People have been inventing new strategies, offbeat calculations and trading ideas throughout the trading history. The High-Frequency Trading algorithms are the trend of the last two decades. It takes fractions of a second to make transactions, which is much faster than a man can do. This article will be devoted to High-Frequency Trading, its history and strategies.
Before reading the article and writing your questions in the comments section, I recommend to watch this video. It’s not long but covers the biggest part of questions on the topic.
Table of Contents
What is High-Frequency Trading?
High-Frequency Trading is the main kind of the automatic trading by means of the algorithms for extra quick transactions using the stock market tools.
HFT is the software, the robot that requires high-end computational performance and the high-speed connection with the stock exchange.
The key features of HFT stated by the CFTC (the USA Commodities Futures Trading Commission):
- Applying of the trading systems that perform a rapid-fast (less than 5 milliseconds) order submission, cancellation or change;
- Applying of the software to automatize the process of deciding on opening the positions;
- Applying of the colocation-services for direct access to the stock exchange;
- Ultrashort period for opening and completing a transaction;
- High portfolio turnover daily;
- Submitting a large amount of the orders that can also be canceled that fast;
- Closing the day trading with no or near-zero positions.
Interestingly, High-Frequency Trading had been existing for many years but the term HFT and its definition was given by Charles Duhigg in the New York Times Magazine article “Stock Traders Find Speed Pays, in Milliseconds” on July 23.
How Do We Make Money out of HFT?
There are two main ways of making money by using the HFT algorithms:
- Market making is the way of supporting liquidity in exchange for the reward from the stock exchange;
- Arbitrage is the way of on-selling the correlated assets in various markets.
As you know, you can see all the orders and transactions in the Order Book and the Tape. Many of you have already seen this incredibly fast flow of transactions displayed in the Tape window and the orders’ change in the Order Books caused by the HFT algorithms.
A trader gets this data on the terminal via the Internet data channel. The HFT companies strive to get information about the transactions before others by using special technologies. That is why physical proximity to the stock exchange servers (the “collocation”) is a matter of critical importance. As a remarkable example of the struggle for the communication to the stock exchange, we can think of the 1,180-kilometer-long distance between Aurora (the suburb of Chicago) and Mavo (the city on the north of New Jersey). It is called the “chord of capitalism” in Russia.
According to the recent data, the MacKayBrothers Company nowadays is providing the fastest connection to the stock exchanges. It took only 4.09 milliseconds for the company to perform a data transfer through 22 stock exchange stations. The rivals are at least 60,000 nanoseconds behind.
Nota Bene: the important principle of HFT involves working with large trading volume. The positions are not transferred to the next day but they are closed during the current trading day instead.
Thus, the robots opening positions at the incredible speed have managed to form their trading niche, in which they challenge for each millisecond and nanosecond. Of course, there are less common speculative systems used for this kind of algorithms but they carry much greater risks.
According to official sources, HFT was invented in 1998 when the members of the United States Securities and Exchange Commission gave a green light for using the electronic platforms. The idea of the HFT algorithms had occurred almost 10 years before that. Steve Swanson was a talented programmer, the holder of a scientific degree in mathematics and the HFT founder. He brought to life an idea of using powerful computers in stock trading.
In the years since, Steve along with two associates (David Whitcomb and Jim Hawks) launched the Automated Trading Desk Company, which was the world’s first HFT company. It took much more time to process an operation in those days but they managed to make an incredible thing and reached making a transaction within 1 second.
Spread of High-Frequency Trading
The High-Frequency Trading robots brought a huge profit. Therefore, this way of trading had quite a few followers. The transaction volume multiplied by 2.6 times and the processing speed increased to 10s of microseconds by 2010.
The largest USA HFT players:
- Virtu Financial;
- Citadel LLC;
- Chicago Trading.
This list is not limited to several companies. Generally, the largest banks also use this technology but they prefer to sweep that under the carpet.
Stock Market Crash Caused by the HFT Algorithms
On May 6, 2010, the Dow Jones Index fell by 990 points in 5 minutes for no reason at all, which resulted in the stock exchange panic and the decline of the quotation.
It became known later, that 70 percent of the market consisted of the HFT traders. All it took for them to collapse the market was to close the positions. Since their trading schemes were very similar, that is exactly what happened within 2:42 PM to 2:47 PM on May 6. This case gained a strong resonance among the public.
The media and many financiers were making announcements and statements against HFT. Many politicians were taking part in the commissions and hearings aimed at prohibiting or imposing a tax on HFT.
It never brought any results and HFT increased its market share.
The traders noticed that HFT was getting less efficient by 2012 and its market share was decreasing significantly. The HFT profit fell fivefold from $5 billion in 2009 to $ 1.25 billion in 2012.
The book “Flash Boys: High-Frequency Revolution on Wall Street” by Michael Lewis was published in 2014 and became a bestseller. It described the HFT background and its mechanisms as a financial fraud and the market development.
Many smaller HFT companies started to leave the market in 2016 because of the low volatility. Their profit was a pittance compared to what it was in 2009 or 2010.
Just have a look at the VIX volatility index to see the difference:
Volatility has a significant influence on the profitability of the High-Frequency Trading algorithms. Michael Beller (CTO of the Tradeworx Inc.) and Thomas Peterffy (a billionaire and a co-owner of the Interactive Brokers Group) told about the complexities of the modern market and the search for deals in 2017.
Who is using HFT Now?
Only large investment vehicles and funds can still afford to keep the HFT programs on the run. Private investors and traders are out of this game, it is completely inaccessible to them. Still few Proprietary Trading companies still use HFT on their nickel.
Generally, you can split the HFT players into four categories:
- Independent Proprietary Trading companies;
- The brokers’ subsidiaries;
- Hedge Funds;
- Large banks and investment vehicles.
It is all so since HFT requires:
- High processing performance;
- Optimization of the trading patterns and location of the HFT servers near the Stock Exchange gateways performing under the FIX/FAST protocol
- Use of high-level programming languages such as C++, Java, etc.
- Large investments.
An overage trader would never have that, regardless of the financial capabilities or desires.
Many people describe this infrastructure as a monopoly on the stock market, which also requires business “associates” and an exceptional position. It is of no surprise since the HFT companies get information about all the market transactions much earlier and subsequently have a huge advantage over other market players. In particular, Michael Lewis’s book provides us with information about the “dark pools” scheme and how large funds and banks use it to handle the transactions of their wealthy clients.
Usually, the HFT strategies are aimed at gaining profit from the market inefficiency rather than taking part in the large price movements. Therefore, the price of the well-known companies stock does not fluctuate a lot. By the way, the HFT traders prefer to handle transactions with this kind of the stock.
High-Frequency Trading Strategies
As I have mentioned before, HFT is usually applied in the sphere of market-making or arbitrage. Of course, that had an impact on the modern trading strategies of such kind. There are several most common variations of the HFT strategies:
- Statistical arbitrage is the strategy based on analysis of the correlation between the tools and on the search of the profitable price variance of the related tools on various markets.
- Arbitrage rebate is the strategy based on placing passive orders on various stock exchanges using the special algorithm.
- News arbitrage is the strategy based on the quickest possible analysis of the newsfeed to open positions when important statistic data occurs.
- Market making is the strategy based on creating liquidity on the market by the specified tools and monitoring spread value for the reward from the stock exchange or other structures.
- Front-running is the strategy based on determining the large orders and placing orders before them.
- Spread trading speculation is the strategy based on determining the micro-trends within the spread and handling the profitable transactions.
- Structural trading is the strategy based on the vulnerability of the market structure, and the connection between the stock exchanges and the brokers’ clients.
- Directional trading is the strategy based on spoofing or manipulation of the market to bring the aggressive traders to the play and capturing the stop orders.
This list is not limited to these strategies as more and more innovative HFT strategies appear every year. There are some of them, which only a limited range of people know.
Criticism of High-Frequency Trading
The HFT algorithms have been heavily criticized over the last decade. It got really heavy after the book “Flash Boys” by Michael Lewis was published. Nevertheless, it describes the market as innovative or technically advanced and oversells it. In real life, the critics may have several arguments:
- HFT makes possible to hide multi-billion dollars profit from the investors and ordinary people;
- The traders using the benefits of HFT skim the cream off the transactions of the mutual funds that keep the pension savings and subsequently denude the money from the people (financial loses are approximately over few billion dollars every year);
- Algorithm failures can lead to the stock market crash as it happened on May 6, 2010.
On the other hand, there are many followers of High-Frequency Trading. They make a point that it has a higher liquidity, it requires less money for the trade and has other advantages that this kind of technology may provide.
HIGH-FREQUENCY TRADING (HFT) HAS BECOME AN INTEGRAL PART OF THE MODERN STOCK MARKET. ITS MEANING IS TO MAKE A DIRECT CONNECTION TO THE STOCK EXCHANGES AND USE THE HIGH PROCESSING PERFORMANCE FOR MAKING AUTOMATIC TRANSACTIONS WITHIN A FEW NANOSECONDS. ONLY LARGE PLAYERS SUCH AS HEDGE FUNDS, BANKS, INVESTMENT VEHICLES ARE USING THE SYSTEMS OF THIS KIND. THE HFT TRADERS GOT A HUGE ATTENTION IN 2010 WHEN THEY CAUSED A MARKET COLLAPSE
The most commonly used HFT strategies are the various arbitrage and market-making ones. Nevertheless, more and more strategies of this kind appear every year as well as the innovative solutions that are known to a limited range of the players. We cannot consider the High-Frequency transactions having a negative or positive effect on the market. The critics say that the HFT traders take the profit and skim the cream off the market at the expense of the honest investors. On the other hand, the adherents of HFT say that it provides liquidity and cuts down the trading expenses while ensuring the safe functioning of the market.