The first thing that comes to mind when we think about stock markets is a room with huge monitors on the wall. On the floor, hundreds of traders battle out on which stock to buy and which one to sell. There will be someone yelling buy while others will be on the phone checking up on the news.
But now, with technological progress, this is not the case. Now is the era of automated trading. Computers now do most of the jobs with fast and effective algorithms and models. Among these models, one is the most known and perhaps the most talked about. That is what this article is about, high-frequency trading.
- What is High-frequency Trading?
- How Does High-Frequency Trading Work?
- Factors to Consider Before Using High-frequency Trading
- High-speed Computers
- Why Choose High-Frequency Trading?
- Volume Trading
- More Opportunities
- Liquidity in the Market
- Reduced Cost
- Increasing Competition
- Current State of High-frequency Trading
- Risks for High-frequency Traders
- Concise Time Frames
- Ghost Liquidity
- Spoofing and Stuffing
- Technical Risks
- Volatility Increase
- Consequences of High-frequency Trading in Stock Market
- Reforms of High Trading Frequency in Stock Exchanges and Hedge Funds
- Final Thoughts
- Frequently Asked Questions
What is High-frequency Trading?
High-frequency trading is a lightning-fast approach trader use today to transact a considerable number of orders within a second. This strategy uses different algorithms and models to monitor and analyze the market state and execute orders depending on the condition.
Hedge funds, institutional investors, and even large investment banks use this automated trading platform to get an edge over average participants in the stock market. Hot strategies involve concise time frames, high turnover rates, and, most importantly, many orders.
How Does High-Frequency Trading Work?
When you trade in the stock market, you usually have two options. You can either buy and hold or buy and sell. Most stock investors buy and retain for an extended period hoping that the share price will go up and get a good return.
But the other approach is buying stocks and selling them very quickly. But you will have a shallow margin. It means there won’t be much difference in the share price. But when your trading volume is high, that little difference will lead to increased revenue. This low margin and high volume trading in an automated way are known as high-frequency trading.
Computers will perform this high-speed trading without any interruptions. The trading programs installed on these computers will independently fulfill complex trading orders with incredible speed. They evaluate the stock market rates and trade total automatically.
High-frequency trading programs will be faster than the other programs out there. It’s only possible when the computers are closer to the stock market. The shorter the cable, the quicker information transmits. When the buying price of a specific commodity increases even a bit, the high-frequency programs will be the first to recognize it. Therefore, they will be the first to respond. By the time the trend ends, it will sell the price at a minimum rate. But with high volumes, this minimum rate results in huge profit.
Factors to Consider Before Using High-frequency Trading
Before indulging yourself in high-frequency trading, you need to evaluate some factors. These factors are crucial in making the whole system work. So, let’s take a quick look at them to get a better understanding.
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Even you can develop a high-frequency trading algorithm and trade at a fast speed. But to create such an algorithm, you will need some extensive knowledge about coding. Also, you will require high-speed computers with complex and advanced software and hardware.
Most importantly, this software has to be updated regularly to keep up with the market. If you don’t want to do it yourself, then you should choose a high-frequency trading firm.
The main criterion of high-frequency trading is that the computers have to be near the exchange servers to be the first ones to execute the order. If you can’t manage that, this strategy won’t work. You have to monitor real-time data feeds to trade efficiently.
Why Choose High-Frequency Trading?
You can trade in milliseconds using high-frequency trading techniques. Standard trading strategies can’t even function anywhere near as fast as this. They scan and analyze the market more quickly than any individual can. But even if this doesn’t convince you, check out some other reasons why you should choose high-frequency trading.
With high-frequency trading, you can make a profit off even the tiniest of price differences. In this trading, you make enough trades in large volumes to guarantee a high return. You can’t get such a guarantee in manual trading.
High-frequency trading algorithms analyze multiple markets at the same time. They monitor when the market is going even slightly up. It provides the traders a plethora of opportunities. You can even take advantage of arbitrage opportunities.
So you may ask how. Well, the New York stock exchange updates its price to match the price of London. So to update, it takes approximately 0.5 seconds. In these 0.5 seconds, an interesting thing happens. For this short period, euros will sell more in the York stock exchange than in London.
A high-frequency computer can buy a tremendous amount of currency from one city then sell it in the other to make a significant profit.
Liquidity in the Market
High-frequency trading increases the liquidity in the market. This trading strategy increases competition in the market as trades occur at a fast speed. It also makes the volume of trade increase as well in a drastic amount.
Evidently, it causes the market liquidity to increase, and the bid-ask spread eventually decline. And finally, it turns the market’s price more efficient.
Besides increasing the liquidity and market efficiency of the market, high-frequency trading reduces the cost. Mutual funds require traders to pay a high price. It is mainly because of the bid/ask.
But high-frequency trading narrows down the bid or ask. It helps the small retail investors in stock index futures. Not just that, it also reduces the cost that comes from more significant transactions.
High-frequency trading platforms help traders innovate and stay up to date with their strategies. Even one millisecond matters here. This aggressive mindset creates competition in the market. It leads to more liquidity and lower latency. Also, high-frequency trading allows small-time investors to compete with larger banks.
Current State of High-frequency Trading
High-frequency trading algorithms have seen enormous growth over the years. Although some stock exchanges are still skeptical about it, many are opening up to the strategy. But on the contrary, many traders have filed a lawsuit against exchanges that use high-frequency trading.
2012 was a big year for high-frequency trading. This year, France introduced a special tax on the use of high-frequency trading. In 2014, the US authority made a study on the impacts of high-frequency trading. But it didn’t cover the risks of it.
Risks for High-frequency Traders
Since its inception, high-frequency trading has become a controversial technique in the trading world. There are several good reasons some hesitate to incorporate it. So, without further ado, let’s check them out.
Concise Time Frames
High-frequency traders only hold their assets for a brief period. Then they liquidate their options. That’s why the risk-reward of this system is high. It is much more significant than average trading. Traders sometimes make a profit of a cent the entire day which can contribute to a substantial loss.
Many of the oppositions have claimed that the liquidity that high-frequency trading creates is not accurate. This assumption is based on the fact that it is held for a short time. Therefore no regular investors can buy it on time. By the time they recognize it, it’s way too late as it is already traded multiple times.
Spoofing and Stuffing
These two activities are undoubtedly fascinating. So, the lack of regulation in high-frequency trading has been a source of controversy for years. Traders exploit this to manipulate the markets. They try to deceive the other market participants.
Think like this. It’s pretty tough to maintain high-speed trading. It is costly and challenging to pull off. But it’s pretty easy to slow down the other market participants.
This is what happens in the stuffing. A trading program makes small, unimportant offers, and it floods the whole market with worthless information. To filter and analyze it, other trading programs lose time. They respond to the valuable offers late.
In spoofing, a trading program generates a lot of underpriced offers. They generate it, and cancel it before one can purchase it. You may ask what the point of this is. Well, this activity creates an illusion that a large number of buyers are interested in the asset.
Therefore the price of the stock will increase. The other traders react to it, thinking the price will rise. But this is nothing but a scam.
High-speed trading also comes with a bunch of technical risks. Traders complain that they can’t track everything properly due to the extreme complexity of the trading environment and the algorithms. Also, these programs are not always error-free and it can lead to the interaction of various trading programs.
If two or more programs subsequently react to one another, they can get trapped in a loop. The problem is the speed at which this happens. Only special programs can respond to this problem. Others can’t handle it quickly enough.
High-frequency algorithms take milliseconds to analyze and respond to the market. This is great on a typical day. But during a crash, this can be troublesome. It will increase the volatility and decrease the liquidity in the market.
Consequences of High-frequency Trading in Stock Market
The risks and manipulations of high-frequency trading are pretty detrimental to the overall economy. Some traders even think that it is quite unethical to exploit high-frequency trading algorithms.
The benefits of high-frequency trading don’t compensate for the risks that it has. High-frequency trading can play a significant role in most stock market crashes. In 2010, there was an incident called a flash crash when the US stock market collapsed in a very few minutes.
Since then, people have been observing the occurrence of these flash crashes. Many think that this kind of crash is due to high-frequency trading.
Reforms of High Trading Frequency in Stock Exchanges and Hedge Funds
To tackle such risks, there has been some introduction of regulations in the stock exchanges. The introduction of automated trading stops is one of them. If a flash crash occurs, trading is interrupted briefly, and it won’t necessarily prevent flash crashes from happening, but it surely helps minimize the risks.
High-frequency trading indeed has tons of risks and ethical issues. Many traders exploit it, and other traders suffer a lot. However, every viable strategy has some disadvantages. Think of the benefits high-frequency trading provides- the short time frames, the large trading volumes, automated trading, and unbelievable speed.
These attributes are something every trader needs to be successful. High-frequency trading enables traders to be much more efficient and strategic.
Frequently Asked Questions
Is it profitable to invest in high-frequency trading?
High-frequency traders buy shares at bidding price and sells at asking price. For every share, they make profit of a penny or even less. But, it turns into a big profit as they usually deal with thousands of shares.
Do high-frequency day traders affect the stock market?
As day traders move their shares on a frequent basis, their trading affects the market’s volatility for a short period of time. But, day traders’ overall impact on the stock market is quite minimal.
What is the percentage of high-frequency trading in the overall stock market?
After mid-2000s, high-frequency trading started to grow rapidly. Around 50% of the US equity market traders today follow high frequency trading strategies.
How much do high-frequency traders make?
According to ZipRecruiter, the national average salary of high-frequency traders is $92,591 per year, which means they make $45 per hour.