High-Frequency Trading is a kind of trading characterized by high speed, high volume of transactions, and a very short investment horizon, all these powered by algorithmic trading.
What is High-Frequency Trading (HFT)?
High-frequency trading (HFT) is an algorithmic trading style that is distinguished by a very short investment horizon, a very high volume of transactions, and high-speed trade execution. HFT uses specialized computers to execute trades as quickly as possible. Due to its complexity, it is mostly used as a tool by big institutional investors like hedge funds and investment banks.
High-frequency trading employs sophisticated algorithms that examine individual equities in milliseconds to identify new trends. If the analysis identifies a trigger, hundreds of buy orders will be sent out in a matter of seconds.
Advantages of High-Frequency Trading
In addition to trading a lot of securities, high-frequency trading enables dealers to profit from even the smallest price changes. It enables organizations to profit greatly from bid-ask spreads.
Multiple markets and exchanges can be scanned by trading algorithms. It makes it possible for traders to discover additional trading opportunities, such as taking advantage of small price variations for the same asset that are traded on many exchanges.
High-frequency traders contend that their practice improves market liquidity. Since deals are conducted more quickly and the volume of trades rises dramatically, High-Frequency Trading undoubtedly promotes market competition. The markets become more price-efficient as a result of the decreased bid-ask spreads brought on by the increased liquidity.
Because there is always someone on the opposing side of a trade, a liquid market is seen as having less risk. Additionally, the price a buyer is willing to pay and the price a seller is willing to sell for will get closer together as liquidity rises.
A stop-loss order is one tactic that may be used to reduce risk; it guarantees that a trader’s position will close at a particular price and stops additional losses.
Disadvantages of HFTs
Lesser known: Because financial professionals, regulators, and some investors don’t know much about high-frequency trading, it is regarded by many as a contentious activity.
High Sharpe Ratio: HFT builds up a small quantity of capital and holds it for a brief time before liquidating because they don’t hold their portfolios overnight. As a result, the risk-reward ratio, or Sharpe Ratio, is very high.
Ghost liquidity: HFT’s detractors contend that because the assets are only held for a few seconds, the liquidity produced is not genuine. The asset is traded several times before an investor can even purchase it.
Unfair to little players: Large financial institutions typically engage in high-frequency trading, and they frequently make money off of smaller institutions and market participants.
Increased volatility: HFT has been linked to market collapses and raises market volatility. Regulators have even caught certain HF traders manipulating the market illegally.
Risks of HFTs
Regulators, financial experts, and academics are still divided on high-frequency trading, which is still a contentious practice.
High-frequency traders rarely keep their holdings overnight, build up very little cash, and retain their positions for a brief period before selling them.
The Sharpe Ratio, or risk-reward ratio, is hence abnormally high. Compared to the traditional investor who employs a long-term strategy, the ratio is significantly higher. In addition to increasing the likelihood of a huge loss, a high-frequency trader may occasionally just make a fraction of a cent, which is all they need to make gains throughout the day.
The claim that HFT only produces “ghost liquidity” in the market is one of its main criticisms. Opponents of HFT point out that because the assets are only held for a short period of time, the liquidity provided is not “real.” The security has already been exchanged several times by high-frequency traders before the average investor can purchase it. The huge liquidity that HFT produced has mostly subsided by the time the average investor places an order.
Additionally, it is believed that high-frequency traders, or big financial institutions, frequently make money off of lesser market participants, such as individual investors or smaller financial organizations.
Last but not least, HFT has been connected to both market crashes and heightened market volatility. Some high-frequency traders have been discovered by regulators using unlawful market manipulation techniques like layering and spoofing. It was established that HFT played a significant role in the extreme market volatility that occurred during the 2010 Flash Crash.
Ethics and Market Impact
High-frequency trading is criticized by certain experts who feel that it unfairly favors big businesses and tilts the playing field. It can also hurt other investors who purchase or sell in bulk and have a long-term strategy.
Additionally, some contend that market volatility is influenced by new technology and electronic trading that began in the early 2000s. These technologies have the potential to magnify both minor and major crashes by mass selling their assets in response to particular market cues.
High-frequency trading should be prohibited in several European nations to reduce volatility and avert unfavorable incidents like the Knight Capital collapse and the US Flash Crash of 2010.
Additionally, algorithms can be developed to place hundreds of orders and then cancel them seconds later, temporarily raising the price. Profiting from this kind of fraud is generally regarded as unethical and occasionally unlawful.