The term High-Frequency Trading or HFT refers to a specific trading practice while trading stocks, where many trade orders are placed and executed at an extremely high speed. It is characterized by a huge number of transactions, a short-term investment horizon, and high-speed trade execution. It makes use of different algorithms for the analysis of multiple markets and executes trade orders in a way that produces the most gains. Due to the widespread accessibility of the highest speed execution and data services, High-Speed trading is used by a number of different individuals and institutions, including banks and hedge funds. However, even retail and instructional investors can access this type of trading through their broker-dealers and certain trading platforms.
HFT accounts for a large proportion of trading volume across security markets currently. There are many proponents in the current market that speak in favor of high-frequency trading. They point out the potential of traders profiting from every small price fluctuation and enhanced liquidity in the market. This trading method clearly enhances the competition in the market, as trades are executed faster, resulting in a significant increase in their volume of trades. The resultant increased liquidity can force the bid-ask spreads to decline, making the market price efficient in the process.
How Does One Make Money From High-Frequency Trading?
As mentioned before, HFT requires you to use algorithms that can find new trends across global markets. It then automatically trades them before other players have the opportunity to cash in. By harnessing advanced technology, traders can essentially place large volumes of trades spread across different markets. This increases the gain potential on transactions, which would normally have very fewer profit margins. As the success of HFT depends heavily on size and speed, better technology can significantly impact how much gains one would receive.
However, the various companies and organizations, barring a few, have mostly negative reputations in the market. Traders often view them as nothing more than rogue market players trying to get ahead of their peers at any cost. It is unlikely that public perception around this niche industry will change any time soon, especially since the emergence of various frauds and scams in this space.
Risks Associated With High-Frequency Trading
Many traders view HFT as a controversial model as it strips out the human element in the decision-making process. Here trades take place within a blink of an eye, creating sudden flash highs and troughs in the market without any obvious reason. Additionally, there are some other risks added for cohesion associated with this type of trading.
There are some who link HFT to increased market volatility and even some major market crashes in recent times. There have been instances of regulators catching traders engaging in illegal HFT involving market manipulations such as layering and spoofing. For instance, the Flash Crash of 2010 was largely caused by excessive market volatility as a result of high-frequency trading.
Another accusation that some have levied on HFT is that it creates ghost liquidity in the market. They point out that the liquidity, in this case, is not real as the securities in question are held by traders for mere seconds. Security is traded multiple times among high-frequency traders before it reaches a regular investor. By the time a traditional investor places an order, the liquidity generated largely decreases.
High Sharpe Ratio
The nature of high-frequency traders is such that they rarely hold their portfolios overnight. They also do not accumulate a lot of capital and establish short-term holding before they liquidate their positions. This causes the Sharpe Ratio or the risk-reward ratio to rise rapidly. It is much greater compared to that of a traditional investor who has a long-term strategy in place.
High-Frequency Trading Strategies
Trading firms that engage in this type of trading employ different trading strategies that vary according to the end objective and the underlying philosophy. They can be classified into numerous groups, such as the following.
Automated High-Frequency Trading Arbitrage Strategies
HFT arbitrage strategies aim to capture pricing inefficiencies in the same manner as statistical or traditional arbitrageurs. However, their ability is bolstered if you have faster data feeds regarding trade executions and orders. Traders who employ this strategy usually have high-speed connections to markets that allow them to enter and exit positions quicker compared to the past. This trading strategy is beneficial for investors as it assures them the prices of ETFs or futures accurately reflect the prices of the underlying assets. This allows them to enter and exit their position in a timely manner at the right price.
High-Frequency Execution Strategies
Execution HFT trading strategies focus on executing large orders of various institutional players without significantly impacting the price.
Some of the strategies that fall under this category include:
- Time-Weighted Average Price Strategy. This strategy is used for purchasing and selling huge numbers of shares without having any effect on price.
- Volume-Weighted Average Price Strategy. This is the ratio of the value traded to the total volumes traded over a particular time period. This HFT strategy is mainly used to execute large orders at a better average price.
Market Making Strategies
Market Makers have to first establish a quote and keep on updating it as a response to other order cancellations or submissions. The main strategy here involves submitting and canceling a huge number of orders for each transaction.
Contrary to what many people believe, the HFT market is not an unfair one. The strategies used in these markets are consistent with the ones used in existing securities markets and are fundamental components of the market. The ability to constantly update prices and high-speed order execution has allowed traders to improve upon these traditional trading strategies. That being said, the competition is really high among HFT traders, and margins are pretty low.