Debunking HFT Myths

I have seen an increase in media attention to high frequency trading lately, following the so-called tweet crash, an article in the Wall Street Journal and sudden price spikes in GOOG and SYMC. Negativity abound. HFTs are stealing your money. HFTs liquidity is fake. Etc. Etc. Etc. We have heard it all before. Please allow me to debunk some of the myths regarding HFTs using layman’s terms so that next time you read or write an article you can put things in perspective.

HFTs do take risk

All strategies carry risk and involve winning and losing trades: in straightforward market making there is a risk of an adverse price movement, in ETF vs underlying arbitrage there is execution risk, pairs trading and statistical arbitrage strategies have correlation risks and so on. The view of HFT firms enjoying a free lunch is wrong; they just try to be right slightly more often than they are wrong – and repeat indefinitely.

Front-running of orders

Contrary to popular belief amongst HFT bashers, no-one can see your order before it reaches the exchange and buy a stock at a lower price ahead of your bid. On the other hand, if you decide to show your hand by resting orders in the market rather than crossing the bid/ask spread then that is a choice you make. You risk the chance of the market running away from you for the potential payoff of getting a better fill. 

Cross-exchange arbitrage opportunities

Buying a stock on one exchange to sell it on another exchange for a penny higher is a perfectly logical strategy and is no different than Starbucks selling you a bottle of water that they bought at CostCo next door. HFT firms take advantage of the ignorance of the counterparty not to use the optimal venue for their trade.

Quote stuffing

A strategy in which a firm sends out an overload of order messages to slow down their competitors’ processing speed at the exchange. The effectiveness of this strategy is debatable as it often tends to slow the order sender down more than anyone else, and well-designed exchange systems won’t be impacted. Exchanges are cracking down on this behaviour as it has no positive impact on price discovery or market liquidity – which makes perfect sense to me. The impact on all non-HFT trading is negligible – no retail trader will ever get hurt from HFTs stuffing quotes.

Dark pools aren’t evil

Dark pools are essentially private silent auctions.The benefit they have is that normal exchange price rules don’t hold up so that investors who think sub-penny spreads are still too wide can get filled at a sub-sub-penny price. All determined by the fairest economic principle of all: the auction. I am struggling to understand how people can be against dark pools. I am struggling even harder to understand how people can be both against HFT and dark pools at the same time, almost by definition someone against HFT should be in favour of dark pools.

HFTs often claim to lower spreads (true) and provide liquidity (true, most of the times). They say that as a justification of their activities to the public; everyone knows they are in the game to make money – oh wait… just like every other trader. HFTs just invested some more money in technology and employ more advanced trading strategies. Sure, it is silly to send tens of thousands of order messages across exchanges in a 5 second window, but if the HFTs think they can make money of it, then let them: it’s not hurting you, is it?

I invite anyone who has a compelling argument against HFT and/or can provide specifics on how retail traders are at a disadvantage to post in the comments.

 

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One thought on “Debunking HFT Myths

  1. Hello.
    Are you going to write about the media attention blow-out HFT got? What do you think it will happen? Do have friends who are worried? Are you worried? How is the people who work on HFT dealing with this that you know?

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