HFT, Reverse Splits and Hidden Signals

 There is sadness in the HFT world today as they are about to lose their poster boy, Citigroup.   Yesterday, Citigroup announced  that they will attempt to get their stock price higher and try  a 1 for 10 reverse split.   We don’t know if it will work but we do know that close to half a billion shares of meaningless volume is about to exit the market.  The WSJ had this quote:

 “It’s going to sting,” said Joseph Mazzella, managing director for equities trading at Knight Capital Group. For high-frequency traders, in particular, he said, “it’s going to have a big impact.”

 We are not exactly feeling sorry for the HFT guys as we are sure they are cooking up some ways right now to offset this lost income. 

 Speaking of HFT, we found a very interesting recently published academic study titled “A Dysfunctional Role of High Frequency Trading in Electronic Markets“.  Click here to read paper Obviously, the title grabbed our attention as we finally found an academic study which could not have been funded by an exchange or large brokerage firm since the conclusion was not that HFT was great since it shrinks spreads and increases liquidity. The authors, Jarrow and Protter, are two very distinguished Cornell professors that have a long history of research in the financial field (unlike the Brogaard study which was published by a “candidate” for a finance PhD).   Here are some highlights of their report:

 -High frequency traders can create a mispricing that they knowingly exploit to the disadvantage of ordinary investors.

-High frequency traders see a common signal that they then transact instantaneously on before the signal is incorporated into the market price.

-Since all HFT sees the same signal, they all do the same trades at the same time.  They create their own momentum which generates profitable returns.

-High frequency traders’s trades cause the price movement creating a self-fulfilling profit.

-The authors liken this activity to market manipulation from large traders except that with HFT profits are unknowingly generated via a market signal.

 The authors appear to be saying that when HFT sees a signal in the market, they all act immediately and simultaneously to trade off the signal.  However, the authors don’t tell us what the signal is that HFT is using to extract there profits.  They say the signal could be the difference between the futures and forward prices of a stock index but don’t say exactly for sure.   We have some ideas on this that we will share with you in future posts.