There is much ado about high Frequency Trading (HFT) these days – even the moribund CFTC is looking into it – which probably guarantees that nothing will be done about it.
Actually it is a pretty hard thing to control. Virtually everyone who trades uses a computer. Some of us use a computer just for assisting our analysis and for entering our trading instructions electronically. The HFT boys are using the computer for the analysis actions and the entry of orders as well. The computer is obviously much faster in these actions than we humans.
As I see it there are several things about HFT that are not healthy for a free market.
First, not only are the HFT guys faster – they are usually trading very large quantities. Not large orders necessarily, but many small orders placed very quickly. This can give the appearance that a market is reacting to some fundamental event – with many traders moving into or out of that market quickly.
Secondly, combine, several HFTs acting in unison (of course this implies a collaboration or conspiracy) and you have a market manipulation capability that is supposed to be illegal.
Because the HFTs use algorithms they can start a market moving in one direction, get the momentum going that way – then immediately reverse direction and not only reverse their precious orders but add more positions before the momentum stabilizes.
We wrote an article for FXTraderMagazine about our observations of this exact phenomenon in the FOREX markets. That article, FX is a Tug of War (appearing in the current edition of the online magazine for those who would like to read it), describes a old tug of war game technique we called, “fake and reversal”.
The idea behind “fake and reversal” is simple: Collectively the participants on one side in the tug of war would suddenly give up a bit of ground – and while the opposing side thought they were getting an edge and gaining – suddenly and collectively a reversal tug could not only regain the freely conceded ground – but additional ground as well. The logic behind the move was that the fakers – if they all acted as one – need not fool all the opposing players – just a few would be enough to make a small but profitable gain.
The HFT boys are using the very same tactic – only it has been computerized.
Knowing what it is doesn’t necessarily mean that I know what to do about it. For the moment, I consider HFTs to be in the same category as unexpected fundamental events that move a market. I cannot predict them – I can only be prepared to exit any time my trading method indicates that my trade is no longer viable – whether HFT or a fundamental event causes that change is of no consequence.
Do I wish that the legal authorities could do something about it?
Absolutely and most certainly – but it is prickly problem – not easily solvable. So I will not hold my breath until it happens.
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