a few pennies to be random noise and not even noticeable. With the way stocks bounce around, why be distracted such irrelevant movement?
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Visitor - JimB: Comment...Thanks, another excellent read.
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JasonLeavitt: Thanks JimB.
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Visitor - Visitor Name...: Is it not against the laws of an exchange for an individual to input fake orders in the mkt? I know people get fined for doing so on ICE. Seems computers can do what they like whilst individuals can not.
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Visitor - Vic W: Test
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Visitor - Dennis: If the machines are all trading among themselves, then it is a zero sum game. One HFT firm wins for the year and another one loses all their investors money and goes out of business. And of course it is not even that good, because being an HFT is expensive in overhead, so all of them could go out of business. Since most HFT firms make money (but less of it recently), that money has to be coming from someone else other than the HFT traders themselves. Do the math. Where are all those billions coming from? Is it just the human day traders footing the bill? Is it the Warren Buffets or swing traders that are paying it in the micro installment plan?
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JasonLeavitt: Since there are so many trading styles, I'm not sure you can match up winners and losers. If I buy and 50 and attempt to sell a month later at 60 but instead get hit at 59.98, I still have a big winner. If a HFT firm makes that last 2 cents, I don't care.
Trading is not a zero-sum game. If the market trends up, there will be many more winners than losers. If the trend is down, there will be many more losers than winners. The only consistent winners are the brokerage firms that collect a toll.
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About the Author

Jason Leavitt is the founder of LeavittBrothers.com, an advisory service for self-directed traders, and PLcharts.com, a web-based tool that enables option traders to draw profit/loss diagrams. He started trading in 1999 and went full time in 2002.

He's traded stocks, options and futures in several bull and bear markets and primarily uses technical analysis to analyze the market. 

Originally from Chicago, Leavitt has also lived in Austin, TX, New York, Boston and Denver and now lives in Costa Rica. 

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