High-frequency trading (HFT) is algorithmic trading that typically involves automatically generated, rapid-fire trades placed by computers. These computers use various indicators to detect market trends and exploit them instantly. HFT strategies can be implemented using low latency direct market access (DMA) or slower algorithmic trading methods via multiple exchanges. As the number of employed strategies increased, so did concerns surrounding the impact of HFT on price discovery in financial markets.
How does high-frequency trading work?
The algorithms are programmed to detect small changes in supply/demand imbalances that human traders would ordinarily have missed due to their lower speed of analysis. Thus, while these programmed machines do not out-think or outsmart their human counterparts, they can perform their analysis much faster, enabling them to outpace the human competition.
The two main kinds of HFT strategies
Market makers seek to generate profits by providing continuous bids and asking for quotes for at least some of the stocks they trade. Market makers use relatively simple trading strategies, which are often technology-dependent due to their execution speed. On the other hand, order anticipators are more complex and try to assess the direction of the market movement before placing a bet or opening up a position.
For these traders, latency is key as it takes less time for information to travel between them and the exchange than what it would take for someone else to pick up on this information. These traders will typically lose money in the long run but have an advantage over human traders because they can work continuously around the clock until they balance out their losses with profits.
Benefits of using HFT strategies
As mentioned earlier, algorithmic trading has given high-frequency traders an edge over traditional investors who don’t have access to DMA and must rely on slower executions; such as sending an order to their broker, which then needs to route the order through a matching engine and electronic network before it can be executed.
Another critical aspect of HFT is that most high-frequency traders receive direct market access (DMA) from exchange members. DMA allows them to “directly participate in the execution of an order against other orders submitted for execution.” High-frequency traders trade both as individuals and as part of larger groups. These groups typically include hedge funds, proprietary trading firms, mutual or pension funds and brokers who provide DMA.
Technological advances have enabled DMA providers to build ultrafast fibre-optic networks linking exchanges with investors’ computers, allowing data to travel in a matter of milliseconds. As a result, sophisticated algorithmic traders have constructed complex trading strategies that can automate specific decision-making processes, allowing them to identify the highest quality trade opportunities from numerous exchanges and execute these trades almost instantaneously.
How is HFT regulated?
The Dodd-Frank Act gave the Securities and Exchange Commission (SEC) the authority to write rules regarding high-frequency trading, with one goal being to reduce volatility within the market caused by HFTs. However, it is unlikely that these regulations will effectively tackle problems such as latency arbitrage or quote stuffing. This type of risk-taking behaviour can lead to flash crashes across various markets, such as the 2010 flash crash when one trillion dollars of market value disappeared in a matter of minutes.
Alongside this, new regulations may make it even more difficult for high-frequency traders to engage in latency arbitrage, or they may find better ways around them. For example, SEC’s Regulation NMS aims to facilitate price improvement and improve the quality of executions for retail and institutional investors.
Still, some HFT firms have been able to work around these rules. Although regulators are cracking down on unfair trading practices, which give HFT an advantage over traditional investors that must rely on slower executions through their broker, it would be unrealistic to expect all forms of HFT behaviour to disappear. High-frequency traders provide liquidity and narrow bid-offer spreads, which benefits all market participants.
Beginner traders interested in the forex market are advised to contact a reputable online broker from Saxo Bank and trade on a demo account before using complex strategies such as high-frequency trading.