Man Vs. Machine: Tracing Trades Through Electronic Maze
Narang trades using statistical arbitrage, where traders are short one security and long another, based on historical performance.
For example, IBM historically trades in a certain relationship with the S&P 500. When it trades above that relationship, Narang's computers may put in large orders to sell IBM and buy the S&P (all in a fraction of a second) assuming the relationship may revert to its historic mean.
Narang says they trade 50 to 100 million shares of stock a day, including many trades in IBM, but the day I am there is a relatively slow one in August. It is 3pm ET, an hour before the market closes, and Narang's firm has traded 21 million shares, for a net profit of $7,000.
Narang and other high-frequency traders execute their trades through direct access. The computers are linked to servers very close to those of the major exchanges. Why? Because the pricing inefficiencies last for only a fraction of a second, so speed is paramount.
"When you have opportunities as small as a tenth of a cent per share, they tend to come and go very quickly. Maximum speed to the exchanges is desirable, so we put our servers physically at the enchants," says Narang.
Bottom Line: Technology, Liquidity, Complexity
So what is happening here? Three customers—Thompson, who wants to buy 100 shares of IBM, Sauter, a mutual fund manager who will be buying or selling tens of thousands of shares or more of IBM, and Narang, a high frequency trader who will also be buying and selling thousands (perhaps millions) of shares of IBM—are all interacting in different spaces: in the computers of market makers who match off the orders, on exchanges, and in alternative trading systems like dark pools.
All three of these orders could interact with each other. All three of these customers, in their own way, are adding liquidity—but there are a lot more places for them to trade.
How did things get so complicated? You can blame it on the relentless march of technology and a decision by the SEC to encourage competition among exchanges.