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A Close Look at High-Frequency Trading THE SO-CALLED "FLASH CRASH" of May 6, 2010, took Wall Street by surprise. The Dow Jones Industrial Average dropped by 1,000 points—and recovered—in a matter of seconds. The cause behind one of the largest single-day point swings in the DJIA's history? High-frequency trad- ing (HFT). A new paper, "The Volume Clock: Insights into the High-Frequency Paradigm," delves into the dan- gers—and benefits—HFT presents to financial markets. HFT refers to some traders' use of sophisticated algorithms, split-second timing, and rapid-fire transac- tions to gain advantage over those who engage in low- frequency trading (LFT). Although today's HFT is sup- ported by the latest technologies, the practice has been around in some form since the 1700s, explain David Easley, an economics professor at Cornell University of Ithaca, New York; Marcos M. López de Prado of Connecticut-based Tudor Investment Corporation; and Maureen O'Hara, professor of finance at Cornell's Johnson Graduate School of Management. HFT also relies on "event-based time" rather than chronological time. That is, these traders act after a certain number of trades, not time frames, to maintain their market shares. So, "even if connectivity speed ceased to be a significant edge," the authors write, "HFT would and will exist." The authors outline the type of predatory behaviors high-frequency traders exhibit. "Quote stuffers" over- other women; and individuals 30 years old or older wield more influence and are less susceptible to influence than those under 30. Of all groups, married people were the least susceptible to the influence of others. The researchers also identified a group they call "super spreaders"—those who are themselves influential and are connected to other highly influential people. Traditional methods that measure influence on social networks cannot tell with accuracy whether two friends who adopt a product one after the other do so because of peer influence or because they share similar preferences. This new method accounts for this so-called "homophily whelm exchanges with data to slow down competi- tors. "Quote danglers" send out data that can force "a squeezed trader to chase a price against her interests." "Liquidity squeezers" trade in ways designed to drain liquidity from distressed companies. Finally, "pack hunters" are groups of traders who become aware of each other's presence even though they don't know one another. They work in concert "to maximize the chances of triggering a cascading effect." Although such behavior increases market volatil- ity, HFT also helps keep markets liquid and efficient. For that reason, it would be unwise to try to eliminate HFT with legislation, the authors write. Instead, the authors outline several strategies for counteracting the negative effects of HFT. These include adopting event-based time strategies, monitor- ing HFT activity more closely, and trading at times when HFT activity is highest, such as the opening and closing of the stock market. "It seems more efficient and less intrusive," the authors write, "to starve some HFTs by making LFTs smarter." Their paper is forthcoming in the Journal of Portfolio Management. It's available at ssrn.com/ abstract=2034858. bias," which refers to people's tendency to make friends with others like themselves, explains Aral. Their approach could help marketers develop "viral" strategies designed to spread through a society quickly, says Aral. It also could be used for social good—the researchers are working on a way of applying their method to promoting HIV testing in Africa. The tool also could support campaigns that encourage exercise, smok- ing cessation, or political awareness. "Identifying Influential and Susceptible Members of Social Networks" was published online by the journal Science on June 12. BizEd September/October 2012 55