The book Flash Boys by Michael Lewis tells the story of how a mild-manner stock trader named Brad Katsuyama, while working at the milder-mannered Royal Bank of Canada (RBC), identified how High Frequency Trading (HFT) firms were stepping between buyers and sellers to make an unfair profit for themselves. How do they do this? The short and no-longer-a-secret answer is that they pay the stock exchanges enormous sums to give them information about what’s happening in the market before it is seen by ordinary investors.
A very interesting passage starting on page 115 describes how Rich Gates, who runs the mutual fund company TFS Capital, conducted experiments which proved one method HFTs used to scam investors.
A little background: One type of order investors can enter to buy or sell stock is called a limit order. It allows entry of the upper limit a would be buyer will pay per share, or if selling, the minimum he will take for his shares. A limit buy order is a known as a bid. A limit sell order is known as an offer.
Mr. Gates went to one trading venue or exchange and entered into the computer a buy order to acquire shares of a thinly traded company with a limit of $100.05 per share. This price is, of course, the upper limit of what he was willing to pay. Next, he went to another venue and put in an offer to sell shares of the same company with a limit of $100.01 per share. This indicates that he was willing to accept as little as $100.01 for each of the shares he wants to sell.
By choosing a thinly traded stock, where his bid and offer were the only ones around, Gates was setting up a situation where he would probably wind up trading with himself. You may notice that there’s overlap here that doesn’t happen so much in the real world. If a seller checked on line while entering his order, he would have seen that someone was offering to pay $100.05 for his shares and enter that price in his offer order. But on purpose, Gates specified that he was willing to accept as little as $100.01 per share.
Note Setting the offer limit price below the bid price is not unreasonable in the real world. Let’s say that you own a frequently traded stock that moves around a lot. The price has been declining most of the day and you decide to sell it. You might set your offer limit price several cents below the highest bid shown, just as a precaution. In the seconds it takes you to enter and confirm your order, the stock may have traded several times and the bid price may have sunk. As long as the highest bid of any of the orders to buy hasn’t dropped below $100.01 by the time your offer makes it to the market, your sale will be successful.
But in Gates’ case, with no one buying or selling the stock he was experimenting with, his buy and sell orders should have met each other and he should have bought the stock from himself at $100.01. But that’s not what happened.
In the imperceptible moment after he entered his offer to sell each share for $100.01, an HFTs (or a “dark pool” operated by the Wall Street bank), saw his order before it reached the general market, quickly jumped in and bought the shares for $100.01 (filling his offer to sell) and then immediately resold them to him for $100.05 (filling his buy order). Pretty slick, huh?
He lost $.04 per share trading with himself while the HFT / dark pool make a profit of $.04 per share for doing nothing. Sadly, neither the SEC nor anyone else with the power to halt this and other dubious practices of high frequency traders seems interested in doing anything about it.