Harvard University Job Market Candidate Papers
- Exploratory Trading
(Job Market Paper)
Using comprehensive, account-labeled message records from the E-mini S&P 500 futures market, I investigate the mechanisms underlying high-frequency traders' capacity to profitably anticipate price movements. Of the 30 high-frequency traders (HFTs) that I identify in my sample, eight earn positive overall profits on their aggressive orders. I find that all eight of these HFTs consistently lose money on their smallest aggressive orders, and these losses are not explained by inventory management. These losses on small orders, as well as the more-than-offsetting gains on larger orders, could be rationalized if the small orders provided some informational value, and I model how a trader could gather valuable private information by using her own orders in an exploratory manner to learn about market conditions. This "exploratory trading" model predicts that the market response to the trader's "exploratory" order would help to explain her earnings on her next order, but would not explain any other traders' subsequent performance. In direct confirmation of the model's predictions, I find that a simple measure of changes in the orderbook immediately following small aggressive orders placed by the eight HFTs explains a significant additional component of those HFTs' earnings on subsequent, larger orders, but this information offers little or no additional power to explain other traders' earnings on subsequent orders. These findings help to clarify nature of the information on which HFTs trade and offer a starting point to address the open questions about social welfare implications of high-frequency trading.