The Markets are Mad: Is High-Frequency Trading Making Things Worse?

(liquidlibrary)

Thursday’s 423-point gain by the Dow marked the first time ever that the industrial average has posted four consecutive days of  400-point moves. Less than two weeks into August, there have already been six trading days that saw triple-digit swings this month. While the recent sell-off has been swift (the Dow is off more than 12% since July 21), it’s also been choppy. Volatility is back in a big way. The VIX Index, also known as the fear index, has shot up recently, nearly doubling over the last week. The VIX tracks the expected price of a range of protective S&P 500 options over the next 30 days.

While your average investor generally hates volatility, there are those who feed off it, namely high-frequency traders. These are the guys who use complex algorithms and super-fast computers to scour the markets for tiny price differentials, often executing trades in microseconds (one millionth of a second). The more volatile the market, the easier it is for them to make money jumping in and out of stocks across exchanges.

Now, it’s not quite fair to lump all high-frequency traders together. They don’t all necessarily do well in volatile markets. While some are killing it, there are certainly others who’ve been getting killed; it all depends on their strategy. But generally, traders need two things:  1) a price, and 2) movement. Recently, they’ve had plenty of both.

Ever since last year’s Flash Crash, there’s been a debate brewing over the utility of high-frequency trading. That debate’s gained steam this week, with some claiming the practice makes things worse, and others coming to its defense. While proponents of high-frequency trading say it adds liquidity to markets, and lowers the costs of trading by tightening bid-ask spreads, critics say it creates volatility for its own sake, turning what would typically be small prices changes into wild swings. There’s also a growing sense that it’s bad for the overall economy.

A pair of recent academic papers have taken a long look at the pros and cons of high-frequency trading, and together paint a not-so-nice picture. On Monday, as the Dow was plunging 634 points, a trio of researchers (Ilia D. Dichev and Dexin Zhou of Emory University, and Kelly Huang of the University of Alabama) presented their new paper, “The Dark Side of Trading,” at an accounting conference in Denver. Here’s the full version, and here’s the abstract:

This study investigates the effect of high trading volume on observed stock volatility. The motivation is that volumes of U.S. trading have increased more than 30-fold over the last 50 years, truly transforming the marketplace. Given existing work that links volume and volatility as simultaneously driven by fundamental information, we are specifically interested in the effect of increased trading controlling for such information. We investigate a number of settings, including a mix of natural experiments (exchange switches, S&P 500 changes, dual-class shares), the aggregate time-series of U.S. stocks since 1926, and the cross-section of U.S. stocks during the last 20 years. Our main finding is that, controlling for other factors, there is a reliable and economically substantial positive relation between volume of trading and stock volatility. The conclusion is that stock trading produces its own volatility above and beyond that based on fundamentals.

The paper concludes that while “low to medium” levels of trading can have market-wide benefits, there comes a point at which the huge amount of volume that high-frequency trading adds make the markets so volatile that “only a small circle of traders” truly benefit.

The second paper, titled simply “High Frequency Trading,” comes from Bruno Biais of the Toulouse School of Economics, and Paul Woolley, of the London School of Economics. It ends at a more sinister conclusion. In a section titled “The Darker Arts” the authors claim that high-frequency traders “may also engage in forms of market manipulation,” such as placing spoof orders, which, as explained in a recent Economist article, “are designed to scare gullible traders into offloading their own shares, at which point the HFT investors withdraw their own spoof trades and snap up the real ones.”

Surely, the debate will continue over the merits (or lack thereof) of high-frequency trading. One thing though is clear: now that the practice accounts for somewhere between two-thirds and three-quarters of all equity trading volume, getting rid of it doesn’t appear to be an option. In the words of Dan Patrick, we can’t stop it, we can only hope to contain it.

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  1. matt says:

    A simple and small fee per trade for the investment houses could be the first step. The money could go right to the SEC for investigation funds.

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  2. Caleb b says:

    It is not the HF traders that are the issue with wider swings, it’s the algorithms in general. Humans used to trade, now it’s just done by bots.

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  3. Lee says:

    At best, high-frequency trading is an enormous waste of human potential. Eve. n if t. hey’re not harming anyone, I’ve yet to see a compelling argument for how they do anything useful (unless you believe that states of the world are measured in microseconds, the liquidity argument is pretty bunk). If we can’t or don’t choose to regulate them out of existence, can those of us who know people in finance at least agree to shame the high-frequency traders out of respectability?

    What ever happened to actually trying to increase the PPF? You know, the reason that we want finance to exist at all? Let’s make that noble again.

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  4. Danny Sigurdson says:

    I wonder if there is any research relating HFT and the collapse of firms such as Lehman? Is there an argument to be made that if HFT didn’t create such wild swings in momentum alternative action could have been taken to spare some (or all) of these firms?

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  5. Jeff Carter says:

    I have been writing extensively at my blog, pointsandfigures.com on HFT. The problem is not HFT itself, the problem is the fragmentation of the cash equity marketplace. Regulation NMS allows firms to pay for order flow, set up dark pools, internalize order flow and trade away from regulated exchanges. This has diminished competition, and price transparency.

    There are other symbiotic rules that contribute to extreme volatility. One is the penny wide bid/ask spread that causes firms to put less size on the B/A. The second in the cash market is the uptick rule. Reinstating it would not eliminate the shorts (which should never happen), but make it tougher to short and recognize the cash markets role in capital formation for the firm.

    As traders, we have seen human marketplaces go to computerized marketplaces. It has increased speed and volume-and given more people access. However, the amount of volume is being concentrated into fewer and fewer hands. Fragmentation causes this volume to allow for markets to be temporarily dislocated-Flash Crashes. The big one on May 6 has been repeated over and over again around the world in single stocks, and ETFs.

    The answers are simple-but the lobby against them are hard. First, end payment for order flow, internalization, and dark pools. Force everyone to trade at a regulated exchange-and don’t limit the amount of regulated exchanges. Force the competition to be on the bid/ask spread-not venues. Ban dual trading. If you are acting on behalf of a customer-you get paid to fill that order-your trading desk shouldn’t be able to make money by bucketing it and trading against it. Show price/volume of trades instantaneously-including block trades. This is information the market can use to price going forward.

    They should also do this in the cash bond market, cash currency market, cash muni market. The average customer on the street gets raped.

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  6. D (Curmudgeon) P says:

    To me, the concept of a stock market is to actually invest in a company, allow the company to use your investment to produce a product and make money. The investor is rewarded with ongoing income through dividends, and over time, increased equity in the company through an increase in the value of the stock.

    High frequency trading ignores all of the above. At the end of the day, what has been accomplished? The high frequency trader (I have a relative that does this for a living) starts the day with zero invested and ends the day with zero invested. All that has been done is manipulation of the market for personal gain. This is a worthless activity for the economy and should be stopped.

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    • Impossibly Stupid says:

      From this perspective, you have to wonder how long it will be until companies get wise to the bloodsuckers and deliberately go looking for an exchange that doesn’t allow this sort of funny business. I mean, if the main purpose a HFT serves is to *extract* the most money from the market, why would a well-run company choose to participate in that market? It sounds like a value-losing proposition for both the companies and for all their shareholders that are actually investing long-term in what that company does. All it would take is a few high-profile companies asking to be delisted (if they can do that) in order to start some serious reform.

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  7. Caleb b says:

    “To me, the concept of a stock market is to actually invest in a company, allow the company to use your investment to produce a product and make money.”

    Maybe in theory, yes, but not technically. The stock market is just a place where people can trade shares in a public company. The investment part was at the IPO. The shares represent a small amount of ownership in the firm, but in non-dividend companies, they only have value bc other market participants believe they do. In many cases, the “investment” is simply a way for senior management to get a big fat paycheck (see bankrate.com).

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  8. Trader says:

    The article is about High Frequency Trading, not to be confused with Day Trading. HFT is not carried out by humans, but by computers. It is not measured in milliseconds, but nanoseconds. The people behind HFT have no shame or honor….they are just laughing all the way to the bank. There should be regulation against it. Too bad more people don’t understand the implications of it.

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