“It appears that until regulations change, High Frequency Traders will continue to freely manipulate markets to their advantage and hence make money. What is the best way to invest in HFT?”

Eoin Treacy's view Thank you for this question which others may also have an interest in. Veteran subscribers will be familiar with Fullermoney's ambivalence towards high frequency trading. Let me summarise our view.

The history of financial innovation is littered with products that heralded a wonderful new world of riskless investment, fuelled bubbles, crashed, underwent reform, regulation and subsequently persisted in one form or another. The availability of leverage during the 1920s was a major contributor to the extent of that bull market and the subsequent collapse. Stock index futures in the 1980s were marketed as “portfolio insurance” and were a causal factor in the 1987 crash. The introduction of CDS in the 2000s allowed investors and more importantly issuers to hedge default risk for the first time. The result was that no one seemed to consider default a potential problem and profligate lending spurred housing bubbles and subsequent crashes.

Program trading has been around for quite a long time and has helped to decrease trading costs, increase liquidity and made ETFs possible. However the sector has evolved to such an extent that the programs are now largely autonomous and many are designed to simply scalp the market. When an increasing number of funds can claim that they have never lost money, we can only conclude that there is no risk. However since the financial markets are based on the premise of attempting to price risk then something is very clearly wrong in terms of regulation.

Co-location of servers within exchanges is front running by any other name because its express purpose is to ensure that the owners of these servers get information before anyone else. Additionally, they often pay additional fees in order to get access to privileged information about order sizes which is not available to the wider public. Quote stuffing, pinging the market with orders that are immediately cancelled and other activities are deliberately predatory and counter to the capital formation raison d'etre of markets.

The fact that high frequency trading strategies are multiplying at an exponential rate is creating a real risk that these innovative trading strategies will eventually cause a meaningful market crash. As they become increasingly influential this outcome is more not less likely.

Despite these considerations the simple fact is that HFT is legal and prospering. Demand for space and increased volume represent growth for exchanges. The sector was hit particularly hard during the credit crisis and the vast majority remain in lengthy base formations. A consolation is that most offer competitive yields. Here are some examples London Stock Exchange (3.37%), Deutsche Bourse (5.56%) Bolsas y Mercados Espanoles (9.65%), New York Stock Exchange (4.75%), Nasdaq (2.17%) Chicago Mercantile (3.23%), Chicago Board of Trade (1.79%), Singapore Stock Exchange (4.03%), Hong Kong Stock Exchange (3%) and Australian Stock Exchange (8.64%).

CBOE has one of the more attractive chart patterns at present and hit a two-year high last week. A sustained move below $28 would be required to question medium-term scope for continued higher to lateral ranging.

I would also welcome some feedback from subscribers on where HFT traders source their hardware. I performed a search on Bloomberg for super computers and Cray Inc came to light as a manufacturer. The share has a market cap of $477 million, forward P/E of 6.35 and its earnings surged last quarter. It broke out of its base in April and has held a progression of higher reaction lows since. A sustained move below $10 would be required to question medium-term scope for continued higher to lateral ranging.