• Aug
  • 19
  • 2009
  • 6:04 AM

High-Frequency Trading Helps Narrow Quoted Spreads

By: Ray Pellecchia
File Under: NYSE, NYSE Amex, NYSE Arca

From my colleague Steven Poser in Strategic Market Analysis:

The debate regarding high-frequency trading has become muddled by confusion over high-frequency trading itself, which generally provides liquidity to the market, and flash-type orders. The NYSE agrees that flash order types are not in the market's best interests, but disagrees with those who try and lump that activity with beneficial high-frequency trading.

One predicted beneficial effect of High Frequency Trading (HFT), should be lower quoted spreads (the difference between the bid price and the offer price on a stock), in stocks where high-frequency activity is common. High-frequency traders tend to be most prevalent in the highest-volume stocks, because such stocks afford more opportunities to execute high-frequency strategies, with lower risk.

We compared average quoted spreads on the NYSE in the top 100 NYSE-listed issues (by share volume) in the 2002-2006 time period, with data since April 2007. This represents pre- and post-Reg. NMS (excluding the January - March 2007 period, just before and just after implementation of required exchange routing). We used these periods because we assume that high-frequency trading became more common following Reg. NMS implementation.
There are many factors that impact quoted spreads: individual stock news, market microstructure and overall market volatility. The below chart shows volatility (as measured by the S&P 500 VIX®) is a major factor in spreads (click chart to enlarge).

We adjusted for variations in VIX by breaking the historical spreads into categories based on several VIX buckets: VIX below 15%, VIX between 15% and 25%, VIX between 25% and 35% and VIX between 35% and 45%. Although VIX rose above 45% during the height of the market's volatility last year, we have no comparable period between 2002 and 2006. Our research shows that for similar levels of VIX, spreads in high-volume NYSE stocks on the NYSE narrowed between 7.5% and 46.4% from the before to the after period.

The story is similar for Nasdaq issues. Although the profile differs, based on VIX levels, spreads for Nasdaq’s highest volume stocks fell between 6% and 48% during the same time period.

We do not see a positive impact for spreads across all issues. NYSE spreads only narrow for levels of VIX below 15%, and Nasdaq spreads improve for VIX levels below 25%. In all cases, even where there is an improvement, it is far smaller when measured across all stocks than for high volume stocks only.

The table below summarizes the statistics for NYSE and Nasdaq (click table to enlarge):

Conclusion: Spreads have narrowed since.Reg. NMS implementation for the highest-volume stocks on both the NYSE and Nasdaq, after adjusting for similar levels of volatility, as measured by the CBOE VIX index. We chose Reg. NMS as a break point because it represented a major change in how all exchanges routed and also approximates the time when NYSE moved to an electronic market. We acknowledge that Nasdaq trading was more heavily electronic in the 2002-2006 period than NYSE trading, but expect that high-frequency trading increased across all venues.

We do not see a similar pattern when spreads are averaged (equally weighted) across all NYSE or Nasdaq stocks. We use all stocks as a proxy for lower-volume issues, since the highest-volume issues make up a very small share of all issues. Equal weighting essentially emphasizes low-volume issues. Spreads generally widened averaged across all NYSE and Nasdaq stocks, during periods of similarly high volatility, and narrowed during the least-volatile periods.

Although the NYSE's new market model may have had some positive impact on higher-volume stocks, the similar lower-spread experience on Nasdaq-listed issues, we believe, validates that HFT is likely a positive factor in market quality for high-volume issues, where these participants are present. The lack of across-the-board spread improvement in lower-volume issues, where HFT is less present, further highlights the generally positive impact from this activity.

Comments

Just because a posted spread might be tighter, does not mean that the liquidity and quality of the market is better. Any real trader will tell you that the quote virtually means nothing anymore. I can not count how many quotes that are suppose to be tightening the spread cancel before they even print or give out a small portion of stock and then leave. I would much rather have a larger spread but know i can trust what i am looking at.

by josh on August 19, 2009 8:39 AM

The greatest market myth is that tighter spreads equals better execution. As an institutional trader, gone are the days of blocks. It takes substantially longer to build positions because you have to pick away at 1,000 share increments all thanks to the high frequency guys. That's not improved market structure. Seems to me that the high frequency algos are nothing more than a clever new trading tax. They should be eliminated.

One other thing. Think about the systemic risk these high frequency algos could create if they start to march out the duration curve. As more and more algos appear on a daily basis, don't be surprised to see profits arbed out and algos guys forced to put capital at risk. What happens then?

by Jim on August 19, 2009 10:10 AM

Tighter spreads relate to lower trading costs. It is not a perfect, 1:1 measure (there are no perfect measures) but it is a measure.

by Steven Poser on August 19, 2009 10:53 AM

there is a new algo that makes the spread 0 and I see it more and more every day. An ecn, usually BATS but it happens on every ecn... locks the market and will only execute its oder if they can add liquidity. I bet the order is prob just ofsetting another oder to just get paid a rebate and push on the trade. I thought with reg nms these types of orders could not exist.
No matter what is said, as a trader who has seen the market before reg nms and hybrid you can not tell me that stocks trade more efficient. And def not due to tighter spreads. Spreads create real demand at real price points. That is what a market should be. Not just a bunch of computers placing and removing bids and offers.
I haven't complained on this blog for a while becasue it is counter productive to my mental health, but I'm sick of hearing the markets defended. I would rather just hear somone say we have gone done a path we can not reverse and we want computers to run the show, things are never going to change, and just get over it.

by josh on August 19, 2009 11:17 AM

On Jim's comment, respectfully: high-frequency trading developed in the wake of several related developments, including decimalization, which reduced spreads and trade sizes and also impacted the role of market makers; regulatory changes that made all markets (including NYSE) electronically accessible; and increased electronic trading capabilities at the firms. You suggest that the high-frequency traders caused the smaller trade sizes; I think that they didn't cause it, but adapted to the changed environment.

Whichever came first, chicken or egg, the independent trading-cost analyses I've seen have indicated that trading costs have come down over time.

by Ray Pellecchia on August 19, 2009 11:52 AM

I'd like to see a parallel study of the effect so-called "algo" high frequency trading by prop shops in US regulated futures markets.

by gene d donney on August 19, 2009 3:36 PM

I totally agree with Josh. REAL market quality has not improved in the last 5 years, ask any market maker, specialist, or independent trader. For the most part, all these algo's just scam the quotes and add very little value. The cancels are really out of control now.

by tony dey on August 19, 2009 5:23 PM

I concur with Tony & Josh... It seems with every "improvement" the NYSE makes, they only make matters worse. Algo's (what purpose do these serve exactly?), dark pools, & HFT, have ruined overall market quality. Call me crazy, but I don't think it's normal for stocks to make both their day highs and day lows within 5 minutes of each other after the open. Market orders have become useless. Also, what happened to the bids and offers?? Rarely is anything more than a few hundred shares visible these days. It looks like I no longer need to drop $75 /month on an open book... I can't remember the last time a stock moved more that 20 cents in one direction without being slammed those 20 cents (and then some) in the other direction. For the most part, there is no strength or weakness in anything. They just tick up & down with the futures...

by kmf on August 19, 2009 9:32 PM

I honestly believe that the NYSE has been dealt a bad hand with reg "NMS" and they are trying to make the best out of it. Market quality will never make any significant progress until the SEC gets rid of all the algos, HFT, and the constant cancels that add zero value to the overall investing public that are being hurt by them. All they do is game the system at the cost of everyone else. The so called tight spreads dont really exist, its just false quotes that get cancelled when you try to access them. So what good are penny spreads when you send a market order for 100 shares and pay up 15-20 cents?? The NYSE needs to finally take a stand and lobby the SEC to crack down on these practices for the benefit of their legitimate customers who rely on them day in, day out.

by tony dey on August 20, 2009 10:00 PM

of course i agree with josh, kmf, and tony.
this has not been good for my mental health either, but at least it is a way to get it out.
does anyone defend nms and the NYSE's actions since implemented? All I hear from the talking heads, fellow traders, elected officials, is that the new market model has destroyed the quality and confidence of those (actual humans) who participate, and change must occur. But...no REAL changes have come forth even though trading looks more and more like the wild west...anything goes...
i guess my stance is...i would like to hear the argument FOR all this. Someone please tell me the benefit of making a high at 9:35 and a day low 15 seconds later. Or the confidence anyone should have on any exchange when you send a market order and you are filled 20 cents higher/lower even though there appears to be plenty of stock available. Tell me its ok to open a stock in NY and have the next print 2 dollars lower. If all this is crystal clear to me, a regular guy trying to put food on the table, how is it not to people who have much fancier titles following their names?

by jt on August 25, 2009 11:18 AM

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