When all else fails, blaming high-frequency traders has become a sport of sorts among a certain set of investors and their brokers. High-frequency trading (HFT) has been fingered as the source of market crashes, price volatility, and general decline of the U.S. economy. Despite the negative press, high-frequency trading strategies continue to deliver strong positive returns well in excess of broader market indices, further fueling conspiracy theories and, now, subpoenas from the SEC.
In reality, the persistent success of most high-frequency trading is based not on some secretive large-scale manipulation of the markets, but on thorough understanding of what exactly makes the markets “tick,” literally. As I detail in my latest research, forthcoming in Frank Fabozzi’s and Harry Markowitz’ (the Nobel Prize Recipient) book, “Equity Valuation and Portfolio Management,” one of the key features of the markets used in high-frequency trading is the lack of correlations observed between any securities at very high frequencies. For example, daily correlations between the S&P 500 and stocks can reach 90%, implying that on the day-to-day basis, when the S&P 500 rises, so do other stocks; the same pattern persists when the S&P 500 falls â€“ most stocks fall along. At the frequency of the so-called ticks carrying quote and trade information in the intraday data, however, the observed inter-security correlations are considerably lower, approaching 0 at second and sub-second time intervals. Correlation of 0 means that securities move independently of one another, allowing for return-generating portfolio diversification methods, no longer possible at daily frequencies due to high correlations observed then.
The lack of dependency between securities at high frequencies is not a recent phenomenon. In fact, this feature of the markets was first documented by T.W. Epps in (shocker!) 1979. This little fact is still obscure to many traders, yet has proven a boon to others who have used it to harness the powers of the classical portfolio optimization theory to generate abnormal returns. Mathematics, not conspiracy, are at the heart of profitability of high-frequency trading strategies.
Irene Aldridge is a quantitative portfolio manager at ABLE Alpha Trading, LTD. She is also a co-author of the Quant Investor’s Almanac 2011: A Roadmap to Investing (Wiley, 2010), an up-to-the-minute compendium of economic announcements upcoming in 2011, and a summary of responses of various equities, foreign exchange and other securities to different economic announcements. She will teach a brand-new course on high-frequency trading in New York and Chicago in September 2011. More information about the class can be found here: ev923.eventive.incisivecms.co.uk/. She can be reached at firstname.lastname@example.org