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High Frequency Trading Market Volatility and Liquidity - Who Benefits?


Although the cause of this event may remain somewhat ambiguous, many point the finger in the direction of high frequency trading (HFT) systems. These are highly sophisticated trading systems that use computer algorithms to process market data and make proprietary trades over very short durations-some pulling trades within fractions of seconds.
Proponents for HFT trading systems present two main defenses. First, they say these types of systems are actually good for the market since they corrected minute mispricings all over the market. Ultimately, they make sure that these securities are price properly down to the penny. In addition proponents of high frequency trading say that these systems provide liquidity. It has been said that high frequency trades account for roughly 60-70% of equity volume. At first, one may think that these proponents of HFT actually make a good point; however when examined closer, we see that these claims are far from valid.
Although these systems identify and capitalize on minute mispricings, they bring much more harm than good. The extremely heavy volume along with the fact that a lot of these systems follow similar trading rules, causes price movement to be severely exaggerated. In turn, the market experienced increased volatility. To give you a better idea of how HFT can contribute to these violent price swings, consider the following, very simple example.
Say there are six HTF systems that follow very similar trading algorithms. Say these algorithms order the system to short sell a stock when it breaks a new 52 week low and buy to cover once the stock price fell.25% off that low. Now the first system (we'll call it "system A") recognizes that the stock has broken this 52 week low and takes a short position. As system A is waiting to exit this position, another (slower acting) high frequency trading system (system B) recognizes that the stock has a broken its 52-week low and takes a short position as well. We can see how each system taking similar positions, one after another, can lead to violent price swings. In rebuttal to the liquidity argument, the only ones receiving the benefit of the mass amount of trades are the institutions and others conducting in HTF themselves.
Franklin Allen, a finance professor at Wharton considers HFT to be a form of "front running" (the advantage one get by jump ahead of another's trade). If a broker receives an order to buy stock A at $50.00 per share, but instead buys it at $49.50 per share and still sells to the customer at $50.00 per share, they cheat the customer out of $.50 per share.
The role of time in these HFT systems is so important that these "statistical arbitrage" firms are actually paying top dollar just to be closer to the stock exchanges themselves. In the world of high frequency trading, even fractions of seconds count. The development of such systems is only widening the performance gap between individuals and institutions.
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