Today's guest post comes from our friends at Lightspeed Trading. In this article, Lightspeed's CEO, Steve Ehrlich, will share his thoughts and some analysis on high frequency trading inspired by a 60 Minutes episode. Please visit their site to learn more about Lightspeed and Steve Ehrlich.
October 27th, 2010 – Where does the blame for the financial meltdown lie? The public is looking for a scapegoat for the financial slowdown and regulators have found one for them… High Frequency Traders. This blame game is very similar to what occurred during the Great Depression of 1929 when short sellers in the stock market were singled out and vilified as the “cause” of the economic woes in the United States. Today, it’s hedge funds, dark pools, and high frequency traders that are being targeted as the prime cause of the financial trouble in the United States and around the world.
Public pressure on the high frequency trading business hit a high point on October 9, when the respected and popular news program on CBS, 60 Minutes, aired a segment on the strategy. As expected, trading blogs and Internet message boards lit up with comments and reactions to the segment. After reading many posted opinions from a wide range of sources, it became very clear – and troubling – to me that even some “experienced” traders don’t fully understand high frequency trading, so how can we expect the general public to understand it? The only thing that we know for certain is that most in the media are telling them to be afraid of it and that high frequency trading is a way for the big players to tilt the playing field in their favor. As a result, individuals begin to put pressure on elected officials to do something about it and then the snowball effect begins with no one ever really stopping to consider that often the unintended consequences of certain actions are actually worse than the problem they set out to solve.
Let’s take a closer look at the 60 Minutes segment to debunk some of the myths it perpetrated. First, after careful analysis the SEC and CFTC concluded that the May 6 flash crash was caused by a mutual fund company unwinding a significant position, not a high frequency trading algorithm gone awry as many pundits and media outlets initially assumed to be the case. Unfortunately, this is not as sexy a story and won’t nearly grab as many viewers as casting doubt over the legitimacy of any firm engaging in high frequency trading. While the segment did correctly note that high frequency algorithmic trading is responsible for upwards of 70% of the volume in the equity markets, as a viewer, if I didn’t know any better, I would have taken away from the segment that high frequency trading firms perform no real service for any market participants other than themselves and that all other traders are at a huge disadvantage because of the speed of a high frequency trading firm’s system and its ability to co-locate its servers.
The truth is the volume generated by high frequency trading firms increases liquidity and narrows spreads. This in turn makes buying and selling stock less expensive for all market participants, not just the HFT shops. Moreover, the added liquidity makes it easier for all market participants including the individual investors to enter and exit trades at their chosen time and price. Trading successfully has never been easy and making money in today’s volatile markets are more difficult than ever before even for the most sophisticated traders, but to point the finger of blame at high frequency traders is not only wrong, it’s ignorant. Some other important points that 60 Minutes failed to mention, but are important for market participants to know is that there are many strategies that can be employed that make the existence of high frequency trading irrelevant to your bottom line. One example is Swing trading tactics, which are not affected in the least by HFT strategies. The market is a big place where different strategies can coexist and different players can find opportunities to be successful. Moreover, while the argument that co-located servers provide a speed advantage over non-co-located servers is indeed true, average traders should know that they can avail themselves to this edge. The speed advantage is not just the province of the high frequency trading firms as the 60 Minute segment led viewers to believe. In fact, Lightspeed offers direct access to co-located servers for its entire retail client base and puts all of them on equal footing with any other market participant – even the high frequency trading firms and their ‘super computers.’
The reality is that there have always been bad actors in the markets, but the answer isn’t to impugn an entire segment of market – especially one that is responsible for the lion’s share of the volume. The regulators should be commended for their thoughtful approach to tackling some of the tough issues impacting trading and market structure today and for not having a knee-jerk reaction and imposing new rules and regulations without first fully understanding all sides of the issues and the impact that any new regulations may have on the broader marketplace.
Perhaps many in the media would be better served by taking a page out of the regulators’ handbook and give due attention to all sides of an issue before reporting on it and creating confusion and making matters worse.
To learn more please visit Lightspeed Trading. Copyright 2010 Lightspeed Financial Inc. All rights reserved. Any comments or statements made herein are not an endorsement of any trading strategy or security and are made for informational purposes only.