High-frequency trading: pros and cons
In this article, Shruti CHAND (ESSEC Business School, Grande Ecole Program – Master in Management, 2020-2022) elaborates on the concept of high-frequency trading.
This read will help you get started with understanding high-frequency trading and how it is practiced in today’s world.
What is it?
As the name suggests, the use of computer programs to place a large number of trades in fractions of a second (even thousandths of a second) is high-frequency trading or HFT.
These powerful programs have complex algorithms behind them, which analyze market conditions and place buy/sell orders in accordance with that.
The Upside
HFT improves market liquidity by reducing the bid-ask spread. This was put to test by adding fees on HFT, and in turn, bis-ask spreads increased. A study assessed how Canadian bid-ask spreads changed on the introduction of fees on HFT by the government, and it was found that market-wide bid-ask spreads increased by 13% and the retail spreads increased by 9%.
Stock exchanges, such as the New York Stock Exchange, offer incentives to market makers to perform HFT with the motive of increasing liquidity in the market. As a result of these financial incentives, the institutions that provide liquidity also see increased profits on each trade made by them, on top of their spreads.
Although the spreads and incentives amount to only a fraction of a cent per trade, multiplying that by a large number of trades per day amounts to sizable profits for high-frequency traders. In January 2021, the average Supplemental Liquidity Providers rebate was $0.0012 for securities traded on the NYSE. With millions of transactions each day, this results in a large number of profits.
The Flip Side
At one point in time, you can imagine HFT companies to be in heavy competition with each other to be the fastest, at the top of the game. Trading companies did everything from eliminating any possible inefficiency in the passage of signals from their IT equipment to the stock exchange; to relying on crunching more data to have an upper hand over their rivals. The boom years of this practice were in 2008 and 2009 when the difference between slower trading systems and the high-tech faster ones were in seconds. Now, all rivals have caught up and it is not as profitable of a business as it once was.
Besides this, HFT is also controversial and is faced with harsh criticism regarding ethical issues and their impact on market liquidity and market volatility as explained below.
Why is HFT criticized?
Critics believe HFT to be unethical. In their view, stock markets are supposed to offer a fair and level playing field, which HFT arguably disrupts as the technology can be used for ultra-short-term strategies. It has closed businesses for many broker-dealers; HFT is seen as an unfair advantage for large firms against smaller investors.
HFT is also said to provide ‘ghost liquidity’ i.e. the liquidity created by HFT in one second can be gone the next second, preventing traders from actually making use of the liquidity.
Moreover, a substantial body of research argues that HFT and electronic trading pose new kinds of challenges to the stability of financial markets. Algorithmic and high-frequency traders were both found to have had a contribution to volatility in the Flash Crash of May 2010, when high-frequency liquidity providers rapidly withdrew from the market. Several European countries have proposed restricting or fully banning HFT due to concerns about volatility.
Conclusion
It is very important to bear in mind the risk involved with high-frequency trading. With practice, you can become an expert, use SimTrade course to better your understanding about the financial markets to become a high-frequency trader.
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▶ Shruti CHAND Algorithmic trading
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Relevance to the SimTrade certificate
This post deals with High-Frequency Trading which is used by various traders and investors in different instruments. This can be learned in the SimTrade Certificate:
About theory
- By taking the market orders course , you will know more about how investors can use various strategies to invest in order to trade in the market.
About practice
- By launching the series of Market maker simulations, you can extend your learning about financial markets and trading approaches.
About the author
Article written in August 2021 by Shruti CHAND (ESSEC Business School, Grande Ecole Program – Master in Management, 2020-2022).