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October 27, 2009 at 08:00 PM
In the current era of financial services re-regulation, high frequency trading has gotten caught up in part of the wave and landed under the microscope. This article is intended to address the misperceptions and a degree of hysteria that has surrounded high-frequency trading of late–although the hype has subsided as more industry professionals speak up in favor of high-frequency trading.
First, to correct a common misunderstanding about high-frequency trading: many traditional brokers with little electronic trading experience tend to confuse “high-frequency trading” with “low-latency trading.” Low-latency trading involves routing trades to the exchange with a minimal delay with the goal of arbitraging potential mis-pricings. Few buy-side institutions deploy low-latency strategies, as they find it difficult to compete with broker-dealers in this space. In contrast, “high-frequency trading” refers to accurate short-term forecasting, typically executed in a systematic, computerized fashion.
According to the survey of hedge fund managers we conducted at FINalternatives this past summer, 84% of fund managers define high-frequency trading as investing with position holding times of up to one day. Overall, there are four broad classes of high-frequency trading, two of which involve market making in which positions can indeed be held in seconds and sub-seconds. The other two types are statistical arbitrage and event arbitrage that retain positions for several minutes and up to one day.
A trading frequency is defined as the position holding time–the period of time between position open and close times. In this article we measure the profitability of three trading frequencies against one trading strategy, trading the S&P 500 on the announcements of the U.S. Leading Indicators Index.
We define low, medium, and high trading frequencies as position holding periods of one month, day, and hour, respectively. We find that trading the S&P 500 on leading indicators is profitable at low trading frequencies and high trading frequencies, but is not cost-effective at the most common medium trading period. To capture maximum profitability for their clients, advisors should therefore consider trades with frequencies other than the most common daily holding periods.
Now, let’s talk about ways to trade the S&P 500 on the basis of the U.S. Leading Indicators Index. The index is a composite of ten indicators that historically preceded peaks and troughs in the U.S. economy. The composition of the Index changes through time, and may include the following indicators: interest rate spread between a U.S. 10-year note and the Fed funds rate, average weekly initial claims for unemployment insurance, average weekly manufacturing hours, index of supplier deliveries (vendor performance), stock prices, and manufacturers’ new orders for non-defense capital goods.
To assess the impact of the Index announcements on the S&P 500, we conduct event studies. We first identify all dates and times of leading indicators in the past two years. Next to the date and time of each announcement, we record the following three figures: change in the leading indicators index in the previous month, consensus forecast developed by several economists prior to the announcement, and the actual realized change in the index that was revealed in the announcement.
