Are High Frequency Trading Robots Just Full Of Air?



An "Air Pocket" stock is by definition, any security that experiences a sudden drop in share price, much as an airplane experiences turbulence causing it to drop unexpectedly. Generally, air pockets come as a result of negative corporate fundamentals, such as a quarterly earnings misses, FDA announcements, or SEC investigations. But now, high frequency trading robots are creating air pockets for so many of the Market's equities, turning investing into a "Buyer Beware Market."

High frequency trading robots (HFT's) now account for 73% of the daily volume. In 2007, automation accounted for just 30%. In four years, HFT's have more than doubled their trading activity. Their ability to succeed strictly depends on speed, how quickly they can enter and exit orders. The need for speed has caused corporate office buildings in New York and Chicago to be emptied, only to be replaced by large computer servers. Submarine fiber optic cables are being set down from New York to London in order to shave .006 seconds off trade execution.

The question under debate: "Is high frequency, robotic automation good for Markets in general"? High frequency trading firms would argue, categorically, "yes". HFT's claim that they bring liquidity to the Market (how quickly investors can buy or sell an asset, converting the asset back to cash.) Currently, there are 20,000 trading firms in the USA, yet only 2,000 are high frequency. Given that HFT's now account for 73% of the Market's "liquidity", the majority of Market activity then occurs between transactions from these firms, buying and selling the same shares, back and forth to each other, for a fraction of a cent profit on every share traded.

While HFT's may argue that they bring liquidity to the Market, they cannot dispell the allegations that liquidity comes at a very high price to investors -- volatility. In a report issed in September 2011, associate professor Frank Zhang of Yale University stated that once an instrument's share volume exceeds 50%, trading becomes basically a "hot potato," as HFT's trade the same positions, passing them back and forth amongst themselves. Inter-firm trading all but eliminates "Price Discovery", determining share price by normal supply and demand factors, such as news events or positive/negative earnings releases.

Inter-firm high frequency trading also wreaks havoc for Mainstreet investors because of "cross spreading". So many liquid stocks, such as BAC and MSFT, now execute in milliseconds, resulting in extreme "competition" for Mainstreet investors. Queues to enter and exit are significantly longer, with hundreds of shares waiting to execute. Long queues force Mainstreet investors into the vulnerable position of having to buy at the offer or sell at the bid, a trading method known as "crossing the spread". Under normal conditions, investors would buy a limit order at the bid and let the Market cross. But with extreme competition from millisecond trading, the only way to "get filled" is to cross, thereby increasing trading costs / reducing profits.

With HFT's orchestrating 73% of the trading volume, is it any wonder that stocks experience "air pockets"? With high frequency trading hindering the Market's ability to convert corporate fundamentals into share prices, HFT's are literally creating their own stock prices, arbitrarily raising shares higher, only to drop them back down in milliseconds. Air Pocket trading is not a "once in a lifetime, Flash crash of 2010" experience any longer. Since 2007 there have been 18,520 such instances of flash crases amongst highly volatile stocks, roughly 10/day. These small crashes have now become the operating normal as HFT's control the Markets, trading the same shares back and forth, looking for the same opportunities, their algorithms pretty much the same as well.

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