Explanation of High-Frequency Trading - Assignment Example

 Explanation of high-frequency trading and an evaluation of its implications for markets and shareholders of equity markets Explanation of high-frequency trading Today’s equity markets operate in a highly sophisticated computerised environment that uses varied approaches and technological trading tools (Narang, 2013, p. 23). High-frequency trading (HFT) uses algorithmic trading tools to enable traders to move in and out of equity positions in seconds or fractions of a second (Lattemann et al, 2012, p. 97). HFT uses algorithms to identify fleeting moves in the direction of equities and commodities (Aldridge, 2013, p. 35). These consist of ‘signals’ such as the movement of interest rates that can provide an indication concerning the manner equities or commodities may move over a short period (Coates et al, 2008, p. 627). Other approaches entail looking for and taking advantage of what are termed as subtle quirks in trading infrastructure (Blair et al, 2010, pp. 1336-1337). The strategy entails capturing profits that can be as low as a fraction of a pence for each trade (Menkveld, 2013, p. 720). The strategy does not entail taking positions in equities or commodities as the process seeks immediate profits using the volume of the trade times the possible return (Jarrow and Protter, 2011, pp. 16-17). The case of Steve Swanson provides important insights concerning how this works (Philips, 2013, p. 1). He developed one of the first high-frequency trading algorithms that predicted stock price movements “… 30 to 60 seconds into the future …” (Philips, 2013, p. 1). This permitted trades to be placed in time to take advantage of these projections and then to move back out of them. The volume of trades moved by high-frequency traders in 2009 ranged around 3.25 billion shares per day, with the average profits amounting to a tenth of a pence to a twentieth of a pence (Philips, 2013, p. 1). By 2012 volume had fallen to approximately 1.6 billion shares a day (Philips, 2013, p. 1). The reason for the decline is that the volume of trading was making it virtually impossible to reap profits as the hundreds of trading programs were cannibalising profits from each other (Philips, 2013, p. 1). Market making is a key technique that is used in the process of high-frequency trading (Campbell et al, 2009, pp. 71-72). It represents where the trader or firm involved in the process places what is termed as a limit order using the computer (Sandas, 2001, pp. 714-716). A limit order is when the buyer of a stock states they will buy the stock only at the price indicated (Ranaldo, 2004, pp. 59-60). This technique is essential to the high-frequency trading process as the strategy is based on buying the stock as a predetermined price, per the movement projections, so it can be sold at the price point to make a profit (Scalas et al, 2004, pp. 699-701). These predetermined buy/sell ranges are the basis for high-frequency trading. High-frequency trading in equity markets – an exploration of fundamentals In exploring the impact of high-frequency trading on equities, it is necessary to provide a summary understanding of the stock trading process in order to understand its impacts. There are a number of reasons for companies being listed. In the instance of newer companies the reasons represent access to non-debt capital (Draho, 2004, pp. 25-28). This means that the issued stock of a company, or in other words its paper, is traded on stock exchanges where, if needed, the company can use this to raise funds for projects, expansion, equipment or other purposes without taking on debt (Draho, 2004, pp. 25-28). In addition, a public listing opens the company to a broad array of individual, institutional and mutual fund investors (Pagano et al, 2001, pp. 775-776). Creating awareness of the company to a large cadre of potential buyers for the stock provides the foundation for the laws of supply and demand to take place (Pagano et al, 2001, pp. 775-776). This is an important aspect as the number of shares outstanding versus the field of potential buyers, the financial stability of the company, its fundamentals in comparison with like companies, and other ratio aspects help to determine the stock price (Harris, 2006, pp. 231-233). In terms of the above, it needs to be noted that these aspects form a delicate balance of fundamentals, relative comparison against other companies, along with the economic climate the company operates in to create a demand for equities among individuals, and institutional buyers (Claessens et al, 2006, pp. 321-322). These factors are part of the inputs that determine stock prices. There are additional factors which add to the above which represent other considerations. One of these represents the ease of understanding the business the company is in (Foreh and Grier, 2002, pp. 351-352). Companies such as fast food, automobiles, computers, software, real estate, appliances, and allied industries are known to potential individual investors because they use them and thus they are easily recognised as well as understood (Mohr and Webb, 2005, pp. 127-128). Other sectors such as pharmaceutical research, biotech companies, and similar highly scientific companies tend to have lower individual buyer interest and involvement (Rundle-Thiele, 2006, pp. 417-418). All public companies have market makers that represent stock brokerage firms which have an interest in the public (individuals, institutional investors and mutual funds) buying of the stock (Steil, 2002 pp. 71-72). The market makers used by the company help to expose it to the public, conduct analyst reviews and help set the list the bid / sell price of the stock (Steil, 2002 pp. 71-72). In addition to these activities, the company’s own public relations department or P.R. agency to devise press releases and conduct structured or planned campaigns to generate awareness with the public to promote interest in the company and its stock (Brockman and Chung, 2001, pp. 421-423). The above broad-based summary of equities, their purpose, operation, and allied factors have been brought forth to provide an understanding of how the stock market, shares and investors work and interact. In understanding the price movements of stock, it is the various parts of the above areas represented by company performance, fundamentals, economic climate, company or industry news, and investor sentiment that drive stock prices upward or downward (Grinblatt and Moskowitz, 2004, pp. 547-548). This delicate balance provides the stock market and equities with the sense of trust and confidence investors rely upon (Grinblatt and Moskowitz, 2004, pp. 547-548). The above nuances guide and impact the stock market and stock pricing which are components used by high-frequency trading programmes to determine price direction and thus generate profits. High-frequency trading in equity markets – how and why they work High-frequency trading programmes are based on using existing investor sentiment, company fundamentals, and allied factors without contributing anything back (Jones, 2013, pp. 5-6). This represents one of the major criticisms of high-frequency trading programs which seek to extract benefit (meaning profits) without contributing anything to the economic value and equity aspects of the stock or stock market (Cochrane, 2002, pp. 6-7). Other aspects are that high-frequency trading can influence price movement, and negatively impact prices thus influencing stocks and the market (Cochrane, 2002, pp. 6-7). In terms of summarising high-frequency trading, the field has gained a foothold in stock trading (Cartea and Penalva, 2012, pp. 23-25). This has come about despite the recent pullback in the volume of trades executed (Cartea and Penalva, 2012, pp. 23-25). The field has also advanced in terms of the increased sophistication of trade execution programmes along with advances in software technology (Fabozzi et al, 2011, pp. 9-11). In terms of comments concerning high-frequency trading the general consensus regarding whether it negatively impacts stocks is inconclusive (Conrad et al, 2012, pp. 321-322). This is due to the extremely short term nature of the trades and the fact that high-frequency traders’ move in and out of a broad array of stocks as opposed to the same selections (Conrad et al, 2012, pp. 321-322). In terms of regulatory views, the possibility for adverse effects that could occur under varied market conditions means that safeguards might need to be incorporated into the high-frequency trading process (Lenglet, 2011, pp. 47-48). Aspects that are being considered in this regard include subjecting the process (high-frequency trading) to prudent trading parameters and potential supervision by a special oversight authority (Malarkey, 2011, p. 1). High-frequency trading in equity markets – impact on stakeholders and prices In terms of the impact on stakeholders, the above segment offered insights concerning individual investors whose investment in the stock could potentially lose value as a result of a loss of confidence in the stock where a rash of selling occurs for no apparent reason (Fairchild and Ribbers, 2004, pp. 66-67). Many stocks are tightly traded (Fairchild and Ribbers, 2004, pp. 66-67). This means that the relationship between the number of shares outstanding, and the investors (which include individuals, companies, and institutional investors) who look closely at price movements could be affected by a short term spike buying and selling (Farmer and Joshi, 2002, pp. 155-157). Spikes in the stock can be seen in some instances as a potential weakness or volatility that could possibly trigger the selling of positions thus driving the price downward for reasons not connected to stock fundamentals (Gabaix et al, 2006, pp. 481-483). Adding to this point are speculators. These are day traders and day trade programmes (Lo et al, 2005, pp. 5-7). In most instances, day traders and other speculators seek to short sell stocks due to the fact that tightly traded equities tend to be susceptible to downward movement (Lo et al, 2005, pp. 5-7). The reason for the above is that the upward trending of a stock entails more variables than a downward trending (Nilsson, 2006, pp. 70-71). This is explained by Spritzer and Freitas (2006, p. 514) as a price barrier resistance. This is because in order to move upward there needs to be a justification for the increase such as entry into a new market, increased sales performance, the use of new technology by the company, upward trending economic conditions and similar factors (Spritzer and Freitas, 2006, p. 514). Many stock speculators and day traders bet against the upward movement through a tactic known as shorting (Nilsson, 2006, pp. 70-7). This means they are betting the price of the stock will trend downward (Nilsson, 2006, pp. 70-7). If enough short sell orders appear that are not countered by sufficient buy orders then a stock will tend to trend downward in the absence of any news (Nilsson, 2006, pp. 70-7). This is one of the negative factors of high-frequency trading as the rapid buy/sell activity can be seen as a negative indication and thus aid in causing downward trending by causing sells from individual investors (Spritzer and Freitas, 2006, p. 5). The effect can also spread to institutional investors as well (Piotroski and Roulstone, 2004, pp. 1124-1125). These can represent pension funds, and mutual funds that consistently review stocks for their strengths in terms of fundamentals, company management, revenues, profitability, and stock price movements (Piotroski and Roulstone, 2004, pp. 1124-1125). Stakeholders such as suppliers can be negatively impacted if they also hold stock positions or were paid in stock for services or supplies (Piotroski and Roulstone, 2004, pp. 1127-1128). High-frequency trading in equity markets – The Flash Crash of 2010 The significance concerning the impact of high-frequency trading is demonstrated by what is called the ‘Flash Crash’ of 6 May 2010 (Easley et al, 2010, pp. 120-121). This affected companies, exchanges, regulators and governments in addition to institutional and individual investors (Easley et al, 2010, pp. 120-121). On that date, the United States Dow Jones Industrial Average (DOW) fell by 10% (which was approximately 1,000 points), and recovered this downward spike minutes after the event. This point swing, at the time, represented the largest one day decline in the history of the Dow (Lee et al, 2011, pp. 65-66). As a point of reference, the Dow Jones Industrial Average is a stock market index created to provide an overview of the most important industry cross sections in the United States (Lopez et al, 2007, pp. 291-292). The theory and purpose behind this are that the thirty stocks comprising the DOW provide an index that helps to gauge the relative movement and health of the United States economy as its companies are spread across a representative section of industrial sectors: Table 1 - Dow Jones Industrial Average Stock Companies (MarketWatch, 2014, p. 1) The ‘Flash Crash’ was investigated by the United States Securities and Exchange Commission and the United States Commodity Futures Trading Commission (2010, pp. 1-12). It was determined that the fragility of the stock market and its dependence on a broad number of fundamental variables and investor sentiment meant that large unexplained trade volumes could cause spikes in company stocks and lead to a potential run on the stocks of the firms affected (United States Securities and Exchange Commission and United States Commodity Futures Trading Commission, 2010, pp. 10-12). In another report conducted by Lauricella et al (2010, p. 8) they stated: "HFTs began to quickly buy and then resell contracts to each other - generating a 'hot-potato' volume effect as the same positions were passed rapidly back and forth…" The event caused some traders in the affected stock to halt trading as the spikes were not explained under normal market rules represented by news, economic events or other variables (Lauricella et al (2010, p. 9). The above event provides an example of the potential effects of high-frequency trading that caused a response by government regulators that were adopted in consideration of exchanges, listed companies, stakeholders, institutional and private investors, speculators and firms that used high-frequency trading programmes (Protess, 2012, p. 1). The first measure entailed the implementation what is termed as “market-wide circuit breakers’ that automatically halt trading when there are unexplained spikes in the system or trades involving companies (Protess, 2012, p. 1). The second measure stops the entering of erroneous trades into the system (Protess, 2012, p. 1). This prevents what is termed as “limit up, limit down’ trades that are placed outside of the normal price ranges of stocks as a measure to end speculative shorting using large volumes (Protess, 2012, p. 1). The ongoing impact of the ‘Flash Crash’ event is that the United States Securities and Exchange Commission and the U.S. government were positioned to have a larger role in overseeing high-frequency trading (Spicer et al, 2012, p. 1). In Europe, the Markets in Financial Instruments Directive (MiFID) is evaluating a similar approach for the Euro area (Durkin, 2014, p. 1). Conclusion The arena of high-frequency trading represents a computer algorithmic profit generation trading approach that is based on detecting small variances in price movement projections. The rationale for these trading programmes to use of high trade volumes using rapid in and out stock positions to generate a fraction of a pence per trade in profit. As a result, high-frequency trading does not contribute to stock value. As brought forth in this examination, the profit only motive of these programmes and the potential for causing spikes in stock pricing has caused concern among government regulators, stock exchanges, companies, stakeholders and investors. Whilst the algorithms of high-frequency trading programmes seek trading variances as opposed to repeatedly targeting any specific companies, the ‘Flash Crash of 2010’ provided an example of the cascade effect such programmes can cause in a cumulative circumstance. The impact the above event had on the market caused regulators to adopt policies to limit high-frequency trades in terms of order placement outside of the normal stock trading ranges. This was designed to move high-frequency trading into the boundaries of established trading routines to limit their potential influence in spiking stock prices. The issue brought forth in this look at high-frequency trading has revealed that the process only benefits the firms using the programmes. High-frequency trading does not contribute by adding value to stocks, and they have the potential to cause havoc in the market. The problem is, the motive is no different from those of day traders, institutional and individual investors and others who seek to make a profit from the market. Given the potential to influence stock price movements due to the large volumes involved, these trading programmes need regulation as a control. References Aldridge, I. 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