High-Frequency Trading Explained (For Beginners)
From the phone calls to yelling traders on the exchanges’ pots to ECNs and electronic trading - in the last few decades, financial markets have transformed notably. The shift towards technology brought speed, efficiency, transparency and comfort for each and every market participant. High-Frequency trading was born.
We reached a stage where to think about trading without using a computer is basically impossible. Even more - today we do not measure trading times in minutes like in day trading. Instead, we execute trades in fractions of a second.
All this paved the way for a new market environment and the total reshaping of the existing structure.
High-Frequency Trading – The Technology Behind Every 2nd Trade
High-Frequency Trading is a subset of algorithmic trading that is based on a high-speed trade execution. Or in other words – orders are opened and closed in fractions of a second.
Although based on the same principles, High-Frequency Trading is different to algorithmic trading in the regard that it requires significant investments in infrastructure, colocation rights and data feed products, in order to ensure a lightning-fast trade execution process that provides the given company with a competitive advantage.
Today, High-Frequency Trading is responsible for more than 50% of all trades. During the last two decades, High-Frequency Trading has become a dominant factor for the way financial markets operate.
Nowadays, it is so embodied in the market structure that it becomes impossible to think how the financial system will function without the high-speed traders.
How High-Frequency Trading Has Become Some Dominant
As soon as the technology took over the financial markets, things started to change at an unseen pace. The trading process soon became digital. From that moment, it was all about speed.
Companies and exchanges tried to optimize the whole process and cut the time needed for trade execution. This lead to the formation of Electronic Communication Networks (ECNs) which slowly, but steadily set the stage for the birth of an advanced breed of traders.
“The main benefit of ECNs was their ability to synchronize the time of investors’ arrival at the trading platform. They enhanced the trading process by matching buy and sell orders.”
These new traders were focused on the constant process of buying and selling instruments without keeping them overnight. With the technological development and advanced computational power, the trading process became faster and more efficient.
High-Frequency Trading in its current form appeared for the first time in the years prior to the Global Financial Crisis. The first signs of sensible high-frequency trading activity were the increased daily trading volume and the more frequent fluctuations in the prices of some instruments.
High-Frequency Trading Nowadays
Today, the industry has reached its maturity. In the last few years, due to the ever-increasing competition, rising trading costs and constant regulatory developments, it has gone through a major consolidation.
Currently, there are a few bigger players that run the industry like Virtu Financials, Citadel Securities, Flow Traders, Hudson River Trading, Jump Trading, Optiver, Quantlab, TradeBot Systems, etc. High-Frequency Trading companies vary in their size, trading strategies, and type as some of them are public, while the majority are propriety.
No matter whether it is a propriety or a public company, all high-frequency trading shops are similar in the regard of their main goal – to outmuscle their competitors and execute as much trades as possible.
In order to achieve that, high-speed traders focus on investments in new infrastructure that allows them to speed up the trade execution process. Currently, the speed at which trades are executed is measured in milli- and even microseconds.
With the introduction of microwave networks and high-performance chips, the process will become even faster.
Although the technology is evolving, High-Frequency Trading companies are not having the best times in terms of profitability right now. In the years up to 2010, the industry was booming.
Due to the increasing competition and the rise in trading costs, some companies were forced to shut down. This basically limited the opportunity for new firms willing to enter the market, thus making the industry a level-playing field only for the biggest and the strongest among them.
Although the noticeable decline in the profitability of High-Frequency Trading companies, high-speed traders remain responsible for more than 50% of the daily trading volume.
This makes them systemically important for the overall condition of the market. The truth is that markets, as it has been proven many times, can be easily destabilized by High-Frequency Trading activity and the aggressive trading strategies that high-speed traders usually employ.
High-Frequency Trading Strategies
In general, the strategies that high-frequency traders apply are focused on capturing small profits from a large number of executed trades.
Their speed and technological advantage allow them to place a large number of orders and front-run other market participants.
That way, they can buy a certain instrument and sell it back to the next one in the queue at a higher price, thus pocketing the difference.
Here are the most popular trading strategies that high-frequency traders apply:
There are separate types of arbitrage-based strategies. Yet, all of them have one and the same idea – to exploit existing gaps in the pricing of certain instruments.
Thanks to the extreme speed at which high-frequency traders can place and execute orders, an instrument can be bought and sold just before a price correction takes place.
Statistical arbitrage is one of the most popular and widely applied High-Frequency Trading strategies.
By trading on separate markets simultaneously, the high-speed traders can take advantage of the price difference of one and the same instrument at different venues.
For example – if the “AAPL” stock is trading at a lower price at NYSE, high-frequency traders can buy it from there and sell it on another exchange where the price is higher.
That way, thanks to their speed, they can capture a small profit from the price margin with no risk.
The Scalping strategy is a great example of a whole subclass of strategies, built around the idea of capturing numerous small profits throughout the whole trading session, instead of having less but bigger profitable trades.
Whenever there is a change in an instrument’s price, high-frequency traders jump on and trade it, no matter whether the movement is bearish or bullish.
Their main goal is to capture a small difference. By executing a strategy like this numerous times per day, the high-speed traders can significantly increase their overall returns.
The Scalping strategy is very effective in times of high volatility when there are more natural price movements.
The other main class of strategies, preferred by high-frequency trading companies, is based on some form of market manipulation. Momentum Ignition is a great example of that.
The idea behind it is to create a market momentum by submitting a large number of orders without any intention for them to be executed.
Thanks to their significant speed, high-frequency traders can form price deviations and exploit them when the price gets back to its normal levels. For example – if the High-Frequency Trading generate a large selling interest in a certain stock, they can drive its price down.
Then, they can easily buy it and hold it until there is a correction. The instrument is then sold and the artificial price fluctuation results in a good profit.
The process of submitting and withdrawing large portions of orders without execution is also known as “spoofing”.
There are plenty of other high-frequency trading strategies, but what is similar between all of them is the fact that they are built around speed and the ability to get ahead of other market participants.
How Does High-Frequency Trading Affect the Market
When it comes to High-Frequency Trading, the most controversial part is the way it affects the markets and other investors. The technology has both – critics and supporters.
There are plenty of studies, many of which point cannot come up with a concrete conclusion whether the high-frequency trading activity is positive or negative for the market. Yet, most of them are pretty clear on the topics of:
The truth is that high-frequency traders usually thrive in periods of high volatility. When the markets are calm, in order to increase their profit opportunities, high-frequency traders try to generate artificial price fluctuations.
Numerous studies, the first of which dates back to 1927, have come to the conclusion that the high-speed trading activity corresponds to increased price instabilities.
When it comes to liquidity, the high-frequency trading activity is proven to be contributing positively. Due to their market-making role and constant involvement in the trading process, high-speed traders are providing liquidity to the other market participants.
Apart from that, many research papers, such as Hendershott et al (2011) and Litzeberger et al (2012) point out that high-frequency traders help narrowing the spreads for certain stocks. But many experts suggest that this is the case only when markets are calm.
When things go wrong, high-frequency traders are often accused of the opposite – to consume liquidity in order to avoid losses. Due to the fact that HFTs liquidity provision is unstable, it is also referred to as “ghost liquidity”.
Market transparency and the other investors
Some of the most popular High-Frequency Trading strategies are built around the idea of submitting and canceling large portions of orders so that a certain instrument’s price can be manipulated. Such actions result into fake illusions about the buying and selling interest.
This can confuse other investors and have a particular effect on the large players in the industry as they cannot tailor their strategies to the real supply and demand on the market.
Apart from that, High-Frequency Trading is known to minimize the spreads and decrease the trading costs. While the first part is true, the second one is a little bit controversial.
When market participants are being front run by high-speed traders, they are basically unaware of the hidden trading costs that they are charged as they are buying instruments at higher and selling at lower prices.
One of the most prominent examples of the harmful effect that high-frequency trading has on the stability of the market is the so-called “Flash Crash”. On May, 6th 2010, for just 36 minutes, the DJIA lost almost 1000 and regained approximately 700 basis points.
Later on, a CFTC report confirmed that it was the high-speed trading activity that was responsible for the market crash. During this 36 minutes, numerous large-cap companies were traded down to pennies, while others stocks’ price exploded.
Numerous research papers, such as the one from the Joint CFTC - SEC Advisory Committee on Emerging Regulatory Issues (2010) and many others, confirmed that the high-frequency trading activity can cause market instabilities and even periodical flash crashes.
High-Frequency Trading: Pros and Cons in a Nutshell
Narrowed bid-ask spreads
Hidden trading costs
Manipulation of the real supply and demand
The Future of the High-Frequency Trading Industry
Although the industry has matured, it is no secret that some companies seek additional ways of optimizing their trading strategies and gaining competitive advantages.
With the advances in artificial intelligence and the ever-increasing accuracy in trading bets, the high-speed traders are expected to become even more dominant in the short-term future.
In terms of speed, the microwave towers that are starting to pop up here and there are another sign that the industry is looking to develop further.
Companies try to additionally decrease the latency, as well as improve the performance of their algorithms so that they can remain competitive within such a hostile industry.
Yet, the main thing that will reshape the future of the industry does not come from within. In fact, it is the regulatory measures that will be decisive for the way high-frequency trading companies will continue to operate. If legal cases against scalpers and predatory traders become more common, HFTs will have to rethink their strategies.
Apart from that, exchanges also can affect the future of the industry. Given that more trading venues follow IEX’s example of introducing a speed bump, then high-frequency traders will lose one of their key advantages – the speed.
In fact, NYSE also introduced such measures in an effort to tackle high-speed predatory traders. But until such actions become more common, High-Frequency Trading will remain the force that shapes financial markets in their current form.
High-frequency trading is a phenomenon that transformed financial markets completely. Like every other disruptive technology, it has its supporters and critics.
The opposing side suggests that High-Frequency Trading has absolutely no social impact and acts in total dissonance with the primary function of financial markets – to raise capital.
Although this might be the case, the truth is that the high-speed traders are taking advantage of the gaps in the existing market structure.
They learned to act that way because they were allowed to. Unless these gaps are fixed, High-Frequency Trading will remain the dominant force on the markets nowadays.
Private investors come closest to the idea of high-frequency trading by using a fast trading computer, ensuring access to a high-speed network, using Artificial Intelligence-based trading strategy development algorithms such as those of Trade Ideas and using an API to execute buy and sell orders automatically.
In addition, a very cheap and API connectable brokerage account is essential for successful high-frequency trading.
One thing private investors should keep in mind, however, is that scalping for trading profits of 1 cent cannot be implemented and will be denied to companies that have their own supercomputers very close to the data centers of the exchanges and receive credits from the exchanges for providing liquidity.