investing

Does high-frequency trading change the game?

That sounds good, except that the behavior can be destabilizing, according to a research paper from the Swiss Finance Institute by Didier Sornette and Susanne Von der Becke, both of ETH Zurich.

The whipsawing created by high-frequency trading in some instances could be the cause of some of the mini "flash crashes" seen since the May 6, 2010, flash crash, which can then spread to the larger investor population. Basically, flash crashes occur when the price of a stock (or many stocks) takes a brief and violent nose dive, after which it recovers.

Researchers are not in agreement about the benefits of high-frequency trading. Studies have shown that high-frequency traders do provide liquidity, though it may dry up in the event of a crisis. And high-frequency trading firms act as market makers -- taking the other side of a trade made by an investor. According to Sornette and Von der Becke, the liquidity provided by algorithmic traders can itself be destabilizing -- more and more liquidity, and trading volume, is not necessarily better for investors.

"The key change is the move to hyper-liquidity. For the retail investor in particular, I can see no advantage in that, and it is doubtful whether there is an advantage even for the professional investor," says Napier.

"Many observers and analysts here in the U.S. and overseas have found that high-frequency trading actually raises costs and risks for small investors as a result of an increase in variability and uncertainty. And it might reduce returns that these investors get because of phenomena like 'front running,'" says Epstein.

Front running is the vilified -- and illegal -- practice of getting information before other traders and getting your trade in before them. With high-frequency trading, it happens in a fraction of a millisecond. Not too quickly to be illegal, however: In 2012, the SEC fined the New York Stock Exchange for improperly distributing their feeds. Some customers had their feeds routed directly to them; others had their feeds routed through an internal distribution system, which had a software issue that caused delays -- and which gave recipients of the direct feed a very slight edge.

Massive volume and hyper-liquidity

High-frequency trading accounts for most of the trades in stock markets in the U.S. and U.K. At the beginning of 2011, TABB Group released a report showing that 77 percent of the transactions in U.K. markets came from automated traders.

In an interview on Forbes.com, published in September 2013, Eric Hunsader, CEO of Nanex, a market data feed provider, said 50 percent to 70 percent of all trading volume comes from high-frequency trades while 90 percent to 95 percent of quotes come from them.

For small investors, there may have never been a worse time to try to institute short-term trading strategies. Day-trading has never been a sure thing, but with incredible volume and transient liquidity from automated trading, individuals are at a huge disadvantage. Long-term investors may not be greatly impacted, but everyone in the market could be subject to increased volatility and more mini-crashes that occur every day in individual securities and assets.

"To the extent that liquidity -- perhaps provided by the activity of institutions -- encourages the small investor to trade more, it is a bad thing," Napier says.

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