High frequency trading might be an elephant in the closet.
Representing perhaps 51% of all daily trading volume, speedy trading hits the headlines only when something goes wrong. But since I’ve been reading Frank Partnoy’s Wait: The Art and Science of Delay, and particularly enjoyed his chapter on the topic, I wanted to share some of what I learned.
Let’s start by imagining 25 milliseconds. Whereas Warren Buffett’s Berkshire Hathaway has owned Coca-Cola stock for more than 25 years, a high frequency trader might own Coca-Cola or a security that relates to it (called a derivative but let’s not think about that now) for 25 milliseconds.
Here is a simplified version of how it works:
Listening to its algorithm, the computer identifies a flood of buy orders for a certain security. It just has to zoom in and purchase those shares. The trick though is doing it before anyone else does. And then, within maybe 25 milliseconds, it has to sell before anyone else does to all of those buyers it had previously identified. The goal? Make a penny or less for each share. Added together? Many thousands of dollars and trades.
Fundamentally, high frequency traders are looking for market volatility. For currencies, futures, options, bonds, when markets are gyrating up or down, price anomalies occur. A stock, for example, might suddenly be cheaper than expected or there might be that deluge of buy or sell orders. At that moment, the super speedy computer swoops in to take advantage and make a penny or 2 for each trade.
Speed is crucial because the very act of buying and selling changes the price. If everyone tries to buy at a lower price, together they push the price up. To beat the increase, you have to be the first one. Similarly, if everyone sells simultaneously, the price of the security declines. Again, to make your pennies, you have to lead the pack. You have to have the fastest computer.
And that takes us to location. You not only need speedy computers but also, you need to be close to stock markets’ servers. Seven years ago, one California firm saw its profits slipping. Slicing several milliseconds off trading time, a move to NY solved the problem.
A New York location, though, was only the beginning of a race. Not cheap, computer “co-location” is now sold by stock exchanges. Nasdaq meanwhile offers a high speed data package and feed for $25,000 a month.
Our bottom line? High speed trading has created a list of concerns. Mistakes are exaggerated. Front running a deluge of buy orders might be harming smaller retail investors. Human wisdom is absent just when you might need it. But still, high speed trading could indeed be a huge source of liquidity–of buyers and sellers–just when stock markets need them.
So, what to do? Is high speed trading the elephant in the closet that requires more attention?
Sources and Resources: For more discussion of high speed trading and the sources of many of my facts, I recommend this NY Times article and Frank Parnoy’s Wait. You might also enjoy this recent Bloomberg discussion of the 2010 “Flash Crash” and this CBS 60 Minutes segment on high frequency trading.
A hat tip to Josh Goldberg!
