Empirical Limitations on High Frequency Trading Profitability

Abstract

Addressing the ongoing controversy over aggressive high-frequency trading practices in financial markets, we report the results of an extensive empirical study estimating the maximum possible profitability of such practices, and arrive at figures that are surprisingly modest. Our findings highlight the tension between execution costs and trading horizon confronted by high-frequency traders, and provide a controlled and large-scale empirical perspective on the high-frequency debate that has heretofore been absent. Our study employs a number of novel empirical methods, including the simulation of an "omniscient" high-frequency trader who can see the future and act accordingly.

The Profitability of High-Frequency Trading

“…In this case, return will be negative. Kearns et al (2010) cast doubt on the validity of the results produced by Aldridge, arguing that while she reports per-period returns of 0.04e0.06% at short trading intervals, she is silent on total profits. Specifically, they question the finding that the simulated Sharpe ratio can rise above 5000 at 10 s trading intervals and the labeling of HFT strategies as "extremely safe."…”

“…While they admit their inability to measure the net return after including the costs of computer systems, labor, overhead, risk management systems, etc., they claim that the magnitude of the profits generated by highfrequency traders suggest that they earn significant net abnormal returns. On the other hand, Kearns et al (2010) conduct an extensive empirical study to estimate the maximum possible profitability of HFT and arrive at figures that they describe as "surprisingly modest." They demonstrate an upper bound of $21 billion for the entire universe of US equities in 2008 at the longest holding periods, down to $21 million or less for the shortest holding periods.…”

Good Regulation, Bad Regulation

“…In any case, these characteristics do not give the impression that there is anything wrong, inappropriate or illegal about HFT. Kearns et al (2010) highlight this issue of confusion by arguing that "the HFT debate often conflates distinct phenomena, confusing, for instance, dark pools and flash trading, which are essentially new market mechanisms, with HFT itself, which is a type of trading behaviour applicable to both existing and emerging exchanges". They argue that the definition of HFT is straightforward: "the ability to electronically execute trades on extraordinary time scales, combined with the quantitative modelling of massive stores of historical data, permits a variety of practices unavailable to most parties".…”

“…While they admit their inability to measure the net return after including the costs of computer systems, labour, overheads, risk management systems and so on, they claim that the profits generated by high-frequency traders suggest that they earn significant net abnormal returns. On the other hand, Kearns et al (2010) conduct an extensive empirical study to estimate the maximum possible profitability of HFT and arrive at figures that they describe as "surprisingly modest". They demonstrate an upper bound of $21 billion for the entire universe of US equities in 2008 at the longest holding periods, down to $21 million or less for the shortest holding periods.…”

“…On that occasion, he claimed that highfrequency traders have rigged the stock market, inflicting damage on the average, middle-class retail investors, arguing that "speed traders" prey on retail investors by "trading against people who don't know the market". This point is also raised by Kearns et al (2010), who suggest that "the overarching fear is that quantitative trading groups, armed with modern networking and computing technology and expertise, are in some way victimizing retail ("mom and pop") traders and other less sophisticated parties". In response, Philips (2014) argues that "the idea that retail investors are losing out to sophisticated speed traders is an old claim in the debate over HFT, and it's pretty much been discredited".…”