The debate around high frequency trading is reaching new heights with Delaware Senator Ted Kaufman this week calling on the SEC to review "questionable" developments in the markets - including high frequency trading, dark pools and flash orders.
But one industry expert goes to bat for high frequency trading. Rishi Narang, founding principal of Telesis Capital, a Southern California-based alternative investment manager focused on quantitative trading strategies, and author of a new book, "Inside the Black Box " The Simple Truth About Quantitative Trading," says that ultimately high frequency trading overall is "really good."
As for the idea that high frequency trading is contributing to high market volatility? Narang does not agree. "I would argue the idea that high frequency traders are increasing the amount of volatility in the markets is somewhere between foolish and total nonsense," he says.
"What they are doing is the opposite of creating volatility. Volatility means inefficiencies in the markets are high and they profit when the markets are more efficient," he explains. Narang says that back in September and October of 2008 when the markets were crazy the high frequency traders were there to provide liquidity when trading needed it.
"Most people were on one side of the market and needed to sell and they should have been happy they were able to sell, " he adds.
He adds that, "Most of the weird or potentially negative things that could be attributed to high frequency trading are hard to tell if it's really from high frequency trading, it's tough to find real evidence," he says. "Intra-day and general volatility has been much lower since high frequency trading has become a big deal." But confusion is still a big part of the controversy, says Narang. "There is a huge array of definitions out there but most would agree that one thing high frequency trading means is that the trader takes home no overnight positions," he explains.
"It's just a label but if you take home overnight positions and if your trading turnover is not north of 100 percent per day then you're probably not really high frequency trading in aggregate," says Narang.
Narang also explains that there are generally two types of high frequency traders in the market. The first is a liquidity provider, or market maker, type of high frequency trader. He points to firms such as Getco, Citadels and Tradebot in this area.
The second types of high frequency traders are more serious buy-side alpha traders according to Narang. "They are not just out there trying to provide liquidity but they are trying to forecast near-term movements in instruments " not just stocks," he says. "They are implementing their strategies on a fast infrastructure to move in and out of positions quickly."
Narang also points out that while the liquidity provider, or market maker, types maybe have an alpha component, the alpha trader type generally does not have a market-making component in their strategy. "The market maker type often employs some type of forecasting to help decide what to own or what to avoid," he adds.
Risk characteristics are also a good distinguishing factor for a high frequency trading strategy. "If you think about economic announcements, outside of the Fed, or earnings releases in particular " they happen overnight " after the close or before the open," he explains. "High frequency strategies then are just profiting or losing from what is happening within the trading day, that is different from taking home risk overnight."
But Narang goes further and says that there is even a different subcategory of high frequency trading—the ultra high frequency trader—that is extremely sensitive to latency and cares about milliseconds and microseconds. "Most of the chatter out there now is really about ultra high frequency trading when co-location really matters and shaving off milliseconds is important. It doesn't matter nearly as much for generic short-term quantitative trading."
He also says that high frequency trading is just like any other trading strategy " it has its good days and bad days and not everyone is making vast amounts of money. "It's a real trading strategy with real problems and risk and it has its flaws and is hard to do," Narang says. "Just being co-located and having great technology is necessary but not close to sufficient."