Recent history has delivered some significant swings in the stock market, leaving most investors scratching their heads in awe. It is not uncommon to see intraday ranges of 500 points. Since August 2, 2011 – when the Dow Jones Industrial Average closed down 263 points – there have been 21 trading days where the average has moved at least 1% from open to close. And that doesn’t account for the daily high-low range.
The shaky economy has a lot to do with the market jitters experienced almost daily. The European debt crisis continues to infect investor behavior. But there also may be a systemic issue that has the market moving so sharply in either direction. It’s called “high frequency trading” (HFT), and it may continue to drive prices up and down for the foreseeable future.
Timing has always been important when it comes to trading; however, during the era of electronic trading, timing the market has become much more challenging. Enter high frequency trading: an algorithm-based computerized system that seeks out opportunities to cash in on small margins between bid and ask prices.
HFT systems move in and out of positions thousands of times per day. By targeting opportunities to make as little as a fraction of a penny, the volume and size of trades is what drives the profitability for this activity. And most of the time, the firms executing this strategy do not hold a position in the stock at the end of the day.
According to a TABB Group study, high frequency trading accounted for about 56% of equity trade value in the US during 2010.
The effects of HFT are seen as both positive and negative. On the positive side, the frequency of trading provides market liquidity and smoothes volatility, ultimately reducing costs for all investors. By shortening the bid-ask spread, trading occurs more frequently and links more markets. The Chicago Board Options Exchange has said, “The fast-growing practice of high-frequency trading… is speeding up execution times for all investors, making it cheaper to buy or sell and posing no risk to small investors.”
However, the negative effects of HFT have been well-documented. Although HFT was found not to have been the instigator of the May 2010 “flash crash”, in which the Dow Jones suffered a history-making 998.5 point drop before quickly rebounding to produce the second largest intraday swing (1010.14 points), it was the existence of HFT that moved the markets so swiftly. The fuel that lit the fire was a $4.1 billion hedge trade, which stoked a frenzy of activity because of automated settings within systems owned by a number of large trading firms. Algorithms had been set to execute trades based upon total trade volume without regard to price or time.
That incident was set off by a purposeful trade, but even a small error can make a huge impact. Hitting an extra zero or an incorrect number – called a “fat finger” trade – will supply inaccurate data that is fed into an HFT system almost instantly. From there the automation executes trades that might not be expected.
The international group LiquidNet, a marketplace institution, conducted an Institutional Voice Study which revealed that approximately 2/3 of institutions worldwide are concerned about the existence of HFT. In fact, at the top five global trading firms “73% of the traders said they regarded high frequency trading as a high-priority market-structure issue.”
With electronic trading, proximity counts. Trade execution servers that are installed next to exchanges – even within some exchange facilities – get their order signals in before traditional trade brokers. The HFT system can read the pending trades a split-second before they are executed, and allows the owner to place an order immediately in front the pending order. This puts many retail outfits at a disadvantage.
In some cases, institutional traders can execute trades for their own accounts before placing client orders.
The long-term corporate investor is hopelessly caught in a structure that benefits speed on a playing field that is not level. Until authorities place restrictions on this activity, trading volume will go up, but investment portfolios may not reap the rewards.
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