High-frequency trading: Concerns of adverse impact appear overblown
By Irene AldridgeSome 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 traders’ 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 ialdridge@ablealpha.com 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-à -vis HFTs? One execution trader at a mutual fund cited his observations of “multiple fills” as proof. Some ten years ago, this trader’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 “fills.” 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 “pump-and-dump:” think of the movie “Boiler room” 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 – 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 trader’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 traders’ 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 ialdridge@ablealpha.com
February 13th, 2012 at 5:19 pm
Monday, February 13, 2012
Irene,
Your article on the concerns about High Frequency Trading is interesting. Yet I have few comments.
Although you try to allay the concerns regarding the monopolistic tendencies of High Frequency Traders, their ability to be the first to access and use pricing movements’ information or even induce same, does not seem to lend itself to being easily explained away.
Since it is obvious that the playing field is no longer level for all the players, the question then becomes, “How do we restore the playing field without being perpetually defensive and perpetually watching the offensive High Frequency Actors’ perpetually dominating the electronic playing field?”
I will appreciate your constructive response to my comment.
Thanks for beginning the conversation.
Francis Onukwue
PhD Candidate (Business: Financial Management).
February 13th, 2012 at 5:49 pm
Francis,
Thank you for positive feedback.
I have to disagree with you re: the premise of your argument.
Your statement “Since it is obvious that the playing field is no longer level for all the players…” is not obvious to me at all.
Instead, I firmly believe that the playing field now is much more leveled than it has ever been:
- Transaction costs have declined exponentially, so that now even retail traders can execute trades for less than a dollar a trade down from more than $100/trade some 15 years ago. (Obviously, some brokers still charging $10+ dollars a trade would like to conveniently ignore this little factoid.)
- Everyone who has any interest in high-frequency data has access to it.
Furthermore, your next statement appears to be emotional and without scientific merit (I am referring to “being perpetually defensive and perpetually watching the offensive High Frequency Actors’ perpetually dominating the electronic playing field”.) As a PhD Candidate, you are certainly aware that some 10 studies written in the past year count multiple benefits high-frequency traders bring to the markets. It’s not at all clear where your information on “perpetually” this or that comes from. I suspect it comes from watching too much television!
In certain cases, however, (and far from “perpetually” as you claim), there are circumstances that may allow high-frequency pump-and-dump. You are correct that in these particular situations, low-frequency traders may find themselves at a disadvantage. These situations are precisely the reason why we launched the new software suite designed to help traders large and small to anticipate such situations and to avoid trading with potentially unscrupulous market participants. If you are interested in learning more about the software, please feel free to contact me at +1 646-233-3513.
Hope this helps.
Best Regards.