Relying on advanced algorithms and exploiting the opportunities opened by minuscule price movements, high frequency trading (HFT) has taken the finance sector by storm. While the adopters of the approach claim it adds liquidity to the market, its opponents warn about its obscure nature contributing to volatility.
With the increased reliance on such trading methods, large players with access to the newest technologies get a cutting edge. However, leveraging algorithmic tools, they may be tempted to employ spoofing and other disruptive practices.
What Is HFT?
High frequency trading is a complex method involving the usage of algorithm-based tools for executing a multitude of orders in a tick. Employing dedicated software designed to identify trends and buy or sell stocks, ventures can essentially predict and shape future developments. The capacity gives them an unfair advantage over traders and results in market volatility.
Data transmission speed has significantly increased with the introduction of fiber-optic cables. When exchanges started to provide incentives to firms injecting liquidity into the market after 2008, it contributed to the adoption of HFT trading. With computers becoming more advanced, it became easier to identify short-term opportunities.
As banks, hedge funds, and other institutions raised concerns about these risky practices, the Securities and Exchange Commission (SEC) came up with a way to define HFT based on such features:
- Employment of powerful dedicated programs to buy and sell securities;
- Speed maximization through the usage of data feeds and privately owned servers in third-party data centers;
- Short orders;
- A large volume of canceled orders.
Even though liquidity providers make valid arguments criticizing algorithmic trading, the proponents of these methods argue that they facilitate quick order execution.
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How Does High-Frequency Trading Work?
While contributing to market making and adding the desired liquidity, the strategy heavily relies on high-end computer hardware and software. Minimizing latency necessitates deploying special tools for placing, routing, and executing orders. Besides utilizing pro-level programs with robust performance, firms must use co-location services.
In addition, working with short timeframes is necessary for buying and selling stocks. After submitting large volumes of orders, ventures cancel many of them once the prices change. HFT traders prefer to end the day with no substantial unhedged positions left.
Advantages and Disadvantages of HFT
Users relying on the HFT method leverage the arbitrage practice, allowing them to purchase and sell stocks at different exchanges at the same time. Here are the main pros of the HFT approach:
- Large profits on small price fluctuations;
- Trend identification;
- Liquidity enhancement;
- Risk mitigation.
Benefiting from small price differences, traders deploy risky strategies aiming to maximize their gains. As they place high amounts of orders, the method they employ yields significant financial returns.
High frequency Forex traders also benefit from the strategy as the tools they use recognize price movements with lightning-fast speed, making them more efficient than their human counterparts. However, there are downsides to the HFT method:
- Regulatory compliance issues;
- A high risk of significant losses;
- Market volatility.
Considering these pros and cons is crucial to understand the limitations of this method.
What are the Different High-Frequency Trading Strategies?
Investors profit from HFT operations conducted by companies with a high expertise level. Firms work with three types of arbitrage deals:
- Slow operations: The high data transfer speed enables traders to earn money by buying and selling at markets with different prices. However, as more hedge funds invest in high-speed solutions, the HFT strategy may become obsolete.
- Dark-pool arbitrage: The method is utilized by those who speculate on the price differences between public and private exchanges. The latter, also known as dark pools, do not have public access. As they typically publish prices with a delay, professionals utilize trading algorithms to increase their profits by exploiting the differences in stock prices.
- Rebate arbitrage: Due to the variety of rebate rules set by platforms, seasoned traders make money from learning the intricacies of these systems. After buying one stock at a platform offering a rebate to buyers, they sell it without adjusting its price to the exchange that gives a rebate to sellers. Despite the low profitability of such operations on a small scale, they bring impressive gains to firms operating large volumes of stocks like cryptocurrency.
Using these types of arbitrage yields significant returns, making regulators and the public question the moral side of such operations.
Ethics and Market Impact
The opponents of automated trading believe that large companies undeservedly enjoy an unfair advantage and harm long-term investors contributing to market stability. Utilizing this method on scale may potentially result in market crashes. European regulators contemplate banning the practices to reduce volatility to the minimum.
As algorithms may provoke price spikes, causing portfolio liquidations, utilizing such tools may be recognized as an unethical practice.
Reaping the potential benefits of high frequency trading while ensuring regulatory compliance requires establishing transparent rules for employing proprietary software designed for market analysis and short-term deals.
