Is High-Frequency Trading Causing Higher Volatility?

by Justin Dove

Is High-Frequency Trading Causing Higher Volatility?

by Justin Dove, Investment U Research

Friday, August 19, 2011

Where were you on August 9, 2011?

Alright, it wasn’t some landmark event like Black Monday. Heck, it wasn’t even the 2010 Flash Crash. But to Art Cashin, it was one of the wildest days for the stock markets in 50-plus years.

"I've been lucky enough to be in this business over 50 years and have seen lots of things, from the Cuban Missile Crisis and the Kennedy Assassination to the Crash of '87 and the 2008 meltdown," wrote Cashin, Director of Floor Operations at UBS Financial Services (NYSE: UBS). "Still, (August 9) was rather special... One of the most frenetic and bizarre trading sessions that I can recall."

Stocks were enjoying quite a rally on August 9 after days of sharp losses due to debt concerns and the U.S. downgrade. Then, around 2 p.m., the Fed released a statement that sent the markets into free-fall. By 3 p.m., the markets began to rally again and the Dow gained 500 points in an hour!

As The Wall Street Journal reported last Wednesday, veterans of The Street were befuddled by the volatility. Can this type of volatility be explained by the rise in high-frequency trading?

High-Frequency Trading by Volume and Volatility

The Aite Group, LLC claims that high-frequency trading (HFT) accounts for 73 percent of U.S. equity trading, despite making up just two percent of trading firms. The TABB Group has a slightly lower number. TABB claims that between January and July, high-speed trades accounted for 53 percent of U.S. equity trades.

But you get the point. Despite which numbers are correct, HFT is making up the majority of stock market transactions in the United States.

According to TABB, HFT volume increased to an average of 65 percent in the first 11 days of August, and hit a peak of 70 percent on August 10, when the Dow fell almost 520 points.

On August 8, the Monday after the U.S. downgrade, the Dow plummeted 635 points. Volume on the New York Stock Exchange was fourth highest on record. High-speed traders profited as many investors lost big.

TABB estimates record profits of $60 million on August 8. The profits for the rest of the week ranged from $40 million to $56 million. High-speed traders were said to have profited on the market’s high volatility and volume by moving in and out of positions in a matter of milliseconds.

Is High-Frequency Trading to Blame?

Anytime trading firms are making millions while the majority of investors are stomaching losses, it’s going to generate attention.

People are also naturally scared of new technology.

Some blamed those new-fangled computers for exacerbating Black Monday in 1987. Back then, algorithms were as simple as, “If the stock price drops to $50, sell.” In theory, this certainly could have exaggerated massive sell-offs that may not have been possible before.

But proponents for high-speed trading claim that it brings more liquidity to the market while keeping transaction costs low. A study released on Monday by the Capital Markets Cooperative Research Centre of Australia suggests that HFT does indeed bring these qualities to the markets.

But a study last November by Yale Professor X. Frank Zhang found contrary evidence.  According to Zhang, “HFT is positively correlated with stock price volatility.” He also found that the positive correlation is “especially strong for the top 3,000 stocks in market capitalization and stocks with high institutional holdings.”

Zhang’s most condemning find is that “the positive correlation between HFT and volatility is also stronger during periods of high market uncertainty.”

This would seem to fit with intuition. But nothing is known for sure. That’s why the SEC has subpoenaed many HFT firms about the 2010 Flash Crash and will investigate the matter more intensely in the coming months.

Protecting Yourself From High-Frequency Trading

Is this a case of unwarranted fear of technology? Are regular investors just jealous of the technological advantage that high-speed traders have?

We don’t really know. But something doesn’t seem to jive right when high-speed traders are reaping record profits as investors are stomaching losses.

The most likely answer is that HFTs in general are good for the market, providing the liquidity and stability they claim. But there are sure to be firms that abuse the power of their technology and the lack of oversight and understanding.

Black Monday didn’t lead to computers being banned from the market though, and HFTs aren’t likely to go anywhere, either. Regulators and investors will just have to improve their understanding of the phenomena.

There’s no reason to stay out of the market because of HFTs. However, it may be unwise to tread these volatile waters without trailing stops to protect gains.

Good investing,

Justin Dove

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