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The Great HFT Debate

19 August 2014

The Truth Behind Price Updating Through Order Cancellation

A common misperception of electronic trading is that high cancel rates imply bad behavior. But frequent updating of prices based on changes in the underlying data is good for market participants and investors because it ensures fair, orderly, and efficient prices. Understanding the purpose behind order cancellations helps to clarify these benefits and calm fears that it denotes bad behavior.

One of the largest benefits electronic trading has brought to markets is transparency in pricing. Never before have so many firms been able to provide liquidity to investors in real time, thanks to high-frequency trading techniques.

In order to provide this service, these firms must constantly update their prices to keep pace with changing market conditions, meaning that a firm cancels an existing order at an old, stale price and resubmits a new order at a new, current price. A common misperception of electronic trading is that high cancel rates imply bad behavior. In reality, cancellations are nothing more than the price change that occurs when market participants react in real time to updates in the data their models are based on.

[Related: “Fact vs. Fiction: Defining the HFT Debate”]

As the markets have become increasingly electronic, they’ve become more efficient than ever before at reflecting the impact of many different data sources affecting market prices. Professional middlemen such as market makers and HFT firms take in many different data sets and apply many different strategies to create the fairest pricing possible.

(As we look at the following example, keep in mind that even though stock markets quote in pennies, HFT firms calculate prices that are much finer grained. They then translate these prices to the penny increments used by the market.)

For example, an HFT firm might be willing to buy shares of stock XYZ at $32.45214 and thus place a buy order (bid) in the market for $32.45. One of the many different data sources may then update (such as the price in an associated stock changing by a few cents or a change in the US 10-Year Treasury note), causing the HFT firm to price the stock at $32.44735; the result is a cancellation of the previous bid and a placement of a new bid for $32.44.

The updates in data sources leading to such a change occur frequently throughout the trading day and HFT firms often change their prices as they happen. The data sources are real time and the markets are real time, so the HFT firms’ decisions and price changes also occur in real time. Changes in the inputs to the pricing models happen hundreds of thousands of times a day – if not more — across many, many data sources. Not every update in the input leads to a change in price, but many do.

Regular updating of prices based on changes in the underlying data is good for market participants and investors because it ensures that they have fair, orderly, and efficient prices when they want to trade.

Gregg Berman, the Associate Director of the SEC’s office of analytics had this to say (Waters, subscription required) about frequent price updates, often referred to as cancellation rates:

“It’s about much more than quotes and cancels, despite the fixation exclusively placed on this topic by media and outspoken pundits. I worry that today’s debate is too narrowly focused and myopic.”

Understanding the purpose behind order cancellations helps to clarify the benefits price updating brings to the market and calm fears that it denotes bad behavior.

This article originally appeared on the Modern Markets Initiative website.

Spotlight-white-trans For more stories in the The Great HFT Debate Spotlight Series click here.

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3 Comments to "The Truth Behind Price Updating Through Order Cancellation":
  • Missing
    kurtkujawa

    20 August 2014

      

    Don’t tell me there is more transparency in the market place.  There has never been LESS transparency.  100 share markets with multiple exchanges and flashing quotes, high intraday volatility, by definition is NOT transparent.  Is it more transparent when all the players are in one spot, or fragmented across an entire system? Was it more transparent when you got a look from the specialist and you knew there was 4 sellers at a price with 200k and 3 buyers at a price?  Are you that naive  or do you think we are all that naïve that you honestly think all cancelations are based off of changing market conditions?  Have you ever stopped to think that just maybe it’s a self-fulfilling situation?  One HFT firm cxl’s his quote, then the next one cxl’s his and so on.  The only underlying change is each firm chasing each other’s tail and trying to get in the way of the natural order.  Markets are not more efficient, the perception is that they are more efficient because they trade in penny increments.  Do you not know there is a difference between working hard and working smart?   If you need to have 100K individual trades at an average price of $20, how is that more efficient than 1 trade of 100k at 20?  The only thing 100 share markets are efficient at is scalping from pension funds and mutual funds that are representing 99% of the so called individual investors.  So please, I beg of you to stop pissing on my leg and tell me its raining!

  • Comment_tabb_-_larry_tabb_hi-res_wo
    ltabb

    20 August 2014

    Kurt First let's be a little more civil. It's a market and different ideas are from different perspectives not animus. Second I am not sure I agree with you views on transparency I don't view a "look" as transparent. A hidden order book is not transparent. How many folks could call a floor broker to have him walk to a specialist to get a look? Larger institutions maybe. Individuals certainly not. Smaller institutions probably not. Could you recreate the book second by second - no. And on the OTC side brokers could back away from quotes. How is that fair

  • Missing
    kurtkujawa

    21 August 2014

    Larry, I agree with you on the OTC market, which is why i didnt refer to it in my argument, so im not sure why you brought that into play, if anything it reenforces my argument of a central open book.  As for your argument of hw many folks could call a specialist? in the first place that retail guy went thru a broker, that broker had acces to specialists, as for small institutions, I covered alot of small institutions, they got just as good of service and looks that FIDO got.  So my point is, the larger the OPEN book, the more transparent it is.  The more fragmented the market, the LESS transparent it is. 

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