0Error! No text of specified style in document.
HIGH FREQUENCY TRADING:
A COMPREHENSIVE ANALYSIS
RIA A. PRICE
MAY 8, 2014
CORPORATE FINANCE (FINA 520)| DR. G. SAWYER
0
qwertyuiopasdfghjklzxcvbnmqwert
yuiopasdfghjklzxcvbnmqwertyuiopa
sdfghjklzxcvbnmqwertyuiopasdfghj
klzxcvbnmqwertyuiopasdfghjklzxcv
bnmqwertyuiopasdfghjklzxcvbnmq
wertyuiopasdfghjklzxcvbnmqwerty
uiopasdfghjklzxcvbnmqwertyuiopas
dfghjklzxcvbnmqwertyuiopasdfghjk
lzxcvbnmqwertyuiopasdfghjklzxcvb
nmqwertyuiopasdfghjklzxcvbnmqw
ertyuiopasdfghjklzxcvbnmqwertyui
opasdfghjklzxcvbnmqwertyuiopasdf
ghjklzxcvbnmqwertyuiopasdfghjklz
xcvbnmqwertyuiopasdfghjklzxcvbn
mqwertyuiopasdfghjklzxcvbnmrtyui
opasdfghjklzxcvbnmqwertyuiopasdf
ghjklzxcvbnmqwertyuiopasdfghjklz
xcvbnmqwertyuiopasdfghjklz
High-Frequency Trading- A Comprehensive Analysis
Abstract
Over the years, as technology has advanced, so has the way financial instruments are
traded. Evolving technology has enabled trading firms to do hundreds of trades in
numerous markets in a matter of seconds. Although there is no common definition of
high-frequency trading across the array of financial activities, it has been defined by
some financial experts as the execution of trading strategies based on computer programs
for algorithms, to capture trading opportunities that may be small or exist for a short
period of time. Following the Securities and Exchange Commission’s introduction of
regulation for alternative trading systems, high-frequency trading has grown
tremendously. Although this trading method has experienced wide popularity, it has also
experienced much controversy, having attributed to the May 2010 “Flash Crash” and
most recently, becoming the center of insider trading investigations. This research paper
provides an in depth examination of the evolution of high-frequency trading, dating back
to the 17th Century. Additionally, an evaluation of the negative and positive impacts that
high-frequency trading has had on the markets which include increased market efficiency
and alternatively an increase fee for exchanges is provided. Also included is research on
the current events surrounding high-frequency trading, its impact, attempts to reduce or
eliminate high-frequency trading by numerous government agencies, and resulting
regulation from the Securities and Exchange Commission.
Page | 1
High-Frequency Trading- A Comprehensive Analysis
Defining High-frequency Trading
High-frequency trading (HFT) is a type of algorithmic trading, defined by Martin
Wheatley, CEO of the Financial Conduct Authority, as the “execution of trading
strategies based on computer [programs] for algorithms, to capture trading opportunities
that may be small or exist for a short period of time”1 high-frequency trading has
received a great amount of attention from the media, investors and politicians. Yet, a
common definition has yet to be established. The lack of a widely accepted definition is
attributed to high-frequency trading being utilized in various financial activities by
trading firms, hedge funds, banks, and brokers.2 Although there is no common definition
for high-frequency trading across the aforementioned financial activities, Wheatley
defined three common characteristics in which high-frequency trading exhibits, including
high volume trades on a daily basis with low level of profits per trade; an extreme short
stock holding period; submitting numerous orders; and no significant open position
overnight.3 Using computerized platforms, high-frequency trading is able to execute a
large amount of trades at super speeds, measured in seconds or milliseconds. Many
traders which utilize high-frequency trading, the volume and value of the trades have the
potential to exceed $1 billion and one billion units on a daily basis. It is estimated that as
of 2012, high-frequency trading was responsible for approximately 70% of all US equity
trades. 4
High-speed trading firms buy and sell stock by way of computers that use algorithms to
compute data. Some programs analyze news stories or react to movements in prices,
holding a high volume of shares for a very short period of time, while earning a profit on
thousands of price differences.5 According to Forbes contributor Bill Conerly, the
objective of high-frequency trading of is to “profit from the price movements caused by
large institutional trades.6 Conerly provided an example from this using a mutual fund
stating that “when a mutual fund sells a million shares of stock, the price dips—and high-
frequency traders buy on the dip, hoping to sell the shares a few minutes later at the
normal price”. High-frequency trading buys when the price is below trend and sells when
Page | 2
High-Frequency Trading- A Comprehensive Analysis
the price is above trend.7 Additionally, high-frequency trading is usually apart of trading
strategies such as news based trading, market making, or statistical arbitrage:
News-based Trading
High-frequency traders attempt to get ahead of the market not just by running ahead of
orders; they also attempt to get an edge of market news. High-frequency trading utilizes
new analytics services to gather news content in a matter of milliseconds in order to
anticipate market movements and begin to trade on them. 8 In the study “Media-Driven
High Frequency Trading: Evidence from News Analytics” compiled by Wharton finance
professor Donald Keim, INSEAD banking and finance professor Massimo Massa and
INSEAD doctoral student Bastian von Beschwitz, it was found that the use of news-based
trading combined with high-frequency trading contributes a significant impact on stock
returns and trading volume.9
Market Making
Market making is a set of high-frequency trading strategies, involving the placing of a
limit order to sell or buy a limit order, or to buy or bid a limit order, to earn the bid-ask
spread. By accomplishing this, the market makers provide a counterpart to incoming
marketing orders.10 According to Thierry Rijper, Willem Sprenkeler and Stefan Kip of
Optiver, “technological evolution in consonance with sophistication of pricing has driven
the development towards more and more automated trading practices.”11 High-frequency
trading facilitates the processing of market data, the timely reaction to changing market
conditions and better enables market makers to manage risks. Therefore, the use of fast
trading applications is a “prerequisites for a market maker to be successful.”12
Statistical Arbitrage
Statistical arbitrage identifies and attempts to capitalize on inefficient pricing of financial
instruments, which are often characterized by temporary abnormalities in the relationship
between two financial instruments.13 This strategy is used in liquid securities, which
include equities, bonds, and futures. Statistical arbitrage involves building a long position
Page | 3
High-Frequency Trading- A Comprehensive Analysis
in undervalued instruments and a short position in overvalued instruments. By utilizing
this high-frequency trading strategy, tiny price differences are arbitraged, thereby
contributing to the efficiency of the market.14
Impact of High-Frequency Trading on the Markets
According to a study compiled by Capgemini Consulting, High-frequency trading has
made a significant impact on the market in a number of ways, both positive and negative.
The report outlines the impact of high-frequency trading on the market, which has
increased liquidity, narrowed spreads, and improved market efficiency:
Increased Liquidity
“It is believed that the high number of trades typically entered by HFT traders results in
greater liquidity in the markets. HFT firms contribute to over 50% of the equity turnover
by volume in some major markets, and play a critical role in providing order flow,
increasing the liquidity level. Traditional liquidity providers such as market makers now
earn rebate fees by leveraging HFT strategies to make up for the loss of income caused
by smaller spreads.”15
Narrowing Spreads
“The use of algorithms and computers in trading has resulted in the prices of securities
being updated more frequently and more accurately. A study from NYSE Euronext shows
that quoted spreads from 2007-2009 were lower than those from 2002-2006, a period
when HFT was relatively less prevalent. This indicates that HFT has resulted in traders
providing the most competitive bid-ask prices and in spreads narrowing.”16
Improved Market Efficiency
“In more efficient markets, prices reflect market information more quickly and
accurately. HFT enables this to happen by ensuring accurate pricing at smaller time
intervals. Also, HFT has enabled smaller spreads and lower trading costs, and these
Page | 4
High-Frequency Trading- A Comprehensive Analysis
benefits are passed on to individual customers who invest indirectly in the markets
through mutual and pension funds.”17
Increased Fees for Exchanges:
High-frequency trading has led to a significant increase in the trading volumes of both,
exchanges as well as ECNs. In 2008, the number of equity trades at both the NYSE and
NASDAQ grew by more than 80% compared to a growth of 76.7% for NYSE and 56.2%
for NASDAQ in 2007.18 This growth has led to higher revenues and transaction fees for
both exchanges and ECNs.
Alternatively, Capgemeni’s report found that high-frequency trading has also negatively
impacted institutional investors, by creating disadvantages to smaller investors and
increasing volatility— the stability of the market.
Impact on Institutional Investors:
“Some institutional investors allege that certain [high-frequency trading] strategies look
for repetitive trading patterns and front run the institution by detecting an incoming order
flow, after which the HFT system buys the same security and then turns around and sells
it to the institution at a slightly higher price. Such strategies from HFT participants may
adversely impact the strategy and market impact costs for these institutional investors.”19
Increased Volatility:
“Since HFT involves rapid intraday trading with positions generally held only for
minutes—or even just seconds—it can give rise to price fluctuations and short term
volatility. Given that HFT volumes are normally a relatively high percentage of overall
trading; the price fluctuations caused by this strategy can lead to overall volatility in the
market. Also, the practice of making trades and instantly cancelling them only to trigger
automated buying from other firms is an ethical issue that has been questioned by many
analysts.”20
Page | 5
High-Frequency Trading- A Comprehensive Analysis
Disadvantages to the Smaller Investors:
“HFT firms leverage special services such as co-location facilities and raw data feeds,
which are typically not accessible for smaller firms and retail investors as they are not
able to make the required investments. This places these smaller firms and investors at a
disadvantage. In addition, some HFT firms often enter trades just for the liquidity rebate,
but this adds no value to the retail or long-term investor.”21
History
Some would argue that high-frequency trading dates back to the 17th century, where the
Rothschilds Family had the ability to arbitrage prices of the same security across country
borders by using carrier pigeons to relay information before their competitors.22 High-
frequency trading officially began in 1998 when the Securities and Exchange
Commission (SEC) introduced regulation for alternative trading systems, including
electronic exchanges. The alternative trading systems regulation permitted electronic
