Understanding High-Frequency Trading and Its Influence

Key Takeaways

• High-frequency trading uses intricate algorithms to evaluate multiple markets simultaneously and transact orders in fractions of a second based on market conditions.

• To help allay liquidity concerns, exchanges began incentivizing companies with fees or rebates to add to market liquidity, which largely led to the popularity of high-frequency trading.

• While HFT can, at times, lessen or increase market volatility, it is virtually impossible for traders to forecast scenarios that could affect volatility in a major way.

High-frequency trading (HFT) is basically a way to exact transactions quickly and at once. Used primarily by large institutional investors, many of them representing hedge funds, the largely unregulated strategy is pervasive across multiple securities, including index funds, derivatives, equities, ETFs, currencies, and fixed-income instruments. Because of that, the strategy also affects retail investors.

Below is a comprehensive overview of this somewhat controversial trading method.

What is High-Frequency Trading?

High-frequency trading is a strategy that employs powerful computer programs to buy or sell a substantial number of orders in fractions of a second.

The method uses intricate algorithms to evaluate multiple markets simultaneously, evaluate trends and patterns, and transact orders based on market conditions. It essentially seeks to forecast market trends before regular traders who are keeping their eyes on the markets pick up on them.

Investors were particularly concerned about liquidity around 2008, when Lehman Brothers collapsed. To help allay such concerns, exchanges began incentivizing companies with fees or rebates to add to market liquidity, leading to the HFT’s popularity.

How Does High-Frequency Trading Work?

There are several characteristics associated with HFT. For one thing, the strategy uses extremely high-speed computer programming to produce, route, and transact orders. It also utilizes incoming data on individual stocks, as well as co-location services, to significantly decrease latencies.

Moreover, with high-frequency trading, there are extremely short timeframes for both the establishment and selling of positions. It is also a fact that, not long after submitting voluminous orders, many such orders do get canceled.

The way HFT typically works, traders usually wind up the day with no large unhedged positions enduring throughout the night. After all, the aim is to be as close as possible to flat.

What are the Different High-Frequency Trading Strategies?

There are several different ways to employ high-frequency trading. In other words, there are a number of strategies within the strategy itself, all comprising slightly different quantitative trades that are characterized by very short holding periods for stocks.

Among the most utilized strategies are different kinds of event and statistical arbitrage, market making, and latency arbitrage.

Statistical Arbitrage

This strategy entails seeking out price discrepancies among disparate asset classes or exchanges. Because such discrepancies are short-lived, any trader profits are due to the ultra-fast trading pace.

Market Making

To earn the bid-ask spread, the trader places limit offers either to buy such orders or sell them. Just as their sell prices are set just above the current market, their buy premiums are just under market prices. The difference between the prices goes to the trader.

Market makers tend to serve as counterparties to new market orders. Not only do HFT traders who employ this strategy profit from the difference between the bid-ask spread, but they also get a fraction of a cent for each trade. That is, in exchange for providing some exchanges with liquidity. With millions of daily trades, such cents do add up.

Latency Arbitrage

This strategy calls for lessening the amount of latency – the time delay between when an order is placed and its execution – involved in transactions. After all, traders rely on their networks’ high speed in price discrepancies to garner an arbitrage edge.

To illustrate, there are many high-frequency traders who have, for long-distance networking, shifted from fiber optic to microwave technology. In air, microwaves’ speed is slashed by less than 1%. But because light moving in a vacuum travels more than 30% slower, microwaves have speeds that can be as much as fractions of a second speedier than fiber option.

Event Arbitrage

Related to statistical arbitrage is event arbitrage, which utilizes recurring events to forecast short-term responses. In only a short amount of time, HFT traders use such events to get in on these predictions and generate profits.

Global Macro

Hedge funds and investment institutions execute strategies based on overall global economic conditions, building short and long positions in currencies, equity, futures markets, commodities, and bonds. For instance, a hedge fund might have short positions in its stock exchange and invest the capital in nations with growing economies – IF it appears that such countries are headed toward a recession.

What is an Example of High-Frequency Trading?

Say there is a stock about which there is no particular news, and its price is stable. It has seen a lot of small trades, and while some investors have experienced gains, they now believe the stock is overpriced. In the meantime, some investors have been tracking the stock, and now have available investment capital. Still others are happy with their stock ownership but are short on cash. Ultimately, there is a balanced mix between buy and sell orders, and the stock’s price trend is steady.

At the same time, large institutional traders are also buying and selling, but the difference between these HFT investors and retail investors is that institutional sell orders are in extremely large quantities. During the day, while such large orders show no noticeable trend either way, they can move the market up or down. Thus, it takes a while for the stock premium to get back to the underlying trend line. High-frequency traders seek to profit from the price movements caused by such trades.

What are the Benefits and Limitations of High-Frequency Trading?

As with most anything, there are benefits and limitations to high-frequency trading. After all, the method is controversial, largely because it employs algorithms and mathematical models to make decisions, rather than brokers and dealers.

Also, because decisions are made in milliseconds, they could unnecessarily cause market movement. Consider what happened on May 6, 2010: the Dow Jones Industrial Average experienced its biggest intraday point drop in history, falling to 1,000 and decreasing 10% in only 20 minutes before shooting back up. According to a government investigation, the culprit was a massive order that sparked a sell-off.

Also, because the vaunted liquidity that HFT provides is only fleetingly available, it is difficult for traders to actually use it.

Having said that, high-frequency trading does provide market benefits. For example, it adds liquidity to markets, which eases the effects of market fragmentation. It also significantly reduces small bid-ask spreads and increases market liquidity. In addition, HFT provides improved price discovery and price formation process assists, since it is based on large order volumes.

Moreover, HFTs make effective use of inefficiencies. In other words, traders have a relatively high chance of gaining profits in fractions of seconds, a time frame that is not possible manually. And with arbitrage trading, HFTs continually find stocks that are trading on various exchanges and execute long as well as short positions to profit from these scripts.

Another high-frequency trading benefit is that the strategy allows traders to make news-based trades sans emotion.

How Does High-Frequency Trading Affect the Stock Market?

There are various researcher views regarding how HFT affects markets. One study published in the Journal of Finance found that such trading on large-cap stocks – no small-cap equities — during periods when they are generally going up lessens trading costs and produces more-affordable quotes.

The opposite was found by another study which reported a tenfold drop in market efficiency due to HFT. For their conclusion, investigators looked at the volume of quote traffic over four years compared to the value of trade transactions.

At times, HFT likely can lessen or increase market volatility. Still, it is virtually impossible for traders to forecast the scenarios that could affect volatility in a major way.

Is High-Frequency Trading Only for Traditional Investments?

Some alternative investments – essentially assets other than stocks, bonds, or cash – also use HFT, particularly the field of real estate, which continues to grow and prove itself as a dependable alternative investment. Real estate investment trusts (REITs) alone have consistently outperformed the stock market over the last two decades.

Due to their low correlation to public markets, alternative investments generally escape volatility, and can provide consistent secondary income. Another key benefit to alternatives is their ability to diversify investments, which reduces overall portfolio risk. The idea is that if one asset class is underperforming, other holdings have the opportunity to do so.

Alternative Investments and Portfolio Diversification

Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk.

In some cases, this risk can be greater than that of traditional investments. This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million. These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform. However, that meant the potentially exceptional gains these investments presented were also limited to these groups.

To democratize these opportunities, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. Learn more about the ways Yieldstreet can help diversify and grow portfolios.

Summary

The pervasiveness of high-frequency trading across markets, as well as its market benefits, renders the strategy very much worth understanding. After all, it ultimately affects regular investors, too.

Note that the strategy can also be used with alternative investments, particularly in real estate, which also helps with investment portfolio diversification.