I recently was asked about HFT and decide to include my comments here.
High-frequency trading (HFT) accounts for about 70% of all U.S. equity trading volume. I disagree with some that this has turned our stock markets “…into an enormous betting system…” though. All HFT requires algorithmic trades (AT) but all algorithmic trades are not high-frequency. And neither algorithmic trades nor high-frequency I believe pose a significant problem.
I do believe in the Efficient Market Hypothesis (all information is available and therefore there truly is a “random walk” for stock prices) -- long-term. Ah, but what about the distortions we have seen in short-term trading? Yes, that does, indeed, exist so I will highlight that short-intervals of time (milliseconds, seconds, minutes, maybe hours) do not necessarily follow a random walk and that is a result of AT and HFT.
However, HFT provides liquidity to the markets (provides a buyer or seller, as needed) and reduces overall trading costs by narrowing the spread between the bid and ask prices. The price all investors pay is in some additional volatility (short-term, usually measured in minutes, hours) yet not a concern for long-term investors. Offsetting that volatility are somewhat discounted trading costs.
I remind myself that what happens over an hour, a day, a week - even years, for me and my clients - should not affect an overall allocation strategy. It is personal. What is happening in one’s life that would possibly change that strategy rather than the economy or the style of electronic trades.
I read an interesting comment that HFT (that, is the speed and the frequency) are not the concern, but only when manipulative strategies are used with it. Most HFT is a result of large volume but very small trades (except when errors occur - like May 6, 2010 - or someone is truly trying to manipulate the markets, hopefully they get caught). AT and HFT provide a market for every buy and sell transaction - very quickly - and actually adds to price continuity. I really believe that is true.
When I process a stock transaction it is filled immediately. Whether bought by the broker for their inventory or by the HFT firm that makes a fraction of a cent filling my order, they are then turning around and reversing the transaction with someone else.
"...HFT firms make their money in the buy and sell part and lose money when they hold a position purchased (or sold) for more than 5 seconds...." (SSRN article) Their desire is to have a net zero position by the end of the day. You may have noticed that most trades occur at the market opening and then at the close.
If you would like to read or research more about this I recommend: The Social Science Research Network (SSRN) at: www.ssrn.com (you can register and have access to great research papers at no cost for just using the website articles).
There is much research on this topic, diverse opinions and a continuing desire by academics to fully understand the ramifications of this on the markets.