Policy Documents

High-Frequency Trading, Stock Volatility, and Price Discovery

Frank Zhang –
December 1, 2010

High-frequency trading has become a dominant force in the U.S. capital market, accounting for over 70% of dollar trading volume. This study examines the implication of high-frequency trading for stock price volatility and price discovery. I find that high-frequency trading is positively correlated with stock price volatility after controlling for firm fundamental volatility and other exogenous determinants of volatility. The positive correlation is stronger among the top 3,000 stocks in market capitalization and among stocks with high institutional holdings. The positive correlation is also stronger during periods of high market uncertainty. Furthermore, I find that high-frequency trading is negatively related to the market’s ability to incorporate information about firm fundamentals into asset prices. Stock prices tend to overreact to fundamental news when high-frequency trading is at a high volume. Overall, this paper demonstrates that high-frequency trading may potentially have some harmful effects for the U.S. capital market.