High-frequency trading: what is it & how does it work?
High-frequency trading is a way of buying and selling stocks using computer programs that work very fast. These programs can make trades in a fraction of a second.
In this article, we’ll introduce you to high-frequency trading, what it means, and how it impacts the markets.
High-frequency trading: history
High-frequency trading has been around since at least the 1930s. Back then, it primarily involved specialists and pit traders who conducted rapid buying and selling at physical stock exchange locations. They relied on high-speed telegraph services to connect with other exchanges.
The modern form of high-frequency trading, driven by powerful computers, began to take shape in 1983 when NASDAQ introduced fully electronic trading. Over time, it evolved significantly. At the start of the 21st century, HFT transactions took several seconds to execute.
However, by 2010, these transactions occurred in milliseconds and even microseconds. Until recently, high-frequency trading remained relatively unknown outside the financial sector. It wasn’t until July 2009 when The New York Times published an article that brought this topic to public attention.
What is high-frequency trading?
High-frequency trading (HFT) is a method of trading in financial markets that relies on powerful computers and algorithms to automate transactions. The key advantage of HFT is its speed, allowing for trades to occur in fractions of a second. The primary goal of HFT is to make tiny profits on each transaction over a very short period. HFT traders use minimal leverage and typically don’t hold positions overnight.
When we discuss HFT, we’re talking about strategies that exploit market volatility and global market correlations. In the United States, it’s estimated that HFT accounts for about 65% of all stock exchange transactions, while in Europe, this figure is around 40%.
How does high-frequency trading work?
High-frequency trading relies on lightning-fast computer systems that execute buy and sell orders rapidly. In some markets, such as Nasdaq, certain traders can see order stacks 30 milliseconds before they’re visible to others.
This knowledge allows them to anticipate immediate demand and profit from it. High-frequency traders aim to make a small profit from each trade, but they make a lot of trades in a day, so the profits can add up.
The image below illustrates one of the strategies commonly used by HFT firms.
Consider an asset listed on various exchanges like NYSE and ChiX. When an order reaches ChiX and is executed at a certain price but remains incomplete, high-frequency trading (HFT) algorithms predict that this order will eventually get completed on another platform, such as NYSE.
It’s at this juncture that HFT comes into play by preemptively buying shares on another platform and placing a sell order just before the initial order arrives. This ensures that the HFT sells at the price it has offered, making a small profit in the process.
To protect themselves from this practice, large investors attempt to program their systems so that their orders reach all markets simultaneously, preventing HFTs from capitalising on order delays. It’s important to note that HFTs are assumed to only obtain order information when it reaches a market; otherwise, they would be engaging in an illegal practice known as “front running” or “tailgating.”
Does high-frequency trading impact market prices?
How much influence do these high-frequency trading machines really wield over the market? Do their operations significantly impact share prices? Unfortunately, the data suggests they do.
In the US, as of 2009, high-frequency trading companies represented a mere 2% of total traders, yet they accounted for a staggering 73% of the business volume.
In 2010, the Bank of England estimated similar percentages for the UK market, implying that HFT had a market share in Europe of about 40% of equity order volume and between 5% and 10% in Asia, with rapid growth potential.
In 2012, according to a study by the TABB Group, HFTs made up over 60% of all volume in the US futures market.
By 2020, roughly 50% of all stock exchange transactions were conducted by these high-speed machines. In fact, it’s estimated that over 20,000 companies now operate using this type of system.
Therefore, it’s safe to say that the presence of HFT significantly influences a company’s stock price. Given this substantial impact, let’s explore the primary investment strategies employed in high-frequency trading.
Investment strategies in high-frequency trading
In the world of high-frequency trading (HFT), various techniques are employed to maximise profits. Here, we’ll delve into the four most commonly used HFT strategies:
| Strategies in high-frequency trading |
| Market making |
| Arbitrage |
| Trend following |
| Order anticipation |
Market making
In this strategy, high-frequency traders offer to buy and sell stocks to make it easier for other people to trade. They make money from the difference between the buying and selling prices, which is known as the “spread.”
Arbitrage
Arbitrage involves buying and selling the same asset in different markets to take advantage of small price differences. For example, a stock might be slightly cheaper on one exchange than another. The high-frequency trader buys the cheaper stock and sells it where it’s more expensive, making a small profit.
Trend following
High-frequency traders use computer algorithms to spot trends in stock prices. When they see that a stock price is going up or down, they quickly buy or sell to make a profit. This happens much faster than a human could react.
Order anticipation
In this strategy, high-frequency traders try to predict the future actions of other traders. For example, if they think a large buy order is about to come in, they will buy the stock first, hoping to sell it at a higher price when the large order arrives.
Difference between latency and speed in HTF orders
In high-frequency trading (HFT), both speed and latency are important, but they mean different things. Speed refers to how fast a trade can be made. In HFT, speed is crucial because the goal is to buy and sell stocks very quickly, often in fractions of a second. Faster speed means that a high-frequency trader can make more trades in a shorter amount of time, increasing the chance of making a profit.
Latency is the time it takes for data to move from one point to another. In HFT, latency is the delay between when a trading order is made and when it is completed. A lower latency means that the delay is shorter, and the trade can be made more quickly. High-frequency traders try to reduce latency as much as possible to make trades faster.
The flash crash of May 2010 caused by HFT
The Flash Crash that occurred on May 6, 2010, was a momentous event where Wall Street experienced an unprecedented and rapid collapse following an unusual pattern. Initially, it was thought that this potential stock market crash had its roots in the Greek financial crisis. Austerity measures in Greece had triggered significant disturbances and unrest in the country, both on financial and political fronts.
However, the shockwave didn’t originate from Greece. It began when the American pension fund Wandell & Reed rapidly sold 75,000 contracts worth $4.1 billion, seemingly wanting to unload those securities. Although this action alone couldn’t destabilise the market, all HFT firms sensed the fear it generated and swiftly joined in the selling frenzy at the microsecond level.
This turmoil lasted approximately 36 minutes. This event served as a wake-up call, illustrating the extent to which a stock market disaster can occur due to certain trading practices. This phenomenon, characterised by a rapid and steep market decline, is known as a “flash crash.”
After the Flash Crash, changes were made to the trading rules to help prevent something like this from happening again. These changes included “circuit breakers,” which are like automatic stop signs that pause trading if prices move too quickly in a short time.
The Flash Crash showed that while HFT can make the market more active and efficient, it can also contribute to sudden and unexpected changes. This event led to more attention and rules around high-frequency trading to make the market safer.
Companies engaged in high-frequency trading
High-frequency trading is a way of buying and selling stocks using computer programs that work very fast. These programs can make trades in a fraction of a second. The idea is to take advantage of small price changes in the stock market that happen very quickly.
| Examples of HFT companies |
| Knight Capital Group |
| Getco LLC |
| Citadel LLC |
| Jump Trading |
| LLC |
| Goldman Sachs |
| Virtu |
Investigations for fraud in companies that use high-frequency trading
Some people think high-frequency trading is good for the market because it adds more trading activity and can make it easier for others to buy and sell stocks. Others worry that it can make the market more unstable or give an unfair advantage to companies that use high-speed trading.
The FBI has initiated investigations into high-frequency trading companies for potential insider trading activities. These investigations delve into the connections between high-speed traders and major exchanges, examining whether these firms receive preferential treatment, potentially disadvantaging other investors.
For the FBI, this investigation marks a novel use of insider information, focused on speed. Agents are analysing market patterns that might reveal any trading activities that violate the law. Proving fraudulent intent in these operations is a complex challenge.
Does HFT affect investors and illiquid securities?
In 2014, the brokerage firm DEGIRO conducted a study on the use of SOR (Smart Order Routing), which aims to reduce transaction costs for end investors when sending orders to various European exchanges. The study revealed that HFT firms are active in European markets and benefit from this order routing system, often at the expense of large investors or those dealing with illiquid securities.
DEGIRO’s analysis aligns with the ideas presented in Michael Lewis’s book, “Flash Boys: A Wall Street Revolt.” The book argues that high-frequency traders exploit the speed of their systems, gaining milliseconds of advantage over small investors in order execution.
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High-frequency trading: summary
High-frequency trading (HFT) is a financial strategy that employs lightning-fast computers and algorithms to execute trades within fractions of a second. This approach aims to profit from minuscule price discrepancies and market inefficiencies.
HFT firms often act as market makers, impacting price movements and market liquidity. While HFT has become a dominant force in modern financial markets, it also faces scrutiny for potential unfair advantages and the risk of market volatility.
FAQs
How does high-frequency trading impact everyday investors?
High-frequency trading can indirectly affect everyday investors by potentially increasing market volatility and leading to sudden price swings. While it primarily targets short-term profits, these rapid trades can occasionally disrupt the stability of long-term investments, impacting the broader market.
What measures are in place to regulate high-frequency trading?
Regulating HFT is a complex challenge, but various measures have been introduced to mitigate risks. These include circuit breakers that halt trading during extreme market swings, enhanced transparency requirements, and efforts to level the playing field between HFT firms and traditional investors.
Do high-frequency traders use artificial intelligence (AI)?
Yes, many HFT firms leverage artificial intelligence (AI) and machine learning algorithms to make split-second trading decisions. These technologies analyse vast datasets and market signals to identify profitable opportunities.
