High-frequency traders (HFTs) are the 800-pound gorillas in the marketplace. Prior studies have produced conflicting arguments regarding the impact of high-frequency trading. Neil Bhattacharya, SMU Cox accounting professor, and his co-authors conducted a first: a macro-level analysis on high-frequency traders’ impact on price efficiency with respect to firm “fundamentals.”
Over the last seven to eight years, high-frequency trading has been 50 to 60 percent of the market’s trading volume. HFTs are essentially the market movers. While high-powered computers and proprietary algorithms are their signatures, they generally employ two types of strategies. One is execution trading to get the best price. The other is geared toward small trading opportunities (with milli-penny profits) and trades executed at lightning speed in great volumes. Because HFTs move markets, some researchers say they are creating more volatility, thus inhibiting price efficiency, but Bhattacharya and co-authors found a surprise.
“We don’t know whether the efficiency at the millisecond, ultra-short level translates into fundamentals and prices,” says Bhattacharya. “There is disagreement about whether they are improving efficiency, making this study all the more important.” The authors found that HFTs are improving price efficiency with regard to accounting earnings information. They analyzed a sample of stocks on the NASDAQ that included both HFTs and non-HFTs. The research found, based on price impacts from earnings announcements, that when HFTs trade, earnings information gets incorporated into prices much quicker and with greater price impact.
HFTs also tend to trade more in liquid stocks, meaning stocks with larger capitalizations like Apple, Microsoft and Ford. “This is where pricing converges quickly,” says Bhattacharya. The study found that analysts were revising and updating their forecasts more quickly. This means more information is getting revealed in prices. According to Bhattacharya: “Analysts’ forecast accuracy improves, and they tend to revise their forecasts faster.”
The research, currently under review, finds that HFTs are improving price efficiency in terms of earnings information. Whether they are reacting to earnings information itself is still uncertain. Nevertheless, the study concludes that HFTs are helping incorporate earnings into prices quickly and more efficiently. Bhattacharya believes that’s “reassuring” for the market.