High frequency fuzzy math

July 31, 2009

One of the many mysteries swirling around high-frequency trading is just how profitable the lightning-fast buying and selling of stocks, options and commodities really is.

The Tabb Group, a financial services industry research firm, recently estimated that the 300 securities firms and hedge funds that specialize in rapid-fire algorithmic trading took in some $21 billion in profits last year. But when pressed on how it arrived at this figure, Tabb representatives won’t say.

My colleague Felix Salmon, on his Reuters blog, says the Tabb figure “is not obviously unreasonable,” but he would like to know more about how the firm got the figure. So would I, and until Tabb comes forward with more information, I’m not sure how reliable a statistic it is to keep quoting.

Of course, the dozen or so Wall Street firms and hedge funds that are the leaders in high-frequency trading — either serving as a market maker or trading for their own account — aren’t much help either. Most prefer to say simply nothing on the subject, leaving us in a very dark pool on the issue of high-frequency profits.

To be fair, Goldman Sachs recently came out and said “even using the broadest definition, high-frequency shares trading accounted for less than one percent of Goldman Sachs’ total revenue in the first half of 2009.”

In the first half of the year Goldman’s total net revenues were $23.2 billion. The dollars generated from high-frequency trading would appear to be a rather negligible $232 million. The firm adds that less than one percent of its daily value at risk — the amount of money it could lose from trading — is due to high-frequency trading.

But Goldman is talking only about high-frequency trading of stocks, not options and commodities. In options trading alone, Goldman’s algorithmic-driven platform is estimated by a market source to account for 15 percent of the daily trading volume.

By comparison, the high-frequency options volume leader is the giant hedge fund Citadel Investment Group, controlling some 25 percent of the daily trading activity.

Additionally, there’s a great deal of latitude for firms to decide what it considers to be proceeds from high-frequency trading. Bernard Donefer, a professorĀ at CUNY Baruch College and a critic of automated trading strategies, says “nowhere in the market is a trade marked as a high frequency trade.”

So it’s entirely up to each firm to determine what constitutes a high-frequency, algorithmic-manufactured trade.

One thing we do know is that a lot of money is being sunk into high-frequency trading technology. The Wall Street Journal reports that NYSE Euronext is spending millons of dollars to construct a new hub for high-octane trading in Mahwah, New Jersey.

By its own admission, Citadel “has expended and continues to expend hundreds of millions of dollars” on building and maintaining its high-frequency trading platforms.

Add it all up and that’s a lot of money Wall Street is committing to high-frequency trading. And if we know anything about Wall Street, it doesn’t invest money in something unless it can generate a sizable return on investment


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