If you are an investor, high-frequency trading (HFT) is a part of your life even if you don't know it. You've likely purchased shares offered by a computer, or sold shares that were purchased and instantly sold by another computer. HFT is controversial. Traders disagree and studies contradict other studies. Regardless of the opinions, what is most important is how HFT affects your money.
Key Takeaways
- High-frequency trading is blamed for the flash crash that occurred on May 6, 2010, when the major indices plummeted in a matter of minutes.
- At least one study suggests that HFT firms make higher profits when trading against retail investors in the futures market.
- Despite fears over high-frequency trading, annual revenue at HFT firms has declined significantly since 2011.
What Is High-Frequency Trading (HFT)?
High-frequency trading (HFT) is a broader term for various trading strategies that involve buying and selling financial securities at extremely high speeds. Using algorithmic trading, computers can identify market patterns and utilize automated and pre-programmed instructions to execute buy and sell orders in a matter of milliseconds.
One strategy is to serve as a market maker, where the HFT firm provides liquidity on both the buy and sell sides. By purchasing at the bid price and selling at the ask price, high-frequency traders can make profits of a penny or less per share. This translates to big profits when multiplied over millions of shares.
Does High-Frequency Trading Hurt the Market?
Because most trading leaves a computerized paper trail, one would think it would be easy to look at the practices of high-frequency traders and answer this question. However, HFT companies are reluctant to divulge their trading activities, and the large amount of data involved makes it difficult to form a cohesive picture.
Critics of high-frequency trading point to the flash crash that occurred on May 6, 2010. The major indices mysteriously plummeted 5-6% in minutes, and just as inexplicably, quickly rebounded. Shares of individual companies were executed at prices more than 60% off their value just moments before. Some trades executed for a penny or $100,000—stub quote prices that were never intended to be filled.
The Securities and Exchange Commission (SEC) issued a report blaming one very large trade in the S&P e-mini futures contract, which set off a cascading effect among high-frequency traders. As one algorithm sold rapidly, it triggered another, creating a financial snowball.
Following the flash crash, the SEC developed new circuit breaker rules that would impose a trading pause when a stock moves up or down by 10% or more within a five-minute period. Many critics asked whether imposing tighter regulations on high-frequency traders made sense, especially since smaller, less visible flash crashes happen throughout the market with regularity.
Does High-Frequency Trading Hurt Retail Investors?
What is important to most of the investing public is how high-frequency trading affects the retail investor. This is the person whose retirement savings are in the market, or the person who invests in the market in order to gain better returns than the near non-existent interest that comes from a savings account. A 2014 study shed some light on this question.
Former economists for the Commodity Futures Trading Commission (CFTC) studied HFT firms over a two-year period and found that revenue was concentrated among a handful of companies in a winner-takes-all market structure.
Studying the e-mini contracts, the researchers found that high-frequency traders made an average profit of $1.92 for every contract traded with large institutional investors and an average of $3.49 when they traded with retail investors. The paper concluded that these profits were at the expense of other traders and this may cause traders to leave the futures market.
The Bottom Line
Unchecked, the proliferation of high-frequency trading could risk creating the perception that the small investor cannot win. Governments have sought to rein in HFT firms, for example, by proposing a per-share trading tax. In 2012, Canada raised fees on market messages such as trades, order submissions, and cancellations, which disproportionately hit HFT firms because they send more messages than other traders.
Despite fears over high-frequency trading, there is also evidence to suggest that HFT firms simply don't pose the threat they once did. Revenue and profits have dwindled, making it tougher for HFT firms to survive. Industrywide, annual revenue is estimated at $6.1 billion in 2021, down considerably from more than $22 billion in 2011.
FAQs
No. High frequency trading provides two important services to the market: adding liquidity and very efficient price discovery. These services used to be provided mostly by specialists at large banks with far less efficiency and much greater end user cost.
Is high-frequency trading still a problem? ›
High frequency trading causes regulatory concerns as a contributor to market fragility. Regulators claim these practices contributed to volatility in the May 6, 2010, Flash Crash and find that risk controls are much less stringent for faster trades.
What is the disadvantage of high-frequency trading? ›
High-frequency trading offers significant benefits to online Forex brokers, including speed, liquidity provision, risk management, and data analysis. However, it also comes with disadvantages such as increased market volatility, concerns about market manipulation, high infrastructure costs, and regulatory scrutiny.
What percentage of stock market is high-frequency trading? ›
High-frequency trading refers to buy and sell orders made on financial markets over an extremely short timeframe. Trading is automated using algorithms and computers, enabling it to react very quickly to market events. On the equity markets, around 2/3 of all transactions are carried out by high-frequency traders.
Will HFT be banned? ›
However, high frequency trading seems to be far from rigging the markets— instead, HFT seems to make markets more efficient for all investors, making the case for stringent regulation unwarranted. One of the most important advantages of high frequency trading is its enhancement of liquidity in financial markets.
Why is high-frequency trading unethical? ›
Ethics and Market Impact
Some professionals criticize high-frequency trading since they believe that it gives an unfair advantage to large firms and unbalances the playing field. It can also harm other investors that hold a long-term strategy and buy or sell in bulk.
What is the alternative to high-frequency trading? ›
Momentum Trading
The age-old technical analysis indicator based on momentum identification is one of the popular alternatives to HFT. Momentum trading involves sensing the direction of price moves that are expected to continue for some time (anywhere from a few minutes to a few months).
What is the average return of high-frequency trading? ›
The exact average return on HFT is difficult to pinpoint, as HFT firms generally keep their detailed trading strategies and performance metrics private. However, most estimates put the average yearly return from HFT strategies between 5-15%, with the top firms generating returns of 20% or more in good years.
What is the future of high-frequency trading? ›
The Future of High-Frequency Trading
The future may see more sophisticated algorithms, the incorporation of artificial intelligence, and even greater speeds. However, this will likely be accompanied by enhanced regulatory scrutiny to ensure fair and orderly markets.
Which prop firms allow HFT? ›
Tower Research Capital – A leading global prop trading firm, Tower Research Capital boasts cutting-edge technology and infrastructure designed to support HFT strategies across various asset classes.
High frequency electromagnetic fields are absorbed by biological systems and lead, above all, to a warming of the tissue. The physical basis of this thermal effect is well known and beyond dispute.
What is the best major for high-frequency trading? ›
There are a few paths into HFT, but most of them require extensive technical skills in one or more of the following hard sciences such as mathematics, physics, computer science or electronic engineering.
Is high-frequency trading still profitable? ›
This type of trading can be very profitable but also carries significant risks. In simple terms, HFT is a method that employs powerful computers to execute a vast number of orders in fractions of a second. It employs advanced algorithms to analyze various markets and execute trades based on current market conditions.
Do hedge funds use high-frequency trading? ›
She has conducted in-depth research on social and economic issues and has also revised and edited educational materials for the Greater Richmond area. High-frequency trading (HFT) is an automated trading platform that large investment banks, hedge funds, and institutional investors employ.
What is toxic trading flow? ›
Flow toxicity is the case where market makers are providing liquidity at a loss to informed traders. Clearly flow toxicity is related to new information entering into the market through an increase of informed trading. Therefore VPIN, a measure of this toxicity, is a factor of the price discovery mechanism.
How does the high-frequency trading system affect the financial markets? ›
HFT uses complex algorithms to analyze multiple markets and execute orders based on market conditions. Traders with the fastest execution speeds are generally more profitable than those with slower execution speeds. HFT is also characterized by high turnover rates and order-to-trade ratios.
Can you make money with high-frequency trading? ›
High-frequency trading strategies
Although the strategy can be extremely risky, even a small difference in price can yield big profits. HFT algorithms can detect very small differences in prices faster than human observers and can ensure that their investors profit from the spread.
Is high-frequency trading useful? ›
Some of those firms could be considered high-frequency traders, bearing in mind the speed at which they operate and the amount of trades they handle. Good high-frequency trading could potentially make markets more efficient and knit liquidity together in a beneficial way for all participants.
