High Fidelity

What is high-frequency trading?

High frequency trading is a computer-driven strategy whereby firms take positions in stocks and options and hold them for seconds, or even fractions of seconds. It’s behind the tremendous increase in volume on stock exchanges around the world. Indeed, last year high frequency trading accounted for as much as 70% of the equity trades done in the US.

Some studies show that such activity benefits the market—higher volume means larger trades can be accommodated, and prices are more consistent across markets. But when things get chancy, these same traders tend to step away from the market. As a result, the liquidity that folks planned on having may not be there. Hence, you can see phenomena like the “Flash Crash” a year ago, where the Dow fell a thousand points and recovered within minutes.

In essence, high frequency trading is computers day-trading with each other. Of course, trading is not investing: someone has to win and somebody else loses. Some are concerned that if all the day-traders are winning, then long-term investors have to be paying more. But it seems more likely to me that the day-trading computers will just try to outsmart each other and pick each other’s pockets.

In the end, day-traders (and computers) supply liquidity to a system that needs it. But investors need to be careful about how markets behave. This innovation gives credence to the old investors’ saw: be long term, but watch the ticks.

Douglas R. Tengdin, CFA
Chief Investment Officer
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