Some institutional investors believe that their orders are routinely compromised by high-frequency traders (HFTs). In my conversations with representatives of mutual funds and pension funds, long-term traditional equities and futures funds tend to be particularly negative about HFTs. The likelihood of adverse HFT activity in any given market, however, can be successfully measured. I illustrate a simple version of the HFT activity analysis on Eurobund futures in my latest study, accessible here (PDF). While the study shows that in the Eurobund futures market large tradersâ€™ fears of HFT are unfounded, the likelihood of adverse HFT activity varies with market conditions. My firm, Able Alpha Trading, is now selling an advanced software solution to help low-frequency investors gauge the market quality of any market as a probability of adverse HFT activity at any given moment. (Please contact me at firstname.lastname@example.org to learn more). Dubbed HFTSpotlight, this real-time system does not miss a beat in checking and reporting the likelihood of adverse HFTs.
What are the major concerns of large traders vis-Ă -vis HFTs? One execution trader at a mutual fund cited his observations of â€śmultiple fillsâ€ť as proof. Some ten years ago, this traderâ€™s large orders (on the scale of $10 million each) would be matched by a single counterparty, whereas nowadays a similar order can be matched by as many as 10,000 limit orders or â€śfills.â€ť In fact, multiple fills are indicative of a liquid and a well-functioning market with a small average trade size. By competing with other HFTs to stay on top of the book, HFTs provide a fast piecemeal fill to large orders, lowering overall fill costs and guaranteeing execution. Still, a theoretical possibility for adverse activity among HFTs exists. An example of a theoretical strategy is the high-frequency â€śpump-and-dump:â€ť think of the movie â€śBoiler roomâ€ť transplanted into the cyberspace.
As I describe in my new study, high-frequency pump-and-dump works only in certain market conditions: if the market price response to a buy order is different to the market response to a sell order, then an HFT can pump the price in the direction of the fast market response, creating a speculative micro-rush, and then dump his position in the opposite direction. All orders are followed by a change in the market price: buy orders tend to be followed by a rise in price to reflect the potential knowledge of the trader placing the buy order â€“ the buyer may potentially know that the price will imminently rise. Similarly, a single sell order often causes a small drop in prices. If the absolute price change following a buy order of a certain size S is significantly higher than the size of a market movement following a sell order of the same size S, then a high-frequency trader could place several small buy orders, driving up the price, and then disburse his position capturing the difference between the market adjustments to the traderâ€™s buy orders and his sell orders. Markets with magnitude-comparable responses to buyer-initiated and seller-initiated trades ensure the absence of HFT pump-and-dump activity.
The new Able Alpha HFTSpotlight software tool incorporates this and other tests of HFT activity to deliver a simple and clear answer to low-frequency tradersâ€™ key question: when is a good time to place an order, given the likelihood of HFT activity? HFTSpotlight, the lightning-fast real-time solution delivers instant updates on the presence of HFT activity in the markets and simplifies the job of many a low-frequency investor.
Irene Aldridge is a quantitative portfolio manager at ABLE Alpha Trading, LTD., where she supervises creation and production of quantitative and high-frequency trading strategies. Aldridge is the author of High-Frequency Trading: A Practical Guide to Algorithmic Strategies and Trading Systems (Wiley, 2009). Her latest research on high-frequency trading is forthcoming in Equity Valuation and Portfolio Management (Frank Fabozzi and Harry Markowitz, eds., Wiley 2011). She can be reached at email@example.com