High-Frequency Trading (HFT)

What is High-Frequency Trading (HFT)?

High-frequency trading, also known as HFT, is a method of trading that uses powerful computer programs to transact a large number of orders in fractions of a second. It uses complex algorithms to analyze multiple markets and execute orders based on market conditions. Typically, the traders with the fastest execution speeds are more profitable than traders with slower execution speeds. High-frequency trading (HFT) is algorithmic trading characterized by high-speed trade execution, an extremely large number of transactions, and a very short-term investment horizon. HFT leverages special computers to achieve the highest speed of trade execution possible. It is very complex and, therefore, primarily a tool employed by large institutional investors such as investment banks and hedge funds.

Complex algorithms that are used in high-frequency trading analyze individual stocks to spot emerging trends in milliseconds. It will result in hundreds of buy orders being sent out in a matter of seconds, given the analysis finds a trigger. In addition to the high speed of orders, high-frequency trading is also characterized by high turnover rates and order-to-trade ratios. High-frequency trading became popular when exchanges started to offer incentives for companies to add liquidity to the market.

Advantages of High-Frequency Trading

• High-frequency trading, along with trading large volumes of securities, allows traders to profit from even very small price fluctuations. It allows institutions to gain significant returns on bid-ask spreads.

• Trading algorithms can scan multiple markets and exchanges. It enables traders to find more trading opportunities, including arbitraging slight price differences for the same asset as traded on different exchanges.

• Many proponents of high-frequency trading argue that it enhances liquidity in the market. HFT clearly increases competition in the market as traders are executed faster and the volume of trades significantly increases. The increased liquidity causes bid-ask spreads to decline, making the markets more price-efficient. The major benefit of HFT is it has improved market liquidity and removed bid-ask spreads that previously would have been too small.

• A liquid market sees less risk associated with it, as there will always be someone on the other side of a position. Also, as liquidity increases, the price a seller is willing to sell for, and a buyer is willing to pay for will move closer together.

• The risk can be mitigated with several strategies – one of which is stop-loss order, which will ensure that a trader’s position will close at a specific price and prevent further loss.

Risks of High-Frequency Trading

• High-frequency trading remains a controversial activity and there is little consensus about it among regulators, finance professionals, and scholars.

• High-frequency traders rarely hold their portfolios overnight, accumulate minimal capital, and establish holding for a short time frame before liquidating their position.

• As a result, the risk-reward, or Sharpe Ratio, is exceptionally high. The ratio is much greater than the classic investor who invests with a long-term strategy. A high-frequency trader will sometimes only profit a fraction of a cent, which is all they need to make gains throughout the day but also increases the chances of a significant loss.

• One major criticism of HFT is that it only creates “ghost liquidity” in the market. HFT opponents point out that the liquidity created is not “real” because the securities are only held for a few seconds. Before a regular investor can buy the security, it’s already been traded multiple times among high-frequency traders. By the time the regular investor places an order, the massive liquidity created by HFT has largely ebbed away.

• Furthermore, it is supposed that high-frequency traders (large financial institutions) often profit at the expense of smaller players in the market (smaller financial institutions, individual investors).

• Finally, HFT has been linked to increased market volatility and even market crashes. Regulators have caught some high-frequency traders engaging in illegal market manipulations such as spoofing and layering. It was proven that HFT substantially contributed to the excessive market volatility exhibited during the Flash Crash in 2010.

• HFT is controversial and has been met with some harsh criticism. It has replaced a number of broker-dealers and uses mathematical models and algorithms to make decisions, taking human decisions and interaction out of the equation. Decisions happen in milliseconds, and this could result in big market moves without reason.

Ethics and Market Impact

• Some professionals criticize high-frequency trading since they believe that it gives an unfair advantage to large firms and unbalances the playing field. It can also harm other investors that hold a long-term strategy and buy or sell in bulk.

• Critics also suggest that emerging technologies and electronic trading starting in the early 2000s play a role in market volatility. Small and large crashes can be amplified by such technologies mass liquidating their portfolios with specific market cues.

• Some European countries want to ban high-frequency trading to minimize volatility, ultimately preventing adverse events, such as the 2010 US Flash Crash and the Knight Capital collapse.

• Algorithms can also be created to initiate thousands of orders and canceling them seconds later, creating a momentary spike in price. Taking advantage of such a type of deception is widely considered immoral and sometimes illegal.

• HFT is controversial and has been met with some harsh criticism. It has replaced a number of broker-dealers and uses mathematical models and algorithms to make decisions, taking human decisions and interaction out of the equation. Decisions happen in milliseconds, and this could result in big market moves without reason.

KEY TAKEAWAYS

• HFT is complex algorithmic trading in which large numbers of orders are executed within seconds.

• It adds liquidity to the markets and eliminates small bid-ask spreads.

• There are two primary criticisms of HFT. The first one is that it allows institutional players to gain an upper hand in trading because they are able to trade in large blocks through the use of algorithms. The second criticism against HFT is that the liquidity produced by this type of trading is momentary. It disappears within seconds, making it impossible for traders to take advantage of it.