High-Frequency Trading Explained in 2020

Everything is getting automated.

Even trading.

The Wolf of Wall Street and other movies depicting the stock market always include a scene where all of the employees are working in a hectic environment.

Can you imagine a movie about high-frequency trading?

Just a room full of robots beeping. 

We are not sure how many people would want to watch a movie about an AI establishing its own brokerage firm along with its bulky sidekick.

We do hope though that at least someone would want to read our article about how the use of high-frequency trading software has affected the market.

Anyway, let’s begin: 

A Brief History of Trading 

In order to explain this concept, we need to go back in time.

Way back.

In fact, the first stock exchange was founded in the 17th century.

With traders in need of a place to trade stocks, coffee shops initially fulfilled that purpose.

Eventually, the first stock exchange was founded and traders started meeting on trading floors.

When we think about stocks, we usually imagine a bunch of men yelling ‘Buy!’ or ‘Sell!’.

That is known as open outcry or pit trading. The brokers yell out which stocks they are selling and at what price and the buyers announce which stocks they are buying.

Those were the simple beginnings of the stock market.

If you want to know more, you can check out some stock market statistics.

Now, where were we?

Right:

Alas, everything must come to an end. Or close to an end. While the old-school floor trading still exists, it has mostly been replaced by electronic trading.

The first electronic trading platform — the NASDAQ — was created in 1971. Since then, the trading has become computerized, automated and algorithmic.

Which leads us to:

What Is High-Frequency Trading?

HFT is an automated type of trading, using powerful computers to execute a large number of orders at subsecond speed.

But that doesn’t make things much clearer, so what we need to explain is:

How Does High-Frequency Trading Work?

Remember those brokers yelling and selling? Well, most of them have been replaced with computers.

These computers represent an automated trading platform. They are programmed to work by specific rules. For example, when highly-wanted stocks reach the desired price, they execute a buy order.

And since the process became automated, trading has become simpler. There is no need for brokers to constantly track the prices and put in orders.

And now for the high-frequency part:

Speed is of utmost importance.

You know how the online gaming community hates lags? So, basically, when one player has a slow connection, he is behind on the action. Which makes him the slowest and last to act.

In the world of trading, this is called latency. Price fluctuations happen constantly — and take time to be reflected.

The trader who is the first to find out about these price changes can benefit from them and make a profit.

And this is where high speed trading comes into play. These computers can manage to make orders within milliseconds.

So, how do they do it? 

They do it by means of colocation. 

The exchange servers are located on the premises of the stock exchange. In order to get the best and fastest connection possible, trading computers are placed close to the exchange servers. That way, they will be the first to receive the new data.

HFT firms can rent out the place or pay a fee to place their computers close to the exchange servers. 

Another way to enable this kind of speed trading is by using a private fiber network, like the one launched by Spread Networks which connects New York to Chicago. 

High-Frequency Trading Strategies

Traders benefit from the speed by employing these strategies:

  • Electronic frontrunning 

Traditional frontrunning, also called tailgating, is when someone has information that hasn’t been made public yet and uses this info to make a profit.

For example, this person might know of a development that would push a stock price up, so they buy shares before this becomes public knowledge, and sell them later.

This is considered an unfair advantage and as such is illegal. 

Electronic frontrunning, on the other hand, is fairly common. 

Let’s say that investor A wants to buy shares from company B. If it is a large order, it can be divided into multiple smaller orders. Or perhaps the investor is buying stocks from companies B and C.

So, when the first order is placed, the high frequency trader will pick up on the pending transaction. The trader will anticipate upcoming orders.

And the trader will come up with the most logical solution to make profits: buy the shares before the investor and sell them at a slightly increased price. Or, if the trader already owns these stocks, step 1 will be skipped, though the price will still be increased.

  • Rebate Arbitrage

Market makers are those who buy and sell stocks and thus provide liquidity. In exchange for this, they receive a commission or a rebate.

These people have now been replaced with high-frequency computers.

  • Slow Market Arbitrage 

In the trading world, arbitrage can be defined as buying stocks from A at a lower price and then selling them to B at a higher price.

It can be considered one of the most lucrative HFT strategies

Herein lies the advantage:

High-speed traders are the first to find out about price fluctuations, which enables them to take advantage of differences between exchanges. 

If the price of a certain stock will increase, these traders will buy shares at the current price and then sell them when the price increases elsewhere, before slower traders can react.

  • Spoofing

Spoofing can be defined as using HFT algorithms to create a false appearance of high or low demand. 

Since a large number of orders can be placed in a short timeframe, traders using the technology can create a sense of false demand and use it to their advantage.

For example, a spoofer can place one large order and cause a change in the prices. Then, the spoofer places a different order taking advantage of the price change. The original order which caused the false impression of demand is subsequently canceled, though not before the spoofer has made a profit. 

This practice has been defined as illegal under the Dodd–Frank Act.

  • Quote Stuffing

Like spoofing, quote stuffing is also considered to be a type of market manipulation

Quote stuffing happens when traders flood the market with a large number of buy and sell orders. This overwhelms the market and slows down rival traders. 

How Does HFT Make Money?

Money is made by utilizing some of the strategies mentioned above (barring the illegal ones, we hope).

So, regarding the slow market arbitrage mentioned:

When you are the first one who is aware of even a slight price discrepancy, you are probably the first, if not one of the only traders to make profits from that.

Let’s say there is a price increase of $0.02 on a certain stock. Those that use this high-speed technology can sell an enormous number of stocks and make a profit. A regular trader operating at regular speed may disregard this small profit margin as not worth it.

Another way in which high frequency trading computers help companies make money is by profiting from the bid-ask spread. 

The bid is the highest price that the buyer is willing to pay.
The ask is the lowest price that the seller is willing to accept.

The bid-ask spread is the difference between the two.

All in all, a good high-frequency trading algorithm has proven to be effective in the popular trading strategy: buy low, sell high.

Other investors need to do it the traditional way: by closely following the best-performing stocks on the market. 

How to Make Money on High-Frequency Trading?

The costs associated with this type of trading are probably too much for small investors. 

For starters, you need trading algorithms, servers, as well as a fast and reliable connection to the exchange servers.

This is one of the reasons why this type of trading is usually carried out by hedge and investment funds, investment banks and companies specializing in it. 

Mere mortals, on the other hand, could consider a career in the field. 

The main roles you can take on are trading and developing.

If you are an aspiring HFT developer, trader or a quantitative analyst, you would need to have a knowledge of programming languages, stock markets, as well as the ability to implement trading strategies and work with analytical tools. 

Wondering what the range of the high frequency trading salary is for the various positions in this industry?

It is upwards of $800,000 and it can rich seven figures. Not bad, right?

You are now probably thinking about googling some companies offering high-paying high frequency trading jobs.

Let us help you out:

Which Are the Best High Frequency Trading Firms?

Not surprisingly, the key players are companies whose revenue is upwards of millions or billions. This type of trading is all about quantity and executing orders in nanoseconds. The risks involved are costly too — a trading glitch cost Knight Capital $440 million.

So, let’s have a look at some of the top high-frequency trading firms.

Two Sigma Investments is a hedge fund founded in 2001 by David Siegel, John Overdeck and Mark Pickard. It is headquartered in New York and has around 1,700 employees. 

As of May 2019, they manage more than $60 billion.

Virtu Financial is also headquartered in New York, USA. It was founded in 2008, by Vincent Viola. In 2019, they reported that they had 483 employees. 

At the end of the fiscal year 2018, Virtu Financial had total revenue of $1.88 billion

Citadel Securities is one of the key players in HF trades. This Chicago-based hedge fund was founded in 1990 by Kenneth C. Griffin. 

Citadel Securities manages around $32 billion

Tower Research Capital is a trading and technology company founded in 1998 by Mark Gorton.

According to the latest reports on the algorithmic trading market, Tower Research Capital is considered one of the key players in the industry. 

How Much Do HFT traders Make?

As mentioned above, these companies probably make less than a penny from each trade.
However, the stock trading time is what matters here, with a transaction made in less than a millisecond. So, at the end of the day, the profits add up.

It would seem though that this trading is no longer as lucrative in the financial market. Aggregate revenue for high-frequency trading companies fell to less than $1billion in 2017. As a comparison, in 2009, aggregate revenue for these companies amounted to $7.2 billion

The technological costs are getting higher. And as lawmakers catch up with the latest technologies, regulations are put in place to define which practices are legal. As a result, many of the unfair advantages have been lost due to high-frequency trading regulations

The Pros and Cons of HFT

While electronic trading using algorithms has been done for decades, there’s no general consensus on whether this is a good or a bad thing.

This  leaves most people wondering:

Is High Frequency Trading Good?

Let’s start by discussing the advantages so that we can see whether the pros outweigh the cons.

The Benefits of High-Frequency Trading

  • Increased Liquidity 

Automated trading is essentially an effective market maker. Computers are definitely faster than humans, so these systems can make more transactions and increase the liquidity of the market.

  • Lower Bid-Ask Spread

The ways in which the bid-ask spread has been reduced and removed have already been proven. Canada tried introducing fees on this type of trading, which led to a 9% increase in the bid-ask spreads in 2012.

The Risks of High-Frequency Trading 

  • Errors in the Algorithm

We can all agree that computers are less prone to mistakes than humans. However, let’s not forget that they are written by humans.  An error or a glitch can mean losing millions.

  • Unfair Advantage

Many might argue that small investors are at a disadvantage. Being able to process transactions in milliseconds means that even the trades with the lowest profit margins are worth it. This isn’t the case for small investors.  And the average investor does not have ultra-low latency direct market access.

  • Market Risk

There are many different terms to describe the market risks that can be triggered by algorithmic trades: chain reactions, ripple effect, domino effect, etc.

The key point is that these algorithms closely follow trends in the market. And they act on them.
Each win or loss will be reflected in the worldwide market.

The 2010 Flash Crash only lasted 36 minutes, yet managed to wipe out $1 trillion in market value. And spoofing is considered to be one of the contributing factors of this market crash. 

Key Takeaways

Now, let’s see.

What are the main points?

First, this isn’t a new concept.

Speed has always been important both on the stock and the foreign exchange market, and high-frequency trading has only served to simplify the process. 

Then, there is no denying the bad sides and the risks.

However, while there have been numerous controversies and open disapprovals, each fiasco high-profile has been followed by fines and new rules.

So, what’s left to see is how this method of trading will adapt to the new regulations.

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