09/19/2012 01:24 pm ET Updated Nov 19, 2012

High-Frequency Trading: Made-up and Real

Opinions on high-frequency trading still run the gamut. On one end of the spectrum we find individuals such as Mark Cuban, a successful Dallas-based businessman, who recently proclaimed that he is afraid of high-frequency traders. Mr. Cuban's fears are based on his belief that high-frequency traders are nothing more than "hackers," seeking to game the markets and take unfair advantage of systems and investors.

On the other extreme are employers in the financial services industry. Just open the "Jobs" page in "Money and Investment" section in the Wall Street Journal, and all you will find are job postings seeking talent for high-frequency trading roles. The advertising employers are the whitest shoe investment banks like Morgan Stanley. These careful firms invest resources only into something they deem worthwhile and legitimate. The extent of their hiring (the only hiring advertised in the Wall Street Journal) implies that the industry is enormously profitable and here to stay.

So, how can Mr. Cuban and Morgan Stanley have such divergent views of the high-frequency world? For one, Mr. Cuban has likely fallen prey to some unscrupulous uncompetitive financial services providers making a scapegoat out of high-frequency traders. Opponents of high-frequency traders identify a range of purported HFT strategies that are supposedly evidence of how HFT destroys the markets. Supposedly malicious HFT strategies compiled by one of the workgroups of the CFTC's Subcommittee on high-frequency trading included such ominous names as "spread scalping," "market ignition," and "sniping," just to name a few.

As my upcoming HFT course in NYC illustrates, most, if not all, of the HFT strategies thought to be malicious are simply not feasible on regulated exchanges (these same strategies may work in dark pools, however, non-regulated trading venues designed for sophisticated investors and operating under the "buyer beware" principle). Take, for example, the dangerous-sounding "spread-scalping" strategy, the mere name of which conjures images of shady characters in trench coats emerging from behind the pillars of an institution to hawk their wares. Spread scalping is thought to be a strategy whereby the HFT trader "simply" places limit orders on both sides of the market and takes the spread, without providing any economic benefit to the markets.

Of course, as any seasoned market-maker will tell you, no strategy taking the spread is simple. In fact, associated risks are huge: 1) the trader posting limit orders may accumulate imbalanced inventory, resulting in sharp market losses due to adverse price movements; and 2) the trader always risks ending up on the losing end of the trade, facing a trader better-informed about the market's imminent direction.

In their normal state, markets are fraught with informational asymmetries, whereby some traders know more than the market-maker. Better-informed traders may have superior information about impending fundamentals or just superior forecasting skills. In such situations, better-informed traders are bound to leave the market-maker on the losing end of trades, erasing all other spread-scalping profits the market-maker may have accumulated.

For a specific example, consider a news announcement. Suppose a spread-scalping HFT has positions on both sides of the market, ahead of the impending announcement on the jobs figures -- information on how many jobs were added or lost during the preceding month. A better-informed trader, whether of the low or high-frequency variety, may have forecast with reasonable accuracy that the jobs number is likely to have increased. Suppose the better-informed trader next decides to bet on his forecast, sending a large market buy order to the market. The presumed spread-scalping market-maker then takes the opposite side of the informed-trader's order, selling large quantities in the market that is just about to rise considerably on the news announcement. In a matter of seconds, and due to activity of lower-frequency traders, our high-frequency market-maker may end up with a considerable loss in his portfolio.

In summary, spread scalping may seem like a predatory strategy to some market participants, yet is hardly profitable in its most naïve incarnation. Spread-scalping enhanced with inventory and informational considerations is what most market participants call market-making, a legitimate activity that is the integral parts of market functionality. Without limit orders sitting on either side of the spread, traders desiring immediacy would not be capable of executing their market orders. Compensation of a spread is a tiny profit when compared to the amount of work required to be able to provide the limit orders on both sides of the market on the daily basis.

Similar analysis can be applied to a range of strategies considered to be adverse. Granted, some strategies are a direct result of market manipulation, and those, like "spoofing" outlawed under the Dodd-Frank act, should be screened for. Many other strategies thought to be malicious, however, are myths reflecting unease with technology experienced by some market participants. As shows, most high-frequency trading strategies are tried and true automated methods of traditionally human market making and short-term arbitrage functions.