E Opportunities In A Volatile Market: Virtu Financial And High-Frequency Trading

It is no secret that 2018 was not the friendliest year for global markets. In fact, it was the worst year for the S&P 500 since the financial crisis over a decade ago. The index fell over 6%, as sectors from technology to financials were devastated by consistent bad news, ranging from rising interest rates to a U.S government shutdown. Fund managers, such as BlackRock and Vanguard, who championed passive investment products and who benefited strongly from the placid market environment of the previous few years, saw themselves crushed by the return of volatility (these types of fund managers saw their stocks fall 29% on average in 2018). Institutional investors also got singed as asset classes like commodities and bonds sold off sharply along with equities, leaving no safe haven to protect portfolios. Even hedge funds, long thought to be the smart money on Wall Street, were unable to navigate the new market conditions. However, while most players in the market desperately tried to fend off the storm of volatility, a certain industry saw it as a breath of fresh air. That industry is composed of the proprietary and high-frequency trading firms.

Generally when people think of proprietary and high-frequency trading the first images that come to mind are of professional day traders and ultrafast computers trading ahead of retail investors in public markets. To some extent that is true, however, these types of firms provide a valuable service in that they improve the efficiency and liquidity of those same public markets. They do this through their main business of market making. This business has been in existence almost since the beginning of the stock market and through advances in technology has been rapidly sped up and automated. Increasingly most of the market making is being done by controversial high-frequency trading firms. The question is why does this matter? The reason is because these firms were some of the only market players who saw the blow up in volatility last year as a good thing and saw a sharp improvement in their earnings. This presents an opportunity. To understand it though, one needs to understand how market makers and high-frequency trading firms make money. 

In order for a financial market to function there needs to be liquidity, buyers must always be able to find seller and sellers buyers. When there are limited counter-parties to trade with, the market becomes illiquid and therefore difficult to maintain. In order to make sure that does not happen, exchanges often ask different banks and brokerages to continuously provide a bid ask spread to the market. With the “bid” being the price these firms will be willing to buy at and the “ask” price being the price they are willing to sell at. Essentially, these firms “make” a market in particular security and make sure there is always a willing buyer and seller available in the market. The spread between the “bid” and “ask” price that the market maker offers is called the market maker spread. This represents the profit a market maker makes from every trade in the security. This spread is usually only a few cents but due to the heavy volume of trading this few cents adds up. The less liquid or more volatile a security, the larger the market maker spread, the larger the spread the more money the market maker makes per trade. 

Over the last 10 years high-frequency trading firms have increasingly taken over the business of market making. Their superior technology and speed have made the business much more efficient and have squeezed many other types of proprietary trading firms out of the market. High-frequency trading has been under scrutiny, especially after Michael Lewis published a damning review of the industry in his best-selling book “Flash Boys”. Most criticism of high-frequency trading revolves around the strategy of “order flow prediction”, where these firms try to predict the market orders of large institutional players and take positions ahead of them. Although that is a controversial trading strategy it is not the main strategy of high-frequency firms. Most of these firms have strategies that revolve around market making and increasingly execution strategies, which is where these firms act as brokerages and execute large orders for institutional players. In any case, market making and high-frequency trading require high trading volumes and volatility to generate strong profits. The lack of both leading up to 2018, translated into a sharp downturn for this line of business. It now appears as though market conditions are changing, which means the high-frequency trading industry could see a strong turnaround. 

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Disclaimer: This material has been distributed for informational purposes only and is the opinion of the author, it should not be considered as investment advice.

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Howie Sandberg 10 months ago Member's comment

Fascinating, thanks for bringing this area to my attention.