“Surprise,surprise” Gomer Pyle (Andy of Mayberry)
“I’m shocked, shocked to find gambling is going on in here.” Captain Renault (Casablanca)
“High frequency traders (HFT) have found ways to use their speed to gain an advantage that few understand.” Michael Lewis (60 Minutes)
Many years ago they called it having an edge, knowing a little more than the next guy. In the 20’s it was simply letting a few select insiders have the information about an action before the action was taken. After the crash of ‘29 rules were implemented to discourage the practice of trading on inside information. Such notables as Michael Milkin and Martha Stewart, who felt these rules did not apply to them, paid the price and a little jail time for enhancing their net worth with advance warnings.
Now however having inside information is a thing of the past, unless your name is Stevie Cohen and your firm is SAC. You simply buy the biggest, strongest, fastest and most strategically placed servers and computers. You then insert a series of algorithms so you are able to trade ahead of everyone else.
To be able to trade ahead of most of John Q. Public has never been a big deal. After a long day at the office the average trader/investor would come home and study a few charts then make his picks, to be bought or sold on the opening the next day. A losing game for John Q., an easy win for the HFT, and no real need for inside information since nothing was a market mover.
Where it gets interesting is when the large institutions place substantial trades that in fact do move markets. The algorithm and computer are able to read the trade and place either corresponding or inverse trades BEFORE the institutional or retail trade is executed.
As an example, if the algorithm sees a 25,000 share block to be purchased it will accumulate 100 and 200 share lots to reach the 25,000 number, without creating an awareness in the marketplace. The algorithm will then sell the accumulated shares to the buyer for a higher price than the accumulated price. All of this is done in a fraction of a second. In many instances the buyer is a customer of the seller. Nothing like loyalty.
High frequency traders will say it is not insider trading it is simply an advancement in technology. Others will say it is just the market and caveat emptor. Regardless, the old inside trading has become algorithmic frontrunning with a quick twist.
Contrary to Mr. Lewis’s opinion, it is not difficult to understand that once again the boys with the biggest baddest and fastest get the spoils. It makes no difference whether its 1929 or 2014 or it’s a ticker tape or an algorithm, inside trading is inside trading over a matter of months or in less than a nanosecond.