In 2010, the DOW Jones industrial average took a sharp dive in what is referred to as the “flash crash”. In a matter of minutes, the DOW Jones dropped by about 600 points. High Frequency Trading seems to be one problem that exacerbated the sudden price swings. But what is High Frequency Trading? As pointed out in Jonathan A. Brogaard’s paper, it doesn’t exactly have one: “Even the Securities and Exchange recognizes this and says that high frequency trading ‘does not have a settled definition and may encompass a variety of strategies in addition to passive market making'”. Essentially, though, it means that stocks are traded in fractions of seconds according to algorithms, rather than by a day trader. In 2010 these High Frequency Traders made up a staggering 60 percent of all U.S. equity volume; when the crash began, these high frequency traders only made matters worse.
“Those that turned their machines off were blamed for accelerating the selloff by drying up liquidity, since there were fewer speed traders willing to buy all those cascading sell orders triggered by falling prices.” (BusinessWeek)
In the BusinessWeek article, Matthew Phillips details the history of High Frequency Trading up to the Flash Crash, and then offers an up-to-date look at the topic. For instance, he discusses how the CFTC is looking at how high frequency traders can manipulate the market as much as major shareholders.
“For example, a firm that owns 20 percent of a company’s stock might be able to manipulate it. Since they rarely hold a position longer than several seconds, speed traders might have at most 1 percent or 2 percent of a market, but due to the outsize influence of their speed, they can often affect prices just as much as those with bigger footprints—particularly when they engage in what Chilton refers to as “feeding frenzies,” when prices are volatile.” (BusinessWeek)
Observations such as this may lead to more restrictions on High Frequency Trading. For more, I definitely recommend the referenced article. And if you’re curious about a more technical analysis of how High Frequency Trading affected the Flash Crash in 2010, check out the paper by Jonathan A. Brogaard.