High Frequency Trading Definition Strategies How It Works

High-Frequency Trading Definition

It is done mostly by large organizations always trying to end a day without actually holding assets. Everything that is bought is sold quickly.

Key Takeaways

High-frequency trading (HFT) enables traders to make hundreds of trades at the same time using algorithms and powerful computers. It is very risky and, therefore, mostly undertaken by large organizations with enough resources to absorb losses. This method uses several strategies based on speed. Strategies include arbitrage, looking for discrepancies in price, etc. HFT is so fast that it can execute trades in less than a second.

How Does High-frequency Trading Work?

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High-frequency trading (HFT) uses specialized software and expensive computer hardware to analyze the market trends. Based on the collected data, the computers make automatic transactions. These actions are faster than any human could do by themselves.

Traders set up automated strategies that define how the software picks investments. Among other characteristics, this automation also predetermines the level of risk. This way, operators can customize the process.

The process works because the algorithms are able to read the laws of supply and demand and act faster than others can. Naturally, this lets them profit more. The Securities and Exchange Commission (SEC) has defined five characteristics for this kind of trading:

Incredible high speed while executing orders on trading platforms.Using several servers to minimize latency as much as possible.Acquiring and liquidating positions very quickly.Several orders are put at the same time, but many of them are canceled in a few moments.Always trying to end a day without actually holding assets. Everything that is bought is sold quickly.

The Risks of High-Frequency Trading

Machines are not infallible. While algorithms can analyze trends more efficiently than humans, they will not always outperform. Machines can’t really predict the future.

Also, this type of trading uses a pretty risky strategy. Traders will have a very small portfolio, and most won’t hold funds overnight. A few cents decide if they win or lose. This pushes the risk ratioRisk RatioRisk ratio, also known as relative risk, can be defined as a metric that is taken into use for the measurement of risk-taking place in a particular group and comparing the results obtained from the same with the results of the measurement of a similar risk-taking place in another group.read more higher and higher. Unlike traditional traders, HFT gains can go down as quickly as they went up.

It’s also essential to note that HFT only works with the right infrastructureInfrastructureInfrastructure refers to fundamental physical and technological frameworks that a region or industry establishes for its economy to function properly.read more. Any kind of latency could seriously affect winnings, so this operation requires an excellent internet connection and capable hardware.

High-frequency Trading Strategies

Trading companies that rely on high-frequency trading use several strategies to improve their chances of making money. Most of the companies hide their strategies very well. They are secretive because allowing others to understand their process would possibly give them a chance to exploit the same aspects of the market to win, which could likely diminish their returns. The uniqueness of each company’s strategy is what gives them an edge over others.

It’s well-known, however, that most firms focus on different kinds of arbitrageArbitrageArbitrage in finance means simultaneous purchasing and selling a security in different markets or other exchanges to generate risk-free profit from the security’s price difference. It involves exploiting market inefficiency to generate profits resulting in different prices to the point where no arbitrage opportunities are left.read more, which is essentially buying an asset for a lower price to be sold later. They buy the assets while the price is rising and sell them within a short timeframe. This way, volatility helps high-frequency traders accumulate a hefty profit in a short period.

A few examples of strategies used by these companies include index arbitrage, merger arbitrageMerger ArbitrageMerger Arbitrage, also known as risk arbitrage, is an event-driven investment strategy that aims to exploit uncertainties that exist between the period when the M&A is announced and when it is successfully completed. This strategy, mainly undertaken by hedge funds, involves buying and selling stocks of two merging companies to create risk-free profit.read more, and volatility arbitrage. Some traders also focus on non-arbitrage strategies, such as trading from both sides. They put both sell and buy orders to move the market in a certain way and get some profit between the difference of prices.

Other traders, however, look for discrepancies in the price of the assets. The software finds differences in the price of the same assets, buys them in the market where the price is lower. And then, it sells the assets almost instantaneously in markets where the assets are priced higher. Speed is the key to profit with all these strategies. Computers don’t need minutes to think; they can detect trends in moments and set orders just as quickly. With this inhuman speed, they have a huge advantage.

How Fast is High-Frequency Trading?

HFT is faster than any human could trade, which is its main advantage. Basically, using software, trades can be made in milliseconds. This gives companies an edge over the competition.

The exact speed depends on a few specifics of a system, but overall, trades are made almost instantaneously. In under a minute, the system can start positions and finish them. In under a minute, the machine also analyzes market data. A human specialist will take hours to execute such an analysis. This opens the door to more profits.

Is it Fair to Trade this Fast?

It’s impossible to talk about high-frequency trading without mentioning the ethical discussion around it. The critics of the technology often argue that it gives an unfair advantage to companies that have the resources to invest in it.

If there are two trading firms, one small and one big, and only one of them can actually pay servers to install an efficient system of HFT, they will compete in the same market but get different results because only one of them has these special tools.

When it comes to the law, however, it’s all fair game. Regulators all over the world have some concerns about how this technology can be used to manipulate the market. The worry is that top-tier traders can achieve a speed that no other traders can come close to.

The ethical debate continues. Many blamed the 2010 Flash Crash on HFT strategies, and some even believe that it leads to unhealthy markets. This was reported by The Guardian.