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High Frequency Trading Explained Simply
High frequency trading has been in the news more, thanks in part to Michael Lewis’ new book, Flash Boys. This article presents a simple explanation of how and why high frequency trading works, and why it is good for small investors.
We will begin by imagining a market with lots of small individual traders. Then we will look at how large institutional investors change the market. Next we will look at high frequency trading. Finally, we’ll explain how small investors are impacted.
Start by imagining a stock with no particular news about it. The price is stable, but there are lot of small trades. Some investors have enjoyed gains but now think the stock is overpriced. Other investors have seen gains and have decided to jump on the bandwagon. Some investors have been watching it, and now have money to invest. Others have owned it and are happy with the stock but need some cash. So lots of orders are coming in, pretty evenly mixed between buy and sell orders. The price trend for the stock looks perfectly steady.
Now consider that the traders are not all small investors. Large institutional traders are doing the same thing—some buying and some selling—but there’s a difference between them and individual investors. When a large mutual fund or pension fund places a buy order, it could be for a million shares, not a hundred shares. Similarly, sell orders from institutions come in very large quantities.
Over the course of the day, these large institutional orders cause a lumpy pattern. The chart shows what such a price line looks like. There is no noticeable trend up or down, but each institutional order moves the market up or down, and it takes a while for the price to return to the underlying trend line. That’s illustrated with the red line in the accompanying chart.
High frequency traders try to profit from the price movements caused by large institutional trades. When a mutual fund sells a million shares of a stock, the price dips—and HFTs buy on the dip, hoping to be able to sell the shares a few minutes later at the normal price. When a pension fund buys two million shares, the HFTs short-sell the stock, hoping to close their position at a profit. (Short selling is selling stock you don’t own; you borrow the shares from a stockbroker, sell them, and then later buy the stock to return the borrowed shares.)
HFTs are buying when the price is below trend and selling when the price is above trend. This tends to reduce the price fluctuations. When they are successful, prices look like the blue line on the chart. The blips are smaller and shorter-lived.
HFT is not as easy as this simple explanation sounds. First, there are many HFTs. If one is slow, the profit opportunity may have been captured by other HFTs. Second, not every blip is just a blip. If the stock is impacted by an downward trend in the overall stock market, the HFT would buy lots of different stocks—and then watch them all go down further. A good HFT has to be fast, but not so fast as to get caught be a surprise. In practice, the HFTs are no longer just looking at just one stock in isolation. They are looking at all the prices coming in, including stocks, bonds, commodities, futures and options. This massive data crunching helps them identify what are likely to be short-term blips but not long-lasting trends.
In the early days, it was fairly easy. As more companies got into the business, the easy trades were quickly taken by others. HFTs needed to move faster and faster, while crunching ever more data to avoid losing trades. Much of the attention they have received lately is due to their extreme efforts to reduce their reaction time, which is measured in milliseconds. This effort is not made to be faster than individual investors or institutional investors; HFTs are already faster than them. Instead, the effort is made to be faster than competing HFTs.
Now, how does high frequency trading impact those of us who are small investors? Look at that chart. If I place a simple buy or sell order, I may get lucky or unlucky. My buy order may be at a downward blip, but it may also be at an upward blip. I don’t want to get lucky if it means a chance of being unlucky; I’d rather trade at that underlying trend price.
Further, investors face a spread between the price at which they buy (the “ask” price) and the price at which they sell (the “bid”). This bid-ask spread compensates the market makers for executing trades at exactly the time that I want to trade. The more volatile the stock price usually is, the wider the bid-ask spread. HFTs tend to narrow the bid-ask spread by protecting the market makers from bad news while they hold their positions. Thus, my trading costs get lower.
High frequency trading is secretive and mysterious, but not at all evil. It make the stock market more efficient and helps small investors who trade at random times over the day. I could almost feel sorry for them being misunderstood—until considering that they have made far more money than I have.
2014-04-15 14:00 GMT (or 16:00 MQ MT5 time) | [USD - NAHB Housing Market Index news event ]
if actual > forecast = good for currency (for USD in our case)
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U.S. Homebuilder Confidence Improves Less Than Expected In April
Homebuilder confidence in the U.S. has seen a modest improvement in the month of April, according to a report released by the National Association of Home Builders on Tuesday.
The report showed that the NAHB/Wells Fargo Housing Market Index edged up to 47 in April from a downwardly revised 46 in March.
However, economists had been expecting the index to climb to a reading of 49 from the 47 originally reported for the previous month.
The modest uptick by the index reflected a notable increase by the component measuring expectations for future sales, which jumped to 57 in April from 53 in March.
Meanwhile, the component gauging current sales conditions and the component gauging traffic of prospective buyers were both unchanged from the previous month at 51 and 32, respectively.
"Builder confidence has been in a holding pattern the past three months," said NAHB Chairman Kevin Kelly. "Looking ahead, as the spring home buying season gets into full swing and demand increases, builders are expecting sales prospects to improve in the months ahead."
The NAHB said the housing market index three-month moving averages were down in all four regions of the country.
The West fell nine points to 51 and the Midwest dropped four points to 49, while the Northeast and South both dropped two points to 33 and 47, respectively.
Wednesday morning, the Commerce Department is scheduled to release a separate report on new residential construction in the month of March.
Economists expect housing starts to climb to an annual rate of 973,000 in March from 907,000 in February, while building permits are expected to dip to 1.008 million from 1.018 million.
EUR/USD rejected by minor retracement
EUR/USD Strategy: Like being square for a few days.
2014-04-16 02:00 GMT (or 04:00 MQ MT5 time) | [CNY - GDP]
if actual > forecast = good for currency (for CNY in our case)
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China Q1 GDP +7.4% On Year
China's gross domestic product expanded 7.4 percent on year in the first quarter of 2014, the government said on Wednesday.
That topped expectations for 7.3 percent following the 7.7 percent gain in the previous three months.
On a seasonally adjusted quarterly basis, GDP added 1.4 percent - shy of expectations for 1.5 percent and slowing from 1.8 percent in the three months prior.
The government also revealed that industrial production gained 8.8 percent on year in March - missing forecasts for 9.0 percent but up from 8.6 percent in February.
Retail sales climbed 12.2 percent, beating expectations for 12.1 percent and up from 11.8 percent in the previous month.
Fixed-asset investment climbed an annual 17.6 percent - missing forecasts for 18.0 percent and down from 17.9 percent a month earlier.
EUR/USD falls to support near 200-period moving average
EUR/USD moved slightly lower but met support near the 200-period moving average, and the 50% retracement level of the 4th-11th Apr. advance.
2014-04-16 12:30 GMT (or 14:30 MQ MT5 time) | [CAD - International Transactions in Securities]
if actual > forecast = good for currency (for CAD in our case)
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2014-04-16 13:15 GMT (or 15:15 MQ MT5 time) | [USD - Industrial Production]
if actual > forecast = good for currency (for USD in our case)
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U.S. Industrial Production Climbs More Than Expected In March
Industrial production in the U.S. rose by more than expected in the month of March, the Federal Reserve revealed in a report on Wednesday, with the report also showing a notable upward revision to the pace of production growth in the previous month.
The Fed said industrial production increased by 0.7 percent in March after surging up by an upwardly revised 1.2 percent in February.
Economists had been expecting production to rise by about 0.5 percent compared to the 0.6 percent increase originally reported for the previous month.
if actual > forecast = good for currency (for CAD in our case)
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Bank of Canada interest rate statement
The Bank of Canada today announced that it is maintaining its target for the overnight rate at 1 per cent. The Bank Rate is correspondingly 1 1/4 per cent and the deposit rate is 3/4 per cent.
Inflation in Canada remains low. Core inflation is expected to stay well below 2 per cent this year due to the effects of economic slack and heightened retail competition, and these effects will persist until early 2016. However, higher consumer energy prices and the lower Canadian dollar will exert temporary upward pressure on total CPI inflation, pushing it closer to the 2 per cent target in the coming quarters. We expect total CPI inflation will remain close to target throughout the projection, even as upward pressure from energy prices dissipates, because the impact of retail competition will gradually fade and excess capacity will be absorbed.
The global economic expansion is expected to strengthen over the next three years as headwinds that have been restraining activity dissipate. The economic recovery in the United States appears to be on track, despite soft readings in the last few months largely due to unusual weather. Indeed, private demand could turn out to be stronger than anticipated. Europe’s economy is growing modestly, but inflation remains too low and the nascent recovery could be undermined by risks emanating from the Russia-Ukraine situation. In China and other emerging-market economies growth is expected to be solid, although there are growing concerns about financial vulnerabilities. Overall, global growth is expected to pick up to 3.3 per cent in 2014 and increase further to 3.7 per cent in 2015 and 2016 – largely unchanged from the January Monetary Policy Report (MPR).
The Bank continues to expect Canada’s real GDP growth to average about 2 1/2 per cent in 2014 and 2015 before easing to around the 2 per cent growth rate of the economy’s potential in 2016. Competitiveness challenges continue to weigh on Canadian exporters’ ability to benefit from stronger growth abroad. However, a range of export subsectors have been growing in line with fundamentals, which suggests that as the U.S. recovery gathers momentum and becomes more broadly-based, many of our exports will benefit. The lower Canadian dollar should provide additional support. We continue to believe that rising global demand for Canadian goods and services, combined with the assumed high level of oil prices, will stimulate business investment in Canada and shift the economy to a more sustainable growth track.
Recent developments are in line with the Bank’s expectation of a soft landing in the housing market and stabilizing debt-to-income ratios for households. Still, household imbalances remain elevated and would pose a significant risk should economic conditions deteriorate.
In sum, the Bank continues to see a gradual strengthening in the fundamental drivers of growth and inflation in Canada. This view hinges critically on the projected upturn in exports and investment. With underlying inflation expected to remain below target for some time, the downside risks to inflation remain important. At the same time, the risks associated with household imbalances remain elevated. The Bank judges that the balance of these risks remains within the zone for which the current stance of monetary policy is appropriate and therefore has decided to maintain the target for the overnight rate at 1 per cent. The timing and direction of the next change to the policy rate will depend on how new information influences the balance of risks.
2014-04-16 16:15 GMT (or 18:15 MQ MT5 time) | [USD - Fed Chair Yellen Speech] :
EUR/USD gains on Yellen comments, mixed U.S. data
The euro rose against the dollar on Wednesday after Federal Reserve Chair Janet Yellen said interest rates will remain low for a considerable time, while a mixed bag of U.S. indicators also softened the greenback against the single currency.
In U.S. trading, EUR/USD was up 0.10% at 1.3829, up from a session low of 1.3804 and off a high of 1.3851.
The pair was likely to find support at 1.3791, Tuesday's low, and resistance at 1.3905, Friday's high.
The Federal Reserve will keep benchmark interest rates low even as the economy improves to ensure sustained recovery, Yellen said earlier.
Monetary authorities hope to see the unemployment rate at the end of 2016 reaching 5.2-5.6% and inflation at 1.7-2%, Yellen said.
"If this forecast was to become reality, the economy would be approaching what my colleagues and I view as maximum employment and price stability for the first time in nearly a decade. I find this baseline outlook quite plausible," Yellen said in prepared remarks in a speech she delivered at the Economic Club of New York.
In the meantime, markets should pay close attention to inflation and unemployment rates, as hiccups can serve as weather vanes when it comes to monetary policy and how long interest rates remain low.
"The larger the shortfall of employment or inflation from their respective objectives, and the slower the projected progress toward those objectives, the longer the current target range for the federal funds rate is likely to be maintained," Yellen said.
Elsewhere, U.S. industrial production rose 0.7% in March from February, beating expectations for a 0.5% reading, which supported the dollar earlier, though soft U.S. housing data watered down the greenback.
The Commerce Department reported earlier that housing starts rose 2.8% in March to 946,000, missing analyst forecasts for a 6.4% increase to 973,000 units.
Separately, building permits, an indicator of future demand for housing, fell 2.4% in March to 990,000, defying market expectations for a 0.6% increase.
Meanwhile in the euro zone, data revealed that the annual inflation rate slowed to 0.5% in March from 0.7% the previous month, but in line with expectations
Core inflation, which strips out volatile items like food and energy costs, fell to 0.7% from 1.0% in February, missing expectations for a 0.8% reading.
Euro zone inflation has now been in the European Central Bank's danger zone of below 1% for six straight months, fuelling speculation that policymakers will need to implement fresh stimulus measures to shore up the fragile recovery in the euro area.
The euro was down against the pound, with EUR/GBP down 0.33% to 0.8231, and up against the yen, with EUR/JPY up 0.45% at 141.41.
On Thursday, the U.S. is to publish data on initial jobless claims and a report on manufacturing activity in the Philadelphia region.
The euro zone is to publish data on the current account, while Germany is to produce data on producer price inflation.
28 Stocks That Could Double In Two Years, No Matter What The Market Does
Business-focused social network LinkedIn LNKD +0.68%, retailer Lumber Liquidators , growing ETF power WisdomTree Investments WETF +3.76%, cloud-based enterprise software company Workday WDAY -0.28% and 3D-printing outfit 3D Systems DDD +3.13% don’t have much in common. Except for the fact that analysts from Jefferies think all five could see their stocks double over the next two years.
In a lengthy note to clients Wednesday, Jefferies highlighted the five aforementioned stocks along with 23 others they believe have the potential to double in price over the next two years or so, through a combination of earnings growth and multiple expansion.
The thinking goes that a small subset of the S&P 1500 doubles over every two-year stretch. According to Jefferies, an average of 67 companies have had trailing two-year returns better than 100% dating back to 2006, a period that encompasses both the brutal financial crisis and the stirring rise off the bottom.