HFT Final

Running Head: HIGH FREQUENCY TRADING UNCOVERED 1
High Frequency Trading Uncovered
Reagen Dykhouse
Olivet Nazarene University

HIGH FREQUENCY TRADING UNCOVERED 2
Abstract
The paper researched the effects of high frequency trading (HFT) on the stock market. There are
two sides of the argument presented in this article; both of which can influence one’s perspective
on high frequency trading. The media has a high grasp-hold of the public’s view of HFT based
on events that have happened in the past. However, this paper looks at facts and research about
HFT and its true impact on the stock market.

High Frequency Trading Uncovered
Whether they know it or not, most working adults in the United States are investors in the
stock market. According to a report issued by Investment Company Institute (Release:
Quarterly), over $24 trillion in the United States are set aside for retirement accounts. Within
those accounts are various types of investments, but many of them are tied up in stock market
equity. As America grew, businesses grew with her. As businesses grew, their need for cash
grew. The result was the turning to securities trading (Day, C.C.). Securities trading allowed
companies to issue debt to an investor promising them a return on their money with interest,
while the company is guaranteed an immediate granting of cash. Just as businesses grew, the
philosophies and ideas of how to trade grew as well. Eventually businesses found that, instead of
issuing securities, they could issue common stock that would grant them cash immediately and
allowed them to not have to pay the investors who bought those common shares. Since the time
the New York Stock Exchange (NYSE) was founded, investors have been searching for ways to
continually gain an advantage in the market place.
Even though many people, whether knowingly or not, have their money tied up in
the stock market, they do not have a sufficient understanding of the processes within those
markets. Unfortunately, this may have an adverse impact on the return these people may be able
to make on their investments. One of the many processes of the stock market is a well kept
secret called high frequency trading. High frequency trading is something that perhaps someone
may be interested in exploring further, but it requires a fundamental understanding of the way a
stock market is operated. Not only is an underlying knowledge of the stock market required;
high frequency trading also warrants an understanding of the controversies surrounding this
process. As a well-kept secret, there has been plenty of speculation about whether this highly

fragile process is beneficial for the markets. It may seem that someone has only to understand
high frequency trading (HFT) if they want to engage in the process. That, however, is a
dangerous viewpoint; since HFT is intertwined within the trading of stocks, one has to take into
consideration the impact of HFT and whether they want their money in the markets where people
are trading in such a fragile way.
Origination of the Stock Market
In the very early stages of trading, there was no real designated place to trade public
securities. Instead, from as early as 1754 until 1790, brokers in Philadelphia resorted to trading
in coffee houses (A financial history, chap. 2). Securities trading initially started out as a very
small, infantile practice. Likewise, the importance of trading securities was very muted. At this
point in American history companies did not require as much capital. Until traders realized there
was significant money to be made in stock speculation the traders in the market were “merchants
that began dealing in securities as a sideline to their other business” (as cited in A financial
history, 2002, chap. 2). Eventually, within a few years, merchants began to realize the full
potential of money making that was presented by the stock market.
In the International Encyclopedia of the Stock Market (1999), it is stated that the NYSE
is founded in 1817 (History, 492). In Day’s report on the history of the United States market,
she notes three important points about the early history of the NYSE. The points he makes are as
follows:
1) Activism in governance, such as that of the NYSE, was not the norm for other stock
exchanges around the world; 2) the NYSE, unlike with debt securities, ‘did not possess a
de facto monopoly position in trading equity securities as of the late nineteenth century’;

and 3) the NYSE’s activism ‘seems directly attributable to its organizational structure and
its competitive position.’ (Day, C.C., 2006, “Dispersed Capital,” para. 88)
At the same time that U.S. markets were free flowing and loosely regulated, the NYSE
found it better to give structure to their organization. The Exchange decided the best thing for a
stock exchange is to make it more of a stringent society. It is important to realize that stock
exchanges are very different from banks; therefore, they require a different type of regulation.
The Role of Banks
Banks played a crucial role in the development of the countries financial system. That
role served to be a great push for every economic system in America; especially stock markets.
An example of the speed can be seen through the research of Christian Day and his research on
the history of U.S. markets
In 1789, there were only three banks. By the 1790s, twenty-eight banks were chartered.
In the next decade, seventy-three more were chartered. … By 1825, it was estimated that
English equity was not significantly greater than United States bank equity of $138
million. … Bank capital increased from $3 million in 1790 to an astonishing $426
million in 1840. (Day, C. C., 2006, “Dispersed Capital,” para. 19-20)
The purposes of all banks are to actually create money in the without actually printing it. Put
simply, this “creation of money” is achieved by receiving money from people who deposit in the
bank. After the bank receives the deposits they lend the money out to other people; thus creating
extra money that flows throughout the economy. Since there was little regulation in the
beginning of U.S. financial history, it allowed for rapid creation of banks. With a whirlwind of
activity in the banking center, the amount of money present in the United States’ financial
system was growing rapidly. This meant that large corporations would begin to develop and,

with the help from bank investments, would become very successful; now, the profession of
investing was born.
Why the Stock Market Began
To answer this question quickly, the Stock Market began because there needed to be a
place that was designated for the trading of stock in companies. Indeed, America’s first major
corporations (railroad industry) needed so much capital that receiving a bank write off for bonds
would not accomplish the goal. In fact, even state subscriptions would not allow for enough
capital to be ushered into the corporations. United States corporations, as a result, were required
to turn to foreign investment (this could be accomplished through the NYSE) (Day, C.C., para.
94). The New York Stock Exchange allowed a public forum for any investors whether small or
large, local or foreign; anyone could invest. Activity of this magnitude catapulted the ability for
money to be made. Activity of this magnitude was beneficial to the government. In fact, activity
of this magnitude was made possible, in large part, due to the banks.
High Frequency Trading
High frequency trading (HFT) is easily the best-kept secret in Wall Street. For anyone to
be able to comprehend the speed of HFT would be like a mere mortal attempting to understand
the glory of God; it just cannot be done. In recent years, this trading process has gained a
significant amount of momentum in the trading world. In fact, as recently as 2012, high
frequency trading was “responsible for 10 to 70 per cent of the order volume in stock and
derivatives trading” (Lattemann, C., et al, 2012, “High”). One can expect that, with the
improvement of technology, the volume of HFT has increased.

What is high frequency trading?
High frequency trading is one of many trading processes found within the stock market.
With that being said, however, it is a very unique process that requires an extraordinary amount
of fine-tuning and precision. Precision comes into play in making the computer algorithm for the
trades a trader wants executed (an algorithm must be used because only a computer can trade at
such speeds and volumes as HFT requires). In fact, HFT has not just become a matter of
milliseconds, or even microseconds, anymore. Nanosecond (billionths of a second;
unperceivable by humans) is now a long enough delay to lose a trading advantage. When
playing with such incredibly small fractions of time a trading firm must have incredible accuracy
and precision. If perfection is not achieved, something drastic could happen. One such case was
that of Knight Capital “which lost $440 million in 45 ghastly minutes … An old, long-unused
trading program mistakenly left on one of its servers suddenly sprang to life …” (MacKenzie, D.,
2014, “Be grateful”, pp. 11). Even more important than not losing money as a company, is the
competition between agencies for maximum profit on a trade.
Essentially, this trading process has become one giant chess match with multiple firms;
this is the reason for the need for speed. Each high frequency trading firm develops their own
algorithms. By developing algorithms, these organizations are hoping to have their computers be
the first to act on a trading opportunity. The speed of a trade then plays the role of allowing a
firm to move their chess piece the quickest (triggering their algorithm first). This race is a never-
ending cycle of algorithm writing and speed development (MacKenzie, D., 2014, “Be grateful”,
pp. 5). Whichever Wall Street firm has the fastest computers and best algorithms reaps the
rewards. These profits typically range in the millions of dollars, so there is large incentive to

develop the best system of executing high frequency trades. As most things Wall Street does,
however, high frequency trading has come under a bit of scrutiny.
Controversies Surrounding High Frequency Trading
It seems nowadays that people cannot do anything without criticism from at least one
source. That especially applies to the activities that are done by people on Wall Street. As a
result, high frequency trading has been the center of negative attention in the media. In their
research of high frequency trading, Dave Michaels and other authors point out a criticism of,
people they refer to as, speed traders (these traders are the same as High Frequency Traders). In
their article they state
One criticism of speed traders is that they use sophisticated trading algorithms to detect
the moves of big institutional investors and then jump in front of their large orders.
Speed traders can then profit from buying and then quickly selling stock a stock for a
slightly higher price to the bigger, slower investor. (Michaels, D., Philips, M., & Brush,
S., para. 3).
Many argue that this takes away from the profits that an institutional company could be making
on their investments. If high frequency traders swoop in underneath a large order, they “steal”
the trade from large investors who are investing with people’s retirement money. Many people
assume that this is a negative aspect that high frequency trading presents to the markets.
Another mystery and negative aspect of high frequency trading is the secrecy behind it.
In Michael Lewis’ book “Flash Boys,” he covers a large range of negative aspects of high
frequency trading. One case he noted was a specific computer programmer he interviewed.
Through the interview he learned that there was and may still be “a gulf in understanding
between computer programmers who create the speed and the traders who make the money

(Lewis, M., 2014, “Flash Boys,” pp. 139). This type of secrecy does not help the case of the
traders who are attempting to make money. All of the sudden, a trading process that is already
questioned becomes very suspicious. It almost seems that the legality of this trading process
should be questioned, and even scrutinized. With the media dominating the reporting high
frequency trading, there is very little opportunity to find positives in the trading process.
Positive Aspects of High Frequency Trading
Even though a plethora of negative news follows high frequency trading like a dog
follows a trusted owner, one can dig into research of high frequency trading to find its true
reality. In the book “High frequency game changer: how automated trading strategies have
revolutionized the markets,” the authors present high frequency traders (HFTs) as positive
players in the market. HFTs provide a platform for both institutional investors and “average joe”
investors to sell shares. In this instance, we call HFTs market makers (Zubulake, P. & Lee, S.,
2011, pp. 3-5). Essentially, this allows both institutional and average investors to have a
guaranteed fill for their order of stock purchases. Quite often, there are not even numbers of
shares traded among non-HFTs. As a result, HFTs are able to come in and add their orders to
other common orders allowing the sell or purchase to be completed. This also keeps the prices
of stocks at an equilibrium price throughout the day allowing a stock to not succumb to large
fluctuations in price within an hour or within the day.
Conclusions
The main media perception of high frequency trading (HFT) is largely negative. I,
however, do not cling to those negative perceptions. There seems to be very little research-
oriented evidence that suggests a rational belief in HFT having a negative impact on the stock
market. In fact, in Michael Lewis’ book, there is very little hard research that supports the

negative views he writes about having. The book Lewis writes is very pop-culture oriented. He
urges the reader to join his baseless fear of HFT. Although events like the “Flash Crash,” which
occurred on May 6, 2010 in which the Dow Jones Industrial Average lost around 1,000 points in
just minutes do contribute to this fear, research of the trends of HFT do not support these freak
accidents (Gomber, P., 2011, “High Frequency Trading,” pp. 94). People like Lewis now live
with an irrational fear that something like the flash crash, or worse, will happen once again
because of HFT. I say, this will not happen.
As an avid investor, I side with those who have a positive view of HFT. I look at HFT as
just another trading process in which people are using their resources to make money. After
sufficient research, I have found much better evidence to support this process as a positive
addition to the stock market. There is, however, clear evidence that suggests this process is
extraordinarily fragile, but if one were to look at things that way, they should be fearful of the
entire market; in one click of a button, the entire stock market could crash to nothing. To live in
fear of a fragile trading system is to cheat oneself out of a potential for money making. High
frequency trading will not keep me out of the markets. Neither should you allow it to keep you
away from investing, and growing your money.

Works Cited
Day, C. C. (2006). Dispersed capital and moral authority: The paradox of success in the
unregulated 19th century New York capital markets. Law and Business Review of the
Americas, 12(3), 303-340. Retrieved from http://search.proquest.com
History of commercial banking in the United States. (1999). In M. Sheimo, A. Loizou, A. Aves,
& A. Boström (Eds.), International Encyclopedia of the Stock Market (Vol. 1, pp. 491-
493). Chicago, London: Fitzroy Dearborn Publishers.
Release: Quarterly retirement market data, second quarter 2014. Investment Company Institute.
September 25, 2014. http://www.ici.org/research/stats/retirement
Lattemann, C., Loos, P., Gomolka, J., Burghof, H. P., Breuer, A., Gomber, P., … Zajonz, R.
(2012). High frequency trading. Business & Information Systems Engineering, 4, 93-102.
doi: 10.1007/s12599-012-0205-9
Lewis, M. (2014). Flash boys. New York: W. W. Norton & Company, Inc.
MacKenzie, D. (2014). Be grateful for drizzle. London Review of Books, 36(17), 27-30.
Michaels, D., Philips, M., & Brush, S. (2014, Apr). Slow cop, fast beat: SEC takes its time on
high-frequency trading rules. Business Week, 1. Retrieved from
http://search.proquest.com
Zubulake, P., & Lee, S. (2011). High frequency game changer: how automated trading
strategies have revolutionized the markets. Retrieved from http://www.ebrary.com

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