Thursday, August 25, 2011

Does High Frequency Trading Stoke Volatility?

There is a lot of speculation in the financial media and among individual citizen traders about whether high frequency trading is responsible for market volatility because it ignores fundamental analysis for data trends.  Obviously, high frequency trading could increase trading volume and accelerate market trend through volume.  While the sheer volume and speed can effect prices and there has been speculation that a high frequency trader could, and maybe has from time to time, driven an equity or futures price up on sells and buys to itself, the real question is the fairness of access.  All high frequency traders have direct access to the market through broker-dealers making trades in nanoseconds, causing the question to be raised whether they have the proper structure to insure proper margins and other technical regulatory safeguards.  Since a single high frequency trader could send a million or more messages a day to a market with few trades, the cost to the stock exchanges for adequate data networks is very expensive.  Individual traders do not have direct access to the market and must meet all regulatory conditions as do broker-dealers who have direct access to the market.  The bottom line question is, consequently, one of fairness.  Do individual traders get speedy market execution and a fair market price? 

The Review of Futures Market has a special issue (Volume 19)of which the first article reviews the research literature and methodologies on high frequency trading and the last article is on the effect of high frequency trading in the futures market.  The first study finds high frequency trading is a natural evolution of the trading process, add "quality" to the market through added liquidity, lower trading prices, and reducing bid-ask spreads at the cost of shifting profits, however small on individual trades, through trading volume, only pose a modest manipulative threat because they typically do not hold positions overnight, and only present a problem when they withdraw liquidity from the market causing system breakdown or cascading.  The study suggests the need to design electronic trading systems and to slow or interrupt trading and/or change the trading mechanism.  The last study finds that high frequency trading increases liquidity in the futures market.

Individual investors would be wise to not spending time researching and fretting about the effect of high frequency trading on equity prices and concentrate on the technical and fundamental information of the equity and the market.  You never fight the market and individual investors need a very profound analytical and economic reason to be in individual stocks during a market correction.  Consequently, individual investors would be wise to pay attention to not just price movement of the equity and the market, but the volumes.  This market is not only in correction but it has been testing March lows for the last two weeks with temporary reflexive rallies of short duration.  A week ago last Monday, Monday the 15th, was the fourth market day in successively lower trading volume (down 16.6% that day) even though it went up 213.88 on the DOW.  The next day was down in price but up only 6.1% in volume.  The next day was up marginally on 14.6% down volume.  Thursday of that week it went down 419.63 on up volume of 63.5%.  Monday of this week (22nd) the DOW was up only 37.00 on down volume of 20.4%.  On Tuesday it was up 322.11 on only 1.7% up volume.  On Wednesday, the DOW was up 143.95 but on down volume of 8.5%.  All of these days of trading have been volatile.  The likelihood that today would be a down price day with up volume would have been a reasonable bet and, in fact, that is what is occurring at this time.  By watching price, volume, and economic news, which means knowing what economic reports are coming out on what days not just event news, the individual investor should have some reasonable trend indication which will serve them well as they stay out of individual stocks during any correction and research stocks to buy when the market trends up for more than a short reflexive rally. 

Pay attention to technical and fundamental information on both the equities you are researching and the market itself.  You can control your buy and sell decisions and learn from them.  You cannot make yourself a better trader by researching the effects of high frequency trading.

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1 comment:

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