High-frequency trading or HFT is a form of trading that uses powerful computer systems and complicated algorithms to execute high volume trades based on market conditions in a matter of seconds or less. With this type of trading, the aim is often to attain profits of just a fraction of a cent, generating worthwhile gains by trading high volumes and trading repeatedly.
High frequency trading accounts for a large percentage of the entire volume of trading on the US markets. This percentage has been estimated to be around 50% since 2012, and was even higher in the several years prior.
The History of High Frequency Trading
High frequency traders have been participating in the markets since the authorization of electronic exchanges by the SEC at the end of the 1990s. In keeping with the ever-increasing computer power, as stated by Moore’s Law, transaction speed has continued to increase. At the onset of HFT, a trade took seconds to execute, but now, in 2015, trades are executed in milliseconds.
Competition among High Frequency Traders
Because of the importance of speed, high frequency traders, who are basically competing against one another can win or lose on the basis of a millisecond; which may be attributed to more powerful software, or a better physical location which enables faster Internet speed. As HFT has become more prevalent, it has also become more competitive and less profitable.
Is HFT Detrimental to Other Market Participants?
There are people who claim that the high frequency trading firms put individual investors at a disadvantage. High frequency trading may contribute to market volatility, in cases such as the ‘Flash Crash’ of 2010. According to a statement from the SEC in 2010, “High frequency trading firms have a tremendous capacity to affect the stability and integrity of the equity markets. Currently, however, high frequency trading firms are subject to very little in the way of obligations either to protect that stability by promoting reasonable price continuity in tough times, or to refrain from exacerbating price volatility.”
The Positive Perspective of HFT
There is, however, an opinion among many within the financial sector that HFT is beneficial to the markets. As well as increasing liquidity within the markets, HFT can also reduce the bid-offer spread, and help to lower the cost of trading for individual traders or investors.
High frequency trading has been encouraged by exchanges as a means of adding liquidity to the markets. In 2009, the New York Stock Exchange began offering a rebate on transactions. Although this rebate is only $0.0015, if a firm is executing millions of trades in a day, this rebate can definitely supplement their gains.
Is HFT Front-Running or Market Manipulation?
High-frequency trading is sometimes believed to be synonymous with front-running trading. When the dissemination of information does not reach all market participants with equal speed, it is easy to see that those receiving earlier information could be seen as conducting front-running.
There has been a lot of controversy surrounding high-frequency trading in recent times. This escalated with the news on April 21, 2015 of the arrest of a trader for market manipulation that is believed to have contributed to the ‘Flash Crash’ of 2010.
For individual traders and investors, it appears that the participation of high-frequency trading firms in the market is not only an inevitable fact, but is more likely to provide advantages than disadvantages. Recent scandal aside, these high-frequency traders generally contribute to the liquidity of the markets, and help to lower the costs of trading, benefitting other market players.