Nanex ~ 12-Mar-2013 ~ Exploratory Trading in the eMini
Update July 10, 2013
On November 14, 2012, Adam D. Clark-Joseph published
Exploratory Trading, which analyzed CFTC audit level trading
data in the eMini S&P 500 futures market. This is a special, "regulators-only"
data-set that contains all orders and trades, and each order and trade has a trader
identifier. What this paper exposes is astounding. The following is our summary of Clark-Joseph's
Exploratory trading is a form of manipulation designed to test the market's reaction
to a trade. Probing for stop orders would be one form of exploratory trading. This paper
specifically investigates exploratory trading that attempts to determine whether the
bid/ask spread is about to shift up or down a level. The impact on the market would
be an increase in intraday volatility. Exploratory trading distorts the market's view
of supply and demand and induces trading activity from other participants. Furthermore,
as participants learn of the strategy, they will employ counter-measures - which will
muddy an accurate picture of supply and demand for everyone else. This is why regulations ban manipulation.
The Top 8 HFTs Remove Liquidity 59% of the Time
Passive market making involves buying at the bid, and selling at the ask, which earns
the market maker the bid/ask spread. Passive market making provides liquidity, narrows spreads, and lowers
trading costs. Aggressive trading removes liquidity: buying at the ask (removes sell
orders) and selling at the bid (removes buy orders).
Between September 17, 2010 and November 1, 2010 in the eMini futures contract (December
2010 contract, symbol ESZ0):
These 30 HFT accounts:
- 41,778 accounts traded this contract
- 30 of these accounts (less than 1/10th of 1%) met criteria to be classified as HFT.
Of these 30 HFT, the top 8:
- participated in 46.7% of total trading volume.
- grossed $1.51 million per trading day.
- were aggressive 59.2% by volume (the other 22 were aggressive 35.9% by volume).
- grossed $793,342 per trading day.
The top HFTs probe the market by sending in small aggressive orders and then
gauging market reaction: a practice that allows them to get a private glimpse of the "true"
supply and demand at the expense of everyone else. Once the market direction is ascertained,
these HFT aggressively remove liquidity, causing an immediate market move. Since the
eMini is heavily arbitraged by SPY (which in turn is arbitraged by its many components
and options), these sudden moves in the eMini will set off waves of
overwhelming message traffic as traders and algos react and
reprice thousands of instruments in milliseconds.
In light of
our discovery that Waddell and Reed's trades in the eMini on
May 6, 2010 were mostly passive, we wonder if this probing by HFTs
may have set in motion the downward spiral on that day, resulting in the Flash Crash.
These HFTs not only manipulated markets on that day in a disastrous way, they drove
liquidity providers away from the market.
A lot of media discussion about HFT focuses on 3 benefits: they provide liquidity, narrow
spreads and lower trading costs. This Harvard paper exposes some disturbing truths:
the top HFT engage in a predatory market manipulation strategy that removes liquidity
59.2% of the time (by volume),
causes undue intraday volatility (which amounts to a tax on investors),
warps the true picture
of supply and demand, and raises trading costs for everyone processing market data.
Perhaps even more disturbing was
the Bloomberg article where we first learned of this paper.
It appears that rather than investigate HFT manipulating the markets, the regulator
is investigating academic access to their audit level data-set.
Next time the media writes about the benefits of HFT - ask them if they've read
Adam Clark-Joseph's paper on Exploratory Trading.