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Throughout the history of the market, there were new strategies, extraordinary calculations, and trading ideas. The trend of the last two decades is the algorithms of high-frequency trading. They perform operations in a matter of fractions of a second, which is not at all inaccessible to the human eye. In the current article, we will look at what high-frequency trading (HFT) is, its history and existing strategies, as well as critics – why some people deem it to be a technology of bygone age.
High-frequency trading is the main type of automated trading using algorithms used for superfast instruments on the stock market.
In practice, HFT is a software, a robot that requires quite a large production capacity and the highest speed of communication with the stock exchange.
Here are the key signs of HFT according to the CFTC (U.S. Commodity Futures Trading Commission):
- The use of trading systems that implement super-fast (less than 5 milliseconds) placing orders and canceling them;
- Using software to automate the decision-making process for opening positions;
- Using colocation services for direct access to the exchange;
- A super-short deadline for opening and closing a trade;
- High turnover in the portfolio on a daily basis;
- Placing a large number of orders, which can also be quickly canceled;
- Closing the day from close to zero or at all with no positions.
History of the appearance
According to official sources, the date of birth of high-frequency trade is considered to be 1998. It was then that members of the U.S. Securities And Exchange Commission allowed the use of electronic platforms. In fact, the idea of HFT algorithms appeared almost 10 years earlier. Its founder is a certain Steven Swanson, who, being a talented programmer and holder of a scientific degree in mathematics realized the idea of using productive computers in stock trading.
Later, Steven, along with two like-minded people (David Whitcomb and Jim Hawkes) opened the world’s first HFT company called Automated Trading Desk. In those years, the processing of operations was much slower, but they were able to carry out incredible – execution within 1 second.
Even though it was first used mostly in stock markets, it later gained a foothold in the Forex industry as well. Even now traders use HFT in forex hedging strategies that work for them, but sometimes it provides an unfair advantage. Forex hedging strategy is a method that means opening new positions in the market in order to diminish risk exposure to currency movements and HFT is a perfect tool for this.
Distribution of high-frequency trade
Robots for high-frequency trading brought huge profits, as a result, there were quite a lot of followers of this direction. By 2010, the volume of operations increased by 2.6 times, and the speed increased to tens of microseconds.
Stock market crash due to HFT algorithms
The case took place on May 6, 2010. On that day, the Dow Jones index fell by 990 points in 5 minutes for no reason. This caused panic in the market and a decline in quotations.
As it became known later, at that time the market share of HFT traders was 70%, and it was enough for them to close positions for the market to collapse. Since their scheme of work is very similar, this is what happened from 14:42 to 14:47 on May 6. The above events caused a strong resonance in the society.
The media spread criticism, there were a lot of protests from financiers, politicians who collected commissions and hearings to ban high-frequency trade or tax it.
However, all this was inconclusive, and HFT trading only strengthened more firmly in the market.
Modern period
By 2012, HFT’s efficiency and market share were declining. Since 2009, in just three years, profits from high-frequency trading have fallen fivefold from $5 billion to $1.25 billion.
In 2014, the book Flash Boys: A Wall Street Revolt was published, detailing the history and mechanisms of HFT as financial machinations and market development. The product became a bestseller, authored by Michael Lewis.
In 2016, due to low volatility, most smaller HFT companies began to leave the market. Their profit was incomparable to that which was in 2009-2010.
Peak volatility
Volatility strongly affects the earnings of high-frequency trading algorithms. Tradeworx CEO Michael Beller, as well as Interactive Brokers owner and billionaire Thomas Peterffy, officially announced the complexities of the modern market and finding deals in 2017.
Who uses HFT?
Only developed investment structures and funds can afford the content of high-frequency trading programs. Private investors and traders are far from such an industry, it is completely inaccessible to them. With rare exceptions, there are also prop-trading companies working with HFT on their own funds.
Criticism of high-frequency trading
Over the past decade, critical propaganda against HFT algorithms has been actively promoted. It became particularly active after the release of the aforementioned book “Flash Boys” by Michael Lewis. However, in its content, the market is rather described as innovative or technically advanced, exaggerating its merits. In fact, critics draw on several arguments:
HFT allows you to hide multibillion-dollar revenues from investors and ordinary people;
High-frequency traders at the expense of their advantages remove the “cream” from the transactions of mutual funds, which contain the pension savings of citizens, as a result, take away their money (approximate losses of more than several billion each year);
The failure of algorithms can lead to a total fall in the stock market, as it was on May 6, 2010.
On the other hand, there are many supporters of high-frequency trading. They note higher liquidity, lower bidding costs, and many other benefits that such technologies offer.
Conclusion
High-frequency trading (HFT) has become an integral part of the modern stock market. Its essence is to directly connect with the stock exchange and use the high production capacity to automatically make transactions within a few nanoseconds. Users of such systems are large players: hedge funds, banks, investment structures. Historically, high-frequency traders attracted special attention in 2010, when they were responsible for the collapse of the market.
In terms of strategies, HFT often uses arbitration and marketing in various variations. However, every year the number of such strategies and systems is growing, there are innovative developments, not known to everyone. It is impossible to note high-frequency transactions as negative or positive for the market. From the point of view of critics, they take profits and remove the “cream” from the market at the expense of honest investors, but according to another view, HFT provides liquidity and reduces trading costs, ensuring the stable functioning of the market.
