Investing > What is High-Frequency Trading?

What is High-Frequency Trading?

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The fastest and most experienced human stockbrokers and traders on the market can make it through an astonishing number of trades every day. Some of the best can make trades numbering in the dozens or the hundreds, and that is at the most breakneck pace possible. Yet true high-frequency trading blows every human effort out of the water, numbering in the hundreds of thousands or millions of trades every day.

High-frequency trading facilitated by computer-based algorithms allows individuals and firms to earn fortunes, creates an unstable and uncertain environment for individual investors, and has the potential to shake the foundations of the stock market itself. Let’s take a look at what high-frequency trading is and what it means for the future.

High-Frequency Trading (HFT) Explained

High-frequency trading, or HFT, is exactly what the name suggests: it’s making a high number of trades on the stock market in rapid succession. It’s carried out via traders that use computer programs that churn out trade recommendations based on algorithms. These aren’t the same things as stock “robo-advisors”: they’re advanced programs built for making trades quickly and accurately with other programs like them.

Thus, high-frequency traders may make hundreds of thousands of trades per day, and sometimes they buy and sell stocks multiple times every second.

Another technically correct definition of HFT is any trading that occurs in a large volume over a single trading day. However, this ignores the commonly used definition of the practice and most of its implications for the stock market at large.

The Securities and Exchange Commission, or SEC, has five trading characteristics or requirements for an act to qualify as HFT:

stock graphs
  • it has to take place in a very short timeframe for establishing or liquidating positions
  • it has to use extraordinary high-speed and sophisticated programs to generate and execute rating orders
  • it must use co-location services and individual data feeds offered by various stock exchanges in order to minimize latency
  • it must include the submission of numerous orders, which are then usually canceled in short order
  • the trader in question must and the trading day in as close to a flat position as possible – this means that they don’t carry any unhedged (and significant) positions into the next trading day

What Do High-Frequency Traders Do?

In a nutshell, high-frequency traders take advantage of speed and analytical improvements in automation in order to make lots of trades very quickly and profit off of the effects.

How Fast Are High-Frequency Traders?

The stock market works when one person sells another person a stock or another type of security. This basic transaction formula comprises the base of the market.

The best algorithms and computer networks can make several trades in just 64 millionths of a second. Thus, high-frequency traders can complete hundreds of thousands or millions of trades in a single hour because of the way they use the computers at their disposal.

This speed demands that the algorithms and computers be as close to correct as possible. Because the orders take place faster than the human brain can process the information, whether or not a trade succeeds largely depends on how the system was set up before the command to begin trading was executed. 

How Does HFT Work?

At its core, high-frequency trading relies on using computers and algorithms that interact with one another based on mandates given by the human handlers. The humans of a firm will set out one day with a strategy in mind, and the programs they have at their disposal carry out those orders by making boggling numbers of trades and gathering incremental progress or profits.

Volume Trading

High-frequency trading can occur in several ways. For instance, many HFTs practice “volume trading”. Put simply, they perform such a high number of trades that it would be impossible for a traditional stock market trader to keep up. Thus, they can make millions of trades using algorithms that only net them very small profits. But added together, all of those meager profits can add up to something substantial.

Opportunity Trading

Other HFTs may capitalize on short-term opportunities. In other words, they can use their computers and algorithms to take advantage of opportunities that only show up in the stock market for a few seconds or minutes. They can do this faster than any human attempting to respond naturally.

One good example is if a company suddenly liquidated a huge number of its stocks or securities. The entire stock market will take time to adjust to this change, which would likely result in the price per share for that company declining. An HFT can take advantage of this opportunity faster than other types of stockbrokers, conducting numerous trades through their algorithms to make a profit before anyone else can keep up.

Arbitrage Opportunities

Still more HFTs might take advantage of arbitrage opportunities. Arbitrage opportunities crop up when you make a profit or take advantage of the same asset having two different prices.

For example, an HFT could buy a product or a stock for five dollars in one location and sell it for six dollars in another location. The only reason this is possible is because algorithms can quickly spot price discrepancies and make a trade before global price networks compensate to even everything out.

A sandwich, for instance, selling in New York will have the same price in London… after a second or so. An HFT can buy tons of sandwiches and sell them inside this very small window before the price correction occurs.

Colocation

High-frequency traders have several techniques they can employ in order to maximize their potential gains. One great example is colocation; this is the practice of placing your trading server as close as physically possible to the data center of your target exchange. In certain cases, HFT organizations or firms can even place their server in the same facility and minimize their data delay or latency to almost nothing.

As you can imagine, this provides a clear benefit for the trading server owner in question, especially over the rest of the market. Millionths of a second may not sound like much to the average person, but it can make a huge difference when computer algorithms are only fighting other algorithms for the same minorly profitable trades. Milliseconds can be everything in this business.

Market-Making

Another possible advantage that HFTs frequently use is “market-making”. This is actually a common strategy in the greater trading world, but it provides unique benefits to high-frequency trading.

In a nutshell, a trader with enough resources places both bids and asks (requests for a product or asset) into the market. This artificially provides liquidity and allows them to make a profit based on the price spread.

Pinging

HFT users can also employ the practice of pinging to their benefit. In this process, they will use several smaller orders made very quickly in order to discover larger orders that may have been segmented into multiple parts in order to reduce their effect on the overall market price for an asset.

High-frequency traders can use this to figure out the high and low ranges of prices that a seller is attempting to sell an asset for. They can then scoop up the lower possible prices quickly and efficiently through the speed of their computers and make a profit by selling it back at a higher possible price. Again, all of this occurs within millionths of a second.

News-Based Trading

Finally, high-frequency traders may also rely on news-based trading the same way that traditional stock market traders might. But they can use their greater speed and agility to make massive profits in a way that regular human traders cannot.

Whenever big news arrives, the stock market has the possibility to shift. This occurs because of two reasons: one, because it may physically affect an asset or company or two, it might inspire people to make stock market decisions based on their perceived risk or potential for profit.

Publicly available news is a known factor in the stock market’s evolution and daily shift. It’s also distinguishable from insider information that is not known by the public at large.

genetic algorithms high frequency trading

While regular investors or retail traders can receive important news and make a decision based upon it just like everyone else can, modern HFT software can analyze new stories in the seconds after they hit the Internet. The algorithms are so advanced that they can then place orders or form strategies in response faster than even the best living investor on the planet. 

This is not necessarily the same thing as insider trading, but it’s hard to deny the benefits it can provide to the owners of HFT software. It provides a serious advantage over retail traders, who have to rely on human speeds.

How Does High-Frequency Trading Make Money?

The bid-ask-spread is best understood as the price difference between how much a buyer wants to pay for an asset or stock and how much the seller wants to sell it for.

High-frequency trading can be a benefit for the stock market at large since it promotes stability and liquidity in the marketplace. HFT’s build their algorithms around ideal trading positions are theoretically suitable for both buyers and sellers; remember, the key is for the transaction to go down almost instantaneously.

In this way, high-frequency trading can connect buyers and sellers quickly and fairly. This allows traders we use these algorithms to make small profits off of hundreds of thousands or millions of trades every day. At the same time, this ensures that the market doesn’t go through any crazy ups or downs while still allowing people to make a profit.

High-frequency traders make money essentially by carrying out a huge number of trades and making a very small profit each time. The sheer number of trades enables them to make a reasonable profit worthy of the technology investment in the first place.

How Does High-Frequency Trading Affect Individual Investors?

High-Frequency trading of the potential to seriously affect individual (also called retail or traditional) investors. This makes up the majority of independent investors in the market who aren’t attached either to investment firms or big companies; think of people like average folks with 401(k)s or beginners to stock market investing.

In a certain light, HFT makes it more difficult for individual investors to predictably adapt to changing market conditions and make small but reliable profits. Additionally, it may be seen in the future that HFT makes more of a profit off of retail investors compared to vice versa.

This eventually results in more money collecting at the top of the market in the hands of those who practice high-frequency trading rather than being spread more evenly around.

While a fully equal market is neither desirable or achievable, there does need to be some wealth flowing downward in order to facilitate good market movement over the long-term.

The biggest potential negative of HFT for individual investors would be the loss of hope. Some retail investors may find that the stock market is not friendly enough to make a profit and begin to leave in droves.

While a full stock market exodus is nowhere near occurring (at least, an exodus unrelated to the Coronavirus pandemic), it may be that the following decades could accompany a gradual “shoving out” of individual investors in favor of greater and greater HFT coalitions. Market shares could one day eventually become totally dominated by algorithms rather than the decisions of individual human beings.

Still, this is all speculation for the moment.

Lag Money

For instance, a high-frequency trader can profit off of an arbitrage opportunity. This allows them to take advantage of a short window of profit once something is a different price in two areas.

In the aforementioned sandwich example, the high-frequency trader is making a profit because of the price discrepancy between the locations, not because of actual change in value for the sandwich itself. Seen this way, it’s almost like high-frequency trading is making money when none should logically exist! 

Some people even say that this is making money off of the natural and inevitable lag between software and computer networks.

Negative Market Effect

Some other critics suggest that this has a negative effect on the market as a whole. Currency traders may see something change but not know why or how the change occurred. This can cause ripple effects throughout the entire stock market.

A different angle of criticism concerns the lack of human input. By necessity, high-frequency trading relies on the precision and automation of computer algorithms to take advantage of trade opportunities that go by faster than the human mind can comprehend. This removes any human decision-making from the equation, which could be dangerous if the market moves occur without a logical reason.

May 6, 2010, saw a good example of this potential issue when the Dow Jones Industrial Average (DJIA) dropped 1000 points and 10% in 20 minutes before recovering to prior levels. The investigation that followed found that a massive HFT order began the chain reaction that caused the drop, which itself shook the market for the rest of the week.

Removal of Regular Investors

As mentioned above, high-frequency trading, if it becomes even more common throughout the market and continues to make reliable profits for those who own the right software, may push out regular investors over time. This is especially true given the advantages that HFT provides when it comes to news stories or just reacting to different market changes faster than any human could ever hope to.

Potential for Error

One last criticism can be seen by pointing out the obvious truth that high-frequency trading relies on computer algorithms to function. This invites catastrophe if an algorithm is improperly coded or if a computer glitch is out at an inopportune moment.

While humans may be relatively hands-off from the process once the algorithms are in play, humans are the originators of the algorithms in the first place. Human error could therefore still affect HFT based on a mistake that may have happened weeks or months earlier.

What Regulators Think About High-Frequency Trading

By and large, regulatory agencies like the SEC are focused on preventing some of the above side effects of HFT from affecting the greater stock market. The Dow Jones example described before what discovered to have happened as a result of a chain reaction where high-frequency traders continually triggered new trades amongst one another. This resulted in the market as a whole going lower than intended, much like a financial snowball.

Thus, the SEC has implemented changes in protective measures. One good example is the placement of circuit breakers on certain products whenever they fall past a certain value level in a short timeframe. This is intended to prevent the same chain reaction snowball effect from happening in the future.

clock with a buy option and stock graphs on the background

The SEC and other regulators will likely continue to monitor high-frequency trading and its many side effects.

In addition, high-frequency trading software’s ability to analyze news stories and make decisions faster than any human could be able to have broad implications concerning the advantage it provides to high-frequency traders.

The SEC may implement legislation in the future that regulates the use of analytical algorithms in the future, as it essentially provides the same benefits as insider trading: by giving one party a “jump-start” on market decisions ahead of everyone else.

Is High-Frequency Trading Illegal?

All this being said, HFT is not yet illegal for any reason. It does not break any market laws for demonstrably make the market too unfair for individual investors or traditional traders. This may change in the future as court cases come to light or as the link between individual investor success and failure can be proven to be significantly affected by HFT.

This isn’t to say that high-frequency trading is not necessarily predatory. There is certainly some argument to be made that HFT is bad for the stock market as a whole and potentially dangerous to individual investors.

Is High-Frequency Trading Good or Bad for the Crypto Market?

Aside from most other currencies and stock market assets, cryptocurrencies are perhaps those destined to be intertwined with HFT in the near future. Cryptocurrency is already traded 24/7 and is much more loosely regulated than any other type of currency on the planet (though this may soon change).

High-frequency trading already places retail or traditional investors on a lower tier of efficacy compared to the algorithms that can trade more quickly and accurately than any human. While this is almost expected for traditional stock market assets, many cryptocurrency investors believe that it has no place when it comes to the cryptocurrency market.

Additionally, high-frequency trading mixing with the cryptocurrency market opens up the opportunity to “flash crashes” like those listed in the examples above. This could make the cryptocurrency market even riskier or more unstable than it is already perceived to be. This could lower the adoption rate of cryptocurrencies or hurt newcomers to the trade that aren’t prepared for this kind of risk. 

Still, high-frequency trading may end up proving to be a net benefit for cryptocurrencies overall. Like with regular stock market assets, HFT can add liquidity on exchanges and can allow stock traders to move money quickly and easily. It makes price discovery more efficient, and facilitates smoother trade and a more stable market overall… Provided another flash crash does not happen.

In this way, HFT could actually make the cryptocurrency market more adaptable. Only time will tell whether it is a net benefit or loss for cryptocurrencies. 

Conclusion

Ultimately, high-frequency trading is a force to be reckoned with but it is still not fully understood in terms of how it will affect the stock market and those who interact with it on a regular basis.

It’s arguably one of the best ways for firms to become wealthy these days, and it has strong applications for cryptocurrencies and other digital goods or services.

Yet there is something to be said for the loss of the human element. Time will tell whether high-frequency trading becomes a staple of the stock market for his eventually regulated like insider trading.

Let us know what you think of high-frequency trading and whether it’s affected your own stock market experiences. 

All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on TheTokenist.io. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.

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