Any time something bad happens, we're always looking for a reason why. Some would say that we're always looking for someone or something to blame but our motives may simply be to make sense of a situation that feels like it's spiraling out of control. The world's financial markets have definitely felt that way as of late.
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There's plenty of blame to go around. Some people blame the Obama Administration while others like CNBC's Jim Cramer say that the European banks are in the midst of their own 2008 and that is causing financial contagion worldwide.
The blame doesn't stop there. Others are coming back to the two financial whipping boys. Any time the stock market takes a big turn for the worse, two groups of people take the spotlight: Short sellers and high frequency traders.
We'll leave the short sellers alone for now but let's put the high frequency traders in the hot seat. Is it true that computers may be responsible for a stock market that has lost nearly 20% of its value? Could computers be taking your investment dollars?
Who Are They?
First, what are high frequency traders? To keep things simple, high frequency traders aren't doing the trading. Highly powerful computers trade stocks based on a series of complicated mathematical rules. When this happens, buy that. When this happens, sell that. Lesser known hedge funds all the way to well-known investment banks like Goldman Sachs take part in high frequency trading.
How impactful is high frequency trading on the market? According to the former head of Nasdaq, high frequency trading accounts for 73% of all trades taking place. Others estimate lower, but the consensus is that between 60% and 75% of all trades come from computers and they happen sometimes within milliseconds. (These include neural networks and high frequency trading. For more, see Arbitrage Squeezes Profit From Market Inefficiency.)
Just like cars use gasoline as a fuel, high frequency traders have a fuel of their own: volatility. Volatility is the amount of movement in the stock market. At the beginning of August, the market had a 50-day average daily change rate of 0.90%. If we compress that number to the big market decline in early August, that number rises to 5.5%. When the Dow Jones sees declines of more than 600 points, that's enough to scare anybody, but a few weeks doesn't make a trend so instead analysts look at an average. In this case, they look at the past 50 days.
In 2008 and 2009 during the financial crisis, the Dow Jones Industrial Average had an average daily rate of change of 3.71%. If a statistically normal market is well below 0.9%, one can see that 3.71% is a lot of volatility.
High frequency trading feeds on volatility because the computers aim to make a profit on the spread. The spread is the difference between the buy price and the sell price of the stock. Many high frequency traders are market makers, people who are both buyers and sellers at the same time and because of that they can make money by purchasing stock at the buy price and selling it for a profit at the sell price sometimes fractions of a second later. When volatility is high, the distance between the buy and sell price, the spread, is often wider allowing for bigger profits. Is it working? According to the Wall Street Journal, high frequency traders are making a lot of money in the early days of August while human traders, many of them hedge funds and mutual funds, have lost.
Those who are against high frequency trading say that when high volatility widens the spread, the computers go in to overdrive with the amount of trades they make. When the market starts to churn lower, the computers cause a snowball effect. Jon Najarian, co-founder of optionmonster.com and a frequent CNBC contributor said that on August 8, the day that the stock market tumbled more than 600 points, human traders had to place buy orders 5 to 20 cents higher or sell orders 5 to 20 cents lower than the printed quotes in order to keep up with the speed at which prices were changing. If this were to happen on a large-scale basis, this would not only provide high frequency traders with more profit but it could also amplify the market move up or down. (For more on volatility, see Using Historical Volatility To Gauge Future Risk.)
Just a Theory?
High Frequency trading accounts for up to 73% of all trading volume and it may amplify the move up or down; however, does the idea that this practice is causing the markets to have these wild swings really hold up to fact?
According to Bespoke Investment Group, possibly not. High frequency traders were in the market during the so-called Great Recession of 2008 and 2009, but how about the last big sustained stock market event? What was the average daily change during the Great Depression starting in 1929? 3.48%! There were no high frequency traders at that time yet the amount of volatility was only 0.3% lower than the Great Recession.
According to Bespoke, when people get scared, they pull their money out of the market and when that happens, the markets lose their liquidity. In other words, there aren't as many buys and sellers to stabilize prices, which causes those spreads to widen and volatility to increase.
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The Bottom Line
With volumes at the beginning of August much higher than normal trading volume, that theory may not hold short term validity, but at the very least we can't put all of the blame on the computers. With large scale financial meltdowns happening in Europe, the U.S. debt rating being lowered for the first time in its history and a mounting national debt, there is plenty of negative fuel to send the stock market lower. Although hard to prove, high frequency trading does appear to be amplifying the volatility of the markets to some degree. (For related reading, see Using Historical Volatility To Gauge Future Risk.)