- ETFs are typically one part of a flash trade.
- These five ETFs are most susceptible to HFT.
- But HFT is not a bad thing.
The #1 ETF susceptible to HFT is easy to identify, but first, high frequency trading (HFT) has taken it on the chin, but HFT adds significant value, and from a professional trader's perspective, I will explain that added value in this article using specific references to five ETFs that are directly influenced by HFT.
Of course, there is corruption in all facets of our global economy, and if someone is dark enough to manipulate the system using HFT that could shed a negative light on the practice, but as they say, we shouldn't let one bad seed ruin it for everybody else. Just because a few criminals hack into corporate websites, we should not shut down the Internet, and just because a few manipulate the practice of HFT, we should not prevent that either. As a professional investor, when I look to buy or sell hundreds of thousands of shares of a stock or ETF, I count on HFT. That provides the liquidity that makes the trade possible, and efficient.
It is all about liquidity. Of course, the algorithms that run these programs are far more concerned with making money, but for everyone else it is about liquidity. The algorithms look for discrepancies in price, and those are best found when comparing ETFs to the value of the underlying entities. The more positions that the ETF holds, the more difficult it is to find and take advantage of these discrepancies, so the first rule in looking for ETFs that are susceptible to HFT is to look for the ones that hold only one or a few underlying securities. The second most important thing is that those underlying securities themselves must have a decent amount of liquidity. These two factors allow us to narrow down the top ETF candidates for HFT.
Top ETF Candidates for HFT:
Top 10 Holdings
The top holdings in Financial Select Sector SPDR ((NYSEARCA:XLF)) include Bank of America (BAC), Wells Fargo (WFC), and other financial companies whose underlying volume is extremely high, satisfying one of our requirements. In addition, the top 10 holdings account for 50% of the portfolio, making it relatively easy to flash trade.
The top holdings of PowerShares QQQ ((NASDAQ:QQQ)), according to the NASDAQ website, include stocks like Amazon (AMZN), Sirius Satellite (SIRI), and Tesla (TSLA), all of which have excellent liquidity as well, but the top 10 holdings here account for less than 15% of the entire portfolio, making a flash trade more difficult.
The top holdings of iPath S&P 500 VIX ST Futures ETN ((NYSEARCA:VXX)) account for 100% of the portfolio, and that is the front month VIX contract. This makes it very easy to flash trade, and that contract has excellent liquidity.
The top holdings for Market Vectors Gold Miners ETF ((NYSEARCA:GDX)) account for 67% of the portfolio, with top positions in Barrick Gold (ABX), Gold Corp. (GG), and Newmont Mining (NEM). These have excellent liquidity as well.
The top holdings of VelocityShares 3x Inv Natural Gas ETN ((NYSEARCA:DGAZ)) account for 100% of the portfolio, natural gas contracts, and that makes it very easy to flash trade. The liquidity from these contracts is also appealing.
After looking at each one of these top five candidates, something stands out quite clearly. The ETFs that have only one underlying entity are much easier for HFT transactions because there is only one entity to match the trade against. An HFT trade might, for example, buy the ETF, and at the same time sell the underlying entities, and in doing so attempt to make a few pennies from the discrepancy, but when there are more underlying entities that trade gets more difficult.
Therefore, the two meaningful standouts in our list are VXX and DGAZ. Next, we can narrow that down even further by looking at volume, and VXX has about twice the volume of DGAZ. That makes VXX our top candidate and the most susceptible ETF on the market to HFT. In addition, this ETF has serious deterioration risk, and when coupled with HFT exposure that increases the risk measurably, but that is a completely different conversation.