High-Frequency Trading

High-Frequency Trading is a specific type of trading enabled by technology that makes transactions so fast that they take milliseconds. Professional traders use algorithms to get an edge over their competition. These algorithms aid professional traders earn profit from sudden changes in stock prices.

It is done mostly by large organizations always trying to end a day without actually holding assets. Everything that is bought is sold quickly.

• High-frequency trading (HFT) enables traders to make hundreds of trades at the same time using algorithms and powerful computers.
• It is very risky and, therefore, mostly undertaken by large organizations with enough resources to absorb losses.
• This method uses several strategies based on speed. Strategies include arbitrage, looking for discrepancies in price, etc.
• HFT is so fast that it can execute trades in less than a second.

High-frequency trading (HFT) uses specialized software and expensive computer hardware to analyze the market trends. Based on the collected data, the computers make automatic transactions. These actions are faster than any human could do by themselves.

Traders set up automated strategies that define how the software picks investments. Among other characteristics, this automation also predetermines the level of risk. This way, operators can customize the process.

These operations use complex algorithms to catch trends in the market, focusing on the ones with rising prices. By trading a very high volume of assets, traders are able to obtain huge profits even if the price increase is not so sharp.

The process works because the algorithms are able to read the laws of supply and demand and act faster than others can. Naturally, this lets them profit more. The Securities and Exchange Commission (SEC) has defined five characteristics for this kind of trading:

• Incredible high speed while executing orders on trading platforms.
• Using several servers to minimize latency as much as possible.
• Acquiring and liquidating positions very quickly.
• Several orders are put at the same time, but many of them are canceled in a few moments.
• Always trying to end a day without actually holding assets. Everything that is bought is sold quickly.

Machines are not infallible. While algorithms can analyze trends more efficiently than humans, they will not always outperform. Machines can’t really predict the future.

Also, this type of trading uses a pretty risky strategy. Traders will have a very small portfolio, and most won’t hold funds overnight. A few cents decide if they win or lose. This pushes the risk ratio higher and higher. Unlike traditional traders, HFT gains can go down as quickly as they went up.

It’s also essential to note that HFT only works with the right infrastructure. Any kind of latency could seriously affect winnings, so this operation requires an excellent internet connection and capable hardware.

Trading companies that rely on high-frequency trading use several strategies to improve their chances of making money. Most of the companies hide their strategies very well. They are secretive because allowing others to understand their process would possibly give them a chance to exploit the same aspects of the market to win, which could likely diminish their returns. The uniqueness of each company’s strategy is what gives them an edge over others.

It’s well-known, however, that most firms focus on different kinds of arbitrage, which is essentially buying an asset for a lower price to be sold later. They buy the assets while the price is rising and sell them within a short timeframe. This way, volatility helps high-frequency traders accumulate a hefty profit in a short period.

A few examples of strategies used by these companies include index arbitrage, merger arbitrage, and volatility arbitrage. Some traders also focus on non-arbitrage strategies, such as trading from both sides. They put both sell and buy orders to move the market in a certain way and get some profit between the difference of prices.

Other traders, however, look for discrepancies in the price of the assets. The software finds differences in the price of the same assets, buys them in the market where the price is lower. And then, it sells the assets almost instantaneously in markets where the assets are priced higher. Speed is the key to profit with all these strategies. Computers don’t need minutes to think; they can detect trends in moments and set orders just as quickly. With this inhuman speed, they have a huge advantage.

HFT is faster than any human could trade, which is its main advantage. Basically, using software, trades can be made in milliseconds. This gives companies an edge over the competition.

The exact speed depends on a few specifics of a system, but overall, trades are made almost instantaneously. In under a minute, the system can start positions and finish them. In under a minute, the machine also analyzes market data. A human specialist will take hours to execute such an analysis. This opens the door to more profits.

By exploiting this speed, traders explore an imbalance between supply and demand to strike at the right second and get profit while barely holding the assets for much time.

It’s impossible to talk about high-frequency trading without mentioning the ethical discussion around it. The critics of the technology often argue that it gives an unfair advantage to companies that have the resources to invest in it.

If there are two trading firms, one small and one big, and only one of them can actually pay servers to install an efficient system of HFT, they will compete in the same market but get different results because only one of them has these special tools.

When it comes to the law, however, it’s all fair game. Regulators all over the world have some concerns about how this technology can be used to manipulate the market. The worry is that top-tier traders can achieve a speed that no other traders can come close to.

The ethical debate continues. Many blamed the 2010 Flash Crash on HFT strategies, and some even believe that it leads to unhealthy markets. This was reported by The Guardian.

This has been a guide to What is High-Frequency Trading and its Definition. Here we discuss how HFT works along with its risks and strategies. You may also have a look at the following articles –

• Trading House
• Algorithmic Trading
• Trading on Equity