High-frequency trading (HFT) firms use ultrafast computer algorithms to conduct big trades of stocks, options, and futures in fractions of a second. HFT firms also rely on sophisticated data networks to get price information and detect trends in markets.
A key characteristic of HFT trading — in addition to high speed, high-volume transactions — is the ultra-short time time horizon.
How high-frequency trading impacts markets is a controversial topic. Proponents of HFT say that these firms add liquidity to markets, helping bring down trading costs for everyone. HFT critics argue such firms are an example of how bigger, better-funded players have an advantage over smaller retail investors, and that HFT technology can be used for illegal purposes like front-running and spoofing.
What is High Frequency Trading?
Ultrafast speeds are paramount for high-frequency trading firms. Executing these automated trades at nanoseconds faster can mean the difference between profits and losses for HFT firms.
There are broadly two types of HFT strategies. The first is looking for trading opportunities that depend on market conditions. For instance, HFT firms may try to arbitrage price differences between exchange-traded funds (ETFs) and futures that track the same underlying index.
Futures contracts based on the S&P 500 Index may experience a price change nanoseconds faster than an ETF that tracks the same index. An HFT firm may capitalize on this price difference by using the futures price data to anticipate a price move in the ETF.
Another type of HFT is market making. Not all market makers are HFT firms, but market making is one of the businesses some HFT firms engage in.
A big market-making business for HFT firms is payment for order flow (PFOF). This is when retail brokerage firms send their client orders to HFT firms to execute. The HFT firms then make a payment to the retail brokerage firm.
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How HFT Works and Makes Money
High-frequency trading enables traders to profit from miniscule price fluctuations, and permits institutions to gain significant returns on bid-ask spreads. HFT algorithms can scan exchanges and multiple markets simultaneously, allowing traders to arbitrage slight price differences for the same asset.
Bid-Ask Spreads 101
High-frequency trading firms often profit from bid-ask spreads — the difference between the price at which a security is bought and the price at which it’s sold.
For instance, an HFT may provide a price quote for a stock that looks like this: $5-$5.01, 500×600. That means the HFT firm is willing to buy 500 shares at $5 each — the bid — while offering to sell 600 shares at $5.01 — the ask. The 1 cent difference is how the market maker makes a profit. While this seems small, with millions of trades, the profits can be sizable.
How wide bid-ask spreads are is also a marker of market liquidity. Bigger chunkier spreads are a sign of less liquid assets, while smaller, tighter spreads can indicate higher liquidity.
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Payment For Order Flow 101
When it comes to payment for order flow, high-frequency traders can make money by seeing millions of retail trades that are bundled together.
This can be valuable data that gives HFT firms a sense of which way the market is headed in the short-term. HFT firms can trade on that information, taking the other side of the order and make money.
Background on High-Frequency Trading
High-frequency trading became popular when different stock exchanges started offering incentives to firms to add liquidity to the market. Liquidity is the ease with which trades can be done without affecting market prices.
Like momentum trading, the HFT industry grew rapidly as technology in the financial space began to take off in the mid-2000s.
Adding liquidity means being willing to take the other sides of trades and not needing to get trades filled immediately. In other words, you’re willing to sit and wait. Meanwhile, taking liquidity is when you’re seeking to get trades done as soon as possible.
During 2009, about 60% of the market was said to be HFT. Since then, that percentage has declined to about 50% as some HFT firms have struggled to make money due to ever-increasing technology costs and a lack of volatility in some markets. These days the HFT industry is dominated by a handful of trading firms.
Pros and Cons of High-Frequency Trading
HFT comes with certain pros and cons.
Pros of HFT
High-frequency trading is automated and efficient, thanks to its use of complex algorithms to identify and leverage opportunities.
HFT may create some liquidity in the markets.
Cons of HFT
Because high-frequency trades are conducted by institutional investors, like investment banks and hedge funds, these firms and their clientele tend to benefit more than retail investors.
Because high-frequency trades are made in seconds, HFT may only add a kind of “ghost liquidity” to the market.
Some HFT firms may also engage in illegal practices such as front-running or spoofing trades. Spoofing is where traders place market orders and then cancel them before the order is ever fulfilled, simply to create price movements.
The Debate Over High Frequency Trading
High-frequency trading is a controversial topic, and HFT firms have been involved in lawsuits alleging that they create an unfair advantage and potentially create volatility.
Criticism of HFT
One complaint about HFT is that it’s giving institutional investors an advantage because they can afford to develop rapid-speed computer algorithms and purchase extensive data networks.
Critics argue that HFT can add volatility to the market, since algorithms can make quick decisions without the judgment of humans to weigh on different situations that come up in markets.
For instance, after the so-called “Flash Crash” on May 6, 2010, when the S&P 500 dropped dramatically in a matter of minutes, critics argued that HFT firms exacerbated the selloff.
HFT critics also argue that such traders only provide a very temporary kind of liquidity that benefits their own trades, but not retail investors. A December 2020 paper published by the European Central Bank also argued that too much competition in the HFT industry can cause firms to engage in more speculative trading, which can harm market liquidity.
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Defense of HFT
Defenders of high-frequency trading argue that it has improved liquidity and decreased the cost of trading for small, retail investors. In other words, it made markets more efficient.
This can be particularly important in markets like options trading, where there are thousands of different types of contracts that brokerages may have trouble finding buyers and sellers for. HFT can be helpful liquidity providers in such markets.
When it comes to payment for order flow, defenders of HFT also argue that retail investors have enjoyed price improvement, when they get better prices than they would on a public stock exchange.
The Takeaway
It’s tough to be an investor in many markets today without being affected by high-frequency trading. HFT firms are proprietary trading firms that rely on ultrafast computers and data networks to execute large orders, primarily in the stocks, options, and futures markets.
HFT proponents argue that their participation helps markets be more efficient. Critics argue that they have a big advantage over smaller investors, given how much they pay for information and data networks.
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FAQ
Is high-frequency trading profitable?
High-frequency trading aims to profit from micro changes in price movements through the use of highly sophisticated, ultrafast technology. That said, HFT investors are subject to losses as well as gains.
Is high-frequency trading illegal?
High-frequency trading has been the subject of lawsuits alleging that HFT firms have an unfair advantage over retail investors, but HFT is still allowed. That said, HFT firms have been linked to illegal practices such as front-running.
What is an example of high-frequency trading?
High-frequency trading can be used with a variety of strategies. One of the most common is arbitrage, which is a way of buying and selling securities to take advantage of (often) miniscule price differences between exchanges. A very simple example could be buying 100 shares of a stock at $75 per share on the Nasdaq stock exchange, and selling those shares on the NYSE for $75.20.
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