How High-Frequency Trading Can Contribute to Volatility and Flash Crashes

Summary

The paper builds an agent-based model to study interactions between low- and high-frequency traders and their effects on asset prices. Low-frequency agents trade according to chronological time and can switch between fundamentalist and chartist rules. High-frequency agents activate in response to price events and use directional strategies to exploit information generated by slower traders. Monte Carlo simulations are used to assess volatility and flash-crash behavior, and the model is reported to reproduce key stylized market facts.

In the simulations, adding high-frequency traders increases volatility and contributes to flash-crash formation. The proposed mechanisms are wider bid-ask spreads and synchronized selling in the limit order book. More frequent order cancellations increase how often crashes occur while shortening their duration. These results are conditional on the model’s design; the excerpt does not provide calibration details, empirical validation, or evidence that the simulated mechanisms explain particular real-world crashes.

Key ideas

• Low-frequency agents follow time-based rules and can switch between fundamentalist and chartist behavior.
• High-frequency agents activate in response to price fluctuations and trade directionally.
• The simulations associate high-frequency trading with higher volatility and flash-crash formation.
• Wider spreads and synchronized selling are identified as mechanisms behind crashes.
• Higher cancellation rates increase crash incidence while reducing crash duration.

Tags

# Rock around the Clock: An Agent-Based Model of Low- and High-Frequency Trading


# Rock around the Clock: An Agent-Based Model of Low- and High-Frequency Trading









We build an agent-based model to study how the interplay between low- and high-frequency trading affects asset price dynamics. Our main goal is to investigate whether high-frequency trading exacerbates market volatility and generates flash crashes. In the model, low-frequency agents adopt trading rules based on chronological time and can switch between fundamentalist and chartist strategies. On the contrary, high-frequency traders activation is event-driven and depends on price fluctuations. High-frequency traders use directional strategies to exploit market information produced by low-frequency traders. Monte-Carlo simulations reveal that the model replicates the main stylized facts of financial markets. Furthermore, we find that the presence of high-frequency trading increases market volatility and plays a fundamental role in the generation of flash crashes. The emergence of flash crashes is explained by two salient characteristics of high-frequency traders, i.e. their ability to i) generate high bid-ask spreads and ii) synchronize on the sell side of the limit order book. Finally, we find that higher rates of order cancellation by high-frequency traders increase the incidence of flash crashes but reduce their duration.

Shown in full with attribution under the source's licence. Licence: abstract CC0

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.