By Shawn Tully
September 9, 2011

Knives are out for high-frequency stock traders for causing wild market swings, but the critics are wrong.

FORTUNE — The stock market has never looked crazier, with the Dow regularly spiking or swooning 500 points a day in unprecedented bursts of volatility. Investors and regulators are pinning the blame on the super-high-speed computerized-trading outfits that now dominate the securities markets, accounting for about 60% of all transactions. The SEC and CFTC are investigating whether these “high-frequency traders” are causing the wild swings and need to be reined in. Top money managers at such firms as Neuberger Berman and Invesco claim that when news is negative, the superfast platforms sell as a panicking crowd, magnifying losses in our 401(k)s and pension plans. The backlash has been especially harsh in Britain. The chief of the Investment Management Association charges that the practice has “no economic value” and milks money from investors.

Not so fast. High-frequency traders, it turns out, actually dampen volatility, while lowering trading costs to investors. These high-speed computer jockeys are essentially market makers. They post bid and offer quotes for thousands of stocks on a number of exchanges, from the NYSE Arca to Bloomberg Tradebook. “With the high-frequency traders, it’s all about speed,” says Ed Nicoll, former CEO of Instinet. The traders’ goal: to buy shares from a mutual fund or pension fund at the bid, then flip the stock in seconds to another investor at the offer, pocketing a portion of the spread, averaging a tenth of a cent a share. “I’d say that the rise of high-frequency trading has helped reduce our trading costs about 50% in 10 years,” says Michael Mendelson, a partner in $40 billion hedge fund AQR Capital.

Those pennies add up. During one trading day in August, these traders amassed $60 million in profits, reckons Tabb Group, a New York City market research firm.

Although big Wall Street firms such as Goldman Sachs (GS) and Credit Suisse (CS) own high-frequency operations, the field is dominated by independent firms like Getco and Tradeworx, along with hundreds of tiny shops equipped with the computers and algorithms to compete with the giants. The more sophisticated high-frequency folks generate extra profit by practicing arbitrage. Their algorithms will raise the bid a penny on Pfizer (PFE), say, if the pharma index is rising but Pfizer is flat, anticipating that it will rise. But they always look to quickly sell what they buy. That distinguishes them from the two other groups of computerized traders that are true risk-takers: “stat arb” and “value and momentum” quant funds that place big longer-term bets on companies or indexes.

So what really drives today’s volatility? It probably isn’t the quant funds either. “When the market sees panic selling, we’re most likely to be on the other side of the trade — buying, not selling,” says Mendelson. No, the lurching swings come from money managers and retail investors who suddenly realize that, because of the U.S. debt downgrade or a looming banking crisis in Europe, the world is riskier than they’d thought. It’s the exodus from equities into gold and bonds that cause those gigantic downdrafts. The high-frequency crowd actually limits the damage by keeping the markets more liquid than they’ve ever been. Don’t confuse computers, speed, and algorithms with the wages of fear.

This article is from the September 26, 2011 issue of Fortune.


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