Commentary

Jos Schmidt
Traders Magazine Online News

Reducing the Regulatory Burden on Public Companies, Yes Please But...

In this commentary, NEO's Jos Schmidt discusses regulatory requirements and needs in the Canadian equity markets.

Traders Poll

Are you concerned about foreign ownership of a U.S. stock exchange?



Free Site Registration

April 21, 2010

Cover Story: Lying in Wait

Rapid-fire traders use pattern recognition tools to exploit large orders

By James Ramage

New predators are using an old strategy to hunt their prey.

It's called anticipatory trading. And fleet-footed traders today are using the strategy to sniff out institutional orders in the marketplace and run ahead of them for profit, many in the industry say. These traders approach their targets with high-frequency technology. Many sport bleeding-edge pattern-recognition software.

 

See Sidebars:

Cat-and-Mouse Game

High-Frequency Trading's Many Faces

 

But critics are accusing some of these firms with high-frequency trading strategies of front-running. They don't appreciate how high-speed firms' software spots footprints left by institutions' algo orders and then buys alongside them, pushing up the prices institutions pay. According to a recent study, one institutional order in five costs significantly more than average due to these strategies.

As a result, some institutions are up in arms.

"We see it all the time," said Luke Lyons, global head of portfolio trading at AllianceBernstein. "For a long-only manager who's forced to trade, we just need to be smarter about the way we do it."

Ted Oberhaus, equity trading director at Lord Abbett & Co., sees this behavior playing out mostly with large caps. "There's absolutely no question that every institution is interfacing with high-frequency traders who are using predatory algos to front-run them," he said.

Ted Oberhaus, Lord Abbett & Co.

High-frequency traders, of course, reject this portrayal of their business outright. Their willingness to cross the spread to interact with limit orders helps the markets, they say. And when they detect, say, a large sell order, they might be providing liquidity to sellers who may not have gotten it otherwise.

Still, concerns about anticipatory trading stretch all the way to Capitol Hill. Early last month, Sen. Ted Kaufman, D-Del., addressed the Senate at length about how HFTs were negatively affecting the equities markets. Among his many complaints, he mentioned how these firms who beat institutions to the punch and trade ahead of them are more than just the latest iteration of an old strategy.

"While traders have long tried to trade ahead of large institutional orders, they now have the technology and models to make an exact science out of it," he said.

The Securities and Exchange Commission, in its Jan. 13 concept release, mentioned order anticipators and asked for comments on their effects on the marketplace. The SEC release seeks information to determine "whether the current market structure and the availability of sophisticated, high-speed trading tools enable proprietary firms to engage in order-anticipation strategies on a greater scale than in the past."