Everything About High Frequency Trading (HFT)

In recent times, high-speed computerized trading, or high-frequency trading has elevated dramatically in the financial markets. 

 

From a small niche practice in the financial market to becoming an extremely powerful trading platform, HFT accounts for a major volume of US and UK based equity markets and now is spreading its reach in growing markets of Europe and Asia. 

 

Some evidence shows that HFT has added efficiency in the financial market, but sometimes also adds instability in the market greatly. However, it is uncertain how HFT produces these outcomes that generates a controversy encompassing its existence.

 

This is an introductory article discussing the concept of HFT in terms of definition, advantages and risk associated with it. 

 

Discussing High Frequency Trading (HFT)

 

Putting things into perspective, in order to conduct securities trading, high-frequency trading deploys powerful computers incorporating speedy connections with multiple exchanges. These computers can execute enormous amounts of transactions simultaneously in fractions of a second. 

 

HFT is immensely employed by investment banks, hedge funds, investment funds, and institutional investors and has become a very common entity in the market by introducing incentives for financial institutions, awarded by exchanges to add feasible liquidity in the respective market. 

 

Awarding minor incentives to market makers supports exchanges to embrace added liquidity, and financial institutions providing the liquidity also gain profits on every trade they could make. 

 

High-frequency traders make their money on any disproportion amid supply and demand with the utilization of arbitrage and frequency of their advantages. These trades excessively rely on possibilities that make impacts rather than fundamental research about the company or the growth assets of the company. 

 

However, high-frequency trading also faces some criticisms as unethical trading or providing unequal advantages to large enterprises than small scale investors and institutions. 

 

HFT traders offer liquidity to markets as well as make volatility moderate and total transaction costs low. The platform also contributes to reducing spreads significantly. The enterprises utilizing HFT must ensure the enactment of the latest emerging technologies in order to maintain low latency to remain competitive. 

 

Thus, HFT serves as a critical player in functioning and efficiency of capital markets with enormous economic benefits. But with technological advancement certain risks such as an expanded volatility, technical errors, extensive feasibility in capital markets etc, can be neglected. 

---

---

 

Objective

 

Aimed to leverage minor discrepancies in price and trade on them in huge quantities, HFT practices computer systems to make various transactions at cosmic speed. 

 

As long as computers are becoming more technologically advanced, trading practises have been expanded and algorithms have become more complicated. This is how AI algorithms benefit trading hugely.

 

As the trading is conducted at the speed of light, HFT companies are shifting server fields near to computer exchanges in order to increase the speed of trading. These companies scheme a variety of strategies for leveraging various market scenarios. 

 

Algorithms trade over prive movement at a certain threshold, corporate activities, price ceilings and floors, disparity between bid-ask spreads while trading are done without human involvement except the initial programming. Even in most of the cases, trades are executed earlier than any individual investor came to know the quotes of prices. 

 

For example, a computer identifies very fluently when an exchange quotes a price 1% more than the quote of another exchange. After that, the computer trades at large scale using this information- simply takes benefit from the arbitrage moment at the blink of an eye. 

 

Once the individuals or investors realize, this 1% spread is erased between two exchanges and stock prices start to trade at a constant rate. (Source)

 

Advantages of HFT

 

1. HFT coupled with other trading of securities facilitates global traders to benefit from every minute price variation. 

 

For instance, HFT enables financial institutions to touch maximum return on bid-ask spreads. 

 

2. In general, trading algorithms can scrutinize various markets and exchanges globally and support investors and traders to explore sufficient opportunities. 

 

For example, to identify small differences in arbitraging prices for the same asset that is trading across many exchanges.

 

3. Many argue that HFT boosts up liquidity in the market as well as originates high competition as trading is occurring at a higher speed and thus the number of trades also increases. 

 

Increased liquidity leads to decline bid-ask spreads and makes the global market more price-efficient. 

 

4. A liquid market faces less financial risk associated with it due to the hold of proponents on the other side of a position. However, these risks can be tackled with various strategies. 

 

As discussed in Corporate Finance Institute, for example, a stop-loss order approach that makes a surety “ a position of a trader will end at a particular price and restrain extra loss.

 

(Similar reading: AI in Trading & Stock Market)

 

 

Risks of HFT

 

• High-frequency trading always surrounded with controversies, or accounted as controversial practice, there is a minor disagreement about HFT among investors, financial experts and professionalists.

 

What traders do actually, they usually don’t keep their portfolio for a short-term, in fact they collect minimal capital and introduce holding for a tiny frame of time before liquidating their positions.

 

Consequently, the risk-award becomes high, the sharpe ratio (a measure of risk-adjusted return of a financial portfolio) then is particularly high for investors who would have invested along with everlasting investment practices. 

 

For an indefinite time period, high-frequency traders could gain a fraction of 1 %, this is what they could make profit throughout the day. This, in turn, sometimes also increases the possibility of huge losses significantly.

 

• One other risk with high-frequency trading is that it produces “ghost liquidity” across the market. Sooner the HFT adversary notices the authenticity of liquidity, “created liquidity is not real as the securities are stood up for a few seconds”.  

 

By the time an investor could make a purchase of a security, it has been traded several times. Before an investor places an order, the colossal liquidity generated by HFT has already fallen deeply as this is ghost liquidity.

 

• Bitter but certain fact, it is highly likely that high-frequency traders, for example large financial bodies, gain huge profit at the cost/expenses of low-scale financial institutions or individual investors.

 

• Another pitfall comes when extended market volatility and huge-scale market crashes get associated with HFT. In continued observation, market regulators catch that high-frequency traders are involved in illegitimate activities in terms of market manipulation such as spoofing and layering. 

 

A flash crash in 2010 was proved to be the result of HFT contribution in the extreme market volatility. 

 

Conclusion

 

Despite such a fascinating zero-sum game, HFT remains a contentious model challenging human decision-making efficiency.

 

When trading occurs at rapid counts, the HFT continues to create active fluctuations- sometimes without warning and sometimes without an actual reason, a single wrong trade could end up in huge loss of millions of dollars within a second.

 

With the acceptance of the fact that the global capital market has evolved a lot over the years, what we are observing now is the result of multiple spontaneous processes, and there are ample possibilities that high-frequency trading booms the market. 

 

Till then, we could learn and assimilate best possible practices to figure out how things unconsciously criticize or approve the hitting note of HFT as there is opportunity to misuse of HFT that could result in severe consequences.

 

(Must read: Effective trading principles)