Last Updated on 31 March, 2021 by Samuelsson
The advent of the internet and electronic trading makes it possible for big players to create automated trading methods that can execute a large number of orders in micro-fractions of a second. This kind of high-frequency trading is now common in all financial markets, but what is it?
Also known as HFT, high-frequency trading is an automated trading method that uses powerful computers and complex algorithms to analyze multiple markets and execute a large number of orders at extremely high speeds. The method is employed by large investment banks, hedge funds, and institutional investors to take advantage of the market conditions before anyone else.
While HFT is such a complicated and controversial topic in trading, we will try to simplify it. So, in this post, we will discuss the following:
- What high-frequency trading is
- How high-frequency trading works
- The history of high-frequency trading
- Why institutions engage in high-frequency trading
- Common strategies used in high-frequency trading
- The pros and cons of high-frequency trading
- Whether high-frequency trading is ethical
- What regulators say about high-frequency trading
What is high-frequency trading?
High-frequency trading (HFT) is an automated trading method mostly used by institutional traders to trade at extremely high speeds. This form of trading uses powerful computers and complex algorithms to analyze multiple markets and execute a large number of orders in fractions of a second. The method is employed by large investment banks, hedge funds, and institutional investors who try to take advantage of the market conditions before anyone else.
HFT is characterized by high speeds, high turnover rates, and high order-to-trade ratios, all of which leverage high-frequency financial data and electronic trading tools. The system uses computer programs, artificial intelligence, and machine learning to scan multiple markets and exchanges in a micro-fraction of a second and execute millions of orders. Since this method relies on algorithms to analyze different markets and identify trading opportunities, it is much faster than any human can ever be.
The aim of HFT is to be able to spot emerging trends and take advantage of them before anyone else. By being able to recognize imminent changes in market conditions, HFT systems can send out multiple orders to the market at ultra-high speeds, beating the bid-ask spreads. Hence, systems with the fastest execution speeds are more profitable than those with slower execution speeds.
While one can argue that high-frequency trading has brought more liquidity to the markets, critics believe that the method of trading offers an unfair advantage to large firms at the expense of the smaller investors.
Understanding how high-frequency trading works
Basically, HFT involves buying financial instruments at extremely high speeds and selling them within a fraction of a second — in fact, such transactions are measured in microseconds, or millionths of a second. The idea is to make small profits from even the smallest price changes while the profits accumulate from making several of such trades over and over. It is estimated that high-frequency trading accounts for about 50-60% of all volume in the stock market.
To understand how HFT works, let’s consider an example with a big trading firm. Assuming the firm anticipates that the price of a stock will rise by a cent or two in a second and fall back to where it was — the typical market fluctuation that occurs every day in any financial market. If this firm buys 2 million shares just before the rise and is able to sell them immediately before the price drops, they’d make $10,000-$20,000 in a second. In trying to make their quick profits, they also provide more liquidity in the market, even for that moment.
While HFT has been around for many decades, the game became popular after the 2008 financial crisis when exchanges began to offer incentives to trading firms (market makers) to add liquidity to the market. The New York Stock Exchange (NYSE), for example, has a group of liquidity providers called Supplemental Liquidity Providers (SLPs), which are there to add competition and liquidity for existing quotes on the exchange. The NYSE pays these firms a rebate, as an incentive, for providing the required liquidity.
So, high-frequency traders don’t only profit from price movements but also make money from rebates they collect from the stock exchanges for providing liquidity via market making — being available to buy or sell shares so that trade orders coming into the exchange can be quickly filled. While rebates are very small, — about $0.0012 per share — they add up quickly when millions of shares are involved. However, since high-frequency traders can take both sides of the same trade, it seems they are being paid for providing liquidity to themselves.
The history of high-frequency trading
It appears that HFT has been around for a long time, even right from the time when pit trading was the only thing. As early as the 1930s, some form of specialists and pit traders swiftly buy and sell positions inside the trading pit of the exchange using high-speed telegraph service to communicate with other exchanges. So, it was a sort of arbitrage trading then.
However, it was after NASDAQ introduced a purely electronic form of trading in 1983 that the rapid-fire computer-based HFT gradually came to life. While HFT trades had an execution time of several seconds at the beginning of the 21st century, by 2010, the execution time had reduced to milli-fractions of a second or microseconds.
In terms of market share and growth, HTF only accounted for fewer than 10% of equity orders in the early 2000s, but the market share grew rather rapidly. The trading volume for HFT grew by about 164% between 2005 and 2009, according to data from the NYSE. In 2009, high-frequency trading firms represented 2% of the approximately 20,000 firms operating in the US but accounted for 73% of all equity orders volume the U.S. markets.
Similarly, in 2010, the Bank of England estimated about the same percentages for the US market share and also suggested that HFT accounted for about 40% of equity orders volume in Europe and about 5–10% In Asia.
As HFT continued to develop and dominate the financial space, especially following the 2008 crisis, little was known about it outside the financial sector until recently. Now, some countries have introduced special taxes for high-frequency traders. For example, Italy became the world’s first country to introduce a tax specifically targeted at firms that employ high-frequency trading when, on September 2, 2013, it started charging a levy of 0.02% on equity transactions lasting less than 0.5 seconds.
Why engage in high-frequency trading?
As we have already stated, high-frequency trading happens in a few millionths of a second — just about the time it takes for a computer to process an order and send it out. This is only possible with the use of supercomputers and superior algorithms with artificial intelligence, which can scan markets for information and respond faster than any human possibly could, creating many profitable opportunities for the trader.
While there are many advantages to the institutional traders who employ the method, these are common ones:
- Short-term opportunities
- Arbitrage opportunities
- High volume trading
HFT allows institutional firms that can unleash it to leverage on short-term opportunities, which occur more frequently in the stock market. Their ultra-fast systems make them the first to take advantage of those opportunities before the rest of the market has a chance to respond.
For instance, a big trading firm liquidating one of its portfolios might mean pushing over a million shares of a particular company’s stock in the market, which can make the price per share decline — even if it’s for a short time until the market adjusts to huge volume. With their automated trading systems that are constantly monitoring the markets for such opportunities, high-frequency traders can take advantage of that decline, even if it happens just for a few seconds.
An arbitrage opportunity arises when there is a difference in the price of a security in different marketplaces, such that a fast trader can buy the security in the marketplace where it is cheaper and simultaneously sell it in the other marketplace where it is more expensive.
While arbitrage opportunities are theoretically possible, they are hard to come by in real-world trading situations for an average trader to take advantage of them. The reason is that most security prices are updated in almost real-time around the world because global information networks have become very fast and reliable.
However, even the slightest fraction of a second lag presents an opportunity to high-frequency traders because of the ultra-fast nature of the automated trading system used in HFT. For instance, if it takes 0.5 seconds for the New York market to update its prices to match those in Europe, euros will sell for more in New York than they do in Frankfurt within that half of a second because that is more than enough time for a trading algorithm to buy millions of dollars worth of a currency in one market and sell it for a profit in the other market.
High volume trading
Finally, HFT benefits from high trading volume because the profit per unit is actually very small. Since the process is automated, a high-frequency trader can take lots of trades with enough volume to profit off even the smallest differences in price. The sheer number of trades that a high-frequency trader makes would be impractical or impossible for a manual trader.
Common strategies used in high-frequency trading
While HFT is about using sophisticated computer algorithms to identify and take advantage of opportunities in the market, high-frequency traders make use of many different approaches. Some of the common strategies they use include the following:
- Market making: Most HFT firms are simply involved in market making, which is a high-frequency trading strategy that involves placing a sell limit order (offer) or a buy limit order (bid) in order to earn the bid-ask spread. In market making, HFT firms help to provide liquidity for incoming market orders. While the role of market-making used to be fulfilled by specialist firms (Supplemental Liquidity Providers), with the wide adoption of direct market access, any HFT firm can use this strategy to earn the bid-ask spread.
- Ticker tape trading: This strategy uses salient information in market data to determine trading opportunities. Of course, there is much information in market data, such as quotes and volumes, which cannot be easily discerned by the public. By monitoring the flow of quotes, HFT algorithms can extract information that has not yet crossed the news screens and act before everyone else. Since the information is public, the strategy is not against any applicable laws.
- Statistical arbitrage: This strategy exploits some predictable temporary deviations from normal statistical relationships among securities. It often involves classical arbitrage strategies, such as covered interest rate parity in the foreign exchange market that capitalizes on the difference between the prices of a domestic bond and those of a bond denominated in a foreign currency while considering the spot price of the currency and the price of a forward contract on the currency. This HFT strategy can be used in all liquid securities, including equities, bonds, futures, foreign exchange, etc.
- Index arbitrage: This strategy aims to exploit index tracker funds, which must buy and sell large volumes of securities in proportion to their changing weights in indexes they are tracking. By predicting these changes before the tracker funds do so, HFT traders can buy securities before the funds and then sell them to the funds at some profit.
- Event arbitrage: This strategy is based on certain recurring events that generate predictable short-term responses in some securities, which high-frequency traders can take advantage of to make some short-term profits.
- News-based trading: Since company news often comes in electronic text format via many sources, such as Bloomberg, public news websites, and Twitter feeds, HFT algorithms can scan the webspace for such information and make news-based trades before human traders can process the news.
- Quote stuffing: Quote stuffing is a kind of market manipulation that involves quickly entering and withdrawing a large number of orders in an attempt to flood the market, creating confusion in the market and trading opportunities for high-frequency traders. Some high-frequency traders (HFT) make use of the strategy, even though it is subject to disciplinary action.
The controversies: Is high-frequency trading ethical?
Now, the question: is high-frequency trading ethical? Well, there is no one answer for this. There are arguments in favor and against HFT. Let’s take a look at some of them.
Arguments in favor of HFT
Here are some of them:
- Liquidity: HFT is believed to provide liquidity to the market, making it possible for traders and investors to find opposite orders for their buy or sell orders at any time. With their huge volume of trades, HFT traders act as makeshift market makers who buy and sell when no one will. Since HFT constitutes a huge majority of the trading volume in a given day, it provides investors with a ready counterparty to take the opposite end of their trades at their desired price.
- Market efficiency: The efficient market hypothesis believes that stock prices already have all public and non-public information priced into them. By taking advantage of price discrepancies and arbitraging away any discrepancies, HFT contributes to market efficiency. Without those huge HFT orders that take advantage of the market’s inefficiencies and provide more liquidity to the market, there would be larger bid/ask spreads. Narrow spreads show that the market is more efficient.
- Reduced costs: Some would also argue that increasing liquidity and market efficiency may contribute to falling trading costs for smaller investors. For example, narrower spreads reduce the cost of trading for retail traders.
Arguments against HFT
Here are some of the criticisms against HFT:
- Momentary liquidity: The liquidity produced by this type of trading is momentary. It disappears within seconds, making it impossible for traders to take advantage of it. In fact, it is as if the liquidity is only meant for HFT firms that have the capacity to utilize them within those short moments.
- Market manipulation: HFT gives the firms that make use of it an unfair advantage and makes it easy for them to engage in market manipulations, such as quote stuffing. Computer algorithms can influence the market for the trader’s own advantage by creating false market activity to induce market participants into trading in a particular direction.
- Unfair to small investors: Even without outright manipulations, high-frequency trading is unfair to small investors as 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. So, small investors are not operating on an even playing field because they lack the resources to do so. They also are unable to see information as quickly as HFT computers. Arguably, this resource and informational imbalance create inequity.
- Flash crashes: HFT has been implicated in many flash crashes that occur in the capital market. An example is the one that happened on May 6, 2010, where the Dow Jones Industrial Average lost 998.5 points (about 9%) within minutes.
What do regulators say about high-frequency trading?
While the market regulators in major economies do not prohibit HFT and may not have plans to do that in the nearest future, they are obviously keeping a watchful eye on HFT firms. In 2012, Italy became the first country to introduce a special tax on high-frequency trading.
Also, regulators in different countries have some checks to prevent the negative effects of HFT. For example, in the US, they have circuit breakers to suspend trading if the market is moving abnormally in one direction. Furthermore, regulators are always eager to punish market manipulators, as can be seen in the case of Trillium Capital that was sanctioned by the FINRA.