High Frequency Trading (HFT) is a method used by financial institutions whereby stocks are traded in fractions of a second. The traditional means of buying and selling required bankers to manually decide whether or not something was a good investment in the (semi) long run.
HFT, on the other hand, is a completely automated process that relies on computers using complex algorithms in order to decide what stocks are lucrative to buy and sell. The catch? The algorithms only look at what is a good investment at the moment, rather than what is good in the long term.
The effect of this method is that stocks are held for mere seconds in order to make a short-term gains. In essence, HFT is day-trading on steroids. The result is quick profit for those that do HFT well, even though it undermines the real purpose of the stock market, which is investment.
As a new report from Demos makes clear, high-frequency trading definitely is the equivalent of admitting rats to a granary, as it extracts value for traders but without bolstering investment. The price of that is ultimately paid by consumers.
Remember the “flash crash” of 2010 where the Dow plunged almost 1,000 points in a matter of hours? Yeah, you can thank HFT firm Knight Capital for that one.
This past January, the Securities and Exchange Commission set up the Office of Analytics and Research, which is designed to study the current idiosyncrasies of the market and implement new regulations at a more efficient rate.
In order to design comprehensive regulation of HFT, the SEC has implemented the Market Information Data Analytics System (Midas) in response to the fact that it simply did not have the necessary data that would have prevented the 2010 crash.
While Midas may be the future of HFT reform, as the SEC will be able to study the fast-paced market and see flash crashes coming (and freeze the market to prevent them), there is a troubling element.
[T]he SEC hired Tradeworx, a high-frequency trading firm, to build Midas for $2.5m…
Critics have argued that a high-frequency firm should not be designing a system which the SEC uses to review market structure due to the obvious conflicts of interest. David Lauer, a former consultant on equity market structure to Better Markets, a non-profit group advocating financial reform, told a Senate committee last year: “They [the SEC] have contracted with a prominent HFT firm to build a ticker plant, the first step towards processing and storing market-wide tick data. This is reminiscent of the fox guarding the hen house.”
Unfortunately, the understanding of HFT has only recently become of serious interest of the SEC. While its usage spiked since 2007, the 2010 crash illuminated the real threat of introducing more volatility into an already unsteady market. With time being of the absolute essence, it seems that, for now, turning to the HFT firms is the only way for the SEC to get a handle on the situation.
I would still be weary of getting market advice from any type of day-trader. Even the ones that don't rely solely on irrational human thinking.