High-Frequency Trading
High-frequency trading (HFT) is a trading method where powerful computer programs are used to carry out a large number of orders and transactions in less than a second. It is an automated trading platform that is used by large investment banks, hedge funds, etc. Multiple markets are analyzed and orders are executed by using complex algorithms.
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How does High-Frequency Trading work?
High-Frequency Trading uses highly powerful computers to carry out a huge number of orders in a fraction of seconds. They help traders scan multiple markets and exchanges and execute millions of orders within a second. Complex algorithms are used by the systems to spot emerging trends, shifts in the marketplace at bid-ask spreads which are beneficial to traders. High-frequency trading also has a high turnover rate and order-to-trade ratios. This is because trades with faster execution are more profitable than slower execution trades.
Advantages:
- High returns: HFT trades in large volumes of securities and helps traders profit from small price fluctuations. Due to HFT, institutions get significant returns on bid-ask spreads.
- Arbitrage opportunities: Algorithms are used to scan multiple markets and exchanges enabling traders to find more arbitrage opportunities as the algorithm picks up on minor price differences for one asset traded on different exchanges.
- Liquidity: As trades are executed faster in great volumes, HFT increases competition in the market. This liquidity declines bid-ask spreads and makes the markets more price efficient. Also, this helps the buyer’s price and seller’s price to move closer.
Disadvantages:
- Less known: High-frequency trading is considered by many, a controversial activity as there is little knowledge about it among financial professionals, regulators, and some investors.
- High Sharpe Ratio: HFT doesn’t hold their portfolios overnight and hence accumulates a minimum amount of capital and holds it for a short period before liquidating. Thus, the Sharpe Ratio which is a risk-reward ratio is extremely high.
- Ghost liquidity: The opponents of HFT exclaim that the liquidity created is not real because the securities are only held for seconds. Before an investor can even buy the asset it is traded multiple times.
- Unfair to small players: High-frequency trading is usually done by large financial institutions and they often profit at the expense of smaller institutions and investors in the market.
- Increased volatility: HFT increases market volatility and has even caused market crashes. Some HF traders are even caught by regulators for engaging in illegal market manipulations.
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Conclusion:
High-frequency trading (HFT) is trading done by using powerful computers and algorithms that complete transactions and orders within seconds. These trades are executed at high speeds and in great volumes. They are generally used by large financial institutions like investment banks and hedge funds. It has numerous advantages but critics see them as an unfair advantage for large firms against smaller market players.
Author – Abha Shetty
About the author – Abha is a second-year BMS student and FRM level 1 candidate. She is very intrigued by the world of financial markets and hopes to master the art of investing and trading.
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