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"Pre-trade risk checks work by recognising how HFT algorithms can create volatility, either by withdrawing automatically from the market or by backing the same side at once."  

DAVID COOLEGEM, PA Capital markets expert  

Using pre-trade risk checks to ensure a positive outcome from high-frequency trading

High-frequency trading (HFT), through which complex computerised algorithms are used to trade securities for brief periods of time, is considered by many analysts to be beneficial to efficient markets. This is because the many HFT strategies operating on both the buy and sell side can create price points which increase liquidity and reduce volatility by cancelling out large market swings. For example, smart HFT algorithms can minimise the impact of large block trades while ‘moving average’ algorithms can bring stocks back to long-term averages and thereby halt irrational trends.

However, in some recent cases, HFT has been blamed by commentators for the opposite: a decrease in liquidity and an increase in market volatility beyond what would normally be expected. In particular, a number of financial advisers considered HFT responsible for the dramatic swings in international stock markets that took place during early August 2011. At this time, the Dow Jones Industrial Average fell by 600 points, jumped by 429 the next day and then dropped by another 520 the day after that. If HFT could be responsible for improved efficiency at some times but for such increased volatility at others, many traders have asked what they should do to protect their investments while using the system.

By effectively using pre-trade risk checks that draw on new data management technology, investors can analyse the market before their trades are sent out so as to ensure that they are not selling into a ‘flash crash’ or being taken advantage of by predatory algorithms. Pre-trade risk checks work by recognising how HFT algorithms can create volatility, either by withdrawing automatically from the market or by backing the same side at once.

Increasing volatility by withdrawing automatically

When significant market swings take place, most well-programmed algorithms withdraw from the market automatically. While these algorithms attempt to sell their remaining positions, these positions are passed around like ‘hot potatoes’ as different algorithms have different timings before they cut out. This has the result of increasing volatility [such as during the Dow Market swings in August 2011]. Pre-trade risk checks can identify when this automatic withdrawal is likely to happen and warn traders in advance.

Riding market momentum beyond justifiable levels

Pre-trade risk checks can recognise when badly programmed algorithms ride the market’s momentum beyond justifiable levels. This happens when different algorithms take the same side at the same time or in synchronisation with large institutional traders. A recent example of this is the May 2010 Flash Crash, which represents the biggest one-day point decline (998.5 points) in the history of the Dow Jones Industrial Average. This event occurred after a large mutual fund began selling a large number of futures contracts, which was then exacerbated by HFT selling its positions aggressively. Combined, this sent the market into a spiral.

PA has extensive and growing experience of working with traders as they seek to profit from HFT. This has included working with a major commodities exchange to identify the impacts that HFT would have on the way it trades derivatives and on market dynamics more generally.

To find out more about using pre-trade checks to ensure a positive outcome from high-frequency trading, please contact us now.

David Troman
Financial Services
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Reiar Ness
Financial Services
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