If you are an investor, high-frequency trading (HFT) is a part of your life even if you don't know it. You've likely purchased shares offered by a computer, or sold shares that were purchased and instantly sold by another computer. HFT is controversial. Traders disagree and studies contradict other studies. Regardless of the opinions, what is most important is how HFT affects your money.
Key Takeaways
- High-frequency trading is blamed for the flash crash that occurred on May 6, 2010, when the major indices plummeted in a matter of minutes.
- At least one study suggests that HFT firms make higher profits when trading against retail investors in the futures market.
- Despite fears over high-frequency trading, annual revenue at HFT firms has declined significantly since 2011.
What Is High-Frequency Trading (HFT)?
High-frequency trading (HFT) is a broader term for various trading strategies that involve buying and selling financial securities at extremely high speeds. Using algorithmic trading, computers can identify market patterns and utilize automated and pre-programmed instructions to execute buy and sell orders in a matter of milliseconds.
One strategy is to serve as a market maker, where the HFT firm provides liquidity on both the buy and sell sides. By purchasing at the bid price and selling at the ask price, high-frequency traders can make profits of a penny or less per share. This translates to big profits when multiplied over millions of shares.
Does High-Frequency Trading Hurt the Market?
Because most trading leaves a computerized paper trail, one would think it would be easy to look at the practices of high-frequency traders and answer this question. However, HFT companies are reluctant to divulge their trading activities, and the large amount of data involved makes it difficult to form a cohesive picture.
Critics of high-frequency trading point to the flash crash that occurred on May 6, 2010. The major indices mysteriously plummeted 5-6% in minutes, and just as inexplicably, quickly rebounded. Shares of individual companies were executed at prices more than 60% off their value just moments before. Some trades executed for a penny or $100,000—stub quote prices that were never intended to be filled.
The Securities and Exchange Commission (SEC) issued a report blaming one very large trade in the S&P e-mini futures contract, which set off a cascading effect among high-frequency traders. As one algorithm sold rapidly, it triggered another, creating a financial snowball.
Following the flash crash, the SEC developed new circuit breaker rules that would impose a trading pause when a stock moves up or down by 10% or more within a five-minute period. Many critics asked whether imposing tighter regulations on high-frequency traders made sense, especially since smaller, less visible flash crashes happen throughout the market with regularity.
Does High-Frequency Trading Hurt Retail Investors?
What is important to most of the investing public is how high-frequency trading affects the retail investor. This is the person whose retirement savings are in the market, or the person who invests in the market in order to gain better returns than the near non-existent interest that comes from a savings account. A 2014 study shed some light on this question.
Former economists for the Commodity Futures Trading Commission (CFTC) studied HFT firms over a two-year period and found that revenue was concentrated among a handful of companies in a winner-takes-all market structure.
Studying the e-mini contracts, the researchers found that high-frequency traders made an average profit of $1.92 for every contract traded with large institutional investors and an average of $3.49 when they traded with retail investors. The paper concluded that these profits were at the expense of other traders and this may cause traders to leave the futures market.
The Bottom Line
Unchecked, the proliferation of high-frequency trading could risk creating the perception that the small investor cannot win. Governments have sought to rein in HFT firms, for example, by proposing a per-share trading tax. In 2012, Canada raised fees on market messages such as trades, order submissions, and cancellations, which disproportionately hit HFT firms because they send more messages than other traders.
Despite fears over high-frequency trading, there is also evidence to suggest that HFT firms simply don't pose the threat they once did. Revenue and profits have dwindled, making it tougher for HFT firms to survive. Industrywide, annual revenue is estimated at $6.1 billion in 2021, down considerably from more than $22 billion in 2011.
FAQs
Some professionals criticize high-frequency trading since they believe that it gives an unfair advantage to large firms and unbalances the playing field. It can also harm other investors that hold a long-term strategy and buy or sell in bulk.
Are high frequency traders really market makers? ›
HFT firms characterize their business as "Market making" – a set of high-frequency trading strategies that involve placing a limit order to sell (or offer) or a buy limit order (or bid) in order to earn the bid-ask spread. By doing so, market makers provide a counterpart to incoming market orders.
How does the high-frequency trading system affect the financial markets? ›
High-frequency trading offers several advantages, including enhanced liquidity, reduced bid-ask spreads, and improved market efficiency. These benefits contribute to more efficient markets and lower trading costs for all participants.
What percentage of the market is high-frequency trading? ›
High-frequency trading refers to buy and sell orders made on financial markets over an extremely short timeframe. Trading is automated using algorithms and computers, enabling it to react very quickly to market events. On the equity markets, around 2/3 of all transactions are carried out by high-frequency traders.
Will HFT be banned? ›
HFT can not be banned as you can not ban derivatives market all around the globe. Banks and many big financial institutions were ahead enough to make HFT strategies to benefit from the discrepancy.
What is the alternative to high-frequency trading? ›
Momentum Trading
The age-old technical analysis indicator based on momentum identification is one of the popular alternatives to HFT. Momentum trading involves sensing the direction of price moves that are expected to continue for some time (anywhere from a few minutes to a few months).
What is the best high-frequency trading platform? ›
Best brokers for high-frequency trading
- Interactive Brokers - 9.9/10 Overall.
- Saxo - 9.7/10 Overall.
- CMC Markets - 9.6/10 Overall.
- FOREX.com - 9.4/10 Overall.
- Charles Schwab - 9.3/10 Overall.
- City Index - 9.3/10 Overall.
- XTB - 9.1/10 Overall.
- eToro - 8.8/10 Overall.
As of Sep 3, 2024, the average annual pay for a High Frequency Trader in the United States is $96,774 a year. Just in case you need a simple salary calculator, that works out to be approximately $46.53 an hour.
Who are the biggest high-frequency traders? ›
Who are the biggest high-frequency traders? Some of the biggest high-frequency trading firms include Citadel Securities, Virtu Financial, Two Sigma Securities, DRW, and Hudson River Trading.
What is the best indicator for high-frequency trading? ›
What is the best indicator for high-frequency trading? Moving average (MA), Exponential moving average (EMA), Stochastic oscillator, and Moving average convergence divergence (MACD) are the best indicators for high-frequency trading.
Be aware that HFT is an extremely technical discipline and it attracts the very best candidates from the fields of mathematics, physics, computer science and electronic engineering, often at the grad school level or with years of industry expertise in a niche area.
Who regulates high-frequency trading? ›
SEC's Rules on the Definition of a Dealer Will Help Protect Investors From the Risks That High-Frequency Trading Firms Pose. WASHINGTON, D.C.—Today, the U.S. Securities and Exchange Commission (SEC) adopted final rules to ensure that market participants that perform dealer functions are required to register as a dealer ...
What is the disadvantage of high-frequency trading? ›
High-frequency trading offers significant benefits to online Forex brokers, including speed, liquidity provision, risk management, and data analysis. However, it also comes with disadvantages such as increased market volatility, concerns about market manipulation, high infrastructure costs, and regulatory scrutiny.
What is the average return of high-frequency trading? ›
The average HFT firm earns abnormal annualized returns of 39.92%. Comparing this number to absolute returns of 39.49% shows that the returns of HFTs are unrelated to market returns.
Does HFT actually work? ›
Advantages. The main benefit of high-frequency trading is the speed and ease with which transactions can be executed. Banks and other traders are able to execute a large volume of trades in a short period of time—usually within seconds.
What are the disadvantages of high frequency? ›
At high frequency, logic circuits run faster, consume more power, generate more heat and more circuit noise.
Why is high frequency bad? ›
In the cochlea, the tiny hairs help translate mechanical sound waves to electrical impulses which are then sent to the brain for interpretation. It is believed that the hair cells responsible for picking up high-frequency sounds are damaged first due to where they are located inside the cochlea.
Is high-frequency trading spoofing? ›
Spoofing is a type of disruptive trading behaviour that can occur frequently in the commodities markets, or where there is the use of algorithmic or high frequency trading strategies.
Why is algorithmic trading bad? ›
While it provides advantages, such as faster execution time and reduced costs, algorithmic trading can also exacerbate the market's negative tendencies by causing flash crashes and immediate loss of liquidity.
