High Frequency Trading Deemed Unfair, but Is That Reality?

by on March 19, 2014 5:58 am GMT

Technology has transformed the trading environment substantially over the last couple decades. Computer technology has offered accessibility to retail traders to a bevy of assets, but it has also stacked more chips in the corner for institutions. Speed is everything. Michael Douglas’ character Gordon Gekko said in the infamous “Wall Street” movie, “the most valuable commodity I know of is information,” and when institutions can trade on information faster than the little guy, things can get messy.

New York Attorney General Eric Schneiderman said that high frequency traders gain faster access to information and that firms can make “rapid and often risk-free trades before the rest of the market can react.” High frequency trading has received a bad reputation over the last couple years, and Schneiderman said the ability to gain access to pricing, volume, and other trading data is unfair. “For instance, high-frequency traders look for arbitrage opportunities between and among the various exchanges, moving on price and order information before the rest of the market is even able to digest it,” said Schneiderman. The only problem is arbitrage trading has been done long before computer algorithms took over Wall Street.

I believe there is a difference between trading information rapidly and trading it right. Computers can trade the “tape,” or order flow, quicker than a mere mortal, but computers often tend to get it wrong most of the time. There are numerous successful retail traders who trade solely on order flow and level II market maker screens, which are often available with the most basic software and data connection.

Quantitative (quant) hedge funds trade using highly complex computer algorithms, and these funds are made up of highly intelligent individuals with heavy hard science and mathematical backgrounds. One would assume these market participants have numerous unfair advantages, but that is not the case. Quant funds have repeatedly underperformed benchmarks over the years. Some have linked it to a discretionary trader’s ability to analyze and think outside a strict set of predefined rules set within an algorithm.

Quant funds have underperformed the broad global market trends for the last three years, and investors have pulled over $6 billion in capital from these funds in 2013, according to Hedge Fund Research Inc. The Newedge CTA Index, which tracks 20 large trend-following funds, gained only .7 percent in 2013 as the S&P500 gained 30 percent. What is really unfair is that investors would have been better suited ina low-cost index exchange-traded fund (ETF). The Newedge CTA Index is down 3.07 percent through March 17.

However, some firms do see a profit. Virtu, a high-frequency trading firm, seen a $184 million profit in 2013, a 108 percent gain year-over-year. Trading is binary. There is only two outcomes, and everyone is looking for an edge. Gekko said it best “it’s a Zero Sum game – somebody wins, somebody loses. Money itself isn’t lost or made, it’s simply transferred – from one perception to another. Like magic.”