High-Frequency Trading Increases Stock Volatility

Debt worries and Standard & Poor’s downgrade of the United States credit rating sent the stock market on a roller coaster ride in early August, with the Dow Jones average shedding hundreds of points and then quickly rebounding in volatility that surprised even veteran traders. The volatility, says X. Frank Zhang, associate professor of accounting, was exaggerated by an increase in high-frequency trading, an automated trading strategy in which computers execute a large volume of trades in as little as milliseconds.

"Events can move markets, but high-frequency trading increased the volatility in the overall market," explains Zhang, who conducted the first study to examine the effect of high-frequency trading on capital markets.

Using a large sample of firms from 1985 to 2009, Zhang found that high-frequency trading increases stock price volatility. The positive correlation between high-frequency trading and volatility was especially strong for the top 3,000 stocks in market capitalization. It was also stronger for stocks with high institutional holdings, and during periods of high market uncertainty.

Proponents of high-frequency trading argue that it provides liquidity to the market. However, Zhang’s research disputes this. He estimates that high-frequency trading accounted for 78% of trading volume in the U.S. in 2009, up from just over 0% in 1995. According to Zhang, once the share of high-frequency trading exceeds 50%, traders generate a “hot potato” volume effect as they rapidly pass the same positions back and forth. This suggests that high-frequency traders are largely trading with each other, and not providing any liquidity to the market.

Zhang’s analysis also shows that high-frequency trading hinders the market’s ability to incorporate news about a firm’s fundamentals into stock prices by exaggerating an otherwise sound price reaction. When high-frequency trading volume is high, stock prices overreact in the direction of earnings news. The price reaction is almost entirely reversed in subsequent months. 

Read the working paper, "High-Frequency Trading, Stock Volatility, and Price Discovery."