Is the Media or High-Frequency Trading Causing Volatility?

This article published with permission from InvestmentU.com.

According to an editorial by a high-frequency trading (HFT) firm’s chief executive officer, increases in media coverage and access to the market are causing volatility, not HFT.

High-frequency trading has received a lot of attention over the last few months, as market volatility sharply increased.

The advantages of high frequency trading are undisputed. Traders with supercomputers have an obvious advantage with the speed at which they can operate. Dealing in milliseconds, the supercomputers can run circles around big-money institutional investors. This advantage is part of the reason these computers are used for 70% of trading.

The TABB Group estimates that annual aggregate HFT returns are in excess $21 billion. Volatility is great for HFT because it creates many more opportunities to profit by moving quickly in and out of positions. This conflict of interest makes it easy to blame HFT for volatility. They certainly benefit from it.

But are they really to blame?

A compelling argument defending HFT

Manoj Narang, founder and CEO of Tradeworx, Inc., raises a compelling argument against the idea that HFT precipitates market volatility. In his editorial for The High Frequency Trading Review, he acknowledges that volatility of the S&P 500 increased since 2007. But he doesn’t feel HFT is to blame.

The foundation of his argument is a set of statistics, which compares the volatility in afterhours trading to the volatility during normal trading hours.

According to Narang, in the period of 2000 through 2006, the S&P 500 moved an average of 0.37% per day when the market was closed. Since 2007, afterhours trading increased 65%, pushing the average to 0.61% per day.

Narang suggests that the “abundance of news which has caused investors to panic” greatly increased since 2006.

Narang adds that volatility during trading hours only increased 12% since 2006. Narang feels that, logically, this can only lead to one conclusion —

that increases in media exposure and access to the markets causes volatility, rather than HFT.

As Alexander Green recently pointed out, the news is certainly bleak considering that many companies are reporting solid earnings. And Marc Lichtenfeld recently explained why it’s in the best interest of the news to keep investors worried and glued to the financial media.

Two sides to every high-frequency story

But while Narang’s argument and statistics are compelling, let’s not forget he has skin in the game. He also provides no sources for his statistics. That’s not to say he may not be correct, but there’s no hard evidence to prove him right. Plus, there’s the fact that HFT uses algorithms that scour the news, which has led to foul-ups in the past. If it’s partially the media’s fault, wouldn’t HFT play into the mania, too?

According to research by Yale Professor X. Frank Zhang, “HFT is positively correlated with stock price volatility.” He also found that the positive correlation is “especially strong for the top 3,000 stocks in market capitalization and stocks with high institutional holdings.” And that “the positive correlation between HFT and volatility is also stronger during periods of high market uncertainty.”

Eventually it will be up to the SEC to decide who is right, and it already subpoenaed HFT firms in relation to the Flash Crash of May 2010.

What Can Investors Do About High-Frequency Trading?

Obviously, things are getting volatile, but as Marc Lichtenfeld recently wrote, “If you can’t beat ‘em, join ‘em.”

In his article, Marc outlines great strategies for investors to use their own know-how and incorporate technology. Through free software from brokers and free stock-screeners on the web, investors can figure out systems that work for them.

Marc also offers his own expertise with a super-computing system called S.T.A.R.S. in his Oxford Systems Trader. In a backtest of his methods, Marc found that this system would have out-produced the S&P 500 by 1,568% over the last 10 years.

Regardless of how they choose to react, investors should certainly be aware of the competition that they face with high-frequency trading. It’s definitely not the same trading environment as it was just five years ago.

Justin Dove is a part of the Research Team at InvestmentU.com. See more articles by Justin here.