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Dennis Dick & Joel Elconin

Dennis Dick, CFA, is a proprietary trader, and market structure consultant with Bright Trading LLC. He has fifteen years of proprietary trading experience specializing in pair trading, crutch trading...

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Stealing Executions

One certainly cannot argue with Jim Chanos' track record, and his market calls have been extremely impressive. His calls on the slowdown in China, and the unsustainability of the solar industry have been spot on. However, we disagree with some of his comments on CNBC this morning regarding high frequency trading (HFT).

Jim Chanos explained that HFT does not really affect his trading because he has a very low portfolio turnover, and uses limit orders. While we agree with Jim that HFT has less of an effect on traders with longer time horizons, we fundamentally disagree with his analysis that traders who uses limit orders need not worry about high frequency trading.

Limit orders, in our opinion, are the most abused order type in the market today. High frequency traders have the ability to jump the limit book order queue by intercepting retail market orders BEFORE they get to the exchange, leaving limit orders unexecuted.

When an investor places a passive limit buy order onto an exchange, the order sits there resting until a contra-side sell order executes against it. Let's assume that the investor's buy order is the best bid on the exchange. A retail investor sending a market sell order to the exchange should normally interact with this passive buy order. This is the basic fundamental principle to a public market, buyer meets seller.

However, in this HFT world, we have an HFT middle man that intercepts the market sell order and they trade directly against that market order which should have interacted with the best bid, leaving the investor's bid unfilled.

In plain english, they STEAL THE EXECUTION.

How do they do this?

Privileged HFT participants buy order flow from retail brokers and trade directly against retail market orders BEFORE they get to the exchange. Shocking, isn't it? Your broker sells your order to an HFT firm, who in turn trade directly against it. This practice is known in the industry as internalization. The payment your broker receives is referred to as payment for order flow.

How often does this occur?

It is estimated by the SEC that nearly 100% of retail market orders are internalized.

What is the cost to the limit order traders?

Statistics from Nanex show that these losses add up to billions of dollars per year for limit order traders.

The scary thing is that the Nanex estimates are even conservative, because they only track those executions where the HFT internalizer actually give price improvement to the retail market order. In many instances the HFT internalizer gives nothing to the retail market order. They simply steal the execution, giving no benefit to any investor whatsoever.

The bottom line is that limit order traders are substantially disadvantaged by these HFT internalization practices, and the costs to these limit order traders is in the billions of dollars per year. So if you think limit orders will save you from HFT abuses, your portfolio is likely part of those billions of dollars in losses suffered by the investing public.

The following article is from one of our external contributors. It does not represent the opinion of Benzinga and has not been edited.

Posted in: Trading Ideas