The flatness of being a high-frequency trader

September 16, 2009

A common claim made by the high-frequency trading crowd is that their funds end the day flat–with little overnight exposure to a given stock.

In other words, high-frequency traders argue they always manage to find some other sucker–I mean trader–to layoff their positions on before shutting down their algorithims for the night.

It’s a claim that sort of defies logic when you consider that most high-frequency traders compare themselves to good old-fashioned market makers–firms that put their own capital at risk to make markets in stocks. Based on that logic, it would seem high-frequency traders would need to go home at night with a sizeable exposure in certain stocks based on trades they did with other parties.

But a story in The Wall Street Journal helps explain how high-frequency traders can make this claim and why these rapid-fire, computer driven traders really aren’t classic market makers. The WSJ story points out that most rapid-fire algorthimic trading is in highly-liquid big-cap stocks–not less liquid small-cap stocks.

And, when you think about it, it makes sense that high-frequency traders generally shun small-cap stocks in favor of bigger names. That’s becuase it’s far easier to trade in and out of stock with lots of shares outstanding–and to do that trading in milliseconds. In a big-cap name, there’s not only more shares available for trading, but more potential buyers.

Of course, it’s the complete opposite with a small-cap stock–some of which may only trade a few thousands a shares a day in a handful of transactions.

The other problem with small-caps is the potential to get stuck with a big position at the end of the day. The slim trading in these stocks raises the possiblity that a high-frequency trading firm could end the day with a lot more exposure than it wants.

And overnight exposure is something a high-frequency trader tries to minimize–otherwise precious capital would be at risk.

In my mind this isn’t market making. It’s simply adding liquidity for liquidity sake in big-cap names and reaping a profit from those super-fast trades.

Is this bad? I’m still not sure but it sounds a lot like churning. And it’s not clear it’s adding anything of benefit to the market other than fattening the pockets of the high-frequency trading crowd.


Comments are closed.