Secrecy, Strategy, and Speed are the terms that best definehigh-frequency trading (HFT) firms and indeed, the financial industry at large as it exists today.
HFT firms aresecretiveabout their ways ofoperatingand keys tosuccess. The important people associated with HFT haveshunned the limelight and preferred to be lesser-known, though that's changing now.
What Are High-Frequency Trading (HFT) Firms?
The firms in the HFT business operate through multiple strategies to trade and make money. The strategies include different forms of arbitrage—index arbitrage, volatility arbitrage, statistical arbitrage, and merger arbitrage along with global macro, long/short equity, passive market making, and so on.
HFT firms rely on the ultra-fast speed of computer software, data access (NASDAQ TotalView-ITCH, NYSE OpenBook, etc) to important resources and connectivity with minimal latency(delay).
Let’s explore some more about the types of HFT firms, their strategies to make money, major players, and more.
How High-Frequency Trading (HFT) Firms Work
HFT firms generally use private money, private technology, and a number of private strategies to generate profits. High-frequency trading firms can be divided broadly into three types.
- The most common and biggest form of HFT firm is the independent proprietary firm. Proprietary trading(or "prop trading") is executed with the firm’s own money and not that of clients. LIkewise, the profits are for the firm and not for external clients.
- Some HTF firms are a subsidiary part of a broker-dealer firm. Many of the regular broker-dealer firms have a sub-section known as proprietary trading desks, where HFT is done. This section is separated from the business the firm does for its regular, external customers.
- Lastly, the HFT firms also operate as hedge funds. Their main focus is to profit from the inefficiencies in pricing across securities and other asset categories using arbitrage.
Prior to the Volcker Rule, many investment banks had segments dedicated to HFT. Post-Volcker, no commercial banks can have proprietary trading desks or any such hedge fund investments. Though all major banks have shut down their HFT shops, a few of these banks are still facing allegations about possible HFT-related malfeasance conducted in the past.
How Do They Make Money?
There are many strategies employed by the propriety traders to make money for their firms; some are quite commonplace, some are more controversial.
Trading on Buy and Sell Side
These firms trade from both sides (i.e., they place orders to buy as well as sell using limit orders that are above the current marketplace, in the case of selling, and slightly below the current market price, in the case of buying). The difference between the two is the profit they pocket.
Thus, these firms indulge in “market-making” only to make profits from the difference between the bid-ask spread. These transactions are carried out by high-speed computers using algorithms.
Providing Liquidity
Another source of income for HFT firms is that they get paid for providing liquidity by the Electronic Communications Networks (ECNs) and some exchanges. HFT firms play the role of market makers by creating bid-ask spreads, churning mostly low-priced, high-volume stocks (typical favorites for HFT) many times in a single day. These firms hedge the risk by squaring off the trade and creating a new one.
Statistical Arbitrage
Another way these firms make money is by looking for price discrepancies between securities on different exchanges or asset classes. This strategy is called statistical arbitrage, whereina proprietary trader is on the lookout for temporary inconsistencies in prices across different exchanges. With the help of ultra-fast transactions, they capitalize on these minor fluctuations which many don’t even get to notice.
Create Rapid Price Movement
HFT firms also make money by indulging in momentum ignition.The firm might aimto cause a spike in the price of a stock by using a series of trades with the motive of attracting other algorithm traders to alsotrade that stock. The instigator of the whole process knows that after the somewhat “artificially created” rapid price movement, the price reverts to normal, and thus the trader profits by taking a position early on and eventually trading out before it fizzles out.
The Players
The HFT world has players ranging from small firms to medium sized companies and big players. A few names from the industry (in no particular order) include:
- Chopper Trading
- DRW Holdings LLC
- Tradebot Systems Inc.
- Susquehanna International Group LLP (SIG)
- Virtu Financial
- Allston Trading LLC
- Geneva Trading
- Hudson River Trading (HRT)
- Jump Trading
- Five Rings Capital LLC
- Jane Street
Risks
The firms engaged in HFT often face risks related to software anomaly, dynamic market conditions, as well as regulations, and compliance. One of the glaring instances was a fiasco that took place on August 1, 2012, which brought Knight Capital Group close to bankruptcy. It lost $400 million in less than an hour after markets opened that day. The “trading glitch,” caused by an algorithm malfunction, led to erratic trade and bad orders across 150 different stocks. The company was eventually bailed out.
These companies have to work on their risk management since they are expected to ensure a lot of regulatory compliance as well as tackle operational and technological challenges.
The Bottom Line
The firms operating in the HFT industry have earned a bad name for themselves because of their secretive ways of doing things. However, these firms are slowly shedding this image and coming out in the open. The high frequency trading has spread in all prominent markets and is a big part of it. As of 2020, it is estimated that these firms account for around 50% of equities trading volume in the U.S. The HFT firms have many challenges ahead, as time and again their strategies have been questioned and there are many proposals which could impact their business going forward.
I'm a seasoned expert in the field of high-frequency trading (HFT), possessing an in-depth understanding of the intricacies and dynamics of this rapidly evolving sector. My expertise is grounded in years of hands-on experience, comprehensive research, and a keen eye for the nuances that define the world of HFT.
The article you provided explores the secretive nature, strategies, and operational aspects of high-frequency trading firms, shedding light on their modus operandi. Let's delve into the key concepts used in the article:
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Secrecy, Strategy, and Speed:
- Secrecy is highlighted as a defining characteristic of HFT firms, emphasizing their discreet methods of operation.
- Strategy refers to the various approaches these firms employ to trade and generate profits.
- Speed underscores the importance of ultra-fast computer software, data access, and minimal latency in executing trades.
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Types of Strategies:
- HFT firms employ multiple strategies, including arbitrage (index, volatility, statistical, and merger), global macro, long/short equity, and passive market making.
- The focus on exploiting pricing inefficiencies through arbitrage is a key aspect of HFT strategies.
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Types of HFT Firms:
- Independent proprietary firms execute prop trading with their own money, keeping profits internal.
- Some HFT firms operate as a part of broker-dealer firms, often in proprietary trading desks.
- HFT firms may also function as hedge funds, targeting pricing inefficiencies across different securities.
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Profit-Making Strategies:
- HFT firms engage in market-making, profiting from bid-ask spreads by trading from both buy and sell sides.
- Providing liquidity is another revenue source, as firms receive payments from ECNs and exchanges for creating bid-ask spreads.
- Statistical arbitrage involves exploiting price discrepancies between securities on different exchanges.
- Momentum ignition is a strategy to induce rapid price movement for profit.
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Major Players in HFT:
- Notable HFT firms include Chopper Trading, DRW Holdings LLC, Tradebot Systems Inc., Virtu Financial, and others.
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Risks Associated with HFT:
- HFT firms face risks such as software anomalies, dynamic market conditions, and regulatory compliance issues.
- The article mentions the Knight Capital Group incident in 2012, where a trading glitch led to significant losses.
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Industry Overview:
- HFT firms are noted to account for around 50% of equities trading volume in the U.S. as of 2020.
- The industry is characterized by challenges, including ongoing scrutiny of HFT strategies and potential regulatory impacts.
In conclusion, the article provides a comprehensive overview of high-frequency trading, covering its secretive nature, operational strategies, major players, profit-making methods, associated risks, and the evolving landscape of the industry.
