The adaptive market hypothesis and high frequency trading

Shouhao Li,Ke Meng,Stefan Cristian Gherghina

doi:10.1371/journal.pone.0260724

Abstract

This paper uses NASDAQ order book data for the S&P 500 exchange traded fund (SPY) to examine the relationship between one-minute, informational market efficiency and high frequency trading (HFT). We find that the level of efficiency varies widely over time and appears to cluster. Periods of high efficiency are followed by periods of low efficiency and vice versa. Further, we find that HFT activity is higher during periods of low efficiency. This supports the argument that HFTs seek profits and risk reduction by actively processing information, through limit order additions and cancellations, during periods of lower efficiency and revert to more passive market-making and rebate-generation during periods of higher efficiency. These findings support the argument that the adaptive market hypothesis (AMH) is an appropriate description of how prices evolve to incorporate information.

Highlights

In this paper, we test the efficient market hypothesis (EMH) using NASDAQ ITCH-feed data on the S&P 500 exchange traded fund (SPY)
Consistent with the existing studies [1,2,3,4,5], our findings suggest that the adaptive market hypothesis (AMH) is a better description of intra-day SPY returns
Because trading activity at one-minute resolution is driven by high frequency traders (HFTs), we study whether their limit order additions and cancelations are related to the level of market efficiency

Summary

Introduction

We test the efficient market hypothesis (EMH) using NASDAQ ITCH-feed data on the S&P 500 exchange traded fund (SPY). Because trading activity at one-minute resolution is driven by high frequency traders (HFTs), we study whether their limit order additions and cancelations are related to the level of market efficiency. This paper is the first to document the relationship between the level of support for the EMH and the level of HFT activity. Following Urquhart and McGroarty [5], we use several tests of predictability as proxies for tests of the EMH using both our entire data set (i.e. either/or) and overlapping sub-sample windows (i.e. time varying continuum) These reveal the time-varying level of efficiency. We apply Blocher et al.’s measure of HFT activity to the limit order data and examine the relationship between HFT activity and the level of support for each of the tests [9].

Background and literature review

Results and discussions

Conclusion