High-frequency trading

July 27, 2023
10 MIN READ
51 VIEWS
High-Frequency Trading (HFT) is contentious. According to some investors, it allows individuals to capitalize on chances that pass rapidly. Others argue that HTF skews markets by processing huge orders in fractions of a second. However, algorithms are used in this trading approach to scan different markets and locate investment possibilities depending on those variables. Consider working with a financial expert to help you establish an investment plan that meets your objectives and goals if you need assistance choosing an investing approach. Let us examine if high-frequency trading is an appropriate investing approach for you.

What is high-frequency trading?

High-frequency trading, or HFT, is an approach to trading that uses sophisticated computer algorithms to execute many transactions in fractions of a second. It analyzes several markets and executes orders depending on market circumstances using complicated algorithms. Investors with the quickest execution speeds are often more lucrative than dealers with slower execution rates. In addition to rapid order speeds, HFT is distinguished by high turnover rates and order-to-trade ratios. Tower Research, Citadel LLC, and Virtu Financial are some of the most well-known HFT businesses.

Perceiving high-frequency trading

High-frequency trading (HFT) uses specialized software and pricey computer gear to analyze market movements. The computers perform automated transactions based on the data gathered. These acts are performed quicker than any person could. Traders create automated methods that specify how the program selects investments. This automation, among other things, determines the amount of risk. This allows operators to personalize the procedure.

These operations use advanced algorithms to detect market patterns, concentrating on those with growing prices. Trading a large volume of assets allows investors to make large gains even if the price increase is not substantial. The technique is effective since the algorithms can understand supply and demand rules and respond quicker than others. Naturally, this increases their profits. SEC has established five criteria for this kind of transaction:

·       Employing multiple servers to reduce delay as much as feasible.

·       Effectively obtaining and liquidating holdings.

·       Extremely fast execution of orders on trading systems.

·       Always attempting to conclude the day without having assets. Everything that is purchased is promptly sold.

·       Multiple orders are placed at the same time, but a number of them are quickly cancelled.

The relevance of high-frequency trading

High-frequency traders may execute deals in less than one 64 millionths of a split second. This is about how long a computer takes to complete and transfer an order to another machine. Their automated technologies enable them to search markets for data and reply more quickly than any person could. They execute deals in less time than it takes a human brain to interpret new data on a screen (much alone physically input new trade instructions into their system).

This generates several financial advantages for the investor, but three specifically stand out:

i.   Volume investing

This approach enables traders to benefit from many deals that would be hard or impossible to execute manually. A high-frequency trader may use automation to execute enough deals in sufficient volume to benefit from even the tiniest price variations.

ii.   Opportunities for the short-term

High-frequency trading helps investors take advantage of openings in the stock market for a limited time. It also allows them to be the first to capitalize on such chances before prices react.

iii.   Opportunities for arbitrage

Arbitrage occurs when you profit from the same item having two different prices. Nevertheless, arbitrage chances are few in most practical applications of trading circumstances. Due to the speed and stability of worldwide data networks, most prices change in near real-time throughout the globe.

Nonetheless, the mantra is "practically." High-frequency trading enables investors to profit from arbitrage opportunities for a fraction of a second. Assume the New York market updates its pricing every 0.5 seconds to reflect those in London. Euros will be worth more in New York than in London for a fraction of a second. It is plenty of time for a computer to purchase millions of dollars of money in one place and profitably sell it in the other.

The positive aspects of high-frequency trading

Aside from the advantages to the individual investor, numerous investors think that high-frequency trading increases both accessibility and economic stability. Proponents argue that this is because high-frequency trading might swiftly link sellers and purchasers at the cost each prefers. (This is known as the bid-ask spread; it is the variation between the amount a buyer intends to "bid" and the amount that the seller "asks" for an item.)

Like other computerized traders, high-frequency traders design their algorithms around the financial positions they want to take. It implies that as soon as an asset reaches an investor's bid price, it will be purchased, and the reverse is true for vendors with already set ask prices. It eliminates inefficiencies, which occur when traders are unable to connect. High-frequency trading, proponents argue, accelerates this process by allowing sellers and purchasers to meet their mutual bid and ask prices significantly more frequently than they would ordinarily.

Many supporters of high-frequency trading say that it improves market liquidity. HFT promotes market competitiveness since deals are done quicker, and the number of trades grows dramatically. Higher liquidity reduces bid-ask spreads, rendering markets more price effective.

A liquid market has less risk since somebody is always on the opposing side of a trade. Furthermore, as liquidity grows, the cost a seller will likely sell for and the value a buyer is prepared to pay will become more similar. A stop-loss order, which ensures that a trader's position closes at a set price and prevents additional loss, is one strategy for mitigating risk.

The potential risks of high-frequency trading

High-frequency trading is still contentious, with little agreement among regulators, financial experts, and academics.

High-frequency traders seldom retain their portfolios overnight, only collect a small amount of cash, and only hold for a short period before selling their position. Consequently, the Sharpe Ratio, or risk-reward ratio, is quite high. The ratio is substantially higher than that of the traditional long-term shareholder. A high-frequency trader may only earn a fraction of a penny, which is everything they need to generate profits throughout the day, but it increases the likelihood of a huge loss.

One of the most common criticisms against HFT is that it produces "ghost liquidity" in the market. Opponents of HFT argue that the produced liquidity is not "real" since the financial instruments are only kept for a few milliseconds. The security has been exchanged several times among high-frequency dealers before a typical investor purchases it. The tremendous liquidity produced by HFT has essentially ebbed away by the time the normal investor makes an order.

Additionally, it is assumed that high-frequency traders (big financial institutions) often benefit at the cost of market participants who are lower in size (smaller financial organizations, individual traders).

Lastly, high-frequency trading (HFT) has been related to higher market fluctuations and even market collapses. According to regulators, some high-frequency traders have been detected participating in unlawful market alterations like masquerading and layering. It was shown that HFT significantly contributed to the high market volatility seen during the Flash Crash in 2010.

Market influence and ethics

Some experts dislike high-frequency trading because it offers huge corporations an unfair edge and unbalances the playing field. It may also damage other investors with long-term plans and purchase or sell in large quantities. Critics also contend that developing technology like computerized trading, which began in the early 2000s, contributes to market volatility. Small and major collapses may be exacerbated when such technologies bulk liquidate their assets in response to certain market indications.

Some European governments seek to prohibit high-frequency trading from reducing volatility and, eventually, to avoid tragedies like the 2010 US Flash Crash and the Knight Capital collapse. Algorithms may also be written to make hundreds of orders and cancel them seconds later, causing a temporary price increase. Taking advantage of such deceit is commonly seen as unethical and, in some cases, illegal.

Techniques for high-frequency trading

Trading firms that depend on high-frequency trading use a variety of tactics to increase their chances of profit. Most businesses keep their plans tightly hidden. They are covert because enabling others to comprehend their technique fully would enable them to use the same features of the economy to win, perhaps lowering their profits. The distinctiveness of each organization's strategy is what distinguishes them from competitors.

Nevertheless, most organizations are well-known for focusing on various types of arbitrage, effectively purchasing an item for a lower price to sell later. They purchase assets when the price is increasing and sell them quickly. In this approach, fluctuation assists high-frequency dealers in making a large gain in a short amount of time.

Volatility arbitrage, index arbitrage, and merger arbitrage are some of the tactics used by these firms. Non-arbitrage tactics, like trading from both sides, are also popular among traders. They use both sell and purchase bids to shift the market in a particular direction and benefit from the price difference.

Market making is setting a limit offer to sell or a limit purchase order to profit from the bid-ask spread. They fix their sell prices somewhat higher than the current market price and their purchase prices slightly lower. Participants for new market orders are market makers. They earn on the gap between the bid and ask prices. High-frequency dealers who are market makers are also paid a fraction of a penny for each transaction in exchange for contributing liquidity to certain exchanges and electronic communications networks (ECNs). Fractions of a penny compounded from millions of deals build up to a substantial sum.

On the other hand, other investors seek price differences in the assets. The program detects price discrepancies in identical assets and purchases them in the stock market where the cost is cheaper. The assets are then sold nearly instantly in marketplaces where they are valued higher. Rapidity is a prerequisite to a profitable outcome with all of these tactics. Computers do not require minutes to operate; they can notice patterns and place orders in seconds. They have a significant edge due to their superhuman speed.

What is the speed of high-frequency trading?

The key benefit of HFT is that it is quicker than any human trader. Essentially, transactions may be performed in milliseconds using software. It offers businesses an advantage over their competitors.

The precise pace varies on several system peculiarities, but transactions are instantly completed. The software can start and complete positions in under a minute. The system additionally evaluates market data in less than a minute. This type of evaluation would take hours to complete by a human professional. It paves the way for more revenues. Dealers use this speed to exploit a disparity between supply and demand to strike at the right moment and profit while holding the assets for a short period.

Is it acceptable to trade so quickly?

It is hard to examine high-frequency trading without considering its ethical debate. Proponents of the technology often claim that it provides an unfair edge to corporations with the money to invest in it.

If two trading businesses, one small and one large, can only afford to pay servers to install an effective HFT system, they would compete in the same market but get varying results since only one of the two has these specialized tools.

When it involves the law, though, everything is fair game. Regulators throughout the globe are concerned about the potential for this technology to be exploited to influence the market. The concern is that outstanding traders can trade at a rate no other dealers can match.

What is the problem with high-frequency trading?

There are a few issues with HFT. In today's diminishing tide of markets, HFT is accused of magnifying both the share market drops and the increased volatility. HFT increases the negative effects of trading-related blunders, abruptly reducing liquidity. HFT activity highlights worries about the financial markets' sustainability and vitality.

Conclusion

High-frequency trading advocates argue that it helps markets quickly identify stable, effective values. They suggest this is especially important for individual investors who lack the time and quickness to place orders on these chances. Critics, on the other hand, argue that high-frequency trading disrupts the markets. Financial institutions with access to sophisticated computers may exploit this faster-than-human pace to carry out trade orders that only have a temporary advantage and may impact the market's response to transactions that have relied more on this automated trading strategy than on market values.