High-frequency trading

Rafael Hurtado. Professor. IE Business School

28 November 2012

Many believe high-frequency trading to be the cause of all the problems we are currently seeing in the markets. Nothing could be further from the truth.

High-frequency trading is an investment tool that has become very popular among institutional investors over the last few years, in much the same way as hedge funds have. Some investment Banks, like Goldman Sachs, also use this type of management techniques. From the end of the nineties this type of trading has been used relatively frequently.

High-frequency trading basically consists of the purchase and sale of financial assets within a short period of time (could be seconds or hours). Investors that use high-frequency trading, at the end of the day, do not have open positions. In other words, if they buy an asset they sell it before the end of the session, or vice versa. The financial assets that high-frequency trading operators normally buy and sell are shares, futures, options, listed funds or ETFs, currencies, and any other asset they can trade with using electronic systems. This type of investors often carry out a very high number of purchases and sales in the space of one day.

This investment strategy is based on the use of quantitative systems and mathematical algorithms that try to leverage small inefficiencies that occur in different financial assets. A large number of financial operations are currently carried out by high-frequency trading programs. Specifically, some sources calculate that 70% of US shares are bought or sold by organizations that use this type of management system. There are several studies that indicate that this type of trading has increased significantly over the last decade.

It is quite usual to read negative articles or comments about high-frequency trading. It is occasionally seen as mere speculation, and is sometimes even accused of generating systemic risks, contributing to the volatility of markets and causing large short-term drops in the stock market. One example of big drops for which high-frequency trading was blamed was the 9% fall in the Dow Jones Industrial Average for a few minutes on May 6, 2010. It was the biggest fall in points in the history of the index (it dropped  998.5 points).

Generally speaking regulators, particularly European regulators, do not have a very high opinion of the effects that high-frequency trading can have on markets. In fact the European Parliament has requested further measures to protect markets from these investment techniques. Nevertheless, many members of the finance industry feel that the negative effects of  high-frequency trading on markets are greatly exaggerated, while the many very positive effects they have tend to be forgotten.  Such positive effects include the increase in liquidity and the of volatility levels due to a reduction in market inefficiencies. The increase in liquidity, in practice, means that the gap between the buying and selling prices of the assets is narrowed, and the other market participants find it easier to buy or sell.

The future of high-frequency trading will depend basically on two factors. The first is how legislation evolves, and the second is the ease with which investors access complex technologies in order to leverage short-term market inefficiencies as they occur.

The first of these, regulation, is essential. If taxes like the famous Tobin tax are levied on financial transactions, they will hinder the development of this type of activity. As far as access to technology is concerned, we can highlight the fact that if a large number of operators are capable of finding small inefficiencies that occur in financial assets, said inefficiencies will end up disappearing. That’s why in order to make high-frequency trading successful, it is very important to have not only an excellent mathematical model, but also a computer system capable of high-speed connection with financial markets.

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