What Exactly Is the Term "High-Frequency Trading" (HFT)?

Nov 24, 2023 By Susan Kelly

HFT is characterized by high turnover rates as well as high order-to-trade ratios. This is in addition to the rapid speed at which orders are placed. Tower Research, Citadel LLC, and Virtu Financial are just a few of the most well-known high-frequency trading businesses.

Trading With a High Frequency (HFT)

When exchanges began offering incentives to corporations to supply liquidity to the market, High-Frequency Trading (HFT) became more popular. For example, the New York Stock works to increase competition and liquidity for current quotations on the exchange. These SLPs try to offer quotes for a wider range of securities. After the financial institution, Lehman Brothers went bankrupt in 2008, and there was a significant lack of liquidity in the market, which prompted the creation of the SLP. The New York Stock Exchange (NYSE) offers an incentive in the form of a charge or rebate to corporations for providing liquidity. This results in a significant amount of income due to the millions of transactions occurring every day.

Explanation of High-Frequency Trading

The Securities and Exchange Commission (SEC) does not have a formal definition of high-frequency trading, although they do attach some characteristics to it, including the following:

  • Utilize very high speed and highly complex computer programs to create, route, and carry out orders.
  • Use the co-location services and individual data feeds provided by various exchanges and other entities to reduce the latency of networks and other factors.
  • Extremely small windows of opportunity for developing and closing positions
  • The placement of several orders, all of which are subsequently canceled soon after being placed.
  • As a result of the introduction of incentives provided by exchanges to institutions to increase their market liquidity level, high-frequency trading has become more frequent in the markets. Exchanges acquire more liquidity when they give tiny inducements to the market makers who provide it. The institutions that provide the liquidity also see enhanced profits on every deal they do and the attractive spreads they offer.
  • Even if the spreads and incentives only amount to a fraction of a penny for each deal, high-frequency traders nonetheless make significant profits since they execute many transactions every day.
  • Many people believe that high-frequency trading is immoral and gives giant corporations an unfair edge over smaller institutions and individual investors. Because high-frequency trading (HFT) may be used for ultra-short-term tactics, it may be argued that HFT undermines the fair and level playing field intended to be offered by stock markets.
  • High-frequency traders make their money by taking advantage of arbitrage opportunities and operating at high speeds to profit on supply and demand imbalances. They do not base their bets on basic information about the firm or its development prospects; rather, they base their transactions on chances to make a profit.
  • Even if high-frequency trading does not specifically target anybody, it has the potential to inflict collateral damage to ordinary investors and institutional investors, such as mutual funds that engage in bulk buying and selling securities.

Advantages of Engaging In High-Frequency Trading (HFT)

HFT has increased market liquidity, resulting in the elimination of bid-ask spreads that were previously considered overly narrow. This hypothesis was tested by imposing fees on high-frequency trading (HFT), which resulted in wider bid-ask spreads. One research investigated how the Canadian government's implementation of high-frequency trading (HFT) fees affected bid-ask spreads. It was discovered that the retail spreads grew by nine percentage points while the market-wide bid-ask spreads climbed by 13 percentage points.

High-Frequency Trading

The HFT is a contentious topic that has faced severe opposition. Making judgments has eliminated the need for human decision-making and interaction by using mathematical models and algorithms. As a result, it has taken the place of several broker-dealers. Decisions are made in a matter of milliseconds, and this may lead to significant market shifts for no apparent cause. For example, on May 6, 2010, the Dow Jones Industrial Average (DJIA) had its greatest intraday point decline ever, falling 1,000 points and falling 10 percent in only 20 minutes before recovering again. An increase followed this. An examination conducted by the government found that the collapse was caused by a huge order that led to a sell-off.

One such argument against high-frequency trading is that it enables giant corporations to make money at the cost of "small folks." Its "ghost liquidity" is also a subject of criticism: the liquidity offered by HFT is accessible to the market one second and gone the next, preventing traders from really being able to trade this liquidity. In other words, HFT's liquidity is a "ghost."

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