High Frequency Trading May Magnify Market Woes

Aug. 11, 2011 -- This week's market flux is not identical to the flash crash of 2010 but experts believe that computer-driven high frequency trading is partially responsible for accelerating stock gyrations.

It has been a rollercoaster week for stocks. The Dow Jones industrial average fell by 600 points on Monday in reaction to U.S. debt downgrade by Standard & Poor's, then jumped 429 points on news from the Federal Reserve on Tuesday, but dove back down 520 points on Wednesday in reaction to bank stock worries in France.

On a volatile week like this one, some experts estimate that high frequency trading makes up 73 percent of stock market transactions.

High-frequency traders use automated tools programmed to react to patterns in the stock market--acting on new information faster that any human could. Specialized high-volume traders are known for the practice but some of the nation's biggest banks have evolved their trading operations to incorporate similar technologies.

But are the new trading platforms to blame for recent volatility or are faster systems merely amplifying a mood of uncertainty that was already underway?

"The use of electronic trading technology, the automated capabilities that become prevalent the market will tend to make markets go up and down quicker," said Sang Lee, a managing partner at the Aite Group.

Critics of this practice say that the automatic process can create a cascading effect that can over react to erroneous trades, potentially causing damage to stock portfolios and 401(k)s. And while there is no conclusive proof to show damage, some critics are already convinced.

"My personal opinion is that I don't believe that high-frequency trading should be allowed because it serves absolutely no economic purpose to anybody other than to people who are trying to make millions of dollars off of tiny little trades," said Peggy Cabaniss, president of HC Financial Advisors.

The Securities and Exchange Commission is still investigating the 2010 flash crash and has subpoenaed several high frequency trading firms according to the Wall Street Journal. On May 6, 2010 the Dow fell 900 points in minutes then sprang back again.

Even Democratic Sen. Charles Schumer, who is a supporter of the Wall Street and is typically resistant to financial regulation, had expressed his concerns with high-frequency trading in a letter to SEC Commissioner Mary Shapiro.

"While I acknowledge that technological advances, including HFT, have brought significant efficiency gains to our markets, I have come to believe that HFT provides less of the benefits to our markets than its adherents claim, and does so at greater cost to long-term investors," Schumer wrote in a letter to Schapiro.

Still some believe that the technology in the right hands could be used in theory to stabilize the market in times of crisis.

"It could also have the potential to dampen volatility," said Lee.

How Does Volatility Affect You The Investor?

Up and down trends are directly tied to your 401(k). And in tough times people are pulling money out of the stock market as investors moved to buy up Treasury bonds.

In the case of a mad dash for the exit, average investors may cash out slower than investors on Wall Street with access to a faster more efficient high-frequency trading computer. And when the markets recover, a faster computer pipeline will get priority before any average investor through a trading website.

One financial advisor sees cynicism and distrust by the everyman as a more dangerous byproduct of high frequency trading.

"It causes suspicion," said Cabaniss. "When you're an investor and you're investing for the long term you need to be investing in something that you trust," said Cabaniss.