High Frequency Trading

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Financial markets have undergone a dramatic change. Traders no longer sit in trading floors buying and selling stocks with hand signals. Transactions are executed electronically by computer algorithms. The application of algorithms on financial markets promotes a new type of electronic market maker called high-frequency traders.

High-frequency trading (HFT), is a method of trading that uses powerful computer programs to transact a large number of orders at extremely high speeds. It uses complex algorithms to analyze multiple markets and execute orders based on market conditions. These platforms allow traders to make a transaction in a matter of seconds. Typically, the traders with the fastest execution speeds are more profitable than traders with slower execution speeds due to market nature.

Features

Latency Arbitrage

Latency arbitrage means getting an advantage by being faster. The market has bid and ask prices. The bid price is the highest price a buyer will pay for a security, and the ask price is the lowest price a seller willing to sell the security. Whenever an order comes to market at a good price, the fastest trader can take it. One of the major benefits of HTF is the speed of trading. A number of theoretical models use HFTs to motivate their informational structure. Martinez and Rosu (2013) and Foucault, Hombert, and Rosu (2013) model HFTs receiving information slightly ahead of the rest of the market. HFTs predict price changes over horizons of less than 3 to 4 seconds. The high-frequency platform also allows traders to profit by making a sheer number of trades that would be impractical for a manual trader. Through algorithms, a high-frequency trader can conduct enough trades in enough volume in a short time to react to the market.

Liquidity

Liquidity is the ability of an asset to be sold on the market. High liquidity means the asset can be sold fast and easily while low liquidity means it is hard to sell the asset. When making an investment, Investors take the liquidity of assets into consideration. HFT improves market liquidity. The amount and volume of the trades using the HFT platform ensure a liquid market. As HFT trades can make up as much as 70% of the trading volume on a given day, investors have a greater ability to be matched up with a counterparty.

Ethical Concerns

Market Manipulation

HFT can give traders an unfair advantage if they engage in market manipulation. A trader would be driving interest in a lightly-traded stock from which he or she would profit through market manipulation. On Oct. 16, 2014, The Securities Exchange Commission charged a New York-based trading firm of manipulating the closing price of thousands of Nasdaq-listed stocks from June to December 2009. By using an algorithm, Athena Capital Research made its trading at the end of the trading day in order to impact the stock prices. “The massive volumes of Athena’s last-second trades allowed Athena to overwhelm the market’s available liquidity and artificially push the market price—and therefore the closing price—in Athena’s favor. Athena was acutely aware of the price impact of its algorithmic trading, calling it ‘owning the game’ in internal e-mails,” the SEC wrote in a release.

Unfair to Small Investors

Hedge Fund companies take advantage of the fast computing system, but individual investors, brokerage firms, or small institutions without access to the expensive computing facilities become harder and harder to gain from the market. According to estimates, the trading volume on U.S exchanges executed by high-frequency computers range from 50 percent to 73 percent. Market research firm, IBIS World, estimated that the high-frequency trading industry is a $29 billion enterprise.