Yahoo Finance Retail Investors Square Off Against High-Frequency Traders
Research shows that high-frequency traders come out ahead
In the time it takes you to read this sentence, a high-frequency trader will have made more trades than many investors make in a lifetime.
For them, time is measured not in minutes, or even in seconds, but rather in milliseconds--and sometimes microseconds. This incredible speed, made possible by complex algorithms that allow computers to execute trades in intervals that are so short that the human mind cannot even process them, also allow some high-frequency traders to be immensely profitable.
But at what cost? And at whose expense?
The short answer, according to new research, is pretty much everybody who is not a fellow high-frequency trader. In particular, their profits come at a significant cost to retail investors.
[Read: Does High-Speed Trading Hurt Investors?]
The report, authored by U.S. Commodity Futures Trading Commission Chief Economist Andrei Kirilenko, along with researchers from Princeton University and the University of Washington, provides much-anticipated insight into the relationship between high-frequency traders and retail investors.
The researchers looked at trades of e-mini S&P 500 futures contracts between August 2010 and August 2012. These contracts, which are electronically traded, essentially allow investors to speculate as to the future value of S&P 500 investments.
By studying the data, researchers were able to determine what happened when a retail investor was on one side of the contract and a high-frequency trader was on the other. Their findings show that when a retail investor was matched up against an "aggressive" high-frequency trader, the high-frequency trader made an average profit of $3.49 per contract. That profit came out of the pocket of the retail investor. On an average day over the two-year period, aggressive high-frequency traders made $379,275 from retail investors.
[Read: Go Beyond Traditional Asset Allocation.]
That number, while substantial, is only a fraction of the profits that high-frequency traders realize. "HFTs consistently [earned] positive average daily profit over the two-year span, with a mean of $395,875 per day over the two-year span, and with a high of $2,745,724 per day in August 2011 and a low of -$86,296 in January 2012," according to the report.
For many retail investors, the whole notion of high-frequency traders is difficult to conceptualize. "[O]ne millisecond is made up of 1,000 microseconds. Now take that type of speed, overlay a quantitative investment model most likely using a price reversion strategy, add in millions of orders to buy and sell billions of shares and that, in a nutshell, is HFT," explains State Street Global Advisers in a memo on high-frequency traders. "There are no trade tickets to fill out, there are no phone calls made to brokers, it's all electronic and it's a growing part of the global marketplace."
This speed has proved crucial to their success. "Whether it is using expedited information to make an investment, reduce risk, or mitigate the costs of adverse selection, those quickest to react to information can best [profit]," according to the Kirilenko research, which is still in draft form.
[In Pictures: The S&P's 10 Worst Trading Days.]
This is hardly Kirilenko's first foray into researching the world of high-frequency trading. In the aftermath of the May 2010 "flash crash," which thrust high-frequency traders into the national limelight (and was caused by trades in those same e-mini contracts), Kirilenko studied the role that high-frequency traders played in causing the stock market to briefly plummet. He and his fellow researchers concluded that "HFTs did not trigger the Flash Crash, but their responses to the unusually large selling pressure on that day exacerbated market volatility."
"We believe that technological innovation is essential for market advancement," he wrote at the time. "As markets advance, however, safeguards must be appropriately adjusted to preserve the integrity of financial markets."
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