Equilibrium Investment in High Frequency Trading Technology: A Real Options Approach

This paper derives an optimal timing strategy for a regular slow trader considering investing in a high-frequency trading technology. The market is fragmented, and slow traders compete with fast traders for trade execution. Assuming all traders adhere to the optimal strategy derived for a single trader, I then determine the equilibrium level of fast trading in the market across all traders, as well as the socially optimal level. I show that there is a unique level of market fragmentation such that the equilibrium level of fast trading and the socially optimal level coincide. Moreover, the real options approach to investment yields an equilibrium level which is less socially optimal than the equilibrium level obtained via the classical net present value approach.