What Is High-Frequency Trading (HFT)? How It Works and Example

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What Is High-Frequency Trading (HFT)? How It Works and Example

What Is High-Frequency Trading (HFT)?

High-frequency trading, or HFT, is a trading strategy that use sophisticated computer algorithms to execute a high number of orders in fractions of a second. It analyzes several markets and executes orders depending on market circumstances using complicated algorithms. Traders with the quickest execution speeds are often more lucrative than traders with slower execution rates.

In addition to rapid order speeds, HFT is distinguished by high turnover rates and order-to-trade ratios. Tower Research, Citadel LLC, and Virtu Financial are some of the most well-known HFT businesses.

Key Takeaways

  • HFT is a kind of complicated algorithmic trading in which a high number of orders are completed in a matter of seconds.
  • It increases market liquidity and eliminates tiny bid-ask spreads.
  • HFT is chastised for giving major corporations an unfair advantage in trading.
  • Another concern is that the liquidity generated by this sort of trading is transient—it vanishes in seconds, making it hard for traders to profit from it.

Understanding High-Frequency Trading (HFT)

When exchanges began to give incentives for corporations to contribute liquidity to the market, HFT grew in popularity. For example, the New York Stock Market (NYSE) has a group of liquidity providers known as Supplemental Liquidity Providers (SLPs) that try to increase competition and liquidity for current quotations on the exchange.

Following the fall of Lehman Brothers in 2008, when liquidity was a big worry for investors, the SLP was launched. The NYSE pays a charge or rebate to corporations in exchange for providing such liquidity. This leads in a tremendous amount of profit with millions of transactions every day.

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Benefits of High-Frequency Trading (HFT)

HFT has increased market liquidity and eliminated bid-ask spreads that were previously too tiny. This was tested by increasing HFT costs, which caused bid-ask spreads to widen. One research looked at how Canadian bid-ask spreads altered after the government imposed HFT costs. It discovered that market-wide bid-ask spreads rose by 13%, while retail spreads rose by 9%.

Critiques of High-Frequency Trading (HFT)

HFT is contentious and has received scathing criticism. It has replaced a lot of broker-dealers and makes choices using mathematical models and algorithms, removing human decision and interaction from the equation.

Decisions are made in milliseconds, which may lead to large market movements for no apparent cause. On May 6, 2010, for example, the Dow Jones Industrial Average (DJIA) saw its greatest intraday point loss ever, falling 1,000 points and 10% in only 20 minutes before rebounding again. A government inquiry blamed the disaster on a huge order that caused a sell-off.

Another criticism of HFT is that it enables giant corporations to benefit at the cost of the “little people.” Its “ghost liquidity” is also a subject of criticism: HFT liquidity is accessible to the market one second and gone the next, preventing traders from trading this liquidity.

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