Co-authored with Steve Krawciw
New research from AbleMarkets shows that stocks with higher participation of aggressive High-Frequency Traders (HFT) experience higher intraday volatility. The new study compares intraday volatility, as measured by the difference between the daily high and low and normalized by the daily closing price, with aggressive HFT participation captured by AbleMarkets aggressive HFT index. Every 1% increase in AbleMarkets aggressive HFT index on a given trading day on average corresponds to 2% increase in volatility on the same day across all of the S&P 500 stocks.
Aggressive HFTs comprise a set of trading strategies that use predominantly market orders (as opposed to limit orders) to execute their trading decisions. As such, aggressive HFT strategies are usually characterized by short profitability windows, known as "rapidly-decaying alpha" in trading language, and strive to capture profitability as soon as possible with the most immediate order execution. The trading signals used by aggressive HFTs may be derived from machine-readable news, market events, inter-market arbitrage opportunities, and other fleeting trading situations.
How much does aggressive HFT participation change from one day to the next? According to AbleMarkets research, the answer is 80% of time (across all the S&P 500 stocks), aggressive HFT increases or decreases by at most 3% from one day to the next. However, outliers exist, and aggressive HFT may spring up in some previously untapped names. For example, on February 26, 2015, aggressive HFT participation in Graham Holdings Company (NYSE: GHC) spiked up to 66% by volume from just 34% observed on the previous business day only to drop back down to 34% on the following trading day, February 27, 2015.
On days when the participation of aggressive HFTs across all of the S&P 500 stocks sparked up by 3% or more, observed intraday volatility on average was 2.4% with a standard deviation of 2.0% during the first six months of 2015. On the other hand, on days when the participation of aggressive HFTs across all the S&P 500 stocks declined by 3% or more from the previous trading day, observed intraday volatility on average was 1.5% with a standard deviation of 0.8%. For a baseline comparison across all days and across the S&P 500 , observed intraday volatility was 1.7% on average with a standard deviation of 1.1%.
The aggressive HFT is "sticky." Stocks with high aggressive HFT retain high aggressive HFT participation as HFT developers ramp up and down their algorithms slowly over time. In fact, the previous day's aggressive HFT participation is a great predictor of the next trading day's aggressive HFT. The analysis of the S&P 500 shows that a daily value of AbleMarkets aggressive HFT index explains 86% of variation in the aggressive HFT participation (measured by AbleMarkets aggressive HFT index) on the following trading day, as measured by a statistical metric known as Adjusted R-squared.
How do these findings translate into prediction of volatility? Both day-to-day changes and absolute values of aggressive HFT index are predictive of the next day's volatility.