What Is High-Frequency Trading

While some traders choose to pour over computer screens for hours every day, others utilize complex algorithms to analyze the market and execute trades. High-frequency trading occurs at incredibly fast speeds, faster than an average human can do. As a result, some investors may wonder, “What is high-frequency trading, and how does it affect me?”

What Is High-Frequency Trading?

High-frequency trading or HFT is an automated trading platform and one type of algorithmic trading. This platform utilizes powerful computers and sophisticated algorithms to analyze the market, identify emerging trends, and place a large number of orders at remarkably high speeds. In theory, this computer system would be able to scan multiple markets and execute millions of orders in a matter of seconds. If the algorithm is written correctly, high-frequency trading may generate high profits faster than a human trader can. Thus, potentially affecting your day trading success rate.

In “Real‐Time Risk: What Investors Should Know About FinTech, High‐Frequency Trading, and Flash Crashes” (Wiley 2017),  Aldridge and Krawciw estimated that high-frequency trading initiated between 10  to 40 percent of trading volume in equities as well as 10 to 15 percent of volume in foreign exchange and commodities in 2016. High-frequency trading has become commonplace in the stock markets.

Although there is no official definition of HFT, the Securities and Exchange Commission (SEC) identified key characteristics of this type of trading. For example, a hallmark of HFT is its: “extraordinarily high speed and sophisticated programs for generating, routing, and executing orders.” This trading style also does not hold significant unhedged positions overnight and typically only hold a position for a very short time-frame.

Hedge funds, institutional investors, and large investment banks typically use high-frequency trading. This trading strategy is not based on fundamental research about a company’s earnings or financial metrics, but instead, find opportunities to strike using ultra-short-term strategies and capitalizing on the imbalance between a stock’s supply and demand.

Advantages of High-Frequency Trading

There are distinct benefits of high-frequency trading.

Higher Market Liquidity and Smaller Bid-Ask Spreads

High-frequency trading adds liquidity to the market, which results in smaller bid-ask spreads. High-frequency traders often act as market makers or the middleman between buyers and sellers. They buy and sell securities in large volumes to fulfill trades that other people place, thereby meeting liquidity demands.

Since HFTs increase competition and can offer faster execution of trades at a lower price, the bid-ask spread is reduced. As a result, high-frequency trading makes the market more price-efficient.

Access to the Market

HFTs have direct access to the market and do not need to go through a broker to place trades. The computer system looks on all available exchanges for the best price for a given stock and can then choose to buy or sell. It eliminates the need for a broker.

Speed

High-frequency trading platforms can find and execute trades in a matter of seconds. This speed is a distinct advantage over other investors. The algorithm or computer program filters through multiple markets and exchanges for the right scenario where all the conditions of a predetermined set up are fulfilled. Then, the platform will automatically execute millions of orders. This process is done faster than a human ever could.

Risks and Criticisms of High-Frequency Trading

High-frequency trading is a controversial topic with risks and has been met with some harsh objections.

Ghost Liquidity

While many advocates for HFT believe that it increases liquidity, a major complaint is that it only creates ghost liquidity. Since high-frequency traders only hold securities for a few seconds, the liquidity is not “real.” By the time a regular investor can execute his buy order, the security has likely already been traded multiple times between other high-frequency traders. As a result, some critics of HFT claim that large companies that use high-frequency trading profit at the expense of the individual smaller investor.

Removes Human Decision and Understanding

High-frequency trading’s primary limitation is the inability to reflect on geopolitical and global economic events. These computer systems use mathematical algorithms and models to execute trades, completely eliminating the human component. Coupled with his lightning-fast ability to execute trades, HFT can cause enormous market moves and volatility without any reason.

2010 Flash Crash

The 2010 “Flash Crash” occurred on May 6, 2010, when the New York Stock Exchange witnessed its biggest stock plunge in decades. While HFTs did not cause the Flash Crash but contributed to the extraordinary market volatility that caused the Dow Jones Industrial Average (DJIA) to fall nearly 9 percent in 20 minutes, the most significant intraday point decline in its entire history.

High-frequency trading exploited the short-term imbalances in the market at the time. Under normal market conditions, this type of trading would not have caused a directional price move. However, at that particular moment when the market was stressed and prone to elevated volatility, HFTs exacerbated the Flash Crash. A U.S. mutual fund that used an automated algorithm initiated a large sell order that led to a liquidity-based crash by sparking a flurry of buying and selling by other HFTs, accounting for 49 percent of the total trading volume.

Knight Capital’s Trading Software Glitch

On August 1, 2012, Knight Capital, a trading firm, launched a new trading program that cost the company $460 million in 45 minutes. Due to an error in the trading program, the firm’s computers continued to buy and sell millions of shares in over a hundred stocks after the market opened. The volume of these shares pushed the value of the stocks up, but the company took significant losses as it tried to sell the overvalued shares.

Knight Capital lost millions of dollars every minute before the program could be stopped. Knight Capital’s financial losses are a clear example of the inherent risks of high-frequency trading executed by computer software. The Securities and Exchange Commission fined Knight Capital $12 million for violating trading rules for failing to establish sufficient safeguards in place to prevent the sudden blast of erroneous stock orders that disrupt the market.

The Future of High-Frequency Trading

With the market crashes that have occurred over the years with global implications, regulators have advocated for more rules and protections to protect the market. For example, the SEC approved NASD Rule 1032 (f) that requires individuals involved in the development of trading algorithms to pass the Series 57 exam and register as a Securities Trader.

The investigation and resulting fine on Knight Capital were the first time the SEC applied the market access rule against a trading firm. The market access rule initially only required brokers and dealers with direct access to American exchanges to put safeguards in place. However, this rule may now be used to enforce fines against other trading firms with technology failures. Additionally, the Knight Capital incident prompted the SEC to create additional regulations on market makers.

In 2014, the SEC charged its first high-frequency trading manipulation case against the New York City-based frequency trading firm, Athena Capital Research. The investigation found that Athena violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 by attempting to manipulate the market. The algorithm, code-named Gravy, was designed to buy and sell near the close of trading to influence the closing price. Athena agreed to pay a $1 million penalty to settle the SEC’s charges for market manipulation.

Some regulations currently being considered propose bans on certain HFT and algorithmic trading strategies as well as a possible transaction tax for every trade executed. Given the enormous number of trades that HFT firms execute, these levies would raise the cost and therefore discourage the use of HFTs.

Despite fines and new regulations, high-frequency trading continues to grow and is likely a natural step in the evolution of markets. New rules can help provide greater transparency and reduce the market’s extreme volatility. HFT firms would require proper risk management, code testing, and quality control.

Conclusion

High-frequency trading is a powerful tool with huge potential for growth. It provides benefits for institutional traders as well as the individual investor. By tightening the bid-ask spreads, HFTs make the market more price-efficient and theoretically provide higher market liquidity.

As HFT firms continuously refine their algorithms and adopt new trading strategies, the market likely braces for the impact. Fortunately, SEC regulations, as well as new legislative proposals, serve to protect the market from manipulation and extreme volatility.

It is crucial to know what is high-frequency trading to evaluate how it may affect your day trade strategy and day trading success rate. Although high-frequency trading may not significantly impact investors who hold their securities for the long-term, there is no denying that HFTs impact market stability.

For tips on options trading, subscribe to Stealth Profits Trader. D.R. Barton, Jr. is a New York Times bestselling author and expert analyst for Fox Business and CNBC that can show you what you need to know about trading.

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