Risk and Reward in High Frequency Trading

By Rajiv Sethi, professor of economics at Barnard College, Columbia University. Cross posted from his blog






To be considered an Aggressive HFT, a firm must… initiate at least 40% of the trades it enters into, and must do so for at least 50% of the trading days in which it is active. To be considered a Passive HFT a firm must initiate fewer than 20% of the trades it enters into, and must do so for at least 50% of the trading days during which it is active. Those HFTs that meet neither… definition are labeled as Mixed HFTs. There are 10 Aggressive, 11 Mixed, and 10 Passive HFTs.

This heterogeneity among high frequency traders conflicts with the common claim that such firms are generally net providers of liquidity. In fact, the authors find that “some HFTs are almost 100% liquidity takers, and these firms trade the most and are the most profitable.”

Given the richness of their data, the authors are able to compute profitability, risk-exposure, and measures of risk-adjusted performance for all firms. Gross profits are significant on average but show considerable variability across firms and over time. The average HFT makes over $46,000 a day; aggressive firms make more than twice this amount. The standard deviation of profits is five times the mean, and the authors find that “there are a number of trader-days in which they lose money… several HFTs even lose over a million dollars in a single day.”


HFTs earn above-average gross rates of return for the amount of risk they take. This is true overall and for each type… Overall, the average annualized Sharpe ratio for an HFT is 9.2. Among the subcategories, Aggressive HFTs (8.46) exhibit the lowest risk-return tradeoff, while Passive HFTs do slightly better (8.56) and Mixed HFTs achieve the best performance (10.46)… The distribution is wide, with an inter-quartile range of 2.23 to 13.89 for all HFTs. Nonetheless, even the low end of HFT risk-adjusted performance is seven times higher than the Sharpe ratio of the S&P 500 (0.31).

These are interesting findings, but there is a serious problem with this interpretation of risk-adjusted performance. The authors are observing only a partial portfolio for each firm, and cannot therefore determine the firm’s overall risk exposure. It is extremely likely that these firms are trading simultaneously in many markets, in which case their exposure to risk in one market may be amplified or offset by their exposures elsewhere. The Sharpe ratio is meaningful only when applied to a firm’s entire portfolio, not to any of its individual components. For instance, it is possible to construct a low risk portfolio with a high Sharpe ratio that is composed of several high risk components, each of which has a low Sharpe ratio.


The problem is compounded by the fact that there are likely to by systematic differences across firms in the degree to which they are trading in other markets. I suspect that the most aggressive firms are in fact trading across multiple markets in a manner that lowers rather than amplifies their exposure in the market under study. Under such circumstances, the claim that aggressive firms “exhibit the lowest risk-return tradeoff” is without firm foundation.





In thinking about the aggregate costs and benefits of all this activity, it’s worth bringing to mind Bogle’s law:







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  1. LeonovaBalletRusse

    The issue is: Cui Bono? HFT serves the most aggressive traders with the fastest computers. Everyone else loses. HFT is front-running skimming RACKET. Bring RICO.

    1. Jason H

      I wont ever go back into equities because of HFT. AAPL is a prime example of the racket.

      Screwem all. Let the market fall Ben Bernanke.

  2. digi_owl

    Do anyone know how this impacts the GDP?

    I keep thinking that if these companies where left to trade paper back and forth all day it could potentially see the GDP skyrocket while there being minimal change in the standard of living.

    1. From Mexico

      Didn’t Sethi answer that, unless one considers onanism and trying to get something for nothing as producion in the real economy?


  3. Can't Help It

    My biggest wish for 2013 is for someone to reverse engineer Skynet and blow this whole thing sky high.

    1. diptherio

      Sadly, one must already be in possession of a technology in order to reverse engineer it. You got one of them Skynet-thingies hanging around? Me neither. I see what you’re saying though, and totally agree. We should forward-engineer some sort of skynet-like device and park it over Wall Street for awhile, followed by K Street.

  4. Tony

    An emini arb-friend of mine argues that the most likely outcome of rules requiring him to lengthen the minimum-quote-life (mql) of his bids & offers would be a smaller-scale version of what occurred after short-selling financial stocks was banned in Sept ’08: volatility spiked enormously. (Is that true?)

    Rajiv, can you confirm whether or not Michael Avery’s sell order of 75,000 eminis caused the basis to fall by 2 full handles? Nobody I’ve seems to know how much the basis fell that day, but they agree that it fell. (The arbs obviously got hit with thousands of Avery’s sell order as the basis was falling, which is always scary. Luckily for them, after Avery shot his wad the basis reverted, enriching the arbs, so only Waddell & Reed’s mutual fund shareholders were worse off. Moral of the story: Never try to sell $4 billion in stock index futures quickly because you’ll get a bad fill.

  5. Hugh

    HFT skims profits off the Wall Street casino in much the same way the mob skimmed profits off of casinos in Las Vegas. It seems strangely beside the point to ask if either served some useful function beyond enriching those immediately involved.

  6. Bud

    If there is anything of value to be made, stolen, scammed or filched, someone is already doing it. Amatures lose to professionals; even professionals lose to professionals, yet the little guy still lowers his head and charges into the fray. Bless’em all!

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