High Frequency Trading (HFT) has come to represent somewhere between 40% and 75% of daily trading volume. The sheer computational scale of HFT systems and their large share in the market has led many investors to conclude that HFT trading essentially dominates the market and that small investors have little chance against such behemoths. It is alleged by many that HFT firms not only possess executional advantages but that they manipulate markets.
I have been asked on several occasions how I factor in HFT to my market forecasting. Here are some considerations that I take into account.
1. HFT is not a conspiracy. There is a notion out there that HFT is some sort of monolith that consciously manipulates markets and robs small investors of their money. The reality is that HFT is a widely dispersed and highly competitive business. HFT operations are competing against each other in a zero sum game that is generally won or lost on fractions of a penny margins (by definition, they have to be competing against each other given their weight in the total volume).
2. HFT do not move markets intentionally. Nobody is bigger than the market. HFT systems generally make money through arbitrage - not through directional bets on the market. In fact, the systems break down and can lose big money when the market breaks out of the patterns that the algorithms predict. To the extent that HFT systems make directional bets on the market, they are designed to be trend followers, not trend makers.
3. HFT has an aggregate impact. HFT systems are dispersed and competitive; they do not conspire. However, all of these systems can have important unintended aggregate effects. Because these systems are generally trend-following systems, when there is a substantial move in the markets, many buy or sell orders tend to be activated simultaneously, magnifying market moves. For example, when a move is sudden and pronounced, massive buy or sell signals are triggered - largely functioning as stop losses; some as directional momentum plays. Because the orders tend to be executed simultaneously, selling and/or buying tends to feed on itself. This tends to magnify the move that is made relative to a marginal piece of information that hits the markets.
4. Yo-yo effect. Interestingly, the phenomenon described above also creates the yo-yo effect that we are often seeing in the marketplace. Big drops are usually being followed by sharp rises. The reason is that massive sell orders necessarily have to be followed by massive buy orders to cover or vice-versa (it's the only way to make money). Thus, intraday and multi-day volatility can be wild, but ultimately the magnitude of sustained moves on a weekly bases tend to be more muted. “Over-reactions” tend to be quickly erased.
How I Use HFT tTo My Advantage As A Trader
As I am forecasting the direction of the market I try to gauge whether an event that I am predicting will be able to move the market sufficiently in the first instance to create a cascading effect (helped along by HFT).
In this same vein, I set a "time stop" on my predictions that must be confirmed by momentum. If the predicted event cannot trigger momentum (partly driven by HFT) it will likely be forgotten by the market and will ultimately have no impact.
Furthermore, I am always mindful of the yo-yo effect. I will try to take gains and even reverse my position when the market seems oversold on a short-term basis relative to the marginal new data that has been made available.
Imagine a bunch of HFT operators shorting the market massively and then covering massively. The market makes a huge move down and then up. Who makes money? In aggregate, nobody. It's a zero sum game among the same HFT guys. HFT is a competition, not a conspiracy.
Ironically, if you are small enough and nimble enough, you can use these insights regarding HFT to your advantage, making money where the HFT operators can't due to their size.
HFT is a fact of life. In the end, nobody can prevent traders from using computer generated trading systems. Certain restrictions can be implemented. But HFT is here to stay - forever.
Interestingly, and contrary to popular belief, smart individual investors can profit from HFT. For one, HFT actually makes market timing more important and valuable since the gains to be obtained by anticipating relevant information are magnified. Second, the predictable pitfalls of HFT systems enhance the opportunity for skilled traders to occasionally exploit inefficiencies and informational asymmetries.
In the end, HFT does not change the value of companies such as Apple (AAPL), Microsoft (MSFT), AT&T (T) or Goldman Sachs (GS). HFT also does not change the nature of information that affects the value of stocks or the equity market (SPY, DIA, QQQ) as a whole. HFT forms a part of the complex mechanism that makes capital markets relatively efficient.
Additional disclosure: I am long SPX puts. I am short TLT and long TBT and SBND