High frequency trading has one of the most-discussed topics in the equity market over the past few months. As with most controversial issues in the business, typical outlets for information become so saturated with different perspectives, angles and agendas from individuals with different depths of knowledge that the issue has become cloudier than when discussion began.

In our most recent Woodbine Opinion, we clarify certain definitional ambiguities around high frequency trading and briefly examine its impact on the market.

High frequency trading strategies generate returns through the rapid turnover of many small positions in one or more financial instruments. These positions may be concentrated in a single instrument or spread across multiple instruments.

In their basic form, strategies take advantage of market inefficiencies, sending waves of small marketable orders to trade into or out of positions on detecting minute changes in markets, instruments, or information. By locking in small profits across a very large number of trades, these strategies generate substantial returns for their backers.

Many types of high frequency strategies exist. Some of the more basic categories include index arbitrage, event arbitrage, and information arbitrage.

High frequency strategies are backed by proprietary capital. Users of these strategies include a number of hedge funds, broker/dealer proprietary trading desks, and a handful of other entities. In the case of broker/dealers, like early algorithms, they are not made available for use by the firm's client base.

High frequency trading is not "program trading" as we normally think of this business. Like program trading, high frequency strategies use technology and algorithms. On an agency basis program trades often involve a human trader leveraged by technology and often algorithms shift capital into or out of specific security positions on behalf of a client.

On a principal basis, the same human/technology set-up exists though the trader may be moving into or out of positions based on a particular strategy or to manage broader risk-based needs of the firm. Program trading may be high speed, but "low frequency".

High Frequency Trading is not "algorithmic trading." While algorithms are central to high frequency operations, algorithmic trading involves an automated means to enter or exit positions subject to a chosen trading strategy, transaction cost considerations and risk appetite. It does not involve repetitive, high frequency turnover of positions.

The controversy over high frequency strategies can be discussed in two contexts: —Are high frequency strategies "fair?" Do aspects of high frequency trading, such as high-powered technology and hardware co-location with execution venues, provide advantages unavailable to or detrimental to other market participants? —Are high frequency strategies good for the market? Do these strategies make overall market more stable and efficient?

Are high frequency strategies fair? "Fair" is ambiguous because it requires a value judgment. Values differ among individuals. Determining fairness depends largely on one's view of the role of the market and the degree to which market participants should or should not be allowed to freely innovate, act and generate returns.

There is a range of different views on the topic. We believe that innovation should be fostered and rewarded to the point that a product or activity leads to a divergence from the historically accepted premise of the market.

We believe that high frequency innovators have every right to their profits so long as their strategies do not detract from the market's efficiency in the transfer of capital between businesses and investors and the transfer of stock among investors.

We do not think that high frequency strategies have adversely impacted the primary market. We do believe that information arbitrage strategies have adversely impacted trade quality of trading in the secondary market, causing value-based disparities in prices and should be restricted. Are high frequency strategies good for the market? We believe that many high frequency strategies have little to significant effect on market operations. Their operation simply adds another type of liquidity to the market. They may contribute to market volatility and impact price but these aspects must be studied in further detail.

We at Woodbine Associates also credit high frequency trading innovators for the advancements they have brought to trading practice.

While, in our view, the majority of high frequency trading does not contribute significantly to the financial markets, it does not harm them either. However, some strategies, specifically those designed to front run investors in a particular instrument, work against the underpinnings of market operations by eroding investor confidence. These harmful strategies must be curtailed.

To read the entire Woodbine Opinion click here.

About the Author Matt Samelson is a Principal at Woodbine Associates, LLC, specializing in equity market structure, trading venues, electronic trading, and transaction cost analysis. He has a wealth of experience in U.S. and international equity sales and trading, quantitative analysis, consulting, and research. He has in-depth knowledge of trade strategy formulation, algorithmic trading, market structure, transaction cost analysis and trading technology.