High Frequency Trading (HFT)
Transacting a large number of orders within some fractions of seconds using computer programs is known as high frequency trading. It is a well-known method of trading that is also known as HFT. The functionality of HFT depends on complex algorithmic trading. It executes orders based on the changing market conditions and after analyzing multiple markets.
In general, the traders with slower execution speeds suffer higher losses as compared to traders with the fastest execution speeds. High frequency trading not only the have a high speed of orders but the order-to-trade ratios and turnover rates are also on the higher side. This is one of the reason why high frequency trading firm and a normal trading firm differ from each other. The leading high frequency trading firms consists of Virtu Financials, Citadel LLC, and Tower Research.
Benefits of High Frequency Trading
Some of the top benefits or reasons for implementing HFT are:
- Improved market liquidity conditions
- HFT is one of the liquidity providers that reduce the effects of market fragmentation
- Bid-ask spreads are removed that makes financial markets more efficient
- Due to the large number of orders, it is an effective process of price formation and price discovery
HFT: Trading Strategies
High frequency trading (HFT) uses various types of trading strategies to make money that are:
It refers to the trading strategy that is based on making profits within the price difference of two or more market. When there is a difference between the prices of two or more market indexes there is an opportunity for arbitrage. The strategy of arbitrage includes buying at a relatively lower price and selling the same at a higher price. It can be used in the stock market when the price is different between two or more than two indexes. The same can be applied to equity markets and currency markets also.
This trading strategy is focused on making profits from the variance of forecasted future price volatility of a stock and implied volatility of options of the same stock or asset. You can take advantage of the two prices to hedge funds. The difference in stock prices occurs because there is a discrepancy between the actual market and the expected price.
Merger arbitrage is referred as a hedge funds strategy. The process involves purchasing and selling of the respective stock of two or more merging companies. It is known as the strategy of creating riskless profits in the market. Arbitrageurs can calculate all the possibilities so that they can take advantage of trading in that respective stock. Profit arises after the completion of the merger or acquisition.
Global Macro Strategy
The global macro strategy is considered as a mutual fund or hedge fund strategy that depends on the holding of the overall economic views of different countries based on their macroeconomic principles. Holdings may consists of long and short positions holdings of currency, commodities, equity, and futures markets.
The factors that can affect the strategies are politics, international trade of the country, interest rates, currency exchange rates, foreign policies, and others. The price discrepancies because of the changing market conditions and other factors give rise to an arbitrage condition.
A strategy of long-short equity is designed to minimize market exposure while making profits from the gains of stock in the long postions. When the short postions of the stocks is expected to decline and the long positions in stocks are expected to appreciate the chances of arbitrage arises.
What do High Frequency Traders do?
HFT High Frequency Trading uses mathematical models and algo trading strategies to make higher profits or increasing their profit margins. Recently, this strategy has been met with some criticism and it has also replaced a huge number of brokers. It is also known as market making strategy because after the calculations of some milliseconds it can affect the market with big numbers.
Traders using HFT are known as market makers because the prices can move up and down without any specific reason. The second complaint about HFT is liquidity to the market, as the market movement does not have any valid reason it is also known as ghost liquidity. It prevents traders from trading this liquidity.
High frequency traders are known as market players and they have all the information and market data required for trading. Trading firms that are using high frequency trading, use computers to calculate order, market share, equity trading volume and much more.
Pit Trader: Market Maker
Pit trading refers to the trading floor that is nominated for buying and selling of a particular type of security. However, the strategies used for buying and selling orders is known as hand signaling and shouting. Pit trading was conducted through the floor but now it is also based on the electronic means of transactions.
The role of pit traders is to enhance the liquidity of the market and this is the reason why they are also known as liquidity providers. They can narrow the bid-ask spread of the market. Automated trading platforms can bring effective results.
Trading Firms with Trading High Frequency
High equity trading volume is used by high frequency trading firms and it consists of a large volume of their day to day transactions. Some of the leading HFT firms are:
Virtu Financials are also known as market making experts around the world. With their strategies they try to make the market more stable by implementing the available resources. They buy and sell securities on behalf of their client.
Citadel deliver market-making strategies that are focused to generate higher returns. We implement a number of strategies developed by our in-house talented minds and our team capture new opportunities. The strategies we develop and implement are constantly improving.
They are offering services like business management, risk management, and many more. After performing trend analysis, real-time tracking, and many more, we develeop strategies for a broad range of assets.
Is High Frequency Trading Illegal for Shares?
There is no such rule that defines high frequency trading as illegal. High Frequency Trading (HFT) is currently not regulated by any rule but it is truth that, this type of trading strategies can affect the market. For every kind of practices and strategies it is necessary to have proper rules and regulations so that, we can use them in the situation of misuse.
The interesting part is that high frequency trading firms implement the same strategies but the trading volume is on the higher side which makes the speed faster. The fast speed is the only reason to affect the market prices. Large orders and speed of trading has always been an advantage for the HFT trading firms.
Apart from the negative effects high frequency trading also have some positive effects on the market. Strategies like this can be proved as a market making strategy and can be beneficial for retail investors or retail traders. Although the amount of profit they make is low as compared to what has been fetched by market participants but the situation of profit making arises due to them.
How does HFT adds liquidity to the market?
High frequency trading (HFT) narrow down the bid-ask spread and adds liquidity to the market. It is the believe of market participants that the liquidity providers only make the market more unstable and unpredictable. The market liquidity is just an illusionary character. There are three main factors that can affect the market liquidity, which are:
- Time of the transaction
- Size (refers to the volume of trading)
- Price of respective stock, currency, or others
It is studied that when the market liquidity is high, big orders are closed on the current price within a short period of time by the speculators and investors. Spread size of bid-ask is a popular indicator of market liquidity.
The New York Stock Exchange (NYSE) says that the liquidity refers to the absorbing of market depth at the prices correspondant with demand and supply. Liquidity is one of the important characteristics of efficient market and the market should adapt the new information received.
High Frequency Trading of Equity Orders
High frequency trading firms trades using higher trade volumes and this practice also affects the prices of various stocks, currencies, commodities in the market. Till date, there is no limitation on high frequency trading that is the reason why it is been used by various trading firms. But it is sometimes beneficial also for retail traders.
Infrastructure Needs of HFT Firms
High frequency trading is a market making strategy that have some infrastructure needs, which are:
- High speed computers that need to be updated with hardware regularly
- HFT requires real-time data of markets for better decision making
- Algorithms, because it is completely algorithmic trading
- Fast servers to respond quickly to the exchange rates of various indices
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