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.