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What is High Frequency Trading (HFT)?

2016-11-18T10:53:21+00:00

The term 'High Frequency Trading (HFT)' is included in the Investments edition of the Financial Dictionary. Get yours now on amazon in ebook or paperback format. Read more here...

High frequency trading turns out to be a platform for program-based trades. It works with super computers that are able to run huge quantities of trading orders at incredibly rapid speeds. This HFT works with complicated algorithms. These analyze a wide range of markets and then place a number fast-paced orders depending on the conditions in the markets. The secret of the trading algorithms lies in their speed. Those traders who have the quickest trade executions usually make more money than do traders who have slower trade executions.

This high frequency trading has not always been mainstream or even possible. It grew in popularity as some of the exchanges began to provide incentives for corporations that could increase the stock market’s liquidity.

As an example, the NYSE New York Stock Exchange works with a number of liquidity providers. These are known as SLPs Supplemental Liquidity Providers. The strive to provide better liquidity and more competition for the exchange and its already existing quotes.

The companies that participate in this program earn either a rebate or a fee when they increase the liquidity. This amount turned out to be $0.0019 in mid 2016 for securities that are listed on the NYSE or NYSE MKT. It may not sound like an enormous amount of money. It adds up to major profits quickly as some of these companies are engaged in millions of transactions on busy days.

The NYSE and other exchanges introduced this SLP program for a specific reason. After Lehman Brothers collapsed back in 2008, liquidity turned into an enormous concern for market participants. The SLP provided the solution to low liquidity. It also made high frequency trading a major part of the stock market in only a few years.

High frequency trading offers some significant benefits to the stock exchanges and financial markets. The most significant one centers on the significantly better liquidity that the programs provide. It has reduced bid ask spreads substantially. Larger spreads are more or less a thing of the past.

Some exchanges tested the benefits by trying to place fees on the HFT. The spreads then increased as fewer trades occurred. The Canadian government started charging fees for high frequency trading on Canadian markets. A study concluded that the end result was 9% higher bid to ask spreads.

There are many who dislike high frequency trading as well. Opponents are harsh in their criticism. Many broker dealers have been eliminated by the computer programs. The human element has been removed from many decisions on the exchanges.

When errors occur, the critics are quick to point out that human interactions could have prevented them. Part of the problem in the speed is that the programs are making decisions in literally thousandths of a second. This can lead to huge moves in the market with no apparent explanation or reason.

The best example of the mistakes that can lead to enormous and scary stock market moves happened on May 6, 2010 during the Flash Crash. The DJIA Dow Jones Industrial Average experienced its biggest drop of all time on an intraday basis. The Dow plunged over 1,000 points and dropped a full 10% in only twenty minutes. It then recovered back much of the loss in the next few hours. When the government investigated the issue, they found an enormous order which had caused the sell off to begin. The HFT computer algorithms did all the rest.

Another criticism concerns large corporate profiting at the expense of the smaller retail investors. The trade off is superior liquidity. Unfortunately, much of this turns out to be phantom liquidity. It is there for the market at one moment and then gone in another. This keeps the traders from benefiting from the liquidity.

The term 'High Frequency Trading (HFT)' is included in the Investments edition of the Financial Dictionary. You can get your copy on amazon in Kindle or Paperback version. See more details here.