(May 13, 2014) — Aggressive high-frequency trading (HFT) firms that were able to make trades milliseconds before others outperformed the rest of the market with minimal risk, according to research.
The study looked at transactions of HFT traders for the E-mini S&P 500 stock index future contract—the second most traded futures contract in the world—over two years from August 2010 to August 2012 and discovered traders who made profits from predicting future market movements showed the highest and most persistent risk-adjusted performance.
These aggressive traders—dubbed “liquidity-taking” HFTs—also tended to intercept and trade ahead of industry news and order flows, allowing them to take in liquidity from the market in 84.22% of the contracts they traded. In addition, the paper argued that these HTFs largely lost money short-term, only to regain it by predicting price movements in longer time periods.
According to the authors—Matthew Baron of Princeton University, Jonathan Brogaard of the University of Washington, and Andrei Kirilenko of the MIT Sloan School of Management—these strategies consistently pointed to higher returns and alpha.
Aggressive HTFs earned an average annualized return of 122.1% in the studied time period, a figure significantly higher than the 25.69% return by passive HTFs, or traders who modified their trades based on informed trading.
These traders also earned an annualized Sharpe ratio of 4.29 and an annualized alpha of 90.67%, compared to the average HTF’s Sharpe ratio of 4.3 and alpha of 22.02%.
The paper also found that speed was an important factor in driving portfolio performance among HTFs, especially the aggressive ones, allowing them to “stay ahead of the competition and maintain their market share.”
“By showing that speed is an important determinant of profitability, our analysis suggests that HFTs have strong incentives to compete over small increases in speed in an industry dominated by a small number of incumbents earning high and persistent returns,” the authors argued.
This phenomenon then indicated a “winner-takes-all” structure among HFT firms, the study found, as the trader who discovers the opportunistic trades first would naturally capture all of its profits.
Unsurprisingly, established HFTs with experience, technology, and speed on their sides continue to take the majority of profits, the authors said. With such disproportionate distribution of profits across the board, new HFTs entering the market are not able to survive and could be pushed out, even when equipped with necessary technologies and financial expertise.
“The cutthroat competitive environment in which HFTs interact may influence their impact on market quality [such as more liquidity, greater price efficiency, lower transaction costs for investors, and less potential for any one firm to influence markets],” the authors said. “With limited competition from new entrants to engage incumbent HFTs, market quality may not improve as much as it would otherwise.”
Read the full paper here.
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