I'm a big fan of Michael Lewis' books such as "The Big Short" and "Liar's Poker". He takes the time to develop characters, making the narrative feel more relevant. He also explains complex financial issues very clearly, making them understadable to anyone. In his new book "Flash Boys", Michael Lewis explains the industry and practices of high frequency trading (HFT) through the eyes of the founders of IEX, a sort of rebel exchange created in response to HFTs and dark pools. He explains how the industry has changed the landscape of Wall Street literally and figuratively and what those at IEX are trying to do to fix it.

HFTs use super fast computers and internet to access ticker symbols, their bid and their offer prices before anyone else. When a stock order isn't fulfilled just in one exchange it gets sent to the other exchanges. HFTs exploit their access to fast information to detect an unfulfilled order and front-runs it in the other exchanges. Front-running is when someone buys up what you order before you and sells it to you for a higher price. What's worse, HFTs create situations for orders to rarely be fulfilled by one exchange so they can front-run trades every time. I admit, as Michael Lewis suspects of most people, I did not know that HFTs were front-running. However, I definitely noticed some odd things happening in the market over the last several years.

Personal Encounter with HFT

My experience of learning about HFT was very fragmented. I initially grew interested in HFTs as companies like Knight Capital and Hudson River Trading came to recruit software engineers in my University. They pay new hires the most out of all the companies represented at our career fair. Naturally, I looked them up. I found that they trade electronically using fast programs and mathematical models, but not much else of what these companies do were transparent. Do they trade quickly in response to news according to financial models? I could not figure out what they do.

Then came the the flash crash, which further piqued my interest in HFTs and their effect on the market. After some research I learned that micro-crashes had already been happening for sometime. Some time ago shares of Campbell Soup suddenly spiked 10 fold and returned to normal, and surprisingly there was no discussion of it. At that time I believed the exchange operators explanations that these errors were caused by software glitches and 'fat-finger' traders. Little did I suspect that this behavior was due to something more malicious and intentional like front-running.

Something else I noticed, but couldn't explain is the constant presence of 100 share orders on the BATS exchange. I like watching trade tapes because it shows all trades in public markets in real time. It's as if I'm present and watching orders at a real market like a fish market. But when I noticed the trades were for a $4 stock, I knew instantly they were HFTs because the lowest brokerage commission of $5 per trade would put the seller at a 1.23% loss and no institutional manager would adjust their holdings by only $400. My naive guess was that they were measuring the impulse response of the market to model it. A model of the market would allow you to guess its price fluctuation if some large shareholder were to suddenly unload. I now know now thanks to "Flash Boys" that it was merely bait to probe orders so HFTs can front-run trades.

"Flash Boys" and Other Resources

Reading "Flash Boys" has been rewarding. The book completes the puzzle of HFTs and market anomalies in a satisfying way that other resources haven't done for me. It is also a refreshing reminder that not all people on Wall street rely on exploitation to make money. I hope to find out soon whether the brokerage I rely on routes trades to IEX. I've listed the other entertaining and informative resources below: