The rise of high-frequency trading in the US stock market has been nothing if not controversial.
The practice, which uses complex algorithms to analyze multiple markets and execute orders based on market conditions, has divided Wall Streeters into two camps: those who think the stock market has benefited from their existence, and those who argue to the contrary.
What’s not in doubt, however, is their overall impact on the stock market.
“They’ve firmly established their place in the market ecosystem, primarily serving as a facilitator connecting buyers and sellers through time, but also frequently criticized in that role for being superfluous, or worse, predatory,” Credit Suisse strategist Ana Avramovic said in a recent note.
“Whatever your view, their impact has been wide and, likely, lasting,” she added.
In a note, titled We’re All High Frequency Traders Now, Avramovic ran through four ways HFTs have impacted the market.
Higher trading volumes
Higher trading volumes are HFT’s “largest, longest lasting, and most visible impact,” according to Credit Suisse.
The report said:
“We estimate that volume from money managers and investors, both active and passive, has remained fairly consistent for at least a decade (between about 3 and 4 billion shares per day). Total US volumes today, however, are more than double what they were in the pre-crisis, largely pre-HFT years. The difference is mainly due to HFT and high speed trading strategies.”
There are complaints that this activity isn’t “real” activity, but rather that this increase is down to unnecessary trading, or is designed to take advantage of slower moving investors.
“While that can be true … a majority of HFT activity serves to connect those natural buyers and sellers and reduce waiting times, often substantially so,” Credit Suisse said.
Bid-ask spreads for large cap stocks have tightened
A bid-ask spread is an important concept on Wall Street. It refers to the difference between the price at which someone wants to buy an asset (bid price), and the price at which the seller wants to sell that asset (ask price). The tighter the better, in theory.
The rise of HFT has seen a divergence between bid-ask spreads for large cap stocks (they’ve tightened) and small caps (they’ve widened), suggesting a concentrating of trading in the most liquid, biggest stocks.
Credit Suisse said:
“Bid-ask spreads for largecaps and smallcaps generally move in the same direction, meaning they both widen or narrow in accordance with volatility. However, we find that the dispersion in spreads between the most liquid and least liquid stocks has grown since mid-2009.”
There is more volatility in large cap stocks at the end of the trading day
Large-cap stocks and small-cap stocks also see the most volatility at different times of the day.
“At the beginning of the day, small caps tend to be more volatile as they take a bit longer to establish fair price,” Credit Suisse said. “But, at the end of the day, they actually have slightly lower volatility than large caps.”
The note said:
“Small caps do seem to experience larger price gaps, yet they tend to have less of the small fluctuations; largecaps, by contrast, with their large presence of market makers, may experience something like “flickering quotes” as the price bounces rapidly between the bid and ask, particularly at the end of the day.
“Both of these phenomena may be attributed to HFT – their absence in the case of smallcaps and busy back-and-forth trading in the case of largecaps.”
There are a small number of price gaps, or big jumps, in large cap stock prices
High-frequency traders often seek to benefit from inefficiencies in the market, stepping in when something has moved too far.
As a result, “there are fewer instances of prices gapping in stocks that generally have a larger HFT presence,” according to Credit Suisse. In other words, those stocks have fewer extreme up and down ticks.
“For several years going into 2009, when HFT hit its peak, the ratio of gaps in small caps to large caps remained around five gaps in a small cap stock for everyone in a large cap,” the bank said.
“Beginning in 2010, though, and largely continuing through today, as we saw some HFT leaving the market and others congregating in largecap land, that ratio increased considerably,” the bank added.