High Frequency Trading - Financial Ethics - Seven Pillars Institute (2024)


What is High Frequency Trading?

High Frequency Trading (HFT) involves the execution of complicated, algorithmic-based trades by powerful computers. The objective of HFT is to take advantage of minute discrepancies in prices and trade on them quickly and in huge quantities. These practices have been around as long as computer systems have been in our lives. As computers get more technically advanced, trading practices have increased in size and algorithms have become more sophisticated. The trades are done at close to the speed of light. Remarkably, HFT firms have moved their server farms near an exchange computer to further increase trading speeds.[1]

HFT firms design a variety of strategies to take advantage of various market scenarios. Algorithms trade on price movements past a certain threshold, corporate actions, price ceilings, price floors, and discrepancies in bid/ask spreads. The trades are executed without any human action except for initial programming. In most cases, the trades are executed before individual investors know the quotes of prices, or that the trades happened at all.

For instance, a computer recognizes when one exchange quotes an ask price of one cent more than the quote on another exchange. This computer then trades in extraordinarily large volumes on this information, taking advantage of the arbitrage opportunity in a split second. Before individual and other investors who do not possess the same sophisticated technology realize, the one-cent spread between the two exchanges is erased and the stock price trades at the same level.

HFT firms have become more fragmented. In the past, large investment firms who had proprietary trading arms experimented with HFTs as a way to supplement their human traders’ activities. Now there are entire hedge funds devoted to this strategy. Managers pool capital based on a proven computer technology and allow the program work for them. In addition, large trading shops incorporate these HFT strategies as part of their overall practice. Such large volumes of HFT trades are being executed that most of the liquidity in daily trading is a result of these trades. By some estimates, HFT makes up 60 to 70% of all trades done in the US on a daily basis.1 Other estimates project that if these strategies keep proliferating at their current rate, 80% of trades will be HFT trades by 2012.[2]

Arguments in Favor of HFT

1. Liquidity

For markets to function properly and for investors to have confidence putting their money into the stock markets around the world, there must be an adequate amount of liquidity. Investors want to know when they put their money into the market they will be able to sell their investment at a later time. HFT strategies improve market liquidity. The amount and volume of the trades using this strategy ensure a liquid market. HFT traders act as makeshift market makers who buy and sell when no one will. In fact, the spreads they make off their trades are “likely less than what was taken out of the system previously by traditional market makers.”1 As HFT trades can make up as much as 70% of the trading volume in a given day, investors have a greater ability to be matched up with a counterparty i.e., the HFT trader, willing to either buy or sell at their desired price. Currently, especially for highly followed companies, it is relatively simple to buy or sell a reasonably large amount of shares.

2. Market Efficiency

HFT contributes to market efficiency. According to the efficient market hypothesis stock prices already have all public and non-public information priced into them. HFT takes advantage of price discrepancies and arbitrages any discrepancies away. Many believe that, “Narrow spreads mean the market is working better.”1 Without the large HFT trades that take advantage of the market’s inefficiencies, there would be larger bid/ask spreads. Consequently, investors may be less satisfied with the prices they get in their trades.

3. Reduced Costs

Increasing liquidity and market efficiency may, some argue, also contribute to falling trading costs for smaller investors. A major cost to mutual funds results from the bid/ask spread.1 This cost may be mitigated by the activities of HFT that narrow bid/ask margins. Narrower spreads also reduce costs that arise from large fund transactions that affect the final price of a security. HFT traders are able to break these big trades into a many small trades to reduce the effect of a large buy or sell order.1

4. Profitability

One last benefit provided by HFT strategies is their profitability. There is no reliable information on the profitability of HFT firms. Hedge funds do not like to disclose their strategies or profits.[3] Despite the lack of concrete information, HFT profit potential can be inferred from statistical data. The below chart shows the Sharpe ratio potential on a typical HFT strategy as opposed to slower implemented trades.3

High Frequency Trading Profitability Potential
Trading FrequencyAverage Maximum Gain per periodRange Standard Deviation per PeriodNumber of Observations in the Sample PeriodMaximum Annualized Sharpe Ratio*
10 Seconds0.04%0.01%2,592,0005,879.80
1 Minute0.06%0.02%43,2001,860.10
10 Minutes0.12%0.09%4,320246.40
1 Hour0.30%0.19%720122.13
1 Day1.79%0.76%3037.30
*The Sharpe ratio is also called the Reward-to-Variability Ratio. It measures the excess return per unit of risk.

As shown, the potential for higher returns exists based on the strategy alone. In fact, the Sharpe ratio is over 200% higher for the 10 second trading frequency than for the 1 minute frequency. The ratio indicates the enormous potential of these strategies and how they can be used to take advantage of market events without significant man-hours spent on research and other due diligence.

But HFT can be Used Unethically

1. Market Manipulation: Trillium Capital

HFT can give traders an unfair advantage if they engage in market manipulation. HFT computers can influence the market for the trader’s own advantage. Take the case of Trillium Capital.

Trillium Capital is an HFT firm in New York that engaged strictly in HFT trades. Trillium entered many trades that were considered non-bona fide because Trillium had no intention of following through on these orders. The placement of the orders was to deceive the market into thinking there was a large amount of activity happening in certain securities. These orders induced other traders to trade based on the mirage of demand or supply created by Trillium. Before these non-bona fide trades were entered, Trillium had limit positions, which executed as a result of ther traders creating buy or sell side demand which moved the prices in certain directions. Once the real trades were executed, Trillium immediately cancelled their non-bona fide trades and profited from their limit orders.[4] These types of trades are illegal and cause market movements or prompt market activity that would not have happened had these HFT traders not manipulated the market to their advantage. Thus, investors and regulators rightly worry about the opportunity for these types of illegal and unethical trading activity that HFT provides.

2. Unfair to Small Investors

Another argument against HFT practices is that they are unfair to small investors. Small investors do not operate on an even playing field because they lack resources to do so. They also are unable to see information as quickly as HFT computers. Arguably, this resource and informational imbalance creates inequity. Charles Schumer, a New York Democratic Senator, is actively campaigning against HFT practices. He argues that the markets work because small investors have just as much of a chance to be successful, and this opportunity is severely diminished with the proliferation of HFT.[5] Senator Shumer is strongly against HFT traders having access to information milliseconds before other market participants and, by virtue of their size and opacity, unfairly influence the market.

3. The Cascading Effect of HFT

The best example of the cascading effect happened on May 6, 2010 in what has become known as the “flash crash.” In this instance, there were a series of global events that made investors nervous about equity markets. This unease contributed to the dramatic fall that day. Initially, the Greek debt crisis led to a market decline early in the afternoon. Other traders bet on a continuous decline in the market by executing short trades on the market. The wave of activity triggered HFT models that track this kind of activity resulting in a further sell-off. The large number of orders overloaded the exchange systems. Information became delayed, which caused many trading firms to exit the market altogether. The simultaneous exit caused a serious liquidity problem. The last straw occurred when a trade for securities known as E-minis was entered (by Waddell and Reed), causing the stock market to crash. Although the market eventually gained most of the losses back investors were scared and shaken by this incident. Below is a chart showing the massive price movements in a day.[6]

This event shows how much of a snowball effect HFTs have on the markets. When one big sell-off occurs, HFT traders using similar strategies sell off as well with dangerous implication for markets.

The Ethics of HFT

HFT is another financial innovation that uses sophisticated computers and software. Ostensibly HFT users do not intend to deceive. Instead, the aim of HFT is to give its users a competitive advantage. Yet, HFT strategies affect more parties than just HFT traders – small investors, large trading firms, analysts, brokers, and other market participants may also be affected. Is HFT good for the majority? May 6, 2010 is an example of how HFT can adversely affect markets. The intense and steep market fall touched all market stakeholders in a negative way. One could argue that the flash crash was a singular and rare event. However, singular market events, like magnitude 7 earthquakes, can be catastrophic. The possible disastrous consequences of the cascading effect of HFT call for early warning and prevention systems. There should be a way to stop the cascading effect. Circuit breakers are a first defense. More should be put in place.

As with many innovations, there is the opportunity for misuse of HFT. Misuse may be hard to detect but the consequences can be severe, harming a number of investors. The mere existence of the opportunity to misuse HFT does not argue for the activity’s immorality. HFT also provides benefits by way of liquidity, jobs, and market efficiency. The opportunity for misuse and its damaging consequences may argue, however, for the intense scrutiny and policing of HFT.

Contributed by: Ryan Wagner

Edited by: Dr. Kara Tan Bhala

[1] The Impact of High-frequency Trading: Manipulation, Distortion or a Better-functioning Market? Knowledge @ Wharton. September 30, 2009. http://knowledge.wharton.upenn.edu/.

[2] Krudy, Edward. Is the May 6 “flash crash” in US stock markets the new normal? Reuters.com. June 10, 2010. http://www.reuters.com/assets/print?aid=USTRE6595GO20100610.

[3] Aldridge, Irene. How Profitable Are High-Frequency Strategies? The Huffington Post. July 26, 2010. http://www.huffingtonpost.com/irene-aldridge/how-profitable-are-high-f_b_659466.html.

[4] Comstock, Courtney. Huge: First High Frequency Trading Firm is Fined For Quote Stuffing and Manipulation. Business Insider. September 13, 2010. www.businessinsider.com/.

[5] Duhigg, Charles. Senator Wants Restrictions on High-Speed Trading. The New York Times. July 25, 2009.

[6] Lauricella, Tom, Scannell, Kara, and Strasburg, and Jenny. How a Trading Algorithm Went Awry. The Wall Street Journal. October 2, 2010.

  • High Frequency Trading (HFT)
  • Efficient Market Hypothesis
  • Proprietary Trading
  • Bid/Ask Spread
  • Circuit Breakers
  • Wall Street Journal
  • Hedge Funds
  • Liquidity
  • Mutual Funds
  • Sell side
  • Ask Price
  • Arbitrage
  • Security
  • Brokers
  • Good
High Frequency Trading - Financial Ethics - Seven Pillars Institute (2024)


Is high-frequency trading ethical? ›

But HFT can be Used Unethically

HFT can give traders an unfair advantage if they engage in market manipulation. HFT computers can influence the market for the trader's own advantage.

What are the arguments against HFT? ›

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.

Is high-frequency trading legal? ›

Is high-frequency forex trading legal? Yes, high-frequency trading is legal. That being said, it's possible that high-frequency trading strategies will not be permitted by your broker. Price-driven strategies (such as scalping) or latency-driven arbitrage strategies are prohibited altogether by some brokers.

What are the basic HFT strategies? ›

The list of the most famous HFT strategies of the beginning of the current century includes market making, arbitrage, statistical arbitrage, momentum ignition, spoofing (imitation of a buy/sell order) and layering. All of these strategies, in one form or another, still function today.

Why is HFT controversial? ›

HFT is complex algorithmic trading in which large numbers of orders are executed within seconds. HFT adds liquidity to the markets and eliminates small bid-ask spreads. HFT is criticized for allowing large companies to gain an upper hand in trading.

What are the negative effects 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.

Why is HFT not allowed? ›

Even though HFT has the ability to make a lot of money quickly, Proprietary Trading Firms don't allow it for a number of reasons. By making fake demand or supply by making a lot of trades in a very short amount of time, HFT can change market prices, even on Simulated Environments.

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).

How does HFT make profit? ›

High - frequency trading ( HFT ) firms use advanced technology and algorithms to execute trades at lightning - fast speeds , often making thousands of trades in a single day . This allows them to take advantage of small price discrepancies and make profits in a matter of milliseconds .

Do banks use high-frequency trading? ›

High-frequency trading (HFT) is an automated trading platform that large investment banks, hedge funds, and institutional investors employ. It uses powerful computers to transact a large number of orders at extremely high speeds.

Will HFT be banned? ›

There are currently no rules expressly against HFT. To have those rules, there would have to be some specific reason to ban HFT (hopefully more than empty political rhetoric and populism) and we'd have to come up with a specific implementation of the regulation which is trickier than it sounds.

Can normal people do high-frequency trading? ›

All portfolio-allocation decisions are made by computerized quantitative models. The success of high-frequency trading strategies is largely driven by their ability to simultaneously process large volumes of information, something ordinary human traders cannot do.

What are the best HFT firms in the world? ›

Firms like Getco, Hull, Citadel, Jump Trading and IMC began a revolution in trading that has significantly reduced trading spreads but also generated an equal amount of controversy. More akin to technology firms these HFT firms did need to be based in the banking hubs.

How to beat high-frequency trading? ›

There's Only 1 Way to Beat High-Frequency Trading in a Rigged Market. You can't compete with high frequency traders in a rigged market measured in milliseconds, so to be successful you need to change the game entirely.

Is HFT 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.

Is high-frequency trading spoofing? ›

Although spoofing isn't a recent phenomenon, high-frequency trading has increased market susceptibility to spoofing by allowing computer algorithms designed to place and cancel orders in milliseconds.

Are high-frequency traders responsible for extreme price movements? ›

Brogaard et al. (2018) examine the activity of high frequency traders around extreme price movements (EPMs). They find little evidence that HFT causes EPMs. Specifically, they find that HFT provide liquidity during EPMs by absorbing imbalances created by non-high frequency traders.

Top Articles
Latest Posts
Article information

Author: Mr. See Jast

Last Updated:

Views: 5845

Rating: 4.4 / 5 (75 voted)

Reviews: 82% of readers found this page helpful

Author information

Name: Mr. See Jast

Birthday: 1999-07-30

Address: 8409 Megan Mountain, New Mathew, MT 44997-8193

Phone: +5023589614038

Job: Chief Executive

Hobby: Leather crafting, Flag Football, Candle making, Flying, Poi, Gunsmithing, Swimming

Introduction: My name is Mr. See Jast, I am a open, jolly, gorgeous, courageous, inexpensive, friendly, homely person who loves writing and wants to share my knowledge and understanding with you.