High-frequency trading (HFT) aims to profit from the pricing volatility facing a specific financial instrument by employing aggressive short-term trading strategies. Through this pursuit, HFT has become a major factor in the global marketplaces of equities, derivatives and currencies.
The current marketplace is a dynamic environment in which the trading of financial instruments is often conducted at near-light speeds. Evolving technologies focused on information systems and internet connectivity have given exchanges and over-the-counter markets the capacity to facilitate enormous trading volumes in small increments of time. One of the byproducts of this evolution in technology is the practice of "high-frequency trading."
What Is High-Frequency Trading?
The practice is a relatively new market activity that lacks a legally binding, universally accepted definition. Regulatory agencies such as the US Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC) have each crafted a definition of HFT.
According to the SEC, HFT is carried out by "professional traders acting in a proprietary capacity whom engage in a large number of trades on a daily basis." In addition, the SEC suggests that an HFT operation exhibits any or all of the following five characteristics:
- Use of extraordinarily high speed and sophisticated software programs for generating, routing and executing orders
- Use of direct data feeds offered by exchanges and co-located services to reduce trade-related latencies
- Short time frames for opening and closing positions
- Large volumes of submitted and cancelled orders
- Ending the trading session at net zero, or as close to "flat" as possible
The CFTC has a similar definition of HFT. As stated by the CFTC, it's a form of automated trading that exhibits or employs the following mechanisms:
- Algorithms for decision making, order generation, placement, routing and execution without any human intervention
- Low-latency technology with proximity to exchange or market via collocated servers
- High-speed connections to markets for order entry
- High volumes of orders and cancelled orders
Aside from the regulatory definitions, HFT is commonly defined as being computerised trading using proprietary algorithms.
The main goal of HFT is to achieve profitability through capitalising on momentary pricing inefficiencies of an actively traded financial instrument. Extremely short trade durations, often measured in milliseconds or microseconds, coupled with substantial trading volumes are the methods by which HFT operations are conducted.
The overriding theme in HFT is speed in the areas of order entry, order execution and reception of exchange or market-based data. They're crucial components of HFT strategies and direct determinants of the ability to establish long-term profitability from operations.
To achieve a competitive advantage over other market participants in the arena of speed, HFT firms pursue "ultra-low latency" technologies. The term "ultra-low latency" refers to technologies that address issues pertaining to the time it takes to receive, assimilate and act upon market data. Ultra-low latency is achieved through optimising performance in two areas: the reception of exchange or market-based data, and market interaction.
In terms of data exchange, the method by which HFT firms reduce latency is through securing direct market access (DMA). This is the ability for a market participant to receive data from the exchange or market directly, without any third-party intervention. DMA provides a trader the ability to enter market orders directly into the exchange's order book for execution. This is a crucial aspect of constructing an ultra-low latency trading platform, as its use ensures that the market participant is receiving data ahead of non-DMA users. As a result, the ability to interact within the marketplace ahead of the competition becomes possible.
In addition to securing DMA, HFT operations achieve a competitive advantage via ultra-low latency through the introduction of two vital inputs into the trading operation:
- Automated proprietary trading algorithms: Commonly known as "black box" trading systems, these are complex algorithms based on numerous market variables that are used to generate signals identifying a potential trading opportunity. The signal is then traded automatically through programmed trading software.
- Collocated servers: These are servers that are dedicated to the trader and hard-wired to the exchange or market being traded. They are physically located at the exchange or market, and provide DMA with greatly reduced latencies than those of remotely located servers.
When taken together, the use of "black box" trading systems in concert with collocated servers ensures a precise and timely interaction with the marketplace. This combination of inputs is referred to as "high-frequency trading DMA."
Essentially, the competitive advantage that HFT firms enjoy over other market participants can be directly attributed to the substantial reduction of nearly all trading related latencies.
HFT firms aspire to achieve profitability through rapidly capitalising on small, periodic pricing inefficiencies. Complex algorithms recognise and execute trades based on strategies centered on order anticipation, momentum and arbitrage opportunities.
"Order anticipation" is a strategy used by high-frequency traders that attempts to identify when large market participants are engaged in a specific market. The strategy uses this information to trade "ahead" of the large participant's pending orders in anticipation of the fluctuation in pricing that is to be generated upon the execution of the bulk orders. Using an order anticipation strategy, the HFT firm enters and exits the market before the other market participants can react, thereby capitalising on the subsequent up or down move in price.
"Momentum ignition" is the practice of executing a large volume of market orders in an attempt to entice other investors to place trades in the same market. If successful, the result is an immediate move in price due to a glut of orders being placed upon the market by the sudden influx of market participants. Profit is realised by this HFT strategy through either holding pre-existing positions in the market, or taking contrary positions at select price levels in anticipation of a pricing regression. Momentum ignition is an extremely controversial trading practice, as the pricing fluctuations that occur due to its implementation are widely seen as artificial and a result of market manipulation.
Trading strategies based on identifying and acting quickly in arbitrage situations comprise a large portion of HFT methodology. Opportunity arising from various market participants receiving market information at different times is known as "latency arbitrage." Essentially, this is the ability to receive and process market-pertinent data before competitors can react appropriately to the changing market conditions.
Although the head start a HFT firm enjoys in a latency arbitrage scenario is often measured in milliseconds or microseconds, it's a large enough increment of time to enter and exit thousands of individual trades and realise a profit.
In addition to latency arbitrage, strategies based on statistical arbitrage provide another avenue by which HFT firms can profit. Based on market data-interpreting algorithms, statistical arbitrage relies upon principles outlined in the "law of large numbers" for validity. Basically, the idea is similar to that of a casino: sustain profitability through taking a small expected profit as many times as possible. The current electronic marketplace, coupled with automated trading systems, afford HFT trading firms the ability to efficiently execute statistical arbitrage strategies. No matter how quickly a trading opportunity presents itself, the trading infrastructure employed by HFT firms is capable of identifying and executing the trade.
Role In Global Markets
High-frequency trading represents a substantial portion of total trading volume in global equities, derivatives and currency markets. In some marketplaces, HFT is the dominant provider of market liquidity.
In the US equities markets, it is estimated that 55% of all volume traded is attributable to HFT. Similar estimates apply to European equity markets, with total volume traded by HFT strategies nearing a value closer to 40%. For the year end 2014, the percentage of total volume traded in the S&P 500 related to HFT was estimated at 23%.
Futures markets are also traded extensively by high-frequency operators. The largest futures exchange in the world, the CME Globex, estimates that 30% to 35% of the total number of futures contracts traded can be attributed to HFT practices.
The vast majority of global marketplaces exist in an electronic form, thus the future expansion of HFT strategies in such markets is likely in the coming years.
Support And Dissent
Since HFT's inception in the early 2000s, it has been a popular topic of debate within the financial industry. Professionals within the industry have weighed in with theories and opinions regarding the potential impacts that HFT could wield upon any marketplace in which it is prevalent. Seemingly everyone involved in the active trading of financial securities has a viewpoint either for, or against HFT.
Proponents contend that it has contributed to the enhancement of market efficiency. Through lightning-fast dissemination of market-related data and providing the ability to take subsequent action within the marketplace, HFT is thought of by some as a catalyst for the creation of truly efficient markets.
A few of the main arguments in favour of HFT are as follows:
- Provides necessary liquidity to the marketplace: Due to the large volume of orders being placed upon the market through the implementation of HFT strategies, it has become "easier" for traders to buy and sell.
- Lower transaction costs: HFT has brought immense business to the market, thereby reducing brokerage commissions and membership fees required for market access.
- Tightened bid/ask spreads: As a function of the liquidity brought to the market by HFT strategies, bid/ask spreads have tightened, thus making efficient entry and exit from the marketplace probable for market participants.
Conversely, detractors claim that the trading practice undermines the concept of a fair marketplace and that it's "predatory." Many HFT strategies, such as order anticipation and momentum ignition, are widely seen as market manipulation and a violation of SEC rules governing transparent trade.
Other arguments against HFT are as follows:
- Market fragility: Trading conditions that are conducive to instant, unpredictable and huge swings in price are facilitated by HFT. These conditions are thought to eliminate the process of true price discovery.
- Lack of transparency: The vast number of transactions and limited ability to account for all of them in a timely manner have given rise to criticism directed at the authenticity of HFT operations. The "lack of transparency" is thought to have increased the probability of deceptive trading practices among market participants.
- Market volatility: Because algorithms used by HFT can generate trade signals to be executed without human intervention, the possibility of dangerous market fluctuations is thought to be amplified. A frequently cited example of this is the Flash Crash of 2010, during which the Dow Jones Industrial Average fell 1,000 points in a matter of minutes.
Billions of dollars are spent annually by institutional investors in the development and implementation of HFT strategies. The ability to receive market-related information first, and then act upon that information before competitors, is the key tenant of the competitive advantage sought by HFT firms. As the capacity of information systems technology and internet connectivity grows, the evolution of HFT is likely to continue.
Although a case can be made either supporting or condemning HFT, it's important to recognise that a substantial number of HFT firms operate in nearly every global marketplace. No matter which side of the debate one is on, it's undeniable that HFT has an enormous impact upon the trading of financial instruments worldwide.
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Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…