The Costs and Benefits of High Frequency Trading: A Profoundly Deep Dive

Because of the lucidity of this post I'm thinking of taking back all the economist jokes (except the J.K. Galbraith, it's not really a vocational jest*) and other negative things I've thought or written about the profession over the years.
From Rajiv Sethi:

Risk and Reward in High Frequency Trading

A paper on the profitability of high frequency traders has been attracting a fair amount of media attention lately. Among the authors is Andrei Kirilenko of the CFTC, whose earlier study of the flash crash used similar data and methods to illuminate the ecology of trading strategies in the S&P 500 E-mini futures market. While the earlier work examined transaction level data for four days in May 2010, the present study looks at the entire month of August 2010. Some of the new findings are startling, but need to be interpreted with greater care than is taken in the paper.

High frequency traders are characterized by large volume, short holding periods, and limited overnight and intraday directional exposure:

For each day there are three categories a potential trader must satisfy to be considered a HFT: (1) Trade more than 10,000 contracts; (2) have an end-of-day inventory position of no more than 2% of the total contracts the firm traded that day; (3) have a maximum variation in inventory scaled by total contracts traded of less than 15%. A firm must meet all three criteria on a given day to be considered engaging in HFT for that day. Furthermore, to be labeled an HFT firm for the purposes of this study, a firm must be labeled as engaging in HFT activity in at least 50% of the days it trades and must trade at least 50% of possible trading days. 

Of more than 30,000 accounts in the data, only 31 fit this description. But these firms dominate the market, accounting for 47% of total trading volume and appearing on one or both sides of almost 75% of traded contracts. And they do this with minimal directional exposure: average intraday inventory amounts to just 2% of trading volume, and the overnight inventory of the median HFT firm is precisely zero.

This small set of firms is then further subdivided into categories based on the extent to which they are providers of liquidity. For any given trade, the liquidity taker is the firm that initiates the transaction, by submitting an order that is marketable against one that is resting in the order book. The counterparty to the trade (who previously submitted the resting limit order) is the liquidity provider. Based on this criterion, the authors partition the set of high frequency traders into three subcategories: aggressive, mixed, and passive:

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."

Despite the volatility in daily profits, the risk-adjusted performance of high frequency traders is found to be spectacular...MUCH MORE

HT: The Big Picture

*This tale is said to be told by John Kenneth Galbraith on himself:

As a boy he lived on a farm in Canada. On the adjoining farm lived a girl he was fond of.

One day as they sat together on the top rail of the cattle pen they watched a bull servicing a cow.
Galbraith turned to the girl, with what he hoped was a suggestive look, saying, "That looks like it would be fun."

She replied, "Well.... She’s your cow."