High-frequency trading (HFT), also known as algorithmic trading, refers to the practice of executing trades within microseconds, milliseconds or even nanoseconds. Traders use sophisticated software to trade stocks, options, futures contracts, commodities and currencies. These computers are programmed to buy and sell securities based on technical indicators like volume, price movement and volatility.
The term “high frequency” refers to the speed with which the trades occur. A trader might want to buy or sell thousands of shares of stock every day, but he or she could do it in seconds rather than minutes. This type of trading is often done in electronic exchanges such as Nasdaq, NYSE Euronext, BATS Global Markets, Chicago Mercantile Exchange and IntercontinentalExchange Inc., among others.
Short term trading involves taking advantage of predictable market movements to create short-term profits. There are two types of strategies used by high-frequency traders: Strategies that exploit predictable temporary fluctuations in stock prices; and strategies that exploit predictable temporary changes in market conditions.
Understanding High-Frequency Trading (HFT)
High-frequency trading (HFT) is becoming increasingly common in financial markets. This type of trading involves computers that buy and sell stocks based on algorithms that are programmed to execute trades within microseconds. In fact, according to some estimates, high-speed traders make up about 70% of stock volume across the world.
The term “high-frequency,” however, refers to how quickly trades occur. Traders use technology such as computer servers, software, and networks to send messages to each other very quickly. These messages tell others what trades are being done, where those trades are taking place, and what price is being paid for the trade.
This makes it possible for traders to see prices move much faster than normal. Because of this speed, many people believe that HFT is responsible for increased volatility in the market. However, there are still many questions regarding whether HFT actually causes volatility.
Benefits of High-Frequency Trading (HFT)
High-frequency trading (HFT) has become a major force in financial markets. In fact, it accounts for about half of all US equity trades. But while many people think of HFT as a high-speed way to execute large block trades, there are benefits to smaller traders and investors as well.
In recent years, the Securities and Exchange Commission (SEC) has taken steps to regulate HFT. These include imposing limits on the number of shares that can be traded within a given time period, limiting the amount of money that can be spent per trade, and requiring firms to report information about their algorithms. As a result, there is now some evidence that HFT has improved market efficiency.
One study assessed how Canadian bid-ask spreads changed when the federal government introduced fees on high-frequency algorithmic trading HTA. It found that market-wide bid-ask spreads increased by 13%, and the retail investors increased by nine percent. It’s believed that there is a correlation between the fee introduction and the bid-ask increase.
Profit Potential from HFT
High-frequency trading (HFT) algorithms are designed to exploit market conditions that can’t normally be detected by the human eyes. This includes arbitrage opportunities and shorting strategies. In fact, there are many instances where HFT algorithms use derivatives to make money off the difference between two assets.
One example is arbitrage between contracts on the same underlying index — such as futures versus exchange-traded funds (ETF). Another example is short selling: buying shares of stock you don’t actually own. For instance, you could buy a contract on Apple Inc. (AAPL), paying someone else to take delivery of the actual shares. Then, after the trade settles, you sell those shares to close out the position.
Critiques of High-Frequency Trading (HFT)
High-frequency trading (HFT) has become increasingly popular over the last decade. This type of algorithmic trading involves computers executing trades based on mathematical formulas and models, rather than humans making decisions. Critics say HFT has taken away human decision-making from markets, resulting in huge price swings and volatility.
Critics cite several examples where HFT contributed to major stock market crashes. In May 2010, the Dow Jones industrial average dropped 1000 points in less than 20 minutes, losing 10%. The cause of the crash was a massive order placed by Knight Capital Group, which caused a sell-off.
Another example occurred in October 2011, when the Dow fell nearly 600 points due to high frequency trading.
Some argue that HFT leads to market manipulation, ghost liquidity, and unfair profits for large corporations.
In addition, critics say HFT contributes to increased volatility and market instability, which makes it difficult for investors to accurately predict future trends.