| Exploding The Myths Of High Frequency Trading |
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| Written by James Underwood |
| Sunday, 04 July 2010 15:23 |
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Since the US equities markets went electronic, there has been a massive growth in the practice now generally referred to as high frequency trading (HFT). However, HFT is much misunderstood, with various myths and misconceptions propagated by the media, leading to continued controversy on the topic. In this article, I will attempt to address some of these misconceptions.
Since the US equities markets went electronic, there has been a massive growth in the practice now generally referred to as high frequency trading (HFT). However, HFT is much misunderstood, with various myths and misconceptions propagated by the media, leading to continued controversy on the topic. In this article, I will attempt to address some of these misconceptions. First of all, a quick explanation. High frequency trading is where traders send multiple orders into the market electronically, to capitalise on opportunities arising from small differences in prices. Positions are generally only held for a few minutes at most, and high frequency traders always end the day flat. So far, so good, but why is this so controversial? There are a number of reasons. First, there is the fact that proprietary high frequency trading firms tend to be profitable and because people generally don't know how HFT works, they think that those profits must come at the expense of retail or institutional investors. Second, the media like to portray high frequency traders as the "bogeymen" of the market, using their computer systems to fleece the investing public. Third, events like the "flash crash" of May 6th whip up commentators to blame such market instability and volatility on high frequency traders. Of all the misconceptions about high frequency trading, one of the most common (which shows how little is generally understood about how HFT works) is that HFT is the cause of increased volatility in the markets. In reality, nothing could be further from the truth. High frequency trading actually restores equilibrium in the market under volatile conditions by capturing those differences in prices. If HFT systems could both cause volatility and profit from that volatility, that would be a paradox whereby they would have the ability to make an infinite amount of money! Another myth is the amount of profits generated by high frequency traders. The typical profit for a single high frequency trade is less than 0.1 cent per share. Based on industry estimates of HFT volume (ten billion shares per day), that is a total of $2 billion per annum in profits, distributed across all the firms who are engaged in HFT. This is actually just a tiny fraction of the profits generated by the investment industry as a whole. A third myth is that high frequency traders use technology to give themselves an unfair advantage over retail and institutional investors. This logic is flawed. The technology used by HFT firms is available to any and every market participant who is prepared to make the investment in that technology. In Formula One motor racing, do McLaren and Ferrari have an unfair advantage over smaller teams because they invest more in technology? No. They have an advantage but the advantage is not unfair because as the smaller teams invest more, their results improve. Another misconception that is fairly common is that high frequency trading systems caused, or at least contributed to, the "flash crash" on May 6th. The reality is actually very different. If you look at the events of that day, once the market started collapsing, most HFT firms disabled their systems while they evaluated exactly what was happening and if there was some king of major news event of which they were unaware. Once it was clear that was not the case, they re-applied their systems and equilibrium was once again restored. There always has been, and there always will be, two types of market participant. Those in it for the long-term and those who are looking to capture short-term profits. That is what makes markets. In the old days, the short-term traders were known as locals, scalpers and day-traders. High frequency traders are the modern day equivalent, providing liquidity to the market by taking the opposing side to the long-term investors' trades. It is just that these days, they do it in a very fast and efficient manner by making use of technology. DISCLAIMER: This article is provided as information only and is not to be taken as financial advice. If you are interested in discovering more about high frequency trading and high frequency trading misconceptions, a fantastic resource with articles, interviews and explanations can be found at the High Frequency Trading Review website |