Fleet-footed traders using sophisticated software and high-frequency strategies are sniffing out block orders and running ahead of them in the marketplace, according to a recent study by Quantitative Services Group.
The QSG study says that high-frequency traders–also referred to as "information arbitrageurs" who use pattern-recognition software–see footprints that block orders leave from algorithmic trades. The high-frequency traders then buy alongside institutions, pushing up the price they pay. They then sell the stock to the institutions for a profit, according to Tim Sargent, president and chief executive of the Naperville, Ill-based provider of transaction cost analysis research.
During the run-up, block order prices can jump by as much as 40 basis points, which is substantial, Sargent said. And they reverse by as much as 10 basis points five minutes after the trade is done.
"And that adds insult to injury," he added. "Not only are you oftentimes paying up to get into the position, but then it’s reversing right away. It’s a real sign of a predatory kind of position."
For the past eight years, QSG has been developing and using measurement technology to identify orders that encounter cost run-ups and reversals in real time, Sargent said. The technology and study originated from the firm’s push to understand how market structure drives trading costs. It has built a product it will soon release that tells traders when anticipatory strategies are working against their orders in real time.
About 20 percent of the orders in the study had "significantly" higher-than-average costs of acquiring liquidity, Sargent said. The run-ups are usually followed by price-reversals. QSG found the high liquidity charges and subsequent price reversals as convincing evidence that there are high-frequency traders in the markets who are sniffing out–and picking off–institutional orders, according to Alex Hagmeyer, a senior analyst there.
QSG, whose client base includes traditional long-onlys and hedge funds, analyzed its client executions from Aug. 18, 2009 through Jan. 21, 2010. It looked at nearly 10,000 individual orders that exceeded 5 percent of the stock’s average daily trading volume. Nearly three-quarters of the orders on which QSG focused involved small- and mid-cap names.
According to the study, high-frequency trading firms with strategies designed for short-term gains run vast amounts of execution data through sophisticated pattern recognition software to determine the direction of prices and find signals generated by large orders. Once they detect, say, a large buy order, they place marketable bids higher than the best offer continuously and buy alongside the institutional order. This pushes up the National Best Bid and Offer. When the high-frequency firm detects that the institution is done buying, it’ll immediately offset the position. This produces a rapid price reversal.
Standard VWAP and arrival price trade-cost analysis fail to track this properly, Sargent said. QSG developed for its study, a way of to monitor algorithm child orders to calculate the cost to access liquidity.
Anticipatory strategies are an old trading practice. Today’s high-frequency trading strategies are just the latest iteration and aren’t illegal, Sargent said. And the study makes no claim that these strategies should be outlawed. But Sargent added that firms need to be aware of the execution providers, algos and venues that allow such practices to flourish.
"We’re trying to find the areas where using the electronic systems, or these algos, are working to our institutional clients’ disadvantage," he said. "One of the obvious areas is your costs of putting a position on, your footprint–the cumulative concessions you have to pay to get into a name."
In November, QSG released a study on how certain high-frequency trading strategies pick off volume-weighted average price orders and lead to higher impact costs. Despite the two studies, Sargent said QSG doesn’t have it in for high-frequency trading. Each study is intended to shed light on the risks associated with QSG’S clients’ order flow in an environment in which these strategies are dominant.
Consultant Matthew Samelson, a principal at Stamford, Conn.-based Woodbine Associates, read the study. He said it shed new light on how the presence of high-frequency traders affects active managers and momentum traders. "What they conclude is if you’re an active equity manager and you’re trading into or out of positions–or you’re a momentum trader–your cumulative trading costs are greater," Samelson said.
Still, the study might have benefited from looking at a wider spectrum of stocks, said Peter Weiler, executive vice president of sales and client services at Abel/Noser, a brokerage that develops trade-cost technology. If you have a study encompassing all trading, he added, it’s the natural order of things for there to be reversions in the marketplace that have nothing to do with high-frequency trading, specifically in very low-volume names. Logically speaking, high-frequency trading is not happening in low-frequency names, Weiler said.
In fact, trading costs have fallen since high-frequency trading increased its overall share of average daily volume, Weiler said. "We haven’t seen anything definitive in our universe about that type of volume that’s out there and whether [high-frequency traders] are having any sort of effect on trading," he said. "At the very least, it’s almost more of a neutral-type of phenomenon."
