High-Frequency Trading — the Pros, the Cons, and the Future
- High-frequency trading is a method of trading that uses robust computer programs to transact a considerable number of orders in a fraction of a second.
- HFT companies take advantage of automation and computing power to conduct these trades quickly.
- HFT has received its fair share of criticism regarding allowing larger companies to gain the upper hand in trading.
- There will always be a difference between HFT and retail trading.
To fully understand the impact of the market and the prices, traders worldwide have taken advantage of automation. Over 80% of trading these days takes advantage of automation.
As such, the investment industry is changing dramatically.
What is High-Frequency Trading?
High-frequency trading (HFT) is finding opportunities in the market, capitalizing on them, and doing so in a manner that relies on speed on execution.
High-frequency traders typically do not care about the asset they are trading; they only care about the price they see in front of their screens. All of the price changes lead to different opportunities.
A price is simply a number on the screen, and different people across the globe have other numbers on their screen for the same commodity.
So, if coke in your country costs $1, somewhere else, it might cost $3.
If you were a high-frequency trader, so, if you got a bunch of people to buy coke in your country for $1 and sell them somewhere else where they cost $3, here, you are using the discrepancy in the price that you can capitalize. Here we see the arbitrage strategy through which you can make money.
Often, the opportunities in high-frequency trading arrive and also disappear just as quickly as they originate. As such, high-frequency traders need to capitalize on options such as these quickly.
While all traders might employ similar basic strategies, different people have different strategies that others do not know.
There are high-frequency trading firms (HFT). These are firms that will typically use sophisticated computer programs.
These programs are developed and intended to execute thousands of trades within a second.
Traders often measure time in microseconds in these sorts of trades.
When a security’s price is lower or higher than specific statistics indicate that it should be, traders can end up making a profit on it from this discrepancy through buying an undervalued stock and then selling it when its price rises to an expected level.
Then we have statistical arbitrage that you can find in pairs trading. Here, traders can identify two stocks that move together, which experience similar rises and falls in their price, where they can take long and short positions on these stocks when they begin moving in either direction.
Traders profit from these trading pairs of stocks returning to similar price levels. High-frequency trading, in turn, encourages firms to engage in statistical arbitrage, where they can sometimes hold securities for brief periods before taking profits.
Then you have a strategy known as an arbitrage strategy, where high-frequency traders will end up targeting the differences between a stock’s price on various trading platforms.
Suppose an HFT firm’s algorithmic trading program ends up detecting that a stocks’ price has increased on the exchange while remaining the same on another exchange. In that case, the program can buy the stocks at their lower price at the second exchange automatically and then sell them at a higher price on the first exchange.
When it comes to high-frequency traders, the speed at which these trades occur is critical. If they end up acting too slowly, this means that the stock’s price discrepancy between exchanges can disappear before a trader has an opportunity to make a profit off it.
How does Nasdaq Handle HFT?
Technology is the driving force behind HFT. Algorithmic trading is a type of trading in which firms use specific computational power pre-programmed with algorithms or sequences of steps developed to identify trading opportunities and then execute their orders.
Then you have low latency, which refers to the amount of time it takes for specific information to reach a trader’s computer or the amount of time for the trader to place an order in response to this particular information. Finally, you have colocation where traders pay to put their computers in the same data centers as an exchange’s computer servers.
Furthermore, high-frequency trading firms take advantage of the better functioning markets and rely on specific methods to conduct this business.
How Traditional Stock Exchanges Handle HFT
These exchanges allow users to trade from both sides, where they can place orders to buy and sell using limit orders that are above the current marketplace, in the case of selling, and below the current market price in the case of buying.
This difference between the two is how they profit. These provide liquidity and play the role of market makers through creating bid-ask spreads. Then you have statistical arbitrage, where a proprietary trader is on the lookout for temporary inconsistencies in prices across different exchanges.
Market makers are firms that simultaneously make offers to buy as well as sell securities at specific prices. They provide liquidity to the other market participants as a result of this. These firms intend to profit from the bid-ask spread of these securities, which is the difference between the lower price at which they buy a security and the higher price where they end up selling it.
Now, exchanges encourage these market makers by offering them rebates or other benefits for their specific services. These rebates will typically equal a fraction of a penny per share; however, since high-frequency traders buy and sell vast amounts of shares, these can add up to something truly enormous.
Then you have dark pools. You see, some stocks get listed on a specific exchange that does not need to trade on that exchange. Many modern trading procedures take place outside of public exchanges, in what is known as dark pools or private trading platforms, which can sometimes get sponsorship by central banks.
Here, you can buy and sell orders that get matched anonymously and at prices that are not displayed publicly until after the trade.
HTF firms emerged as significant providers of liquidity in these private platforms.
Furthermore, high-frequency trading companies will place small immediate orders that are canceled for security to determine if there is interest in buying or selling it in dark pools.
How the Banks Handle HFT?
Much of the high-frequency trading occurs through investment banks and hedge funds through automated trading platforms. These platforms facilitate HFT automatically, which means that there is no need for any human interaction, which allows for a high level of speed.
How Cryptocurrency Exchanges Handle HFT?
HFT in the cryptocurrency market sees investors taking advantage of small price fluctuations and exploiting the bid-ask price.
The bid-ask spread is the difference between the price at which you buy a cryptocurrency and the lowest price you can sell it.
For example, when you buy Bitcoin, you are not paying the market price but the asking price, which is higher.
If you sell it, you will pay the bid price lower than the current market price.
One of the fundamental practices in cryptocurrency trading is colocation, which is used when a trading server is placed as close to an exchange’s data center as possible.
The server should typically be found within the same facility as the exchange, which results in minimal latency for data transmission.
Millisecond delays can have a significant impact on institutional traders. Furthermore, HFT algorithms are used for arbitrage as well as short-term trading in these cryptocurrency markets.
As such, HFT can leverage profits on speed and automation on cryptocurrency exchanges, provide liquidity to sustain the trading markets, and eliminate potential errors.
Positives of High-Frequency Trading
Another exciting aspect of the HFT industry is that it has a negative aura associated with it. However, this might not be the case. You see, ultimately, it changed trading conditions for the better. With the Electronic Communications System or ECN, brokers can easily pair buying and selling orders.
Pairing a client’s orders with the liquidity provider’s orders has never been complicated; however, through the usage of computers, when this process does indeed become automated, pairing gets better.
Trading has always experienced some form of change, and the chances are high that it will experience changes in the future and technology evolves further. The difference between HFT and retail trading will, however, always be present.
Trading robots are machines that automatically execute trades for us. The entire HFT industry trades the seventh or the eighth decimal in a cryptocurrency pair. This gap will never close, and trading will change to become a lot more sophisticated in the following years.
Given that all of this is dependent on computers, this would imply that everything that surrounds us in this field is also reliant on computing power.
The future belongs to artificial intelligence. When this AI gets to a point where it will completely replace humans in making trading decisions, unaffected by emotions and work only based on raw data, only then we can say for sure that the HFT layout has changed globally.
Negatives of High-Frequency Trading
This industry has a problem, and this is the fact that it influences the way the market moves significantly. Today, we follow robots. HFT players, firms with more capital and computing power than any retail trader, program their algorithms to make “buy” or “sell” orders on a cryptocurrency pair. These robots can react to any economic data that gets released.
Summary
High-frequency trading is ultimately the complex algorithm trading where many orders get executed within seconds, adding liquidity to the markets and eliminating small bid-ask spreads.
It has received its fair share of criticism regarding allowing larger companies to gain the upper hand in trading. The liquidity produced this way is momentary, meaning it disappears within seconds, making it difficult for others to take advantage of it.
However, it does provide improved market liquidity, and all decisions happen in milliseconds, which results in significant market moves.
The future of trading will be in computing power and artificial intelligence. Still, for the time being, high-frequency trading is a showcase of how traders can take advantage of arbitrage on a large scale.
You can achieve high-frequency trading by using state channels. State channels have unique properties that make them suitable in the cases where rollup-based solutions would struggle.
One of these properties is the ability to disintermediate transactions, where once two parties establish a channel, they can exchange value without needing to involve a third party. We will be discussing the rest of this in our State Channels & Redefining High-Frequency Trading article.
Thank You for Reading
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