High-frequency trading or HFT is a method that involves buying and selling stocks at incredible speeds. Sometimes in a matter of microseconds. A profit can be made from small changes in pricing in a matter of seconds and it’s all done using computers.
Here we’ll explain HFT in more detail, delve into the history and discuss how it works. There are benefits and drawbacks to HFT which we will go over along with the laws associated.
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High-Frequency Trading (HFT) is a trading strategy used by large firms to earn profits on the stock market over short periods. It uses algorithmic trading to execute thousands of orders in fractions of a minute.
The strategy has received criticism over the years that companies have been using it to trade. There are even instances where HFT resulted in large market shifts and drops.
But how does it work? What is its history and why are so many people critical of it? Let’s go over these details to help you understand one of the most controversial aspects of the modern stock market.
History of High-Frequency Trading
High-frequency trading actually began back in the 1930s, well before the proliferation of personal computers. If you’ve seen any movies where brokers are standing in a bull pit at the stock exchange and shouting their orders, you’ve seen high-frequency trading.
Once computers became widely available, the face of HFT changed. Now companies can set up complex algorithms that monitor markets and execute trades automatically.
Before the 21st Century, HFT made up less than 10% of the orders on the New York Stock Exchange. According to their most recent data, HFT now accounts for nearly 70% of the equity orders on the NYSE.
How High-Frequency Trading Works
High-frequency trading is similar to the retail trading strategy of Scalping.
HFT firms open and close massive positions on the stock market in seconds, or sometimes fractions of a second.
One of the driving forces behind HFT is to provide liquidity to the market. Liquidity is a market’s capability to fill both sides of an order.
Similar to scalping, firms that use HFT strategies make a profit by capitalizing on tiny shifts on securities that happen quickly.
Unlike scalpers, HFT firms can commit millions of dollars to any trade at a time. Where retail traders are limited to tens, maybe hundreds, of thousands of dollars, HFT firms can earn enormous profits from holding a position for only a couple of seconds.
Benefits
Despite its detractors, high-frequency Trading does provide some benefits to the stock market as a whole.
One of the biggest benefits is the massive amount of liquidity that it adds to the market. For example, the collapse of the Lehman Brothers in 2008 resulted in major liquidity concerns for the NYSE.
As a result, the exchange incentivized firms to provide liquidity. This meant that traders could keep filling orders without there being no one to take the other side of the position.
Drawbacks
Many experts believe that the ubiquity of HFT is a cause for concern and could result in unexpected market crashes.
A famous example of this is the “Flash Crash” of 2010, where the Dow Jones dropped 10% in a matter of minutes. Although it quickly recovered, it left many people concerned that larger problems could lie ahead.
It was argued that the volatility of HFT was a contributing factor to the market’s short-term crash, and that stronger regulation was needed to prevent something similar from happening in the future.
Another criticism is that, although it provides liquidity to the market, it’s too short-lived to be useful. HFT is executed in a matter of seconds. Experts argue that this timeframe is too short to be useful to retail or institutional traders.
There have also been criticisms that HFT firms have an unfair advantage over retail investors. Because their trades are so large, HFT has a large influence on market trends.
Laws and Regulations
As a result of all of the controversy surrounding HFT, many countries are now introducing laws to restrict their movement and reduce market volatility.
Italy in particular has targeted the practice. The Italian government has put in a tax on HFT traders whose trades last less than half a second. This tax has earned the government a lot of revenue, and HFT orders in the Italian market have slowed.
In 2015, a Parisian regulator, the European Securities and Markets Authority, set up time standards for all HFT traders in the EU. Clocks were synchronized to within one one-billionth of a second.
This gave regulators highly accurate timestamps of when trades were executed so that they could be more reliably scrutinized. Auditors can use these timestamps to determine exactly when orders were placed and pick up any instances of market manipulation.
Laws in the US on HFT
American market authorities like the SEC have been slow to regulate HFT firms.
There are many instances where HFT strategists in America have been found guilty and fined for various forms of market manipulation.
For example, in 2013 HFT company Panther Trading was fined over $4 million for using their HFT to feign interest in futures and stocks. This tactic is called “spoofing” and Panther’s owner was charged with commodities fraud.
Another instance of a firm getting fined for spoofing happened as recently as 2019 when Tower Research was fined nearly $70 million when it came to light that some of their top traders had been spoofing.
Conclusion
High-frequency Trading is controversial for a lot of reasons. Many people are critical of how it provides liquidity to the market. Other detractors are concerned with the instances of market manipulation that HFT firms use to benefit themselves.
Either way, HFT isn’t likely to disappear any time soon. The best move forward is to clamp down on the practice and try and regulate it so that the damages it causes can be somewhat mitigated.
HFT is not a strategy that retail traders can use. It’s limited to large companies with millions in cash that they can afford to trade on the stock market. It also relies on high-powered computers executing closely guarded algorithms.
But it’s still important that retail traders pay attention to the HFT market. Because they are one of the largest participants on the stock market by volume, HFT firms have a large role to play in movements and trends.
