High Frequency Trading: an analysis of the phenomenon and the effect of the human component

Abstract

This work starts from my passion about stock exchanges and capital markets. I’ve always be fascinated by them, since when I was a kid. For this reason, I decide to begin with a brief introduction about their history, passing through the open outcry system to finally get to the main topic: the high frequency trading.

Financial markets, as we know them today, seem modern and recent, but their origins are in the past and their development is directly related to evolution in commerce and technology. Until 1991 trades took place with the so call open outcry method. Professional traders met each other in a physical floor of a stock exchange and used to shout and gesticulate to buy and sell shares. In recent decades important and radical transformations of financial markets occurred thanks to developments in technology. The electronic revolution started in the ‘70s, in the US, with the creation of the NASDAQ. Subsequently, in the ‘80s program trading emerged thanks to the use of fully electronic financial markets. The digitalization of the process allowed for decentralization and the physical places are now replaced by virtual areas managed by computers; people can send their orders wherever they are, what is required are just two things: a computer and an internet connection.

The most recent developments bring us to algorithmic trading (AT) and high frequency trading (HFT). We can define algorithmic trading as “Computerized trading controlled by algorithms”. Hence, we can deduce that AT is a process for executing orders using pre-programmed and automated trading instructions which takes in consideration multiple variables. Financial markets are a competitive environment, and competition has always led to go further. This process and the run-up for speed led to development of high frequency trading. Every single instant in the world of HFT is important, and time represents the principal challenge for these algorithms where also a microsecond is important to beat the competitors. Obviously HFT is characterized by powerful and extremely sophisticated computers which allow to execute a huge amount of orders at a very high speed, even more than 5,000 per seconds. New investments and new technologies permit to reach execution time smaller than 1 millisecond.

After having analyzed the machine side of capital markets, I was interested in understanding how it is related to human investors. During my master’s degree I’ve studied behavioral finance, a subject that really interested me a lot. I started introducing briefly the topic, analyzing the main biases which affect individuals. Then, I noted that emotions play a very important role in decision making process of individuals. During my researches I was able to ascertain that humans are not particularly good at sticking to a process, biases, like overconfidence, regret, cognitive dissonance and many other introduce inconsistencies in financial markets. On the other hand, computers seem to not suffer such subjectivity: they follow rules and form objective estimates of risks. This reasoning leads many people to say that algorithms are more efficient and rational than human traders, and at the same time less prone to emotionally motivated decisions. However, some researchers have found out that algorithmic trading does contain behavioral aspects which lead us to say that, in practice, it is not possible to eliminate completely emotions from capital markets.