High Frequency Trading is a term used to describe a group of trading methods that incorporate high levels of automation into the buying and selling of securities where large volume trades are executed in seconds or fractions of seconds.
Come Again?
One way to think of high frequency trading is to think about the difference between writing a letter and sending an instant message. When you write a letter, you try to cover a lot of bases by conveying as much detail and meaning as you can because what's happening at the time you write the letter could easily be different once your friend receives it. To reduce the effects of this time delay, you involve your computer or your smartphone and send an instant message. Tweeting or texting require a lot less when it comes to word choice because you can send thousands of messages in sequence and in the end, your friend will know what you're talking about. High frequency trading strategies attempt to do something similar for securities traders, as computers are used to make trades at specific points based on conditions that are predetermined by the trader.
So We're Letting Computers Handle Our Money?
In a way, yes. Most transactions that are processed today are handled electronically, simply because computers can more efficiently process large amounts of data at speed. High frequency traders use complex computer models to analyze a vast array of market conditions in real-time and make trades that can occur in seconds or between seconds depending on what a given trader is looking for. So in this sense, computers are the processing agents for the buy and sell orders but human traders are supplying the when, where and how much.
What Does High Frequency Trading Look Like?
High Frequency trading is generally defined by the following characteristics:
- uses computer software to analyze incoming market data and conduct trades based on this data.
- trades remain open for very short periods, usually from hours down to fractions of seconds. Trading occurs very rapidly often trading thousands to tens of thousands of trades each trading day
- High frequency traders usually do not have any positions open at the end of a given trading day.
- Relies heavily on the processing capability of computers to find, analyze relevant market data.
There are also different types of high frequency trading:
- Market Making: places buy or sell orders on various securities in order to earn it's bid-ask spread, thus creating a new market by acting as a counterparty to incoming market orders.
- Ticker tape trading: uses fast processing computers to analyze ticker quotes and volumes to glean information that has yet to be reported.
- Event arbitrage: using recurring events and past price history to forecast short-term market moves and profit accordingly
- Statistical arbitrage: an HFT strategy that attempts to take advantage of predictable deviatiions in "stable statistical relationships" between securities.
Why Trade At Such High Speeds?
Article comments
1 - Igor
The appeal of high-speed trading is seductive. One imagines himself to have an advantage over competitors by virtue of placing orders before other investors can react. We all know the stories of how the Rothschilds became rich hundreds of years ago during European wars by attaching messages to homing pigeons in Paris that would then fly to London so that Rothschild traders were first to trade in the London markets.
In the 80s my partner and I each had a decent stash so we bought two "Omega" systems that tied us into the markets and provided highspeed trading as well as highspeed access to all data sources. We figured that all we had to do was properly program the computers and sit back and watch the money roll in. But it didn't work out that way. In fact, my mathematical analysis showed that we were doing about as good as throwing darts at a dart board. We were trading down in the market noise. After about two years we both withdrew.
What happened? We got beaten by "insider trading". Traders who knew before announcements what was going to happen. I confirmed that by tracing back some trades. People were trading on information before it was released.
Of course, insider trading is illegal. Martha Stewart went to jail for it (poor lamb, while she was suitably greedy, she just didn't realize how REALLY greedy the rest of investors are. She was setup for a fall, maybe as a sacrificial distraction).
All my life experienced traders have told me that all successful trading is insider trading. And I believe it. Now.
But the constant influx of hopeful small traders provides constant cashflow for the stock mills that extract commissions.
So new highspeed techniques don't promise to make winning easier, but they will certainly increase cashflow through the mills, and IMO just accelerate the loss rate of small uninformed outside traders. The Big Guys will more efficiently fleece the small guys.
But that's a benign effect: who cares about the fortunes of any individual investors, especially small disorganized guys?
The malignant effect comes about from the high-speed nature of the trades, which increase the instability of markets. Instability is the plague of capitalism and has been known for hundreds of years. Capitalisms instability is systemic, it's caused by internal mechanisms, not by externals, like famine, plague and flood.
Instability is increased by higher speeds, so it's a bad thing for the overall economy.
What can we do? Speed is already too fast. Well, we can try slowing things down by demanding time delays for trades, but the market will quickly discount that by establishing derivatives or secondary markets.
The best solution is a Financial Transaction Tax. This is beneficial in two ways: it reduces Marginal Propensity To Invest, and it is non-conservative, i.e., money withdrawn by the tax is not saved and re-injected in another form. That money goes elsewhere, it doesn't feed back into the same subsystem.
A Transaction Tax works a lot like a shock absorber in an automobile suspension system: constant retardation of bound and rebound stops the wheels from bouncing unnecessarily after a little bump.
A carefully calibrated Financial Transaction Tax would smooth out the excess oscillations of the economy and provide money for useful societal enterprises.