What is High-frequency Trading

What is High-frequency Trading

What is High-frequency Trading! How it Works, Strategies, Advantages, Disadvantages

We know that short-term trading requires a spike in prices to be profitable. However, stocks rarely rise significantly in a short period of time. It takes a lot of money to make a short-term trade profitable.

So, how do investors profit from these rare price fluctuations? Since prices don't fluctuate often, how do they make money? Well, this is where algo trading comes in. Basically, High-Frequency Trading (HFT) is when computers buy and sell stocks.

Professional traders and big fund houses use HFT to profit from price fluctuations. They prioritize orders instead of price fluctuation. 

To better understand how professional traders use HFT, we'll go over what high-frequency trading is, how it works, its advantages and disadvantages, and more.

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Table of Content

  1. What is High-frequency Trading! How it Works, Strategies, Advantages, Disadvantages

What is high-frequency trading?

High-frequency trading involves transacting a lot of orders quickly with powerful computer programs. 

The main purpose of HFT is to execute a large number of orders rapidly. Thus, using complex artificial algorithms, high-frequency traders analyze and execute large volumes of orders at extremely fast speeds.

Basically, faster execution speed means more profits for traders. So, to execute trades at the fastest speed possible, HFT uses special computers. Since it's so complicated, it's mainly used by institutional investors like hedge funds and investment banks.

Additionally, those engaged in HFT believe that if the number of orders is high and they are executed quickly, the profits from multiple trades are greater. Also, in HFT, turnover rates and order-to-trade ratios are high.

What is Algorithmic Trading?

An algorithmic trade is a process of executing orders at high speed in the financial market using pre-programmed trading instructions. 

Based on time, volume, and price, investors and traders feed software trading instructions. As soon as the set instructions are triggered in the market, the software executes the orders.

Most hedge funds, mutual funds, insurance companies, banks, etc., use algorithmic trading to execute huge volumes of trades. 

How does High-Frequency trading work?

It's pretty simple how HFT works. The more trades you make, the more you make. Plus, in the short term, it's a better strategy than holding stocks and waiting for their price to rise.

Also, it's crazy how fast stock prices fluctuate. Even just a change of one or two rupees can make a high-frequency trader money.

In HFT trading, computer-based quantitative models make all portfolio allocation decisions. It works because the artificial model is pre-fed with specific information. Investors and traders feed trading software instructions. And when the set instructions are triggered in the stock market, the artificial model executes them.

Additionally, an artificial model is capable of processing vast amounts of information and data, something that a human cannot accomplish. 

Strategies of High-Frequency Trading

Market making, quote stuffing, tick trading, and statistical arbitrage are some high-frequency trading strategies. Let's take a closer look at HFT strategies:

  • Market Making: Normally, this is a company or investor who is willing to buy and sell shares at a public price on a regular basis. In many HFT firms, market-making is an effective strategy. Using HFT strategies, limit orders are placed to sell or buy stuff.
     
  • Quote Stuffing: The goal of this HFT strategy is to create confusion. By buying and selling large numbers of orders rapidly, high-frequency traders try to gain market share. This confusion leads to a surge in trading volume, which gives high-frequency traders profitable opportunities to start multiple trades at the same time.
     
  • Tick Trading: The tick trading process involves powerful computers. As market data and trading volumes flow, the computers track the quotes and market information. A tick trade is usually used to mark the beginning of a large order.
     
  • Statistical Arbitrage: In this type of arbitrage, various securities are priced differently across multiple markets or exchanges. It is used in liquid securities like bonds, stocks, currencies, futures, etc. 

Advantages of High-Frequency Trading (HFT)

There are several advantages to HFT, including:

  • HF traders make quick profits: With HFT, investors make quick profits by executing many trades at the same time. Despite price fluctuations, a bid-ask spread can make investors a lot of money.
     
  • It opens up more opportunities: A high-frequency trader uses powerful computers and software to scan multiple markets at once. This lets investors identify arbitrage opportunities and profit by buying on one exchange and selling on another.
     
  • HFT enhances liquidity in the market: With increased competition and volume, HFT decreases the bid-ask spread, resulting in more efficient prices. Additionally, as liquidity increases, the market becomes more transparent and flexible, and less risky.
     
  • A lower chance of human error: When trading, humans can make mistakes or enter or exit at the wrong time. However, the benefit of HFT is that it avoids the interference of humans. Moreover, humans cannot execute such a high volume of orders at the speed of HFT.
     

Disadvantages Of High-Frequency Trading

There are also disadvantages to HFT. Here they are: 

HFT is difficult to monitor and regulate: It is challenging to monitor and regulate HFT due to its complex algorithms and software. It is also a controversial topic, as scholars and finance professionals have little consensus on HFT. 

A lot of people criticize high-frequency trading: Generally, HFT gets criticized because it replaces lots of brokers and dealers with software. Also, it's considered a bad process since investing most of the time requires human intelligence.  

There are one-sided profits: The infrastructure required to do HFT isn't available to retail investors. Thus, only large companies with the right infrastructure can make money from the strategy, at the expense of retail investors. Therefore, this liquidity is commonly referred to as 'Ghost liquidity'.

Conclusion

The high-frequency trading (HFT) technique uses computers to execute millions of trades at incredibly fast speeds. With algorithmic trading, investors execute trades quickly and accurately with minimal risk of human error through preprogrammed trading instructions. 

There are many types of HFT strategies, including market making, quote stuffing, tick trading, and statistical arbitrage. Fast profits, more opportunities, a greater liquidity pool, and reduced human error are some of the advantages of HFT. However, there are also disadvantages of HFT, such as difficult monitoring and regulation, criticism of replacing brokers with software, and infrastructure needs that are unreasonable for retail investors. Generally, HFT is a controversial topic in finance, and scholars and practitioners have little consensus.

High-Frequency Trading FAQs

Yes, HFT can be profitable. However, newcomers should stick to manual trading until they gain experience. They can slowly refine their strategies as they progress to HFT.

A high-frequency trader uses powerful computers to trade financial assets quickly.

Yes, HFT systems are legal, but they're also controversial. In HFT, there are some practices that are just illegal, like spoofing and front running.

Yes. Though High-Frequency Trading is a new idea in India, many have figured out the key points and turned it into a money maker. Today, there are start-ups that deal exclusively in HFT.

Investment banks, hedge funds, and institutional investors use high-frequency trading as an automated trading platform.