High Frequency Proprietary Equity Trading

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            In recent years, small investors have expressed alarm about the growing complexities of securities trading systems, particularly (equities or stocks), which are the most traded financial security in the United States.  While many industry proponents and skeptics agree that the issue deserves attention, consensus dissolves around what advantages firms trading proprietary strategies using high-powered algorithmic trading systems have over small retail investors. This paper examines the structure of US equity trading firms and markets and isolates a few select cases in which select financial institutions and market-makers have priority and sometimes even control over the matching of bids and offers for underlying securities resulting in potential abuses of order flow. Likewise, smaller participants in the markets can often gain an edge over other investors by creating the illusion of false volume and orders. The SEC (United States Securities & Exchange Commission)  has implemented policies and procedures for registered firms and market makers. Today’s trends relate to high-powered computer systems using super low-latency fiber optic networks connected over a physically short distance to exchanges boasting latency in the micro-second time-frame. This examination of United States equity trading firms and market structure and the history of steps taken by both private market participants and government agencies to protect consumers points out some of the limitations of regulatory bodies in keeping up with high-frequency trading strategies given the early-adoption of new high speed technologies and market-indication tools by proprietary trading firms. Surrounding the issue are complex problems relating to free and open access to markets for small investors with behavioral, social and political implications.


            Proprietary Trading occurs when a firm or individual trades securities risking their own capital for profits as opposed to profiting from commission dollars by processing trades on behalf of the clients of the firm (U.S. Securities and Exchange Commission, 2008). Some of the underlying technologies contributing to high frequency trading include user-friendly Application Programming Interfaces (APIs) allowing for trading strategies to be automated based on input data criteria (Kim, 2007, P. 23).

In order to understand the scope of the activities which can be defined as proprietary trading, we must first identify the structure of the US securities markets and  financial services firm. The underlying securities-related organizations which make up the infrastructure of the financial services market are exchanges which contain multiple markets, both primary and secondary in which sellers offer shares or contracts for sales and buyers, commonly referred to as bidders, bid for ownership of the underlying securities (Gehm, 2008). These industries started on the streets of New York & Chicago and have now progressed to digital systems matching bids & offers. Some examples of exchanges are the NASDAQ, NYSE, AMEX, CME and LSE, which will be discussed in depth (Gehm, 2008).

For future contract exchanges, The Chicago Mercantile Exchange (CME) is the leading exchange (Gutmann, 2008). Most proprietary trading firms have access to some or all previously mentioned US exchanges but also access to the London Stock Exchange which is the most important stock exchange in Europe. Other markets include Euronext and the Toronto Stock Exchange.

Exchanges are generally divided into two divisions: primary and secondary markets. The primary market is for new issues of securities, as distinguished from the secondary market, where previously issued securities are bought and sold. A market is primary if the proceeds of the sales go to the issuer of the securities sold.

There is no physical or virtual defined location for the primary market. The transactions are rather happening between investment banks and institutional investors (Benoit, 2012). Once all the transactions for an issue are completed on the primary market, there is what we call an Initial Public Offering (IPO) and the stocks start trading on the secondary market (Jarrow, 2011).

The recent public concern over proprietary trading activities mostly revolve around institutional order manipulation using algorithms to make split-second decisions and outpace the opportunities for less sophisticated investors while increasing volatility in the market. Generally, the way this is accomplished is through order-manipulation. (Jarrow, 2011). Weston (2000) contends this idea:

The competitiveness of dealer and auction markets has recently become a contentious debate in both political and academic spheres. Proponents of dealer markets such as the NASDAQ  argue that competition for order flow between market makers reduces transaction costs. Moreover, the ease of entry and exit in dealer markets may also contribute to lower trading costs. Conversely, proponents of auction market systems argue that expositing limit orders to the public lowers trading costs by allowing investors to trader with each other directly.

Prior to understanding the role proprietary trading firms play in our equity markets, some definitions need to be made. These include: What are the NASDAQ, NYSE, AMEX, CME & LSE exchanges and what are their roles in facilitating free and open markets?; What categories of trading activities are used to qualify an entity as a proprietary trading entity?; In terms of US equity markets, how are orders, transactions, limit orders, and market orders defined?

An exchange is an organization, which allows transactions of financial products to occur in an orderly manner and in a centralized location (physical or virtual) (Geisst, 2004). Stock exchanges are the most widely known example. The New York Stock Exchange (NYSE) and the National Association of Securities Dealer Automated Quotation (NASDAQ) are the two most important stock exchanges in the United States (Buck, 1992). For future exchanges, The Chicago Mercantile Exchange (CME) is the leading one. Proprietary trading firms have access to all previously mentioned exchanges but also have access to the London Stock Exchange which is the most important stock exchange in Europe (Buck, 1992).

A  market is the consolidation of exchanges or transactions in a specific financial product (Buck, 1992). For example, the US stock market is the consolidation of all the transactions happening in the stocks exchanges in United States. Other popular markets are the futures market and the options market which together can be called the derivatives market (Gehm, 2008). The primary market is for new issues of securities, as distinguished from the secondary market, where previously issued securities are bought and sold. A market is primary if the proceeds of the sales go to the issuer of the securities sold (Gibbs, 2008). There is no physical or virtual defined location for the primary market. The transactions are rather happening between Investment bankers and Institutional Investors. Once all the transactions for an issue are completed on the primary market, there is what we call an Initial Public Offering (IPO) and the stocks start trading on the secondary market (Gehm, 2008).

Established in 1971, the National Association of Securities Dealers Automated Quotations System (NASDAQ) is a dealer market and is the first and world’s largest electronic stock market listing nearly 4000 companies. It is operated by the NASDAQ Stock Market, Inc. More than 500 Market Makers use their own capital to buy and sell NASDAQ securities, and then redistribute the stock as needed. The NASDAQ network also connects alternative trading systems like electronic communications networks (ECNs), which enable investors to trade with each other. The NASDAQ Stock Market is composed of two separate markets: The national market and the Small Cap Market. The NASDAQ recently became a public trading on the NASDAQ under the symbol NDAQ (Bretan, 2010).

The New York Stock Exchange (NYSE), founded shortly after the NASDAQ in 1792, is the largest auction market place in the world (Buck, 1992). It is located at 11 Wall Street in New York City. The NYSE is often called The Big Board or The Exchange. It is a physical market using a specialist to match orders; however, the exchange is becoming more electronic with its acquisition of the Archipelago Exchange (ARCA Exchange) and more volume on the Intra-market Trading System and different ECNs forming the third market (Sobel, 1980). Approximately 3000 companies worth nearly 18 Trillion dollars in global market capitalization are listed on the exchange (Hintz, 2006). Average Stock volume is more than 5 Billion shares. Listing requirements on the exchange are very strict. Therefore most stocks traded are older companies and blue ships. A lot of foreign companies are also listed on the NYSE as American Depository Receipts or other form of entities (450 Non-US companies valued at nearly 5 Trillion dollars). The exchange trades many other products like bonds, warrant, rights and ETFs (Buck, 1992).

The AMEX, which stands for the American Stock Exchange, is a smaller market for equities but it is the second-largest options exchange in the World (Geisst, 2004). The AMEX was bought by the NYSE in January of 2008 (Zwick, 2011). About 800 different stocks were trading on the exchange and a lot of different ETFs, since the AMEX is a pioneer in that field. A lot of AMEX stocks are now traded electronically on the NYSE through Archipelago (ARCA Exchange) Exchange (Zwick, 2011). The AMEX was also an auction market using a specialist. The Spiders (SPY) and Diamonds (DIA) which are ETFs respectively based on the S&P500 and Dow Jones Indexes were two of the major ETS trading on the exchange (Samelson, 2010).

The Chicago Mercantile Exchange, which recently acquired the CBOT and the NYMEX, is the largest US derivatives exchange in the world. It was founded in 1898 as the Chicago Butter and Egg Board, evolving into the CME by 1919 (Samelson, 2010). This exchange is a major marketplace for trading futures and options on agriculture products, currencies, indices, and interest rates. The exchange went public in December of 2002 and is currently traded on the NASDAQ under the symbol CME (Samelson, 2010)­­. The most popular contract traded on the CME and also the most active future contract in the world is the S&P 500 big futures (SP) contract (Gehm, 2008). It represents 250 times the index. Proprietary trading firms access the CME through its electronic exchange called GLOBEX which is the first electronic trading network for futures and options (Samelson, 2010). GLOBEX trades many futures contract with a smaller value often called the minis. The ES traded on GLOBEX is a very active contract and represents 50 times the S&P 500. It is also used at Proprietary trading firms as a global market indicator (Jarrow, 2011).

The most common exchange outside of the U.S. that we conduct business with is the London Stock Exchange. The London Stock Exchange formed in 1760 as a club at Jonathan’s Coffee House by 150 brokers thrown out of the Royal Exchange for rowdiness. The Stock Exchange name was adopted in 1773 and it became a regulated exchange in 1801. Following deregulation in 1986, The LSE, also called the Big Bang, introduced computerized trading via the Stock Exchange Automatic Quotation (SEAQ) and SEAQ International Systems that display share price information in brokers’ offices throughout the United Kingdom (Weston, 2000). The LSE became a public limited company in 2000, with its shares listed the following year. In 1997, the exchange introduced the Stock Exchange Electronic Trading Service (SETS).

Participating firms facilitate transactions by placing orders. An order is a request or advertisement with the intention to buy or sell a specific financial product (Sloane, 1980).  An order identifies the terms relative to price, quantity and conditions in which it needs to match buyer and seller.  An order is said to be open or pending until it is matched with an opposite order. Since about 1976, An open order can normally be cancelled by the sender (Sloane, 1980). For example, if you sent a request to buy 1000 shares of GE at 24.50 this is considered to be a “buy order” on GE. A buy order is called a bid and a sell order is called an offer. The best bid and offer on a stock from all participants is called the NBBO (highest bid and lowest offer) (Sloane, 1980). There are five conditions a trade needs to think about when sending an order and they are: side (is it a buy or a sell), size (the amount of shares), route (is is a NYSE or NASDAQ stock), ticker (the stock’s symbol) and condition (is it a fill or cancel order) (Sloane, 1980).

An order becomes a transaction when it matches with another order that can fulfill its conditions (a sell order matching a buy order for price and share quantity). In this case we say that the order has been filled or executed. Therefore a transaction, which is also called a trade, always has a buy side and a sell side electronically. From the previous example, if somebody else sends an order to sell 1000 GE at 24.50 then a transaction is recorded and both orders are filled. If the sell order would only be for 500 shares then the buy order of 1000 shares would be partially filled and 500 shares would still be open (standing as a pending order) (Kyrolainen, 2008). By convention we say that a trader is buying when he buys from the offer (also referred as taking the offer); and biding when he place a buy order below the best offer. In the same manner, we say that he is selling if he places a sell order at the bid price (also referred as hitting the bid); and offering if he is offering above the best bid (Kyrolainen, 2008).

A limit order is an order to buy/sell at a specific price or lower/higher. Execution can happen at the price specified or at a better price (rarely). Price improvements happen more on the NYSE at the open or the close because the specialist is going to find a price that can match the most orders Limit orders are standing in the market if they are not executed. They will be only filled if a match with another order can be made. Limit orders are the most popular order at Proprietary trading firms because they limit the risk of errors; however, despite improvements such as NBBO (National Best Bid & Offer), uncertainty remains about the manipulative capabilities of sophisticated algorithms on individual retail investors (Kyrolainen, 2008).

Therefore, this study’s purpose is to identify possible threats to volatility and small investors with the growing use of both algorithmic trading systems and electronic communications networks, which serve as a third market. The first being the primary IPO market and the secondary market being the aforementioned exchanges.


The research questions that are posed here are:

  • What markets and categories of trading activities, specifically types of orders and transactions are useful to high-frequency proprietary traders?
  • What are proprietary trading firms’ primary sources of income?
  • What are the effects of proprietary trading on inventory?
  • What are the primary differences between market making and proprietary trading activities?
  • How do ECNs (Electronic Communication Networks) and Dark Pools function and what are the technological characteristics of an ECN or Dark Pool?
  • What effects do proprietary trading firm activities have on volume, liquidity, volatility and the execution systems of the underlying securities?


Literature Review

            Trading firms have a variety of mechanisms in place to place orders using limit order, stop losses and other sophisticated tools that simply may be unavailable to retail traders. Contrasted with a limit order, a market order is an order to buy or sell a security at the best price available. Market buy orders are filled against available limit order in the market (Kyrolainen, 2008).

Sergey Perminov examined trends in financial markets in this book Trendocracy and Stock Market Manipilation based upon order flow and noticed trends in behavior based on greed and feed often invoked by market makers and algorithmic trading systems on customers using market orders. Market orders can be very dangerous for many reasons. If you were an investor, one big concern is that you have no control over what price you get. One scenario in which a larger institution can take advantage of smaller retail traders is dishonest Market Makers and dealers that could cancel and move their limit orders if they see a big order coming in. It’s important to note that there is a big difference between buying/selling 1000 shares and 10000 shares but sometimes it is easy to mistakenly enter an extra 0. Those are called keystroke errors and they happen all the time in the market (Perminov, 2008, pp. 22-25). Recently, in December 2005, a Japanese Trader lost hundreds of millions of dollars because of a keystroke error (Perminov, 2008, p. 42) Traders using market orders are impatient and normally it does not pay to be impatient with the market. There seems to be a strong discourage of use of market orders at proprietary trading firms since there are less risky ways to get quick executions with special limit orders (Perminov, 2008).

Nissim Taleb, a british economist an author notates how unlike individual investors, larger firms may have the ability to borrow stock and give it back at a lower cost, earning income off a decline in value. When you are buying stocks, you are said to be getting long. If you own stocks, you are said to be long that stock (Taleb, 2008, p. 48). For example, if you send a buy order on 1000 shares of IBM and get filled, you are now long 1000 share (assuming you had no previous trades/transaction in IBM). It is possible when you trade to sell stocks that you don’t own. We call that shorting. You are borrowing the stock with the intention to sell it on the market and buy it later at a lower price (obviously if the stock goes up you will be paying a higher price to buy it back and therefore lose money on the operation) (Taleb, 2008, p. 52).When you sell stocks that you don’t own you have a negative position in that stock and you are said to be short. For example if you send a short order of 1000 Shares of IBM and get filled, you are now short 1000 share (assuming you had no previous trades/transaction in IBM). You now have -1000 shares in your possession.

For banks and trading firms, Short selling in an important tool, which allow traders to take advantage of a declining stock/future price (sell high, buy low). Without this position, traders would not be able to make money 50% of the time or hedge their bets to limit risk exposure. Since stock prices fluctuate every day, if a trader can only go long, he or she will miss out on at least half of the opportunities to make money each day. Most of the investing public does not know about short selling. This results in a long bias towards investments. Trading firms and baking institutions have more knowledge than the general public in this area (Perminov, 2008, p. 101).

Leonard Sloane in his book The Anatomy of The Floor (1980) noticed the trend to lightning fast execution systems over three decades ago. He had spent time on the floor of the New York Stock Exchange and  noticed throughout the day inventory/positions constantly change, faster than the blink of an eye. It varies from a positive amount of shares owned to a negative amount of shares that can be the product of a short sale. When no inventory is left, traders are said to be “flat” (Sloane, 1980, p. 25). Likewise if you had no execution on a stock you are said to be flat (Sloane, 1980, p. 25). Every time the NBBO of a stock is moving and a position is opened, you are said to be  incurring an unrealized profit or loss. It is called unrealized because you haven’t closed your position yet. However the unrealized profit is a realistic view of how much you would make if you would be close your positions and go flat (Sloane, 1980, p. 27).

Every time that a transaction is made in the opposite side of your current position (selling when you are long or buying when you are short) you are realizing a profit or a loss. For example, if you are long 100 shares at 11.23 and you sell 100 shares at 11.24 you are incurring a 1 dollar profit. This is called realized profit. Realized profits and losses are accumulating all day (Samelson, 2010).

Michael Gutmann, an author for Futures Magazine Group covers automated high frequency trading and has isolated markets into broker markets and dealer markets (2008). A dealer market is one where many participants are competing against each other by posting different bids and offer. The NASDAQ is the most important dealer market in the world where orders are filled through market makers and ECNs (Gutmann, 2008). Any Over The Counter market or fully electronic market is also a dealer market. Unlike an auction market, where there is only one specialist per stock, there are many market makers per stock in a dealer market (Gutmann, 2008). A market maker is an individual trader employed by a financial institution to manage the company’s inventory of a particular security. They maintain their inventory and use it to make money for the company by buying and selling on the market. A market maker’s primary responsibility is to provide liquidity to the market – to literally make the market – they are there to provide a flowing market while following the rules as set out by the FINRA and SEC (U.S. Securities and Exchange Commission, 2008).

The general consensus among experts is the difference between Market Makers and traders at proprietary trading firms is that market makers are better capitalized in many scenarios and more experienced. The market makers that are the most powerful on a particular security are common referred to as the AXEs (Gutmann, 2008). They have the same goal as prop traders – to make money trading full time; However, Market makers have additional restrictions and responsibilities that proprietary trading firms do not have including:

    1.  They must fill orders (bids, offers, buys, and sells) on a first come, first serve basis.
    2.  They cannot fill orders pre or post market hours.
    3.  They cannot back away from a level 1 price. (requires more detail)
    4.  They cannot buy through an advertised price
    5.  They must appear on both sides of the level 2 between 930am and 4pm.
    6.  Buy and sell what the public wants (This refers to retail clients – average investing customer)
    7.  Fill institutional orders (Mutual funds, pension funds, etc)
    8.  They earn the least from retail clients – the commissions are small and so are the orders
    9.  The company earns the most in commissions from the institutions – they pay a premium for a top trader to execute their orders
    10.  The market maker – the person – makes the most from earning money on the house account

Without prioritization of responsibilities, retail clients would be ignored and institutional orders would be executed when convenient.

In the late 1970’s, ECNs appeared. Electronic Communication Networks are electronic systems that display and matches securities buy and sell orders placed on exchanges and over-the-counter by market makers and traders (Weston, 2000). Brad Hintz published his report on institutional equities (2006) and concluded that ECNs have assisted in making the markets more liquid and competitive. The highest bid and lowest offer is published on the NASDAQ (National Association of Securities Dealers Automated Quotation) workstation and distributed through information vendors around the world. There has been a lot of consolidation recently in the sectors. NASDAQ which operated Supermontage recently bought Instinet and Brut. The NYSE bought Archipelago. Another example is when NITE, a very active market maker, bought Direct Edge. ECNs are making the market more liquid and competitive (Hintz, 2006).

At Proprietary trading firms, traders have direct access to all major ECN quotes and they can also post bids and offers on all those ECNs including but not limited to: NASDAQ, ARCA, BATS, EDGA, EDGX and TRAC. ECNs allowing for the following advantages over placing orders directly to the exchange, including: Quotes and Execution (when there is a match) are instantaneous; They allow to post bids and offers to advertise on Level II; Posting takes milliseconds to appear on the level 2; There is no charge for a trader to post a bid or offer, actually, the trader will get a credit if the order is filled; Partial fills are a common occurrence with the more popular ECNs. In addition, Most ECNs have IOC (Immediate or Cancel) order types (Hintz, 2006).

Dark pools are Alternative Trading Systems that are not publishing their order book publicly. Dark pools are generally used by institutions to try reducing market impact when placing large orders. Dark liquidity pools offer institutional investors many of the efficiencies associated with trading on the exchanges’ public limit order books but without showing their hands to others. Dark liquidity pools avoid this risk because neither the price nor the identity of the trading company is displayed. Most dark pools also offer advanced algorithmic-decision-based trading to improve chances of executions of big orders. Since there is no book the execution range is based on the NBBO to avoid prints outside of the market (Hintz, 2006).

Christina Gibbs of Advanced Trading (2009) examined proprietary trading and market makers tools which generally held too high of a barrier for individual investors. She suspects level 2 and 3 data provides insight into which market participants are active. The high cost of these tools make them unavailable to most retail investors. With the high number of market participants and all the different Exchanges and ECNs, Orders must be organized in a way that allows easy access to information. Level 2 windows are used by all active and serious market participants to access information about limit orders on specific stocks no matter what exchange or ECNs they are trading on (Gibbs, 2008). On the Level 2, all the market markers and ECNs limit orders, with the same price and the same side (buy or sell), are called the players of the level, the players being market makers or ECNs and the level being the specific price. On a stock the highest/lowest level bid/ask provided by one or more ECN called the Level 1 Bid/Ask. The total number of shares on a specific level is called the Size of that level (Gibbs, 2008). The Time and Sales window is very important when you combine it with the level 2 screen. It gives you information about the last trades that have been made in the stock. This provides you a unique advantage if you have access to Level 2 data. The size and the market are very important because they give you information about where you should place your order to get a better execution. The level 2 gives you information about which side the trades are made: the offer and the bid. A “print” is a trade between the bid and the offer, which is also called the mid-point. All the information in the times & sales window is often called the tape. Reading the tape is a commonly referenced practice in trading to this day (Gibbs, 2008).

Gibbs also notes Tape Reading plays a key role in the split-second decision making of firms and high-frequency traders. Tape Reading refers to getting crucial information and reading between the lines of the time and sales window. Traders must adjust their orders in real time according to all the trades in the time and sales (Gibbs, 2008). The rhythm at which trades are executed on a specific ECN/exchange or where they are executed is also referred to as the order flow. For example, you  could say that there is a lot of order flow on ARCA or a lot of order flow on the bid.

The concept of FIFO means that in a list, the first one to come is the first one to be served (Weston, 2000). ECNs work on the FIFO principle. For example, if on NASDAQ there are 3 pending bids of 1000 shares at 25.10, NSDQ will show 30 on the Level 2. If somebody sells 500 shares to NSDQ then the first order of 1000 that was submitted will be partially filled and 500 shares will remain on top of the list. At that time the Level 2 will show 25 on NSDQ.

Michael Bretan examines (2010) how firms use indicators, volume, moving and other averages in order to make the most informed decision possible regarding placing a trade. A specific ECN is based on FIFO. However the whole Level 2 does not work like FIFO. For example, if you send an offer on NSDQ for 1000 shares of MSFT at 25.11, somebody else could send another offer at 25.11 after you on ARCA and if the next trade happens on ARCA he will sell before you! That concept is very important when you come to decide which ECN to use based on how trades are made on a specific stock (Bretan, 2010).

The volume is the total number of shares executed on one stock since the beginning of the day. It is a good indication of the level of activity when you compare it to previous day average volume on the same stock or other stocks average volume. If you traded 50k volume on a stock that has 500k volume during the days you did not trade 10% of the volume but only about 5% since one trade always has two sides (Bretan, 2010).

Liquidity refers to the ability to buy or sell an asset quickly and in large volume without substantially affecting the asset’s price. Shares in large blue-chip stocks like Citigroup or General Electric are liquid because they are actively traded and there are always substantial buyers and sellers on the bid and offer (Bretan, 2010).

The notion of adding liquidity therefore refers to adding pending orders to the market. Removing liquidity refers to take it away from the market by removing limit orders. Market orders are always removing liquidity. Limit orders are removing liquidity if the bid/offer price is equal or higher/lower than the current offer/bid on the ECN they are submitted to (Bretan, 2010).

While volume can be a good indication of liquidity, two stocks with the same volume can have a liquidity that is completely different.

A Swipe is the action of taking all the liquidity available on the bid or the offer in a single transaction (Bretan, 2010). For example if a stock has a bid of 25.10 and an offer of 25.11 and there are a total of 14200 shares for all participants on the offer, A market maker could decide, the price being too low, to buy everything at 25.11 with a single order. Normally he will then place a buy order at 25.11 and the bid-ask will now be 25.11 to 25.12. Bretan points out the increase in spreads is likely to be a permanent feature of our markets in the future.

A Rip is a sudden increase in price on a particular stock. When that happens, all the trades are happening on the offer (active buying on the stock) and market makers and ECNs are showing higher bid and offer for the stock. More than one Swipe can happen on a rip. Rips usually happen when there is a unexpected good news on the stock (Perminov, 2008).

A tank is the opposite of a rip and it happens when the stock is going lower because almost every trade happens at the bid and Market Makers and ECNs are lowering their bid and offer. More than one Swipe can happen on a tank. Tanks usually happen when there is an unexpected bad news on the stock (Perminov, 2008). The main aspect of Rips and Tanks is that they happen so quickly that most traders have no time to react. Losing 5 cents on a tank when you are long is different than losing slowly cent by cent when the stock is going down.

Volatility refers to how much movement there is in a stock. The more volatile the stock the more it is going up and down (Bretan, 2010). More volatile stocks are this riskier it can be for traders but they can also be good opportunities for profit. The volatility of the market is also important. On slow moving days where the market is not volatile, traders should not try to go for the long shot (Cutler, 1991).The VIX is the volatility index measuring the implied volatility from all the options traded in Chicago (Gehm, 2008).

Petri Kyrolainen reviewed day trading and stock price volatility for the Journal of Economics & Finance. His research focuses on a few moving averages such as the VIX. The level of the VIX will tell you how much the market is volatile. Normally when the market is going down and there is fear among participants the VIX is going up. VIX is going down when the market is stable or going up slowly (Kyrolainen, 2008).

In 2010, Matt Samelson isolates venues into gateways to simple the structure. A gateway is a trading route. Each individual ECN is a Gateway. NSDQ is a gateway and BATS is also a gateway. When a connection to a specific gateway fails, no order can be sent or cancelled. Therefore the risk controllers need to handle all the orders by phone. The gateway itself can also fail. In that case no trader in the world can send or cancel orders (Samelson, 2010). The execution system sends confirmation of pending, filled and cancelled orders to the market participants for a specific ECN. The Proprietary trading firms Execution System is sending back confirmations concerning all the consolidated gateways to all the traders at Proprietary trading firms and then, modifies each account properly (Samelson, 2010).

A book is the name used for the window containing orders information on a specific gateway. When you have this information available, you say that you have the book. At Proprietary trading firms we have access to the NASDAQ book, the Arca Book, The Bats book, the EdgX Book, the EdgA Book and the New York Book. An ECN book is like a level 2 but shows the information for only one ECN. Therefore individual orders on the same price level can be shown in detail instead of being combined. Such a feature is available for the NASDAQ book if you subscribe to it online (Samelson, 2010).

Nowadays most traders have the ability to access all ECNs and to send order to each one of them; however, most traders are retail trader. Retail traders are like the traders at proprietary trading firms and market makers except that they trade from home with their own capital, through a broker (Zwick, 2011). They normally pay high commission relative to the proprietary trading world where economies of scale take place. Also, they normally don’t receive rebates from ECNs (more on that later). They therefore need a lot of capital and a lot of experience (Zwick, 2011).

In contrast to retail traders, proprietary traders use capital from a trading firm and they share the profits they make trading the market. The Job of proprietary trader is to watch what is happening on different Level 2 and Time & Sales windows for specific stocks and send orders that allow being long or short at a good price (Bretan, 2010). It might seem like a simple definition but recognizing opportunities and good prices are very complex. It is believed that there is a necessary natural instinct to find those price points. In some market conditions you might want to buy high and sell higher. Experience will teach proprietary traders when to send their order, at what price and on what gateway based on the information available. The price is mostly at their discretion if trading the firms account (Cutler, 1991). There are many buyers and sellers on the market and they don’t always see each other. Proprietary traders buy from active sellers who don’t have enough information and market access tools to know that there are also active buyers in the market. Proprietary traders are making money because they facilitate trading between uninformed traders. The profit they make is basically the average difference between the bid and the offer or the “spread” (Hintz, 2006). This serves as the primary source of revenue for market makers and larger trading firms. Another popular strategy is arbitrage, which consists of taking advantage of prices in different markets (Hintz, 2006).

Arbitrage can be extremely profitable as it can imply instantaneous and risk free profit. It is basically like picking up money that you find on the sidewalk. There are many types of arbitrage. Interexchange arbitrage happens when a stock is trading on more than one exchange (Hintz, 2006). There is a chance that a participant on one exchange bid higher than the ask price on the other exchange. In this situation all you have to do is take the offer price on one exchange and sell at the bid price on the other. This is called pure arbitrage. However unless you are able to send 2 orders at the same time you always have the risk for the bid to be cancelled before you have time to get it (Hintz, 2006).

Semi-arbitrage is more common and we take advantage of it almost every day at Proprietary trading firms. This happens when there are people selling on an exchange (not offering but selling at the bid) and other people are buying on another exchange (taking the offer) while bid and offer are the same on both exchange. If there are not too many orders on the level 1 bid and ask this is normally a quick way to make money by buying from the sellers on exchange A and selling to the buyers on exchange B (Hintz, 2006). There are many other types of arbitrage like risk arbitrage, statistical arbitrage, index arbitrage, etc. etc. (Hintz, 2006).

Lots refer to a specific standardized number of shares. 100 shares is usually the smallest regular lot traded on the different stock exchange. Round lots orders or trades refer to a quantity of shares in multiple of 100, for example 1200 shares. Odd lots are the opposite, for example 1238 shares. The expression can also be used in other circumstances, like buying in 1k 5k or 10k lots. It is illegal as a prop trader to enter a position with an odd lot. However if you have been partially filled and have an odd lot position you can exit it legally (Kyrolainen, 2008). It is said  that the market is locked when the bid on one exchange or ECN is equal to the ask on another ECN or exchange. That is to say that there is a limit order at the bid on a specific ECN or Market Maker that has an equal price to a limit order on the offer (Bretan, 2010). Only some ECN allow locking the market. Locking the market is a common practice on small stocks on the NASDAQ. It sometimes also happens on the NYSE. It used to be that when the market was locked you could see it on the level 2. Nowadays the ECN that is creating the locked market is not allowed to display the quote on the level 2. The only way to know that a market is locked is to send a small order in the opposite side to the ECN we expect to be locking and get a fill (Bretan, 2010).” Crossed markets happen when the bid price on one exchange or ECN is superior to the ask price on another ECN or exchange. This is pure arbitrage and does not happen too often. It is also good to note that it is rarely on big orders. Most ECN and dark pools prevent executions outside of the NBBO (national best bid / best offer)” says Uri Aboutboul, Managing Partner of Acclaim Capital Partners LP, a New York City based hedge-fund with a proprietary trading investment strategy and Aboutboul & Company Management Consulting.

Rebates are part of some type of profit sharing program with the ECNs. They are an incentive to add liquidity to the market. To encourage people to add liquidity, ECNs pay rebates to the market participants that are adding liquidity (Gibbs, 2008). They pay around 2$ for each 1000 shares that add liquidity (rebates are different for every ECN). Conversely, they are charging around 3$ to remove liquidity from the market. Therefore when a trade happens, they get 3$ from the liquidity remover, pay 2$ to the liquidity adder, and keep 1$ for themselves. Rebates are more popular on the NASDAQ and they are a lot lower on the NYSE (Gibbs, 2008).

Without rebates, the market would be a lot less liquid and the industry in general would be far less profitable. Now you probably know why people are locking the market. This is because you can make money by buying and selling at the same price if you add liquidity on both sides.

An index is simply the average of a group of stocks based on a unique characteristic of the company. It is a group of stocks averaged out to help us get a general indication of market sentiment (Jarrow, 2011). There are many different indexes. The most widely known ones are:

  • DJIA – Dow Jones Industrial Average
  • S&P 500 – Standard and Poor’s 500
  • NASDAQ Composite – All the NASDAQ stocks
  • NASDAQ 100 – NASDAQ top 100
  • Russell 2000 – Small cap stocks

The Dow Jones Industrial Average (DJIA) is a well-known US equity index.  It is an old established private company, which provides many services to traders and the financial community. They do market research; come up with averages and other market indicators (Buck, 1992). The reason the DJIA is so widely known and powerful is because of the reputation and credentials of the company. They are known for strong and reliable analysis.

Anyone can come up with an index. However, the reason we all look at the Dow is because they are well known and established. The Dow Jones is not just NYSE stocks. MSFT and INTC are also in the average. Many traders make the mistake that DJIA is the NYSE. It is not. There are 30 stocks in the Dow Jones Industrial Average (Kent, 1990). They pick leaders in each of the different sectors. Example: who is the leader in soft drinks? Coca-Cola. And yes, they are in the Dow 30. Who is the leader in fast food? McDonald’s is also in the Dow. How about building and home renovations? Home Depot is also in the Dow. Who is the leader in retail? Wal-Mart, which is also in the Dow.

S&P is another private company like Dow Jones, which does financial research and creates indexes. S&P stands for Standard and Poor’s. The S&P 500 is the most widely watched index in the world. The 500 stocks that S&P have selected to be in this index are also leaders in their fields. Once a stock is in the S&P 500 they will stay there until they are no longer a leader in the field (decided by the S&P) (Kent, 1990). Standard & Poor’s is widely recognized as a leading provider of indices. S&P indices are used by investors around the globe for investment performance measurement and as the basis for a wide range of financial instruments. The S&P 500 Index is strongly representative of the sentiment of the broad, or general, stock market. Widely regarded as the standard for measuring large-cap US stock market performance, this popular index includes a representative sample of leading companies in leading industries.

Some Important points about the S&P 500:

“Most liquid instrument in the world after the US dollar.

All fund managers’ returns are compared relative to the S&P 500.

If you add a stock to the S&P 500 that stock goes through the roof. (Go and find out which stocks have recently been added to the S&P 500, and how much the stock went up the day they announced that they were going to be added to the index.) This is because many index fund managers will have to buy the stock

Why are stocks dropped from the S&P 500? Usually because they were merged or bought out by another company already in the index.

A futures contract is a trade made in the present, for an item that will be delivered at a later date. In other words, two traders agree on a price, one of them agrees to buy, and one of them agrees to sell. The actual item being traded does not change hands. It is agreed that the seller will provide the item, and the buyer will take delivery of the item at a pre-set date in the future, for a price, which is agreed upon at the present time.

In simplest terms, futures are traded by agreeing on a price in the present, for an item that will not actually be ready for delivery until a specified date in the future” (Gutmann, 2008, p. 54)

The S&P 500 futures can be a powerful leading indicator for stock traders. After the US Dollar, they are the most liquid trading vehicles in the world and as such, they represent the sentiment of the broadest array of market participants at any one given time. By observing the price action of the S&P 500 futures, traders will notice that more often than not, stock sectors and individual stocks will tend to follow the movement of the futures. Perceptive traders will learn to recognize this correlation, and use it to successfully anticipate price movements (Gibbs, 2008).

Liquidity refers to the ability of market participants to buy and sell securities.  The more orders there are available in a market, the greater the liquidity.  Liquidity is significant because with it, it is easier for traders to buy or sell securities, and as well, it is more likely for the trader in question to pay or receive a competitive price for securities bought or sold (Gibbs, 2008).  There will be lower liquidity in extended hours trading as compared to regular market hours simply because the tremendous amount of buying and selling done by the market makers and specialists is no longer part of the equation.  As a result, your order may only be partially executed, or not at all.

Volatility refers to the changes in price that securities undergo during trading.  In most cases the higher the volatility of a security, the greater the price swings, the greater the potential for large profits and large loss.  There may be increased volatility in extended hours trading than after the regular trading session has closed and as a result trader orders may only be partially executed, or not at all.  Furthermore, traders will often run the risk of receiving a price in extended hours trading inferior to one likely to be obtained during regular market hours (Cutler, 1991).

The price of securities traded in extended hours trading may not reflect the prices either at the end of regular market hours, or upon the opening of the market the next morning.  As a result, traders receive an inferior (or admittedly a superior) price in extended hours trading than you would during regular market hours (Cutler, 1991).

Depending on the extended hours trading system or the time of day the prices displayed on an extended hours trading system may not accurately reflect prices available worldwide. There may be substantially different prices available on other concurrently operating extended hours trading systems dealing in the same securities.  So once again, the price the trader may receive for a particular security may be inferior or, again superior, to a price available on another extended hours trading system.


            In order to determine the impact of high-frequency trading on volume, liquidity and other aspects of our financial markets and the best actions to take to protect small investors from predatory activities, a hierarchal analysis of the aforementioned literature in terms of seeking structure and roles of participants in markets in necessary in order to assess the impacts one organization, firm or individual has over another. The use of information regarding regulatory oversight and policies is of little use in this case due to the political nature of financial firm regulation in the United States. Some rules meant to protect consumers such as margin requirements or licensing programs for financial firm representatives can often cause unbalanced distortions in distribution of market volume, liquidity and income. It is therefore a more systemic approach to draw out the structure of the market and how participants in these markets profit in the short-run (high-frequency trading) as opposed to the long-run (retail investors).

Finding and Results

What markets and categories of trading activities, specifically types of orders and transactions are useful to high-frequency proprietary traders?

Proprietary Equity Traders in the US access the NASDAQ, NYSE, AMEX, CME and LSE markets. In order to analyze their positions, traders will use limit orders, market orders, stop orders as well as ECNs (electronic communication networks) and technical   indicators, which are usually based on statistical analysis of price and/or time and sales.

What are proprietary trading firms’ primary sources of income?

The primary sources of income for high frequency proprietary trading firms are direct  profits from realized and unrealized losses. Many firms support other streams of  generating revenue through brokerage services or hosting their own Electronic Communications Networks. In addition, many firms take advantages of rebates provided by ECNs and exchanges ( up to $3 USD per 1000 shares traded) for adding liquidity by entering into positions at an opportunistic time.

What are the effects of proprietary trading on inventory?

Proprietary Trading and high-frequency algorithmic trading systems have historically  shown little effects on inventory price; however, trends have been noticed in spreads    growing larger (the difference between the bidding and asking price) as well as pricing   out of orders by market-maker sweep orders which temporarily distort prices under the  illusion of false demand to purchase the underlying securities.

What are the primary differences between market making and proprietary trading activities?

Proprietary Traders trade their own or a firm account strictly for net profits resulting from those trades. Market Makers are firms that stand ready to buy and sell stock on a regular  and continual basis at a publically quotes price. They must be ready to buy and sell at  least 100 shares of a stock they make markets in. While a trader may place a large order to be filled, the market makers are responsible for being able to fill these orders at publically active pricing. The NASDAQ is a good example of a market maker. Roughly    500 member firms act as market makers for NASDAQ, keeping orderflow efficient because they are willing to both bid and offer prices for an equity.

How do ECNs (Electronic Communication Networks) and Dark Pools function and what are the technological characteristics of an ECN or Dark Pool?

ECNs and Dark Pools are similar yet function in a different manner. ECNs act as a market within a market where buyers’ and sellers’ offers are matched. The resulting tape of bids and offers is available electronically. Generally speaking, Dark Pools use more       sophisticated algorithms which match bids and offers across multiple Electronic Communications Networks (ECNs). If you place an order for 1000 shares and the BATS ECN does not have the available volume, you will likely have to wait for a market maker to move some volume to get filled. Dark Pools such as NITE allow for those 1000 shares  to be distributed  (in a dark pool) among other ECNs to get the trader the quickest fills at the best prices.

What effects do proprietary trading firm activities have on volume, liquidity, volatility and the execution systems of the underlying securities?

Historically, there has been little evidence of algorithmic activity affecting volume, liquidity and volatility. Despite lightning-fast capabilities, algorithmic trading systems still play a small role in our overall markets. The flashcrash of 2010 has once again raised speculation regarding securities transaction. Within a few minutes, the market had dropped roughly 8% without evidence supporting other possible causes aside from high-frequency algorithms triggering a sell-off. The use of newer ECN and other technologies   have had little impact on volume trends or the ability to get in and out of a stock; however, the flash clash of 2010 has raised questions regarding the impacts of these systems on volatility which have remained mostly unanswered.


            One way possible abuses have been addressed is through strategic time release of possible market-moving information. Issuers normally make news announcements likely to affect the price of their security after regular market hours have concluded.  Important financial information is similarly announced outside of regular market hours to foment stability of trading (Perminov, 2008).  In extended hours trading these announcements occur thus during lower-volume trading when this is combined with the naturally higher volatility it will likely cause an exaggerated and unsustainable effect on the price of that security.

Despite such protections, much like securing digital information, there is no completely secure way for a financial firm to protect their assets when trading for profits or, for that matter, for a small investor or trader to protect his assets from larger institutions. Trading firms remain some of the most early adopters of high-speed technology, boasting latency in micro-seconds (Bretan, 2010). There are five considerations investors and/or firms need to think about when sending an order and they are: side (is it a buy or a sell), size (the amount of shares), route (is is a NYSE or NASDAQ stock), ticker (the stock’s symbol) and condition (is it a fill or cancel order) . (Gehm, 2008). In contrast, an investor in the markets should look at diversified portfolio options and seek a qualified investment advisor prior to putting any capital to work in the markets.

While the use of new technologies in the financial industry has increased as quickly as the development of consumer technology, governments and communities are poised to determine whether or not their communities stand to benefit or gain from instilling consumer protections such as limiting or banning proprietary trading at larger institutions. In theory, limiting these abilities may severely handicap an institution’s abilities to do due diligence and hedge against their clients’ bets. The capabilities for both good and misuse are present in the world of proprietary trading. Proprietary trading activities have made our markets more efficient & liquid, attracting capital from all the world. While free and open access to the markets remains a concern of all participants, the growing relativity between market performance and technical resources poses a threat to all retail investors. In order to limit these type of systemic risks to our system, regulations and policies set to ensure market-makers act in the best interest of their client are necessary. Consumer protections such as SIPC (Securities Investor Protection Corp.) supply an additional level of certainty when dealing in a very uncertain world. In order to tackle these problems, society has to shift their views from the macro perspective of the stock-market as one large entity and into the mindset of a market of stocks with organic and individual needs.


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2 Responses to “High Frequency Proprietary Equity Trading”

  1. james says:

    Dear Sirs,
    From your website I know you have very rich knowledge on prop trading business.I would be very grateful if you could inform me how to open a prop trading firm and how to operate the business. thanks


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  2. webmaster says:

    Thank You, James. Glad I can help.

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