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Five Things You Should Know About High-Speed Trading

By most accounts, high-frequency trading (HFT) is behind half of all equities traded in the United States each and every day.

HFT is under the microscope, once again, following the 1,000-point drop on the Dow during a 20-minute period on May 6. The SEC and CFTC are trying to assess the impact this type of trading, often in milliseconds, had on the market and whether changes need to be made in the way HFT is regulated.

Many individual investors have questions about how HFT works and how it may affect their portfolios. Here are five things you should know:

1. What is High-Frequency Trading?

Tabb Group, a financial markets research firm, defines it as fully automated trading strategies (in equities, derivatives, or currencies) that seek to benefit from market liquidity imbalances or other short-term pricing inefficiencies. These opportunities could last from milliseconds to minutes, and possibly hours.

While these strategies can be employed overnight, the majority of HFT strategies attempt to be market-neutral or closed out by the end of each day.

An HFT primer on the Tradeworx website puts it this way:

  • A strategy which trades for investment horizons of less than one day
  • A strategy which seeks to unwind all positions before the end of each trading day

Tradeworx, a trading firm in Red Bank, NJ, operates a high-frequency fund. Its CEO, Manoj Narang, says high-frequency traders are the modern day equivalent of day traders, market makers, specialists and even SOES (small order execution system) bandits.

Addressing what he calls the seemingly negative bias in the press, Narang says, “high frequency traders have ceded the public discourse to short term traders that have a grudge…which is why I want to be as transparent and open as possible." (Watch Narnag's interview with CNBC here.)

2. How Much Daily Volume is Done by High-Frequency Traders?

According to Justin Schack at Rosenblatt Securities, high-frequency trading is “…approximately 50-66 percent of U.S. equity volume. "During late 2008 and early 2009, when volatility was extremely high and other market participants were sitting on the sidelines, we were probably at the high end of that range. More recently we’ve probably been more toward the lower end.”

The Tabb Group suggests high-frequency trading accounts for 64 percent of the total number of daily trades.

3. How Has High-Frequency Trading Changed the Market for Average Investors?

“Basically all investors now have access to cutting-edge HFT technology,” says Rafi Reguer, head of corporate communications for the exchange Direct Edge. “The sell-side brokerage firms used by institutions and the retail brokerage firms also have super-fast computers connected to the major market centers," he says.

"Most of their clients aren’t in and out of the market hundreds of times a day (though some day traders are), but they still enjoy the same technology. You can place a trade in your i-Phone and have TD Ameritrade execute it in about a second or less. Some of the [news] coverage of HFT would make you think only proprietary traders at HFT shops enjoy technology’s advances and that your viewers still have to phone their brokers to fill out a paper trade ticket.”

4. Are Computers and High-Frequency Traders Taking Over the Market?

“Computers are not taking over the market. The biggest profits last year were made by long-term investors,” says Narang. “Where “firms had people making decisions, such as Paulson, Soros and Warren Buffett.”

Joe Saluzzi, co-head of equity trading at Themis Trading had this to say about markets today: “What we have now is extremely high volume with tight spreads, though the volume is not necessarily liquidity when you need it.” He would like to see a market with little less technology, a few more humans.

5. Is High-Frequency Trading Here to Stay?

“Not necessarily in its current form”, says Saluzzi. “Right now it is the market; overnight anything could change. If regulations change, if there is a financial transaction tax,” he says. "Basically, high-frequency traders face regulatory issues that could change the game quickly."