HFT


High Frequency Trading




What is HFT?

High frequency trading (HFT) is a powerful computerized trading system based on proprietary algorithms.
Using complex algorithms to analyze multiple financial markets, the system is capable to capture even the most minor fluctuations in prices of tens of thousands of assets, and execute orders on a large scale at milliseconds speed. In a time that would take a human trader to say the word “order”, HFT system, connected to a stock exchange via low latency trading infrastructure, can make approximately 1000 trades. Implementation of HFT algorithms in AI technology resulted in a breakthrough improvement of the return rates for the investors. The innovative technology enables not only to execute orders at a superior speed, but also to accurately evaluate the markets and to respond to constantly changing conditions with a speed impossible for any human. Much anticipated by short-term investors, integration of HFT in artificial intelligence technology opens new horizons in the investment.

Key Advantages of HFT :

  • Speed – multiple orders execution at milliseconds.
  • Arbitrage Gaps – capitalizes on minute fluctuations in prices.
  • Reduced Costs –increases market efficiency and decreases trading costs.

The HFT Effects - Advantages, Controversy, Consequences

Speed:

In the time it takes you to read this sentence, a high-frequency trading (HFT) algorithm, connected to a stock exchange via “low latency” trading infrastructure, could make approximately 1,000 trades.
Let’s clarify what it means “to make a trade” in this instance:

  • Absorb the financial market data.
  • Process the data through a coded algorithm in multiple steps, prior to making a trading decision
  • Send a message with an order back to the financial market.
  • Get the order executed and confirmed
  • Do all of the above over again approximately 250 times a second.

It is hard for a human mind to comprehend what can be accomplished in microseconds – one microsecond is equal to 1/000 of a millisecond; but in a new era of algorithmic trading and lightening seed transaction processing, HFT can accomplish a lot. Eric Hunsader, founder of Nanex LLC, the U.S. financial markets consultancy, performed a time-stamp analysis recently and what he found is astonishing. High frequency trading, which uses a direct feed from the exchanges to quote prices, has a 500-microsecond advantage for Nasdaq NDAQ, +0.40% over any other type of trading.

Is HFT good for individual trader?

Michael Lewis, an author of the recently published book “Flash Boys”, claims that “the market is rigged” and some traders call it “an unfair game”, complaining that HFT users “jump the queue”, having immediacy ahead of other market participants. Much has been disputed in the media about the far reaching effect of HFT on financial markets and institutional investors. The problem is, despite the fact that 60% of all trading today is HFT, little is known about the impact it makes on the average retail trader. The objective of HFT is to take advantage of minute discrepancies in prices and trade on them quickly and in huge quantities. HFT algorithms are able to seize the smallest fluctuation of the asset price. Over a large volume of trades, even fractions of a cent can accrue quickly and generate profits. This is perhaps easier understood when translated into numbers. For instance, a high-frequency trader buys 100 shares of IBM for, say $128.59, and sells it a fraction of a second later for $128.60. The profit: $1.00 (100 shares at a profit of $0.01). Multiply this by 10000, which is an approximate number of orders HFT can execute in one minute, and you get an idea. But there is more to HFT that superior speed. Other obvious benefits, both to individual and to institutional investors include:

Liquidity:

HFT provides liquidity to the markets and here is why this is good for the individual traders. 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. The trend over the past decade shows that HFT trading has greatly increased in the market and so has the market liquidity. Liquidity is an important characteristic of a good market as it inspires confidence among the participants.

Reduced Costs:

Increased liquidity adds to market efficiency and contributes to decreasing trading costs for smaller investors. A major cost to mutual funds results from bid/ask spread. This cost can be mitigated by the activities of HFT that narrow bid/ask margins. Narrower spreads also reduce costs that from large fund transactions that affect the final price of a security. HFT traders are able to break these big trades into a numerous smaller trades to reduce the effect of a large buy or sell order.

Profitability:

There is no reliable information on the profitability of HFT firms. Hedge funds do not usually disclose their strategies or profits. But despite the lack of concrete figures, 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 trades:

High Frequency Trading Profitability Potential:


Trading Frequency
Average - Maximum Gain Per Period Range Standard - Deviation per Period Number Of - Observations in the Sample Period Maximum - Annualized Sharpe Ratio*
10 Seconds 0.04% 0.01% 2,592,000 5,879.80
1 Minute 0.06% 0.02% 43,200 1860.10
10 Minutes 0.12% 0.09% 4,320 246.40
1 Hour 0.30% 0.19% 720 122.13
1 Day 1.79% 0.76% 30 37.30

*The Sharpe ratio is also called the Reward-to-Variability Ratio. It measures the excess return per unit of risk.

As can be seen, 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.

Market Growth:


As recently as early 2000s, high frequency still accounted for fewer than 10% of equity orders, but this proportion has seen rapid growth over the decade. According to data from the NYSE, trading volume grew by approximately 164% between 2005 and 2009, with high frequency trading thought to have contributed to the boom. In 2009 high frequency trading accounted for 73% of all equity orders volume in the U.S. The Bank of England estimated similar percentages for the 2010 U.S. market share, adding that HFT accounted for approximately 40% of equity orders volume in Europe. A potential for growth also seen in Asia. As of value, HFT was estimated to make up 56% of equity trades in the U.S. and 38% in Europe as of 2010. Overall expenditure on computer software increased to $26.4 billion in 2005.


The Ethics of HFT

Is HFT good for the majority?

The impact of high frequency trading is a subject of ongoing research as well as dispute. As any technology innovation, there is a lot of controversy surrounding it. The aim of HFT, however, is not to deceive, as some critics claim, but to give its users a competitive advantage with an aid of a speed. And this aim is much older than HFT itself. As long ago as 1873, the brokers were leasing private telegraph lines to provide customers – and themselves- with faster information and trading. Any worthy technology innovation can be a subject to misuse. But the mere existence of such opportunities does not argue for the activity to be fraud or unethical. While regulations and policing are necessary, the benefits of HFT, in terms of providing liquidity, jobs and market efficiency, at the same time reducing costs outweigh the concerns it raises. If technology expedites the execution of trades and/or improves the efficiency of market making, HFT should benefit all market participants, including institutional investors.


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