Fast, Loose, and Out of Control...High Frequency Trading (Newsweek)

Trading billions of shares in the blink of an eye has made stock markets more responsive—and volatile—than ever.

Newsweek
On April 26, the Dow Jones industrial average stood at 11,205, up nearly 70 percent since its low in March 2009. While there were bumps along the way, the ride from 6,500 to 11,205 was generally smooth and steady. But the placid markets were about to get hit by a tsunami. When it became evident that Greece’s financial woes might spark a Europe-wide sovereign-debt crisis, the waters began to churn. The Dow lost 214 points on April 27 and posted triple-digit moves on 13 of the next 17 trading days. Worst was the “Flash Crash” of May 6, when the Dow lost 998 points in a matter of minutes, only to rally more than 600 before closing down nearly 350 points.

Suppressed for much of the recovery that began in the spring of 2009, market volatility has come roaring back. On May 21 the VIX, which measures the volatility of the S&P 500, and is also known as the “fear index,” spiked 25 percent. Who is to blame? Many analysts have fingered high-frequency traders, computer jockeys who plug complex trading algorithms into superfast computers and scour the markets for tiny price differentials. By trading vast amounts of stock at warp speed, as many as a billion shares a day, high-frequency traders gobble up fractions of cents at a time. The more volatile the market, the easier it is for them to make money jumping in and out of stocks across exchanges.

Markets become volatile when liquidity dries up—in other words, when people can’t trade stocks when they want, at a fair price. “High-frequency traders thrive off volatility, because when liquidity is in short supply, it becomes very profitable to provide it,” says Manoj Narang, founder and CEO of Tradeworx, a hedge fund and high-frequency trading firm in Red Bank, N.J., that trades an average of about 80 million shares a day. “On days with big movements, in the realm of triple digits, we make a lot of money.”

High-frequency traders, who on the whole have maintained a low profile, say that because their frenzied trading provides liquidity, they help markets run smoother, improving the environment for all investors. But combine the speed at which they operate, the outsourcing of decision making to computer codes, and an almost complete lack of regulation, and this shadow market can fuel and exaggerate volatility. Speed traders argue they actually tamp it down. Nonetheless, politicians and regulators are starting to get nervous. “I’m afraid that we’re sowing the seeds of the next financial crash,” says Sen. Ted Kaufman (D-Dela.), arguably D.C.’s most vociferous critic of high-frequency trading, or HFT.

High-frequency traders may have become the new villains of finance. But their computer-driven methods, which now account for upwards of 70 percent of all U.S. equity volume, aren’t going away. To a large degree, fundamental investment strategies—i.e., buying and selling stocks based on a company’s performance—have taken a back seat to algorithms hunting for inefficiencies. And the practice is beginning to spread from the U.S. stock market into new areas (Europe, Canada, Brazil, India) and asset classes (bonds, futures, currencies). Assuming the financial-regulatory-reform bill forces derivatives onto exchanges, high-frequency traders will no doubt trade them too. And every day, things are getting faster. Four years ago, executing a trade in a millisecond (one thousandth of a second) was considered fast; now the top firms are trading in microseconds. That’s one millionth of a second.
Fast-loose-and-out-of-control link