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Study: HFT Benefits Traditional Trader

A new report by Woodbine Associates, finds that high-frequency trading in general has improved execution quality and reduced volatility, enabling the more traditional investment trader to benefit from reduced execution costs and increased alpha preservation.

A new report entitled “High-Frequency Trading: The Impact of High Frequency Strategies on Spreads and Volatility in Highly Liquid U.S. Equities,” by Woodbine Associates, finds that high-frequency trading in general has improved execution quality and reduced volatility, enabling the more traditional investment trader to benefit from reduced execution costs and increased alpha preservation.

Matt Samelson, principal and equity market analyst at Woodbine and author of the report, says that while many have questioned whether high-frequency trading negatively impacts the “traditional trader,” which he defines as institutional, retail or proprietary broker-dealer trader, that is not the case.

The study relies on data evaluating trading in the 40 most liquid stocks in the U.S. equity market during 2008 and 2009. “These were effectively all large-cap securities and we created an analytical framework where we could split up the different types of traders within the market,” explains Samelson.

Two separate metrics were then applied. The study looked at affected spread or the measure of execution quality – examining the NBBO and how far away from the midpoint the execution occurred. Realized spread or the movement of a security price after execution was also analyzed.

“We looked at that data on a monthly basis and found that 76 percent of the names’ execution quality improved on average and in 67 percent of the names volatility decreased,” he notes.

“One of the big unfounded criticisms from high-frequency trading detractors is that it makes it harder for these traditional investors to trade and has been detracting from execution quality and we generally don’t see that,” Samelson adds.

In other words, according to Samelson, if a portfolio manager or trader expected a particular return from trading – moving in or out of a name - in 2008 or 2009 the execution quality improved and volatility declined on average meaning more of the actual investment return could be retained.

The data was further broken down to identify high frequency activity by first defining it and then noting the different styles. “If you’re a high frequency trader, you are interested in speed and you’re out there using marketable and limit orders,” says Samelson, adding that the report then analyzed these types of orders for changes in execution quality and volatility.

As for the definition the report concludes that, “high-frequency trading is a style of trading that involves the use of technology and algorithms and normally involves large-scale turnover of very small positions,” Samelson says.

The strategies associated with high-frequency trading include index arbitrage, pairs strategies or other directional strategies, which means buying or selling one security not doing both simultaneously. There are also market making strategies or net rebate maximization strategies that involve both buying and selling.

“We’re using our background and knowledge of how the market works and how different types of participants react to come up with the framework, make evaluations based on what the numbers tell us and conclude who it’s been beneficial for,” says Samelson.

The data used for the report was pulled from the Rule 605 data mandated for release by ECNs, exchanges, brokers and others on a monthly basis for displayed limit orders and marketable orders.

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