High-Frequency Fallacies

Some investors may fear high-frequency trading a little too much. Source: Getty Images.

High-frequency trading (HFT) continues to be overhyped in the media and among regulators-commonly, you still hear claims HFT "is bad for investors;" "technology is out-of-control and must be monitored;" "has an unfair advantage;" and "causes volatility!" (Bad volatility I presume, not a sharp move up.) Farfetched? Unfounded fears? I think so-HFT may even offer some benefits for investors.

Let's take a step back. What is HFT? It is an automated form of algorithmic trading used by firms to look for short-lived supply and demand mismatches, yielding trading opportunities. As a refresher, algorithms (programmed by humans!) are advanced mathematical models that find patterns in huge data sets to make predictions based on probability. HFT firms use these algorithms and super computers to trade securities at high speeds (microseconds)/high volumes (thousands of transactions per day). And they often hold these positions for less than a minute with the intention of making a profit off the slightest change in price (netting less than a penny per share traded). Further, HFT has existed since at least 1999 and accounts for about 50% of US equity market trading volume.

Given HFT's hefty market share, are critics on point when they claim it impacts long-term retail investors? They argue HFT causes heightened volatility (intra-day and even "flash crashes"), taking a toll on investors. But it's a moot point since volatility occurs whether HFT exists or not due to investors' emotional responses to myriad things like political gridlock, tension overseas, etc. (HFT doesn't deserve all the credit!) To see intra-day volatility transpire over time, we can examine daily S&P 500 closing change data (the number of daily market movements exceeding 1% up or down). It indicates plenty of periods with above-average or median volatility from 1928-2010-this timeframe includes paper trading, too! Irregular ups and downs are normal for securities, and history shows markets rise over time offsetting short-term gyrations anyway.

Volatility makes it pretty difficult to stay focused, though. Yet if long-term investors can manage ignoring the daily noise, they likely needn't worry since they're in it for the long-haul.

A prime example of some market wobble-the May 6, 2010 Flash Crash. You've probably heard of it and the unwarranted gloom it casted on HFT, but here's a recap: The SEC/CFTC speculated Waddell and Reed's sale of 75,000 S&P 500 e-mini contracts (electronically traded portions of normal futures contracts) in 20 minutes caused the day's sharp price declines (the S&P 500 hit an intra-day low of -8.6%). HFT may have initially helped alleviate the crash by absorbing some of the preliminary "sell pressure." But ultimately, HFT systems exited the markets, which could have been a contributing factor (not the cause). The jolt likely pained long-term investors who sold out of false fears the markets wouldn't recover. But, since the markets rebounded for the day and even the year (the S&P 500 closed the day down less than half the intra-day low, -3.2%, and the S&P Total Return Index finished up 15.1% for the year), the Flash Crash didn't prove to negatively impact long-term investors who remained disciplined.

It is worth mentioning concerns about HFT's impact on short-term investors-specifically day traders. According to critics, HFT may overwhelm day traders since they're competing against HFT machines that can be programmed to analyze the same data points-only faster. But that's a topic for another day.

So, should we fear this technology? Since technology is constantly evolving, folks will always gasp over something-whether it is HFT or an even more ground-breaking technology. In this case, folks are downright alarmed these "super computers" (not humans) control HFT. Not exactly ... think about it ... who programs the HFT algorithms? Humans! And it's pretty common for humans to make cognitive errors-tendencies to think in biased ways causing our brains to blindside us-leading to investing errors. For example, a HFT programmer may be overconfident in the algorithm he or she created and unwilling to update it even when it's proven to be a flop-overconfidence is a common cognitive error that can derail folks. Or a programmer may rely too heavily on assumed patterns, creating control rules with the false belief certain events predict a stock's future movement. Many folks forget these patterns are backward looking (while markets are forward looking) and by themselves are well-measured to have no predictive power. That humans run the "HFT show" means HFT makes cognitive errors just like the average investor. Yup, I said it-HFT isn't perfect (nothing is for that matter). Based on a study, most HFT strategies are right about 51% of the time. So get it out of your head-HFT doesn't always win.

HFT may even benefit retail investors. In many cases, proponents find HFT likely reduces bid-ask spreads. It acts as the intermediary between buyers and sellers decreasing these trading gaps and, in turn, increases liquidity leading to more efficient markets. Proponents even claim these spreads may lead to lower trading costs for the average investor. On the flipside, some opponents may deem this liquidity as "false liquidity," meaning high-frequency traders absorb securities for only a limited amount of time. In some cases-illegal trading practices such as wash trades and spoofing-this may be true. But these are isolated events in the grand scheme of the markets.

Even regulation remains limited. Regulators are scrutinizing risk controls given some of the recent mishaps (such as the Knight Capital Group trading software glitch last summer or the Nasdaq Facebook IPO malfunction), but for now, they certainly don't seem to be laying down the law.

Growth-oriented investors: Don't be concerned-HFT isn't out to get you.