High Frequency Trading and its Impact on Markets

this video is sponsored by North Vee pn goto nor VPN comm slash the plain bagel and use coupon code the plain bagel to get 70% off a three year plan plus one month for free for all the benefits the stock markets provide there's of course no lack of criticism around how the large institutions of Wall Street have taken advantage of everyday people just trying to fund their retirements just recently we saw Wells Fargo settling a case for opening fake accounts under client names and of course in 2008 we saw how large investment banks and credit rating agencies hid risks from investors ultimately leading to thousands of jobs lost and contributing to a crash in stock markets but there's a more nebulous practice that's been supposedly rigging markets in the favor of insiders for a number of years now high-frequency trading now sure trading stocks really quickly probably doesn't sound as bad as lying or committing fraud but according to the SEC high-frequency trading is one of the most significant market structure developments in recent history and not only hasn't made institutions billions at arguably the cost of market participants but as we saw nearly a decade ago it could cause stock markets as a whole to crash how folks way on the topic and more on today's plain bagel today's video is not necessarily something you'll be able to utilize in your own investment journey and the subject is certainly more complicated than what I typically cover on this channel but it's a fascinating and important part of the industry because as you'll soon learn it has a direct impact on the stocks that you and I invest in but before we can dive into high-frequency trading we first need to dive into algorithmic or algo trading of which high-frequency trading is a subset algo trading is the practice of using computers and algorithms to trade stocks with programs analyzing multiple markets to identify attractive trade opportunities and executing transactions accordingly often without any human interaction it sounds like the plot of a dystopian sci-fi right but I'll go trading is already a popular practice in the field with some estimates claiming that over 80% of market trading volumes come from machines that's right over 80% of stocks traded on exchanges are allegedly bought and sold by computers but to be fair algo trading is a very broad approach that a compass has many different strategies well some programs indeed look to automate the investment process others simply augment trades put in by investors themselves to change how they're executed in the market using strategies like iceberg aim to split big trades across a number of smaller trades high-frequency trading or hft is a type of alka trading that is thought to make up roughly 50% of trading volumes so a fairly popular approach interestingly there isn't actually a formal definition of what constitutes high-frequency trading but it typically refers to any strategy they use as algorithms to quickly send out waves of orders to the market in other words it involves trading stocks well frequently high-frequency traders are typically investment banks hedge funds or institutional investors in the positions these groups obtain are often traded shortly after they're acquired furthermore a defining feature of hft is that a high percentage of the orders sent to market are actually canceled before they're fulfilled in other words while these companies might send 1,000 buy orders for plain bagel stock at $50 a share only say ten of those orders will actually find an investor to buy the stock from and the rest of the orders will be cancelled immediately by the company who submitted them before other investors are found strange isn't it and it raises a number of questions like why why are these companies submitting so many orders if they're just gonna end up canceling most of them well as you would probably expect the main reason is that it makes them money each of these trades has the potential of generating profits for a company via the stock's bid-ask spread you see when you buy a stock you don't actually pay the market price instead you'll pay what's known as the asking price which will be slightly higher than the price you might find by searching the stock on Google and if you sell the stock you'll be paid the bid price which will actually be slightly lower the difference between these two amounts is known as the bid-ask spread and hft companies will identify attractive bid-ask spreads that they can utilize to earn a small margin sometimes they'll make a few dollars sometimes cents sometimes just fractions of a cent and while that doesn't seem like a lot producing thousands or even millions of these trades can make it a profitable venture so by submitting thousands of these orders companies are essentially casting wide nets to try and take advantage of bid-ask spreads sometimes the companies will miss out because another trader has swooped in and grabbed the stock before they could but so long as some of these orders execute in time there's money to be made on top of this some high-frequency traders are actually paid by exchanges to place orders on the market since this is thought to improve market liquidity you see some high-frequency traders place rusting orders that only execute if another order matches its stated price if companies have 1,000 sell orders on plain bagel stock pending on the exchange anyone looking for those shares will be able to quickly purchase the security rather than needing to wait for another investor to sell their own holding the traits submitted by these entities known as passive market makers are actually thought to reduce the bid-ask spread on stocks lowering bid prices and increasing ask prices so sure well high-frequency traders are in it for the profits some are actually beneficial to investors because they directly lower the cost of buying and selling stocks problem is other high-frequency traders use the technology for more aggressive strategies with mixed impacts for example a recent report by the financial conduct authority in the UK found that many firms carry out latency arbitrage a strategy that represents roughly 20% of total trading volumes and involves using speed to beat other companies to attractive trading opportunities you can think of it as a sort of ticket scalping method algorithms are able to identify attractive prices quickly and execute trades before other investors even notice the opportunity and when I say quickly I mean these traders operate in microseconds meaning these systems can analyze and carry out hundreds or thousands of trades in the same time it takes you to blink your eye it's an incredible feat one that's required building transoceanic fiber-optic cables microwave links and even Halloween out real estate close to or even on the rooftops of exchanges to get as close to the data as possible and minimize latency and while amazing the advancements have allowed traders to create arbitrage opportunities out of even widely known information for example if a company reports positive earnings algorithms can interpret the data and buy the stock of the company before others have a chance to even finish reading the headline allowing them to get in before others bit up the price needless to say individual investors don't stand much of a chance for acing these companies on short-term fluctuations and there are a number of side effects we've seen from these strategies for one their plot to increase stock price volatility after all with more algorithms trading on scraps of data and information market swings can become more dramatic when algorithms are involved these aggressive hft strategies also actually worsen liquidity when there's competition between high-frequency traders meaning they actually work against the benefit of passive market makers increasing transaction costs for investors in fact the FCA report suggests that these strategies cost markets roughly 5 billion dollars annually and that we're moving them would reduce transaction fees by 17 percent and of course as with most technological advances people have found ways to use the technology for more nefarious practices some companies have used hft to send and cancel thousands of orders as a way of slowing down other traders tricking other algorithms and even manipulating stock prices in their favor now these practices have since been made illegal but with the obscurity surrounding hft strategies and the difficulty of identifying the trades it's difficult to tell whether it still occurs or not but perhaps the most concerning consequence of high-frequency trading is its instability hft strategies utilize algorithms that have grown so complex that even those using them don't fully understand how they work and as these unstable algorithms meet one another in the marketplace they can enter dangerous feedback loops and trigger extreme volatility events like the infamous flash crash of 2:45 on May 6th 2010 the Dow Jones Industrial Average saw a 1,000 point or 10% drop in just 20 minutes one of its largest intraday drops ever and within the hour it recovered as if nothing had happened with many blaming algorithms for exacerbating the sell-off it goes to show just how dangerous these strategies can be for investors like you or I and it's been a difficult problem to tackle while some politicians have suggested implementing trading taxes to discourage high-frequency trading a similar feat introduced in Canada was shown to a cause and 9% increase in bid-ask spreads for stocks as it impacted both aggressive high-frequency traders and passive market makers clearly it's something we need to be very careful with moving forward but well this video may have convinced you that markets are rigged and life is cruel I'll end on a more reassuring note as mentioned hft operates in the very short term on very marginal price differences in other words algorithms have not replaced long term investment strategies in their impact on long term prices should at the moment may be minimal so don't worry individual investors can still benefit from putting money in solid stocks and as companies improve over time you'll be sure to benefit but if you're looking to day trade and take advantage of those minute or second price swings well be sure not to blink you may just miss the competition thanks for watching if you want to learn more about algo trading or hft I'll leave a few links in the description down below to some interesting research articles as well as some really cool TED talks on the subject matter and of course if you liked the video make sure to LIKE subscribe and hit the bell icon for notifications about future videos for the plain bagel my name's Richard coffin thank you for joining me today this video is sponsored by North Vee PN if there's one thing discussing hft makes abundantly clear it's that technology has evolved quickly and without the 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Channel: The Plain Bagel

Views: 110,973

Rating: 4.9297776 out of 5

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Id: zi78J-h1XgY

Length: 11min 54sec (714 seconds)

Published: Fri Mar 20 2020