%20has%20been%20generating%20a%20lot%20of%20controversy%20in%20the%20equities%20markets.%20But%20what%20exactly%20is%20high%20frequency%20trading%20and%20why%20is%20it%20so%20controversial?%20And%20why%20are%20there%20so%20many%20misconceptions%20out%20there%20around%20these%20activities?%20This%20article%20will%20attempt%20to%20answer%20those%20questions.So%20first%20things%20first.%20What%20exactly%20is%20high...){kind=link}
High Frequency Trading Myths And Misconceptions
Over the last eighteen months or so, the practice of high frequency trading (HFT) has been generating a lot of controversy in the equities markets
. But what exactly is high frequency trading and why is it so controversial? And why are there so many misconceptions out there around these activities? This article will attempt to answer those questions.So first things first. What exactly is high frequency trading? There are many definitions for it, but most agree on it being the practice of using computer systems to submit multiple orders to the market electronically and holding positions for no longer than a few minutes, always ending the day flat.
This all sounds perfectly reasonable, so why is there so much controversy around the practice? For a start, the mechanics of high frequency trading is generally not understood by the investing public and where there is ignorance, there is fear. People think that if these computers are making money, it must be at their expense. Secondly, media coverage of high frequency trading is generally pretty negative, for a variety of reasons. And third, when events like the 6th May "flash crash" happen, they are attributed by various commentators to high frequency traders, regardless of the facts of what actually happened.
The misconceptions around high frequency are many and varied. For example, a common myth is that HFT causes market volatility. This is illogical when you think about it. Without market volatility there would be no high frequency trading, because there would be no price differences for the HFT strategis to take advantage of. HFT cannot both be the cause and effect of market volatility, they have to be one or the other. Otherwise they would have an infinite money-making paradox (a beneficial paradox but a paradox all the same).
Another myth is the amount of profits generated by high frequency traders. The typical profit for a single high frequency trade is less than 0.1 cent per share. Based on industry estimates of HFT volume (ten billion shares per day), that is a total of $2 billion per annum in profits, distributed across all the firms who are engaged in HFT. This is actually just a tiny fraction of the profits generated by the investment industry as a whole.
Another myth revolves around technology. Many people seem to think that high frequency traders have an unfair advantage over other investors because of the technology they use. Yes, the technology the HFT firms use enables them to anticipate prices, trade small differences at high speed and thus capture small profits on a consistent basis. But what is unfair about this? Any firm that invests in the required technology and the staff who are able to program the computers can compete at the same level. All it takes is the necessary investment. Since when has investing in technology to give you a competitive advantage been unfair?
Another misconception that is fairly common is that high frequency trading systems caused, or at least contributed to, the "flash crash" on May 6th. The reality is actually very different. If you look at the events of that day, once the market started collapsing, most HFT firms disabled their systems while they evaluated exactly what was happening and if there was some king of major news event of which they were unaware. Once it was clear that was not the case, they re-applied their systems and equilibrium was once again restored.
High frequency trading serves a useful purpose in that it provides liquidity in electronic markets by taking the opposing side of trades to institutional and retail investors who are buying or selling positions for the long term. In the same way as dealers and specialists used to make markets on the trading floors many years ago, high frequency traders serve a similar purpose now, they just do it faster and more efficiently.
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