The animated .gif above shows the rise of high-frequency trading across several U.S. stock exchanges over the last five years. You’ll notice that there’s relatively little activity in 2007, followed by spikes in activity at the opening and close of the market starting in 2008. And then, sometime around the start of 2010, activity becomes much, much more frenetic and erratic. The image was originally posted by Nanex, a company that provides market data to traders.
Algorithmic trading lets financial firms to spot and exploit market patterns at lightning speeds. This can bring a tidy profit, but it also puts computers in charge of making decisions that can cost a company millions, and that may have an unpredictable effect on the rest of the market.
The ascent of high-frequency trading has long been a concern within the financial industry (see “Trading Shares in Milliseconds”). But criticism reached a fever pitch last week when Knight Capital Group, a well respected and fairly conservative trading firm, suffered catastrophic losses when one of its algorithms went haywire for 30 minutes. Reuters’ financial blogger, Felix Salmon, suggests that the chart above shows that algorithmic trading is already out of hand:
The stock market today is a war zone, where algobots fight each other over pennies, millions of times a second. Sometimes, the casualties are merely companies like Knight, and few people have much sympathy for them. But inevitably, at some point in the future, significant losses will end up being borne by investors with no direct connection to the HFT [high-frequency trading] world, which is so complex that its potential systemic repercussions are literally unknowable.
(Thanks to Tom for the tip).