Presented to you by: Dennis Dick, CFA Bright Trading LLC

1. Trading in an HFT World Presented to you by: Dennis Dick, CFA Bright Trading LLC

2. Financial Advice Disclaimer The information contained in this presentation and from any communication related to this presentation is for information purposes only. The material in this presentation does not constitute advice and you should not rely on any material in this presentation to make (or refrain from making) any decision or take (or refrain from taking) any action. The investments and strategies mentioned in this presentation may not be suitable for you. Before making any investment decision, you should contact an independent financial advisor. This presentation does not make recommendations for buying or selling any securities or options. It is up to the viewers to make their own decisions, or to consult a registered investment advisor when evaluating the information in this presentation. THE PRESENTERS WILL NOT BE LIABLE FOR ANY DIRECT, INDIRECT, OR CONSEQUENTIAL DAMAGES, ARISING OUT OF OR IN CONNECTION WITH THE USE OF THE STRATEGIES AND INFORMATION DISCUSSED IN THIS PRESENTATION.

3. Trading in an HFT World • Topics: • Clear up the confusion: High frequency trading, internalization, sub-pennying, flash trading • Quick update on internalization, flash trading • Trading Against the HERD • Tape-reading examples – Identifying the herd • Large size orders and the HFT tractor beam

4. HFT vs Internalizers High Frequency Trading vs Internalizers The majority of HFT firms are NOT internalizers. • They are not responsible for the majority of sub-pennying. • HFT firms typically trade on the exchanges. Sub-pennying is done OFF-EXCHANGE. • Important not to villainize the wrong participant Internalizers operating on a high frequency level, are the real villain here. • Approx 200 broker-dealers that internalize flow. • Report trades to FINRA TRF.

5. Broker-Dealer Internalization What is Broker-dealer Internalization? • When a brokerage firm acts as a dealer and internally executes against its customer’s order (taking the other side of trade) • Alternatively the b/d may routes its customer’s order to an internalization pool where other market participants will execute against the order - done off exchange – reported to a TRF – Trade Reporting Facility Reasons for internalizing: • To avoid paying take fees. • To receive payment for order flow, from internalizing participant. • So internalizer can jump the displayed order queue.

6. Profit by queue jumping Consider the following example: Ticker: C Bid Size Ask Size 4.18 30287 4.19 48298 An internalizer can take the opposite side of their customer’s market buy order and sell the stock at 4.19, jumping ahead of the 4.8M shares offered there. Similarly, take opposite side of marketable sell orders and buy at 4.18 ahead of queue.

7. Sub-Pennying Sub-pennying to improve 605 stats: The SEC keeps track of price improvement stats in their rule 605 reports: Internalizers will offer a few sub-pennies of price improvement to improve their 605 stats, and give them justification for jumping the queue (price improvement, and saving taker fee). Eg. Sell C at 4.1899 or buy at 4.1801 in front of displayed NBBO.

8. Flash Trading Flash Trading HFT firm gets a ‘sneak peak’ at an incoming order. • Done at exchange level • Allows HFT firm to match or beat NBBO, which can lead to sub-pennying. • SEC has proposed a ban on flash trading, but is still seeking comment. • Most exchanges have voluntarily ceased the practice. • Exchanges that still offer flash trading – Direct Edge on equities, CBOE on options. • Bottom line - some sub-pennying done through flash trading, but vast majority of sub-pennying done by internalizers.

10. Quick Update - Internalization Update – Internalization / Sub-pennying issues • Number of firms discussing concerns with Internalization • NYSE – discussed concerns in their Equity Market structure comments, and support for Trade-at rule. Recently discussed concerns with flash trading in letter to SEC. • Nasdaq – discussed concerns with internalization, and indirect support for trade-at rule. • CFA Institute – two letters to SEC discussing concerns of NBBO being compromised by sub-penny trades • Interactive Brokers – Thomas Peterffy publicly attacked internalization at the General Assembly of World Federation of Exchanges. • Ewing Marion Kauffman Foundation – In an 88 page report, attacked ETFs and internalization. • These reports can be viewed on http://www.defendtrading.com

11. Trading Against the Herd Presented to you by: Dennis Dick, CFA

12. What is the Herd? The Herd of Traders • The vast majority of trading population. • Chase moves. • Copy strategies. • Last to get in the trade. • When the herd is in….you need to get out. Why? Because once the herd has entered the trade, there is no one left to continue the buying or selling.

13. Retail traders - the Herd Vast majority of HERD, is retail traders, and longer term players (cause they don’t care about paying an extra nickel to get in/out). But their orders are now internalized. So you can’t trade against them. Regulation could help but in the meantime….let’s stay profitable. For most part on exchanges, it’s professionals trading with other professionals now. So we need to find the herd on the exchanges to trade against.

14. Profiting from the Herd How do I profit from the Herd? Figure out which side the short-term herd is on, and trade against them. How do I figure out which side the herd is on? Number of predictable spots to find the herd, but first we must understand the strategy life cycle.

15. Strategy Life Cycle • Life cycle of a successful strategy: • 1. Research and Development • - Finding the ‘Edge’ and back testing it. • 2. Implementation and Production • - implementing it, and profiting from it. • 3. Herd joins in • - other traders notice the edge, and exploit it. • 4. Over-saturation and eventual unprofitability • - too many traders on same side of strategy. • 5. Traders cease strategy (herd backs off), and strategy may start working again (not always though).

16. Why do strategies stop working? Why don’t successful strategies work forever? • Because they get over-subscribed to. • If a specific strategy is making money consistently, it attracts more participants. As more and more participants participate in that specific strategy (the HERD), it becomes over-subscribed to and stops working. • Eg. OPG strategy • If a few traders doing it….no problems. • Hundreds of traders doing it…..there won’t be enough fundamental traders to bring the stock back up to fair value (in short-term).

17. OPG Strategy example Example of Strategy Life Cycle – OPG Strategy • Edge – Opening print too high or too low relative to fair value. • Implementation – Surrounding Fair value by placing sell short orders above, and buy orders below. • Why does this strategy work? Fundamental traders, index arbitrageurs, pair traders bring price back in line. • Herd comes in – OPG traders begin to outnumber fundamental traders, pair traders. Strategy is now oversubscribed to. • Not enough fundamental traders to offset OPG traders, OPG trades continue in direction of gap and becomes unprofitable.

18. OPG Strategy example Consider KO example: Closing price = $60.00 S&P futures = down 1% Fair value KO = $59.40 Opening price = $59.20, OPGers filled long on opening print. If there’s only a few OPG players, fundamental traders, pair traders, will press price back to fair value. But if strategy is oversubscribed to, there will be vicious shake-out as OPG players scramble for liquidity. Often a play to get in after opening print, when OPG players shake-out.

19. Option expiration Why does this strategy work better on option expiration? More fundamental traders, option traders participating in market on opening. They can often still outnumber OPG traders, even if there is mass participation in the strategy. So should I just do the OPG strategy on option expiration? • I would say No…..I never cease doing a strategy completely, because what is oversubscribed to, can become under-subscribed to quickly, and can start working again. I reduce size when strategy is not working, to limit losses.

20. What does this have to do with HFT? What does this have to do with HFT? One HFT player can saturate a strategy. • 10 years ago, successful strategies lasted a while, as it took time before traders over-exploited them. • One HFT computer can process thousands of orders per second • Kind of like 100 traders participating • Dramatically reduces the life cycle of profitable strategies. Tips: • Protect profitable strategies. • Continue to research and develop new strategies. • Re-visit previously unprofitable strategies.

21. Identifying the Herd – Tape Reading Identifying the Herd by Reading the Tape • Kind of a war going on – HFT vs Internalizers • Internalizers have a strong upper-hand • Internalizers will often trap HFT players in stocks Lets consider the following example:

22. Consolidated Tape of AWR December 2, 2010 Ticker: AWR Time & Sales Time Last Share (100 lots) Exchange 14:09:34 34.66 1 NYSE 14:09:50 34.7191 3 FINRA TRF 14:09:54 34.66 1 NYSE 14:10:12 34.7197 5 FINRA TRF 14:10:14 34.66 1 NYSE 14:10:34 34.66 1 NYSE 14:10:46 34.71 1 NSDQ 14:10:46 34.71 1 PCSE 14:10:54 34.66 1 NYSE 14:11:10 34.66 1 NYSE 14:11:10 34.65 1 EDGX 14:11:14 34.65 1 NYSE 14:11:29 34.65 1 NYSE 14:12:05 34.6899 5 FINRA TRF 14:12:09 34.65 1 PCSE 14:12:10 34.64 1 NYSE 14:12:27 34.68 1 FINRA TRF 14:12:30 34.64 1 NYSE 14:12:47 34.65 1 NYSE 14:12:50 34.62 1 NYSE 14:13:30 34.56 2 NYSE 14:13:45 34.625 3 EDGX 14:13:45 34.6249 3 FINRA TRF 14:13:45 34.625 1 EDGX 14:13:45 34.6249 1 FINRA TRF 14:13:45 34.6249 1 FINRA TRF • Notice all the sub-penny trades - trading in front of ask • No sub-penny trades printing in front of bid • What do you think happens next?

23. AWR Continues Down December 2, 2010 Ticker: AWR Time & Sales Time Last Share (100 lots) Exchange 14:41:20 34.49 1 NSDQ 14:41:20 34.49 1 EDGX 14:41:37 34.44 1 BATS 14:41:50 34.45 1 EDGX 14:42:26 34.43 1 FINRA TRF 14:42:34 34.43 1 NSDQ 14:42:47 34.42 5 NYSE 14:42:47 34.42 5 BATS 14:43:06 34.39 4 FINRA TRF 14:43:10 34.38 5 NYSE 15:59:53 34.10 1 PCSE 15:59:57 34.09 1 NYSE 15:59:59 34.10 5 NYSE 15:59:59 34.10 3 NYSE 15:59:59 34.09 2 NYSE 15:59:59 34.12 1 NYSE 15:59:59 34.13 1 NYSE 15:59:59 34.10 1 PCSE 16:00:00 34.10 1 PCSE 16:00:00 34.10 1 NSDQ 16:00:43 34.09 8 FINRA TRF 16:01:33 34.10 2 FINRA TRF 16:03:43 34.07 60 NYSE • Continues downward move, as traders can’t get out on offer (due to internalizers, sub-pennying ask price. • Traders (the HERD) are trapped long, unless they pay spread.

24. Trapped Short-term Traders AWR – 2 day chart

25. The HFT “Tractor Beam” What is a “Tractor Beam”? • Defined – a device that attracts an object from a distance • Remember Star Wars – the Millenium Falcon would get caught in the Death Star’s Tractor Beam - Once it was in the Tractor Beam, there was no escape. - The falcon would be pulled into the Death Star. Large size on a stock, can act like a tractor beam, pulling the stock towards the size. We’ll explain this in a minute, but first, we have to understand Rebate Trading and the concept of providing and taking liquidity.

26. Providing Versus Taking Liquidity Liquidity providing versus Liquidity taking: Providing Liquidity: If you place a passive bid, or passive offer, you are a liquidity provider. You have added a bid or offer to the market. Typically, if your execution is not immediate (for orders placed during market hours), you are providing liquidity. Taking Liquidity: If you take an offer or hit a bid, you are a liquidity taker. You have removed a bid or offer from the market. Typically, if your execution is immediate (for orders placed during market hours), you are taking liquidity. ALL market orders take liquidity.

27. Rebate Trading What is Rebate Trading? • Defined – The practice of buying and selling stocks to capture the liquidity rebates given by the exchange. - Liquidity rebates are given by the exchanges to encourage the practice of displaying liquidity, and adding depth to the market. High Frequency Traders with a low commission structure, can profit on trades that are scratched, by providing liquidity and capturing the exchange given rebates.

28. Leaning on Size HFT players lean on Size: • Rebate trading is a low return game, so therefore need to have low risk to remain profitable. • HFT rebate traders trade thicker stocks like C, Q, S. • But they’ll also trade thinner stocks if they have some size to lean on. • The size is like their insurance. • Alternatively, internalizers (because they have early access to order flow) can lean on any order, so they really don’t need the size.

29. What is a big offer? What do you consider a big offer? • It’s all relative to the stock’s volume • If a stock trades 100K shares a day, a 5K share offer may be considered large • If the stock trade 2M shares a day, 5K share offer is meaningless • Don’t be confused with the envelope traders, those are not real bids/offers - orders are pegged to NBBO

30. The HFT Tractor Beam captures the Stock Think of the Millenium falcon as the current price of the stock. Think of the Death Star as the Big bid or Big offer. If the Falcon flies outside the reach of the tractor beam, it will not be affected by it. But if it gets too close, it will get captured by the beam, and pulled towards the Death Star. Same thing for the current price of the stock, if it gets too close to the big size, Rebate traders will jump in, and “capture” the stock price pulling it closer and closer to the big size. Think

31. Mechanics of the “Tractor Beam” Mechanics behind the Tractor Beam • HFT rebate traders see the large offer, and place sell short orders in front of it. • As they get filled on their shorts, they immediately bid the stock, adding support. As more and more rebate traders get filled on their shorts, they place more and more bids. • It takes a lot more selling pressure for the stock to go down because of the added bids. Therefore the path of least resistance is towards the size, pulling the price of the stock towards it. • As time passes, and the stock price gets closer to the larger offer, the rebate traders get nervous about missing the offer and getting caught, they then cover on the size.

32. Tractor Beam is Gone, how fast? Tractor Beam is getting taken out, what now? Two Scenarios: 1. Size goes quickly (often in one or two large prints). - HFT rebate traders are caught. - This will cause the stock to spike quickly, as rebate traders panic, and drive the price higher, out-bidding each other. 2. Size goes slowly (large number of small prints). - HFT rebate traders get covered, and the HERD actually has time to get long for breakout - If they are not caught, stock may have a vicious shake-out as there is no longer the rebate trader bids to support the price, and there is added selling pressure from the traders who just speculated on a breakout. When stock doesn’t breakout, HERD stumbles over each other trying to get out, driving the price lower.

33. Summary Summary of trading tactics in HFT world • Take liquidity, because internalizers will sub-penny your passive orders • Be conscious of the HERD, if everyone is on same side, trade is bound to go the other way. • Research and Develop new strategies, as HFT has dramatically reduced the life of successful trading strategies • Read the Tape, follow the sub-penny prints and FINRA TRF to see what side the internalizers are on. • Sizeable orders tend to get printed, so leaning on size game is over for manual traders.