The Impact of High Frequency Trading on Retail Investors

Whether you are a trader looking to earning your daily keep or a corporate hedger looking to lock in cash flows, participants in the capital markets are focused on maximizing revenue in the most efficient manner.

What makes most of the capital markets efficient is the underlying belief that you can experience liquidity in nearly every tradable market.  Liquidity is a benefit to investors, and it goes hand in hand with trading strategies and provides the basis for prudent risk management. Most day traders whether they are trading forex products, or equities or even commodities participate because they can control their risks and exit positions when they are right as well as when they are wrong.

This luxury comes with a cost.  The cost of participating in a market that has adequate liquidity is that there are many traders who are looking to benefit from creating that liquidity. Capturing most of the headlines are the high frequency traders who provide liquidity but in many cases inflict a cost that might outweigh the benefits retail investors receive by participating in liquid capital markets.

History of Liquidity

Prior to discussing the pros and cons of high frequency traders to retail investors it is important to tract the roots of these liquidity providers to see how they made their way into trading liquid assets. In 1871, in an effort to promote liquid markets, the NY Stock exchange adopted a system of continuous trading giving rise to the need for a human to help foster this process.  This person was known as a specialist, and the role was to provide liquidity by trading a specific security in an effort to make sure retail traders as well as institutions received the best market when transacting in that particular security.

Based on the current supply and demand for a specific asset, the specialist was responsible for finding a fair market price. The specialist would make sure that if a customer order to buy a security was above the best offer, that the transaction was filled at the lowest offer.

As floor trading was replaced by computerized algorithms, the process of providing liquidity switched from humans to machines.  Although in many cases the specialist still remains as a needed process, many liquidity providers in the capital market structure are computerized algorithms that are looking to exploit opportunities and provide liquidity.  It is important to understand that the underlying reason high frequency traders exist is the markets present opportunities to quickly turn a profit and therefore in many cases the algorithms will provide liquidity by consistently placing bids and offers in multiple securities.

Historically traders are looking to generate alpha and they look to market makers and brokers to provide liquidity.  Beyond generating alpha, and determine the best risk adjusted strategies to trade the only other decision for an investor was choosing a broker to execute their trades.

Today, investors are still concerned with generating alpha. However, the trading process required to execute their alpha strategies has become more complex. With markets fragmented and high frequency traders taking advantage of orders, the market has become a more sophisticated environment.

Creating an Ongoing Auction

High frequency traders participate in never ending electron auctions. An auction brings together buyers and sellers and the process helps explore a range of values until a fair value is discovered.  So why is understanding an auction important for those trading the capital markets? The answer is that financial assets, such as futures contracts, utilize auctions to trade.  Every day buyers and sellers around the world gather in a global electronic marketplace and continuously evaluate the price of an asset in an effort to find the current value at that specific point in time.  The more bid and offers involved in an auction the more likely it is for the auction process to achieve fair value.

What are High Frequency Traders Trying to do?

The term high frequency traders describes an algorithm that is trading thousands of times a day in an effort to capture inefficiencies in the prices of a securities. The concept is a relative term, describing how market participants use technology to gain information, and act upon it, in advance of the rest of the market.

In the wake of the regulatory changes the concept of creating competition between trading operations the equities market has fragmented. Liquidity is dispersed across many equity trading operations and dark pools. This complexity, has created profit opportunities for technologically savvy traders. High frequency traders use high speed connections in conjunction with trading algorithms to exploit inefficiencies created by the new market. There are many strategies used by high frequency traders, some made infamous by Michael Lewis’s book “Flash Boys”.

The strategy that caught the public’s attention is one in which computer algorithm searched for orders going through the multitude of electronic exchanges available to trade securities.  These algorithms would detect a trade and attempt to transact the same trade before the order was filled at another electronic exchange.  In essence these algorithms were front running many securities orders and were predicated on the idea that speed was of the essence.  Speed has become so important to the success of a high frequency operation, that business have put billions of dollar into their operations.  Additionally, the proximity of a high frequency trader to an exchange will reduce or increase the speed at which a transaction is recognized which has further created competition for real-estate around a physical exchange location.

Why High Frequency Trading Expanded

In 2007 the National Market System (NMS) altered the regulations increasing the transparency for an automated visible market. The new regulations were implemented to enhance efficient price discovery, but as a results created opportunities for multiple venues to enter the market competing for trade volume and generate fragmented liquidity.

High frequency trading has permeated nearly many aspects of the capital markets. Investment strategies have migrated from stocks to bonds, currencies and commodities. Within the FOREX markets retail investors who previously generate revenue from attempting to capture small changes or the difference between bid / offer spreads on other exchanges have been decimated by high frequency operations which can use superior technology to capture these discrepancies.

Why High Frequency Traders Help Generate Liquidity

Traders transact and have to pay a spread between the price at which they buy which is referred to as the offer or the ask, and the price at which they sell is referred to as the bid. This bid-ask spread compensates the market makers for executing trades and provides liquidity for market participants who what to have access to the market at any time.

The more volatile the underlying asset, the wider the bid-ask spread. By consistently trading in a market high frequency traders tend to narrow the bid-ask spread by protecting the market makers from news that will generate unwanted volatility. Thus, the trading costs for market participants decline.

Liquidity goes hand in hand with the exchange.  For the exchanges to be successful they need liquidity and hence there is a demand for high frequency traders.  The partnership is key to the success of both entities.

So is High Frequency Trading Beneficial

The liquidity provided by high frequency trading is beneficial to market participants as in many cases it allow exchanges to provide the liquidity needed to make a venue viable.  Unfortunately, the reality is that in practice the negatives associated with high frequency trading outweigh the benefits.

Not only is there an issue with front running where high frequency trading firms front run clients to generate revenue, but they additionally create unwanted volatility when liquidity is needed the most. The May 2010 “flash crash”, which occurs during the heart of the financial crisis showed how detrimental a fragmented market can be for market participants. Even more recently there have been other events that have resulted from the unpredictable interaction of trading algorithms.

So investors look to exchanges to provide a market place that is fair and liquid which will allows them to generate income if the market works as expected. During periods of complacency and relatively low volatility high frequency traders provide a stop gap for market markets and add a layer of additional liquidity.  Unfortunately, asset markets a fraught with periods of adverse scenarios when volatility perks up and high frequency traders are the first refrain from providing liquidity.

Algorithms that are meant to track market sentiment are the first to pile on and generate unwanted market reactions to what might be a mundane event.   Huge increases in volatility is the enemy of the individual retail investor.  Most are looking for reasonable gains without outsized losses.  Although high frequency traders provide the benefit of enhanced liquidity, they can also be the most significant reason for the retail investor experiencing devastating losses.

David Becker is a New York-based finance writer and capital markets analysis. With more than 20 years of experience in portfolio management, David runs a consulting business that focuses on investment analysis and personal finance. David is a senior capital markets analyst for FXempire.