Not with a Bang but a Whimper – The Risk from High Frequency and Algorithmic Trading

Rick Bookstaber gives good explanations of both high frequency and algorithmic trading — why neither has introduced the sort of tight-coupled feedback risk exemplified by portfolio trading (which precipitated the 1987 crash). Rick is a hedge-fund risk manager and author of the excellent “A Demon of Our Own Design“.

High frequency trading is a type of proprietary trading. The trader (or his computer) sees a profit opportunity and trades accordingly. This profit opportunity might occur because the high frequency trader observes signals in the way the market is trading that makes him think the price is moving up temporarily because someone needs to buy. He supplies the other side of that person’s demand, and once the demand is satiated the market price will most likely revert, and the high frequency trader will make a profit. And in doing so, he will be providing a service to the market – he will be a liquidity provider, and by getting into the market faster he will provide that liquidity for a lower price. Put another way, the better he is at his business, the less the price will be moved by the person who is requiring liquidity, and thus the lower transaction costs will be. Another way the high frequency trader will make money is by getting into the market before others do when there is information that is moving the price. Which explains the arms race in getting news feeds and executing based on the news a few milliseconds faster than others.

Algorithmic trading uses computer algorithms to facilitate trade execution. For example, some investor has decided to buy ten thousand shares of a particular stock. Once that decision is made, the question remains of how to execute the trade. One way to do it is to put a ten thousand lot buy order into the market. Another way is to have somebody sit on the phone and call the order in a hundred shares at a time in ten minute intervals until it is all done. Or, another way is to program a computer to do it. The computer can be programmed to do it any way a person can be told to do it. It can parcel the order out in fixed intervals, it can parcel more of it out during periods of high volume, it can throw orders out at random times and in random quantities. The point is that all this computer program is doing is facilitating a buy or sell order that has already been determined, and doing it based on a trading algorithm of the investor’s choosing. It is cheaper and more exacting than having someone do it on the phone, but really is not much different. If we are going to pose a horror story based on the huge volumes of computerized trading, we should not count the substantial portion of that volume that is occurring due to this algorithmic trading. Because one way or another, these trades are going to be done, and it is simply cheaper to have the computer do it.