Abstract:
We examine the role of high‐frequency traders (HFT) in price discovery. Overall HFT play a positive role in price efficiency by trading in the direction of permanent price changes and in the opposite direction of transitory pricing errors on average days and the highest volatility days. This is done through their marketable orders. In contrast, HFT passive non‐marketable orders are adversely selected in terms of the permanent and transitory components as these trades are in the opposite direction as permanent price changes and in the same direction as transitory pricing errors. HFT marketable orders’ informational advantage is sufficient to overcome the bid‐ask spread and trading fees to generate positive trading revenues. Non‐marketable limit orders also result in positive revenues as the costs associated with adverse selection are smaller than the bid‐ask spread and liquidity rebates. HFT predicts price changes over short horizons measured in the tens of seconds.

Hendershott, Terrence and Riordan, Ryan, High Frequency Trading and Price Discovery (October 10, 2011). Available at SSRN: http://ssrn.com/abstract=1928510