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It's not front running; it's getting out of the way
Front-running[1] isn't really a thing that's actually happening. Here's what is actually happening.
The HFTer/liquidity provider wants to sit there all day long buying IBM for 99.99 and selling for 100.00
making his penny a share in return for providing liquidity. But the liquidity provider has a problem.
Every now and then Brad Katsuyama (or someone like him) shows up with proprietary information that,
say, IBM should really be trading for 101.00. Brad tries to suck up all those shares being sold for
100.00 as fast as possible before the price moves. That's great for Brad but all of a sudden the
liquidity provider has lost a bunch of money when IBM moves to 101.00 and he can no longer buy for 99.99.
So the liquidity provider tries to recognize as accurately as he can, and as fast as he can, that Brad
has shown up on the scene and get out of the way by canceling all his orders and resubmitting them with
a new price. That's why when Brad tries to buy 100,000 shares (from multiple exchanges) in the book he
sees a bunch of his orders not get filled because the liquidity provider is running away from him.
So it's not the HFTer jumping in the middle like people think. It's actually the HFTer running out of
the way of a big fish.
So how is this good for you when you're buying a small number of shares? The more often the HFTer gets
eaten by a big fish the wider his spreads have to be to make an overall profit. If he gets eaten too
often he has to buy for 99.95 and sell for 100.00 (5 cent spread) instead of 99.99/100.00 (1 cent
spread). Spreads used to be really big: 12.5 cents or 25 cents. They're smaller now because computers
can react a lot faster than humans to get out of the way of Brad. They also don't demand really big
salaries so they cost less to operate.
To sum up: HFT isn't jumping in the middle. It's jumping out of the way. And because they keep getting
better at that they can afford to offer lower prices for liquidity when you show up and want to by 1000
shares of IBM to hold for the next 5 years.
There are other advantages for you as well having to do with faster price discovery by the market, but
I'll leave that aside for the moment as a separate issue.
1. Incidentally what Michael Lewis, and others, are describing as front running is already a big
distortion of the term. Front running is illegal when a stock broker acts on a clients intentions
in a way that is not in the best interests of his client. This is because the broker and the client
have an agency relationship that the broker violates. It's NOT front running when one party simply
acts on public information faster than another to gain an advantage in the markets.
@edwingon
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edwingon commented Apr 6, 2014

There is a difference between legally wrong and morally wrong. Yes it may be legally ok to game the markets and use your speed advantage to scalp slower participants. But the net effect is stealing from other investors and that is always morally wrong. But this is Wall Street and that distinction may be a bit to subtle.

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