Knight Capital Group Case Study
Knight Capital Group, a financial services firm engaging primarily in market making, was founded in 1995 by Kenneth Pasternak and Walter Raquet. A market maker is a company that stands by to buy and sell financial instruments while hoping to make a gain from the bid-offer spread. Using high frequency trading algorithms, Knight was once the largest trader in U.S. equities. High frequency trading (HFT) algorithms started in 1989 when Steve Swanson worked together with Jim Hawkes, a statistics professor, to program algorithms, predictive formulas for the stock market that were designed by Jim’s friend David Whitcomb, who taught finance at Rutgers University. The idea was to create a mechanical trading system that could predict the direction of a stock and act in a fraction of the time it would take a human. This would be a prime example of extremely efficient technology dethroning the human as master of his domain. In fact, it worked best on the NYSE where trading was still done in person. Here’s how it works, the algorithm predicts the next move. The system would then buy stocks on one of the exchanges that were selling below the predicted value and then sell it a split second later at the higher value and gain from this arbitrage. They could even buy and sell on the same market when a stock was predicted to climb. Or sell then buy if the stock was falling and they intended to short the market. In mere fractions of a second, the system would then adjust where the price point should be and continue trading. Historically, you can make money in the market by intelligently riding the market volatility or being a market maker. HFT effectively changed the market completely. If a stock was too high, the algorithm would automatically sell off the shares, if a stock was selling too low, it would buy. However, if something goes wrong with using high frequency trading algorithms as in the case with Knight Capital Group where it was on...
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