There has been a lot of talk in the industry over the past few months about high frequency trading and whether it is the cause of markets being more volatile than usual.
Liz Ann Sonders, Schwab’s Chief Investment Strategist, provides some interesting detail about the situation in the following excerpts from her October 17 commentary.
- High-frequency trading (HFT) is a program-trading platform that uses high-speed and ultra-powerful computers to transact a large number of trades at very fast speeds. HFT uses complex algorithms to analyze multiple markets and execute orders based on market conditions.
- According to several sources, including TABB Group, Aite Group and Thomson Reuters, HFT now accounts for between 55-75% of trading volume on average, with some days even higher
- On August 8, the Monday after S&P downgraded US debt, the Dow Jones Industrial Average fell by 635 points. Volume on the New York Stock Exchange was the fourth highest on record. TABB estimates record profits of $60 million that day for HFT firms. The bottom line is that any time trading firms are making millions while the majority of investors are either getting killed or simply watching market action with horror, it’s going to generate attention.
- The proponents for HFT claim that it brings more liquidity to the market while keeping transaction costs low via narrowing bid-ask spreads, and a recent study by the Capital Markets Cooperative Research Centre of Australia supports that view. But there are plenty of studies that refute the aforementioned benign characterization of HFT.
- Leveraged ETFs give investors the opportunity to bet on a basket of stocks, commodities or an overall index and have become very popular vehicles for traders generally and HFT firms in particular. Their attractiveness to HFT users comes from the fact that investors can bet long or short and leverage the bet, while also moving in and out during the trading day to lock in gains (or limit losses, which can be substantial). There are also “inverse leveraged” ETFs that go up when the price of the basket of goods goes down and vice versa.
- In times of high market volatility, stock movements tend to be more correlated and the link has grown increasingly strong since the mid-2000s. That was when regulatory reform encouraged financial exchanges to switch from floor-based trading to electronic trading.
- The hoped-for benefit of this increased scrutiny and (regulatory) action is confidence among traditional investors in markets and the belief that we can all again play on a relatively level playing field.
Sonders’s last point here about fairness for the common investor is an important one. If lack of confidence in the fairness of the system prevents people from putting their money to work to outpace inflation and pursue their goals the challenge to achieve financial security will become even tougher.
~ Brooks, Hughes & Jones, Partners in Wealth Management, Tacoma, WA