By Ryan DeCaro, Associate Investment Strategist

October 21, 2011

The last two months have been quite chaotic for the global markets. Stock prices are down, yields on Treasuries have plummeted, and investor panic has resurfaced. We have seen multiple occasions where countries in Europe have been on the brink of collapse, have observed politicians in the United States battle until the 11th hour over the debt ceiling debate, and have watched key economic indicators, such as manufacturing and productivity, fall into a summer slumber. Looking at all these things, one can ascertain that market volatility would likely be on the rise, but the fact that it has risen so sharply (up over 135% since July 1st) makes us wonder if other forces are driving up volatility. The fundamentals within the stock market have not changed and corporations are actually reporting better than expected earnings. There is no clear fundamental rationale as to why the S&P 500 has dropped over 12% since the beginning of July. We believe other forces have been the catalyst for this decline: the use of high frequency trading (HFT) strategies and the proliferation of exchange traded funds (ETF).

 High frequency trading, also known as algorithmic trading or flash trading, is the use of sophisticated technological tools to trade securities, and is typically characterized by several distinguishing features. These characteristics are as follows: 1) Being highly quantitative; 2) Employing computerized algorithms to analyze incoming market data and implement proprietary trading strategies; 3) Holding an investment position only for very brief periods of time (even just seconds) and trading into and out of those positions thousands or tens of thousands of times a day;  4) Ending a trading day with no net investment position in the securities they trade; and, 5) Being very sensitive to the processing speed of markets, often moving their servers to buildings closer to the market exchanges so they can get a fraction of a second edge on other trading firms. Since their inception in the mid 1990’s, these strategies, representing less than 2% of all trading firms in the US, have slowly bombarded the equity markets; accounting for over 78% of trades in the US in 2010, up from ZERO percent in 1995.

High frequency trading usually follows one of four strategies: 1) Market Making; 2) Ticker Tape Trading; 3) Event Arbitrage; and, 4) High-Frequency Statistical Arbitrage. All of these strategies have a common theme-speed. Traders at high-frequency shops, ranging from proprietary trading firms to hedge fund replication mutual funds, battle one another to take advantage of short-term market inefficiencies to make small profits. They do this millions of times a day. The average investor is usually not privy to the way these organizations trade because it all happens in a “black box.” We have seen occasions where these strategies have a major impact on the equities. One recent occasion, deemed the Flash Crash, was May 6, 2010 when U.S. equity markets plummeted nearly 10% within 15 minutes then reversed course gaining nearly 10% within the next 15 minutes. The SEC explained the crash as “the combined selling pressure from the Sell Algorithm, HFTs and other traders drove the price of the E-Mini[1] down approximately 3% in just four minutes from the beginning of 2:41 p.m. through the end of 2:44 p.m. During this same time cross-market arbitrageurs who did buy the E-Mini, simultaneously sold equivalent amounts in the equities markets, driving the price of SPY [an exchange-traded fund which represents the S&P 500 index] also down approximately 3%. Still lacking sufficient demand from fundamental buyers or cross-market arbitrageurs, HFTs began to quickly buy and then resell contracts to each other – generating a “hot-potato” volume effect as the same positions were rapidly passed back and forth. Between 2:45:13 and 2:45:27, HFTs traded over 27,000 contracts, which accounted for about 49 percent of the total trading volume, while buying only about 200 additional contracts net.”Basically, the markets were so fragmented and fragile that these algorithms were the catalyst for one of the largest intraday price swings in our history. It shows that these strategies play a major role in volatility of markets and could be the catalyst for irrationalities and inefficiencies in the market.

Additionally, the proliferation of exchange-traded funds (ETF) has had an impact on the increased level of volatility in the market. ETF’s have become widely accepted investment vehicles over the past decade, with over $900 billion invested in these products. ETFs represent over 30% of the trading volume (not mutually exclusive of HFT volume) on national exchanges and have become a fixture in many institutional accounts. ETFs unlike index funds are traded intra-day. When someone sells a share of an ETF, they are selling out of each underlying security that comprises the ETF. As the ETF market grows, the level of buys and sells within these products increases. To accommodate these transactions, it is imperative that the market maker find liquidity in the markets they make. Unfortunately, in times of market turbulence this liquidity tends to dry up. As a result, when someone sells an ETF during a turbulent market, they force the market maker to sell out of or buy into the underlying securities in a market with potentially a less than ideal level of liquidity. Spreads tend to be very wide and the forced sells or buys can cause dramatic price swings in the underlying securities. This leads to less liquidity and more volatility. The cycle continues as buys and sells increase. Much like the high frequency trading strategies before, the level of trading in ETFs during the Flash Crash helped lead to the drastic market movements we witnessed.

When we look at the current market situation, we can see similar stories developing. We have seen wild swings in the market, with huge intraday movement over 5%, on what seems to be a daily basis. While the initial decline in the markets may have been due to nervous investors concerned about the debt ceiling debate or the fiscal problems in Europe, the acceleration of these declines was likely due to high frequency trading strategies kicking off massive amounts of sell orders as the market hit key support levels. Evidence shows that once the share of high-frequency trading exceeds 50%, traders generate a “hot potato” volume effect as they rapidly pass the same positions back and forth. This suggests that high-frequency traders are largely trading with each other, and not providing any liquidity to the market. Analysis also shows that high-frequency trading hinders the market’s ability to incorporate news about a firm’s fundamentals into stock prices by exaggerating an otherwise sound price reaction. Since their inception in 1995, quarterly stock turnover has increased from 20% to well over 100%. Stock price volatility is positively correlated with HFT after controlling for the volatility of a firm’s fundamentals and other external volatility drivers. These wild swings create a domino effect as technical traders sell off as the markets hit key support levels and individual investors follow suit as their nerves get to be too much for them. While this provides great opportunity for fundamental investors, it also creates a cloud of uncertainty that stifles the markets. The positive correlation between high frequency trading and volatility is also stronger during periods of high market uncertainty. Additionally, high frequency trading has increased by over 30% from July to August when compared to the January to June. High frequency trades profited greatly as a group during this most recent period, with profits of up to $60 million on a single day.[2]

ETF strategies gained greater momentum in 2007 with the elimination of the uptick rule, allowing firms to trade on down ticks. Prior to 2007, if you wanted to sell a stock that you did not own (also known as shorting) you had to sell into an uptick in the price. The new rules allow the computers to work at full speed even during down markets, rather than slow the process down and take the emotion out of the equation. This exacerbated declines and caused even greater angst among individual investors. Since 2007, there are been numerous occasions were the markets have witnessed massive gyrations for no apparent fundamental reason.

As trading volume increases, profitability increases for the exchange because they receive compensation for each transaction.  Since these exchanges are no longer a public utility, they became privately owned in the early part of this century, they have the duty to maximize profitability for their shareholders. Thus, instead of attempting to limit volume and volatility, it is actually in the best interest of the exchange and its shareholders to maximize volatility and volume.

 The most recent flash crash has caused the SEC to investigate possible regulatory measures to help reduce the impact that high frequency traders have on the markets.  U.S. Securities and Exchange Commission Chairman Mary Schapiro said her agency will examine whether market participants who buy and sell thousands of shares in milliseconds should face restrictions on their trading strategies. Schapiro has stated that “new regulations may include limits on the prices at which trades occur, with circuit breakers triggered only if prices do not improve within a preset period of time.” The SEC is also asking high frequency trading firms for information about their proprietary strategies and is increasing scrutiny over their computer codes. By understanding the algorithms that these firms use, the SEC could help reduce the impact that these high frequency trading firms have on the market and help reel in excess market volatility. The SEC could also look at moving back to the 5(c) trading increments used prior to 2000 when they quoted prices in fractions rather than in decimals as they do now. Since decimals are easier to work in than fractions, it is easier to trade and volume increases. Trading costs were also reduced, making the business more profitable and resulting in a spike in trader firms and individual traders, thus increasing volume on the exchanges even more. Additionally, reintroducing the uptick rule may help remove the microsecond advantage that these computers have and help restore order to the markets. While the degree in which these strategies have impacted the markets is not entirely certain, we can ascertain from a number of occasions that high-frequency trading has caused undue stress on fragile markets. This amplifies investor fears and has a negative impact on the financial markets. Instilling regulations to help minimize the effects of these computers on the markets will help reduce overall market volatility and the emotional rollercoaster it causes the average investor. 

[1] A stock market index futures contract traded on the Chicago Mercantile Exchange's Globex electronic trading platform. The notional value of one contract is $50 times the value of the S&P 500 stock index.

[2]Frank Zhang’s “The Effect of High-Frequency Trading on Stock Volatility and Price Discovery”