Don’t fear high-frequency trading
Bill Radke: We talked earlier in the show about how small investors are fleeing the stock market. We gave some possible reasons — maybe they’re nervous about the economy, maybe they prefer the safety of bonds. Or maybe people are just still freaked out from the “flash crash”.
Remember the stomach-dropping plunge this spring when almost 1,000 points just vanished from the Dow in just a few minutes, and then reappeared just as fast? Well, a group called the Financial Industry Regulatory Association is still struggling to explain exactly what happened. But over the weekend, it announced a probe that could lay some of the blame on high-frequency trading. We’ve told you about these — those high-tech,
high-speed computer trades that now account for most of the buying and selling on Wall Street.
Well, commentator Matt Samelson says high-frequency trading might sound intimidating, but let’s not make it the enemy.
Matt Samelson: Wild swings in the stock market always trigger a hunt for a bogeyman. Short sellers used to be the favorite target for blame, then algorithmic traders. Today, it’s high-frequency trading.
It’s easy to blame high-frequency trading, because most people know little about it. Talk of superfast computers and complicated algorithms makes it sound like a sinister plot line in the movie “The Terminator.”
In reality, high-frequency trading is quite simple. It generally involves the frequent buying and selling of securities to profit from small changes in prices. The computers used in high-frequency trading are extremely smart: They’re programmed to spot the best time to make the trades. They’re quite fast, too: Orders are often executed in about one-ten thousandth of a second.
Being faster, and maybe even smarter, than a human trader isn’t a bad thing. High-frequency strategies squeeze every ounce of value out of the market in ways that humans can’t. They add value in other ways, too. In some instances, they buy and sell stock purely to collect rebates. By doing this, they provide shares that otherwise wouldn’t be available, easing the pressure of supply and demand. They also identify stocks in which the market price has diverged from fundamental value. In taking advantage of these instances they correct the mispricing, pushing market prices back in line with fundamental price.
In other words, rather than creating problems in the market, high-frequency trading often solves them. It provides more stock for people to buy and sell, it often results in better execution prices, and it helps smooth out the ups and downs in price movement.
Nobody has yet managed to work out what caused the near 1,000-point drop in the Dow on May 6, but we do know that high-frequency traders helped correct the problem. The tremendous drop in the market prices of certain securities was stopped fairly rapidly thanks to high-frequency traders. They were the first to see prices were far lower than they should have been. They bought in, and they drove the market back, almost to where it had started.
It’s true that high-frequency trading is reshaping our stock markets, and it’s right that regulators should want to investigate. Hopefully, once regulators and legislators gain a full understanding of HFT, they’ll see the enormous benefits that it can bring. Hopefully, then, we’ll stop hearing paranoid rants about the rise of the machines.
Radke: Matt Samelson is a principal at the independent consulting firm Woodbine Associates.
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