With graphs of stock market prices looking like the Alps recently, people are hearing a great deal about high-frequency trading (HFT) and its impact on the market.
Except for hearing media comments about it after last May’s “flash crash,” though, most investors know little about it. So what is it and why should you care?
HFT, which is conducted by proprietary trading desks at big banks and private hedge funds, uses computers to make trading decisions and execute trades based on perceived pricing inefficiencies.
It now accounts for 73% of all equity trading in the U.S., up from 30% four years ago, according to TABB Group, which researches financial markets. It
is not as dominant in other countries, but its use is growing.
Not only has HFT grown in volume, it has grown in speed. While computers took a couple of seconds to execute trades a few years ago, today trades are being executed in nanoseconds – that’s billionths of seconds.
The greater the use of HFT, of course, the greater the impact it can have. And, because programs in place today trade so rapidly, HFT can wreak havoc on the market.
During the “flash crash,” the Dow Jones Industrial Average fell nearly 1,000 points in 20 minutes – the fastest and largest drop in market history.
Individual investors have been leaving the market as HFT has grown. As HFT continues to fill the void, it may continue to push out the individual investor
and take on an even greater percentage of trading volume.
Some support the use of HFT, suggesting that it lowers volatility, narrows the spreads between bid and offer prices, creates liquidity and reduces the cost of trading for all market participants.
If HFT lowers volatility, shouldn’t the market be less volatile than it used to be? HFT may also increase liquidity, but that liquidity is not available when it is needed most.