The following is a guest post from Alexander. He started his career in the financial business back in 1999. For many years, sharing investment ideas with his readers on his website daytradingz.com is an important part of his life.
High-frequency trading describes the practice to submit thousands of orders per second. The aim is to profitably benefit from even the smallest price changes within this short period. With fiber optic cables and increasingly sophisticated programs, the advantage of this practice lies in its incredible speed.
Since the emergence of high-frequency trading, it has kept the stock market afloat, causing millions upon millions of orders – per minute! Most of these orders are ultimately not executed because HFT-Traders are looking for short-term arbitrage only.
In the past, it was common practice for investors to make arbitrage trades by exploiting the price differences between individual stock exchanges. Nowadays, this trading practice and its potential profits must be left to the high-frequency traders with the best high-end trading computers.
Arbitrage profits can no longer be achieved with manual order entry. High-frequency trading now constitutes for a large part of the trading volume in some market segments.
Algo-trading is not the same as high-frequency trading
Frequently, the terms algo-trading and high-frequency trading are used as synonyms. However, this is not correct.
While “algo-trading” describes the practice of computer-aided and partially computer-controlled orders in general, the term “high-frequency trading” explicitly refers to such computer-based trading practices where speed is at the forefront as well as strategic.
The fastest lines are installed, and the best possible proximity to the exchanges is sought (shorter line = faster transmission). Additionally, the programs are structured in such a way that they minimize the need for human intervention to an absolute minimum.
High-frequency trading is literally about milliseconds! This incredible speed, in which orders can be made in large numbers, allows the pursuit of very diverse market strategies, such as profits through arbitrage, where speed is everything.
Controversial high-frequency trading
However, high-frequency trading does not only show positive market developments. In fact, for the following reasons it is very controversial:
- More volatility – The sheer volume of orders within a short period significantly highlights the price volatility.
- Lower Real-Economic Price-fixing – Measured by the fact that a large number of high-frequency traders pursues strategies that are more likely to use mathematical benchmarks, i.e., often have little or nothing to do with real economic considerations, prices are mainly strategically influenced.
- Terrified investors – Investors who want to commit themselves to a company in the long term are scared by excessive volatility. Day traders don’t like HFT-Algorithms, because there is a lot of cheating and hiding going on in the order-book.
- Small investors have the disadvantage – small investors have to endure significant competitive disadvantages in many places. Until their individually entered orders are transmitted to the exchange, they usually have many high-frequency orders pending before them. In that time, traded stocks can change, and potential profits melt together. Even stop-loss limit orders do not prevent this disadvantage because they are not a high priority in processing and they will be queued at the end of the order book.
- Doors are open for manipulations – with millions of orders within the shortest possible time and a huge lever, the manipulation possibilities are obvious. High-frequency traders can significantly influence even the prices of entire stock indexes. The temptation is high to push prices in certain directions to provoke certain market reactions and then capitalize on them. The Flash Crash on May 6, 2010, clearly demonstrated the far-reaching effects High-Frequency Trading can have on market developments.
The challenges and the future of HFT
To master all of this has become more of a wish. One of the main reasons is because the stock market is so strongly internationalized that the various jurisdictions legally complicate effective supervision. Regulations are confronted with a global armada of supercomputers.
While the computers generate millions of transactions per day, the respective auditor has to look at the trading transactions individually or even fall back on computer-aided verification procedures. It is a game of cat and mouse.
High-frequency trading will not decline. On the contrary. It will continue to increase and become a natural part of life for investors. And private investors now also have the opportunity to benefit from algorithm-controlled trading strategy development and order execution.
Unlike institutional investors, private investors will never have the advantages of the server location, but they will catch up and benefit from technological progress.
The computer protected digitalization of stock exchange has created a foundation for further innovations. Good ones and bad ones. On the one hand, the potential for human error has been minimized, and liquidity has significantly increased.
On the other hand, a regulative hard-to-tame Hydra in the form of high-frequency trading has been created, turning an actual secondary market into an insatiable impulse generator with high potential, as the Flash Crash of 2010 has already shown.
In financial movies and financial documentaries such as the YouTube production “The Wall Street Code”, you can see down to the last detail the power of high-frequency trading and the challenges it poses.