High-frequency trading or HFT is a trading strategy employed by computers allowing them to trade a large number of stocks more rapidly than any individual would. These computers use algorithms to follow the stock market and seek minor changes in the prices. Upon realizing that they can make a profit, the trade is executed within seconds. Financial institutions like banks also practice high-frequency trading or HFT to make risk-based returns by executing lots of trades in a day.
HFT enhances the functioning of stock exchanges by providing efficiency in making quick trades. But there are those who argue that it is unfair because it is only big companies with fast computers who have the ability to do so. Other people's worries are that it will make the market too volatile. This article will explain the strategy used in high-frequency trading, useful aspects of HFT, and valid causes for worry.
Understanding High-Frequency Trading – Form of Algorithmic Trading
High-frequency trading or HFT is a type of automated trading that involves computer protocols for trading and execution processes. Such computers followed the patterns in the stock market and executed the trade accordingly. What is noteworthy about HFT is its speed of operation which is much faster than any person can work at.
The contrivance that makes up high-frequency trading is a computer that has the ability to place many orders or conduct certain operations in mere seconds. High-frequency trading, unlike normal trading, is different in terms of the number of trades that occur within a day and that can be in hundreds in a sub-one-hour strategy rather than the few trades that a single individual could manage in a week or even a month.
The standouts of HFT are:
They hold a number of distinctions that make high-frequency trading unique from the rest.
- Fast Trades: High-frequency trading takes a very short time frame measured in seconds.
- Lots of Trades: Again due to the speed and not so much the trader funny enough even high-frequency trading performs several trades in a day.
- Short-Term Focus: The distinct advantage of high-frequency trading is that it requires almost no investment in terms of how long a stock can be held. It does not simply buy them and hold them for days on end. It buys them briefly and sells them again within a short span with the hope of making tiny profits.
Most of the frontage users of high-frequency trading are big institutions like banks and hedge funds. They apply high-frequency trading to make rapid trades and make profits on the slight variations in the market.
How does high-frequency trading work?
Mechanics of HFT
With the advent of high-frequency trading (HFT), individual investors have lost the ability to trade stocks within a very short time frame. In order to perform high-frequency trades, special computers are used. These computers contain algorithms which are complicated rules that dictate when it is beneficial to buy or sell stocks. Simply put HFT is a short-term proposition seeking to exploit inefficiencies in a bid-ask pricing window.
The computers are able to observe the trends of the stock market and make attempts to understand them. For example, when they figure out where they could make a buying transaction at a reasonably lower stock price and immediately afterward be in a position to sell at relatively higher prices, they will execute the trade in under a second. This is why many such firms who practice HFT, end up making many minuscule returns very fast.
Technology in HFT
To ensure even faster order execution, the order matching engines are always kept very close to the competing stock exchanges to reduce order latency. In other words, this is called co-location. The trade execution time will only take as long as it takes for the signals to be transmitted to the two computers as long as they are connected. Winning and losing trades in HFT trades is a game of seconds and a few milliseconds could cost the trader a lot.
Another part of HFT is using arbitrage. It is when different exchanges have different prices of the same stock and the traders utilize that difference to earn. The procedure #{is: this}, is systemic institutional Jul on symposium Fall 2013 coursing FAMCSH and culinary Drew Zoonex “List reducing each stock lower price”. This profit sale prompted the HFT system to revert.
HFT however requires speed as well! I mean, the quicker the computers execute the trades, the more profits they earn from those trades. This is why companies invest heavily in fast computers and fiber optic cables for little or no latency (the interval of time taken for information to be transferred from point A to point B. Also known as Overview of High Frequency Trading.
Advantages of High-Frequency Trading
Increased Liquidity
High-frequency trading (HFT) has a major advantage – it contributes to liquidity in the stock exchange market. This means there are enough buyers and sellers present in the market so trading can be carried out in a fast manner. It is more active when there is high-frequency trading, as, there are systems, which attempt to trade at all times via the churning of computers and this enables people to buy or sell stocks more easily than in traditional methods.
They often act as a buyer or seller in the stock market in what is referred to as taking or making markets. When there is a big gap between the number of orders at each price point and the number of sell orders, which is called the bid-ask spread, HFT traders tend to come in. It also enhances market efficiency since the spread is narrowed whereby the securities are transacted at prices that are more aligned to their market value.
HFT in Trading
HFT greatly speeds up the trading process as trades can occur in milliseconds. This fast pace makes it possible for traders to make quick actions when there are changes in the market. For instance, when the price of a stock to, for example, rises, an HFT computer is probably the first to buy the stock before other traders can notice the upturn and seconds later, sell it at a profit.
Price Improvements on the Stock Market
As the HFT algorithms are developed and constantly perfected, they will always look to exploit differences in the prices of stocks ensuring that these differences are eliminated with speed. This means that prices in the stock exchanges are more precise and in the long run, everybody from retail investors as well as larger institutions will gain.
At the end of the day, all HFT does is add to the constancy of the operation of the stock exchange by providing additional money and, controlling the prices.
Flash Crashes and Market Volatility
Flash Crashes and Market Volatility
One of the most nagging effects of high-frequency trading (HFT) is that it is highly disruptive to the normal order of any technology-driven exchange and induces what the investors term flash crashes. These phenomena arise mainly due to high-frequency trading (HFT) where traders with these kinds of computer trades sell massive amounts of stocks within a short time, bringing about drastic declines in price. An Example of such was the “Flash Crash” which occurred on the 6th of May 2010 when the stock market lost an astounding 1000 points in under several minutes creating a frenzied atmosphere only for the market to be fully recovered shortly thereafter.
Flash crashes are an example of the ways HFT comes with increased market volatility, as this means that prices may change drastically within certain periods of time. This can be dangerous for nonprofessional investors as they would not be able to reach the markets as quickly as the HFT computer does.
The Edge
HFT favors big companies against small-scale investors. These corporations own the best computers and cutting-edge technology that helps them mitigate the effects of sudden change in the market better than any ordinary trader would. This is viewed as unfair because these traders will be able to make a killing out of the price changes before the smaller market players are even aware of what happened.
Another thing that is often inherited is ghost liquidity. HFT has been criticized for producing liquidity that is only fleeting, rather than permanent; that is, HFT adds liquidity but it often lasts only a that. If the liquidity is available for a split second and no possibility for other traders to get it up, then the market seems to them rather erratic predictable elusive.
In the general context, HFT is a very hot topic because, on the one hand, it is helpful on the way improve markets’ speed and liquidity while on the other hand, it raises issues surrounding fairness and stability.
Regulatory Concerns & Responses
HFT Regulation
HFT has become a hot topic with regulators worldwide. One reason is that HFT can create problems such as, but not limited to, flash crashes and amplified market volatility. Even regulatory agencies like the SEC have made plans to ensure that HFT does not cause damage to the stock markets or provide opportunities to only the large organizations.
In order to fulfill some of these concerns, measures have been taken to institute rules that focus on reducing the rate of trading in such a manner as to discourage undue privileges. For instance, some cash equity exchanges have imposed such rules as “speed bumps” which prevent HFT orders from being completed instantly by delaying them for split seconds. This ensures that proper equilibrium is achieved as normal traders are given time to respond to the alterations in price.
Ethical Issues
HFT is also ethical in nature. One area of concern is flash trading where HFT companies are given access to the order book for a short period before a particular order is placed or finalized. This makes it possible for the trader to buy or sell an asset before the investor is able to do so, which in the opinion of many people is unethical. While steps have been taken to lessen the practice of flash trading in the U.S. it remains a hot topic issues.
A further threat is predatory trading. This happens when HFT firms use their speed to hunt down and pick up large orders from other slower trades, for example, mutual funds or pension funds. Often these slower orders are filled at lower prices simply because HFTs are faster. Regulators are trying to put a time clock on this practice to enhance protection for the average investor.
Examples of HFT in Action
Case Studies of Prominent HFT Firms
Out of the several high-frequency trading (HFT) firms in the industry, Tower Research Capital, Citadel LLC, and Virtu Financial are some of the leading and very well-recognized in the industry. The trading strategy of these companies is built on the possibility of using sophisticated technologies and some algorithms for the purpose of doing hundreds and even thousands of trades within a few seconds as the company makes a profit taking advantage of the small price variations in a number of markets.
Virtu Financial once claimed that it showed a gain in more than 99.9% of its trading days for four years. Illustrating how effective and practical HFT is for firms that manage to outperform competition in executing trades. Furthermore, Citadel LLC, another behemoth in the marketplace also uses HFT for its core function of strategic liquidity provision by executing trades in the marketplace on behalf of other investors and earning profit from the small cost differentials.
These firms spend significant resources on, among other things, high-speed computers and wires to the stock exchanges to make sure that they are ahead of the game. In doing so, these companies are able to seek arbitrage opportunities at a rate that is unprecedented to most antiquated topside traders.
Practical Usage
HFT however is not solely limited to stock trading, but other markets, including traded futures, options, and the foreign exchange markets also have a high-frequency trading component. An example of this deals with the foreign exchange market, where HFT firms engage in practices of making earnings through means of buying and selling currencies across various platforms at differing rates and thus seek to take optimum currency conversion exchange. This gives them the ability to exploit these arbitrage strategies and react to news or events that may affect the prices of currencies.
This class of firms sometimes called HFT firms trade in diverse markets and these examples demonstrate how they have done this presenting the need for speed and HFT technology to be ahead of competing traders.
Conclusion
High-frequency trading can be defined as a strategy that utilizes speed in the trading environment. Over the years, it has been due to such practices that the financial markets have been evolving. its benefits such as improvement of liquidity in the market and further enhancement improvement of competition in a market. However HFT has disadvantages such as causing more trouble to the markets in the forms of flash crash markets as well as providing an undue advantage to large corporations over retail investors.
Some controls have been instituted to minimize the risks and abuses related to HFT, but the issue of its fairness continues to be discussed. As technology advances, it is reasonable to assume that HFT will continue to be at the heart of the financial industry. For traders, it is critical to comprehend HFT, its influence on the market, and its operational dynamics whether they are just starting to trade or are seasoned investors.