In recent years, significant improvements in communication technology have brought market participants closer together and reduced latency to mere nanoseconds. Among other new developments, these advancements have led to the emergence of high-frequency trading (HFT). With HFT, investors use powerful computers to run complex algorithms designed to find profitable investment opportunities within the market. Such algorithms take snapshots of a various technical indicators, trading volumes, and/or other real-time quantitative factors to formulate a strategy with the highest predicted changes for success. Computers then execute trades with little or no human interaction.
More than anything else, speed has become the most crucial differentiator between winners and losers in HFT. Trading, calculation, and delivery of market information must be performed more quickly and effectively than the competition in order to make a profit. While it takes about 500,000 nanoseconds to click the button on a mouse, a delay of even 5 nanoseconds in receiving market information or placing trades may prevent a high frequency trader from being successful. Accordingly, a share of a particular stock may be sold within just a few seconds or even sooner after it is purchased.
The search for the best and the fastest has become somewhat of an arms race within the financial services industry. However, the war may actually be fought through financial propaganda. That is, while market participants look for investment opportunities by scanning through thousands of real-time data points, they may also be sending out information intended only to confuse the HFT computers of their competitors. As an example, one investor might generate orders to purchase a security at prices far below those currently available in the market (e.g., offering $5 for a security trading at $50). This investor might then cancel the order and generate another buy order at $6, only to immediately cancel it. This process is performed not to actually purchase any securities, but simply to produce “noise” which the other market participants must filter out before they can generate their own trade ideas. In effect, market participants are cluttering the landscape so that their competitors take longer to process real-time information with the goal of making profits at their expense.
The speed and high levels of automation associated with HFT may have far-reaching consequences. HFT is widely believed to be a major contributor to the “Flash Crash” of May 6, 2010, when the Dow Jones lost almost 1,000 points (about 9%) within just a few minutes. Although prices quickly rebounded, investors were left wondering how the market could fluctuate so significantly within such a short amount of time. HFT may well have played a large part in causing this sort of volatility, however there are other automated systems and conditions within the markets which may also have contributed to the crash. One cause may have been the use of leverage, which allows traders and institutions to increase their positions and maximize returns through the use of short-term borrowing (such borrowing can also amplify losses). Another cause may have been the use of stop orders which trigger a sale when a stock price falls below a certain predetermined threshold.
These recent developments in financial markets have attracted the attention of the SEC, which has taken an interest in the matter. It remains to be seen whether the agency will make efforts to regulate or prohibit HFT.
With all of the new technological developments changing the dynamics of finance, you need to work with a qualified and experienced investment adviser who can assist you in navigating the fast-paced modern financial markets.
Athelon Wealth Management is an Independent Fee-Only Registered Investment Adviser based in Staten Island, New York. We help our clients reach their financial goals while protecting them from excessive and often unnecessary downside risks. To accomplish this, our process involves creating highly customized portfolios to obtain the desired level of return while effectively managing risk through diversification, ongoing in-depth research, and periodic portfolio rebalancing. In choosing investments for our clients, our methodology emphasizes transparency, liquidity, and value. This helps to ensure that each portfolio is working most efficiently and increases the chances of reaching the financial goals of our clients.
Give us a call today at (347) 706-1414 for a FREE introductory consultation. You may also visit our website at http://athelonwealth.com for more information.
Alexander Efros, MBA, CPA
President / Founder
Athelon Wealth Management, LLC