Algorithmic Trading is Not High Frequency Trading

It’s not every day I come across a widely-shared article whose first sentence is factually incorrect, but a 9/9/11 story in Computerworld UK, “Algorithmic stock trading rapidly replacing humans, warns government paper”, is just such a creature.

The first sentence begins,

“Algorithmic trading, also known as high frequency trading (HFT), is rapidly replacing human decision making, according to a government panel…”

Problems

  1. “Algorithmic trading, also known as high frequency trading (HFT)” — no, algorithmic trading and HFT are not the same.
  2. “is rapidly replacing human decision making” — no, algorithmic trading is not replacing human decision making, and never will.
  3. “according to a government panel” — self explanatory.

The Difference Between Algorithmic Trading & HFT

Algorithmic trading is like the GPS navigation system in your car: you tell the car your destination, and the GPS picks the route. The car generally doesn’t drive for you, and it doesn’t replace your decision of where to drive. Similarly, traders employing algorithmic trading systems pre-decide which stocks to buy or sell; they’re simply handing over the actual execution of the orders (when to trade during the day, and at what price) to the algorithm.

High frequency trading is a different game. True, an HFT algorithm actually does choose which stocks to buy and sell, but the program is not making decisions on the same scale as a pro fund manager. A fund manager (what bombastic writers would refer to as a “human”) says “I’m bullish on Amazon.com this year, so I’ll buy $100M of AMZN over the next week and hold the position until my view changes.” A high frequency trading system says “I estimate a high probability of AMZN going up within the next 30 seconds, so I’ll buy $10,000 worth” (and sell it 30 seconds later).

In short, algorithmic trading is used to implement large scale, economic views on asset prices, whereas HFT systems place automated, small scale, probabilistic bets on structural inefficiencies.

Algorithmic trading does not replace human decision making, and it never will.

HFT is a form of computerized decision making, but it doesn’t replace humans because humans don’t make decisions on millisecond scale to begin with.

Richard Bookstaber wrote an in-depth article two years ago about the difference between algorithmic trading and HFT, Risk from High Frequency and Algorithmic Trading Not as Big as Many Think.

Scary HFT

Ever since high frequency trading came onto the scene around 2007, there has been an unfortunate trend in the press of using HFT as a platform for linkbait stories. It’s fun to make computerized trading sound spooky, and it gets pageviews.

Common signs of HFT article linkbait:

  • Referring to traders/people as “humans”.
  • Calling computer programs “robots”, and saying they can “adapt” or will become “intelligent”.
  • Citing the pseudo-statistic “X % of trading is now computer driven”. So? Eventually, 99% of all trading will be computer driven, in the sense of orders being executed by computers. But “humans” will still be making the underlying, economic decisions.
  • Fake omens, like people being “replaced”.
  • Jokey headlines like “Rise of the machines”.
  • Pictures of the Terminator.

If you retweet or share such an article, congratulations. You’ve been linkbaited.

Addendum

9/13/11 5:00pm: noted that the author of the Computerworld UK source article modified the first sentence to read, “Algorithmic trading, including high frequency trading (HFT)”.

» Photo credit: Max Sang / Flickr