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How Does High Frequency Trading Affect The Market And You?

High Frequency Trading (HFT) and algorithmic trading has become increasingly prominent in the markets. On May 6, 2010, the Dow Jones Industrial Average lost nearly 9% of its value in a matter of minutes, dropping nearly 1000 points before bouncing back just a few minutes later. It was the biggest one-day point decline in the history of the Dow, and it came to be known as "The Crash of 2:45" or the "2010 Flash Crash." While there were a number of factors that contributed to this anomalous market behavior, it is generally agreed that HFTs played a large role in exacerbating the situation.

As strange as the Crash of 2:45 was, "flash" events precipitated by HFTs have continued to plague markets. The most recent example of this occurred on October 3rd of this year. At the open of the market, Kraft Foods Group's stock price inexplicably climbed 28% in about a minute. Another notable flash event this year was precipitated by a trading system glitch in HFTs managed by Knights Capital Group. This single error affected 140 stocks and wiped out nearly $440 million worth of Knight Capital's assets, nearly forcing the firm to fold.

Since the 2010 Flash Crash, many exchanges around the world have implemented flash crash rules to prevent such huge trading glitches from happening, but it's unclear whether these rules have been as effective as they were intended to be. The new SEC rules mandate that trading of a given security will be halted for five minutes if it experiences a rise or fall of 10% or greater in the preceding 5 minutes.

Thanks to shifts in demographics and a lack of trust in the markets by retail investors, volume on exchanges is shrinking. With this decline in volume, HFT has grown to assume an increasingly large proportion of what trading remains. Currently, nearly 70% (depending on the calculation method) of trading volume on the NYSE is actually some form of high frequency trading. When HFTs from different firms interact with one another on the open market, these interactions can often have unpredictable consequences, such as the Crash of 2:45.

The New York Stock Exchange actually pays various HFT operators for the volume they provide, and even maintain an entire floor of servers at the exchange, dedicated to their use. HFTs trade via this platform and receive a small kickback for the volume they provide to the exchange. Some trades that don't produce any real profit from the trade itself still end up being profitable for the company because of the volume they've provided. Because HFT operators are trading thousands of times a second and can conduct hundreds of thousands or millions of trades a day, these tiny fees can add up quickly. These transactions are the most controversial and include what's known as "quote-stuffing," where false bids and offers are posted and taken down in milliseconds. In these situations HFTs are trying to fool investors into seizing bids and offers that in fact do not exist. There is pressure on the SEC to do something to limit such phony trades, however the exchanges have found these to be enormously profitable and are resistant to change, especially given the investment they've poured into this technology to service HFT firms.

Ultimately HFTs have only served to exacerbate the negative impression individual investors and financial advisors already have of them: that the markets are manipulated and unfair. However, investors can surmount these negative impressions by expanding their market views with the use of technical tools, avoiding much of the noise and volatility HFTs cause in day-to-day trading. Utilizing weekly and even monthly time frames should be more effective and produce better investment returns.