What is high-frequency trading?
High-frequency trading (HFT) is a form of computerized trading that uses complex algorithms to buy or sell large quantities of assets. HFT trades these large quantities at the fastest speed, and this quality sets it apart from other algorithmic trading programs. HFT algorithms are always the first on the market to fill buy-and-sell orders.
Not only are these algorithms extremely complex, but most HFT processors are also physically closer to their target exchange. The smaller the distance to reach a market like the NYSE, the quicker an HFT machine will process transactions. HFT firms often pay high fees to stock markets to co-locate their devices on an exchange’s premises.
HFT programs can analyze data from multiple markets and asset classes to take advantage of price differences. Although HFT firms are commonly associated with stocks, they’re active in markets such as precious metals, commodities, derivatives, and cryptocurrencies. There are also HFX trading platforms that focus on fiat currencies in the foreign exchange market.
An HFT’s built-in algorithm tells the program how to do trades depending on the target price of preselected assets. HFT machines typically process millions of transactions in milliseconds.
HFT trading is the most popular among institutional traders, banks, Wall Street hedge funds, and financial firms. Prominent examples of HFT firms include Citadel, Virtu Financial, and IMC.
How does high-frequency trading work?
HFT is a short-term trading strategy that focuses on minuscule price discrepancies in assets, and traders place large orders at lightning-fast speeds. It’s especially common in arbitrage trading, a practice that involves buying or selling one asset across multiple exchanges. An arbitrage trader is always looking for slight price differences between the same asset.
For example, let’s say Dogecoin was trading for $0.067 on Binance and $0.060 on Gemini. Once an HFT algorithm detects this difference, it could buy a large quantity of DOGE on Gemini and instantly sell it for a profit on Binance. A $0.007 profit per coin may not seem like much, but HFT machines can buy and sell millions of orders in less than a second.
HFT traders can also take advantage of the differences between bid-ask prices, where the bid price is the max price a buyer will spend on an asset, and the ask price is how low an individual is willing to sell it. The difference between these prices is the bid-ask spread. HFT traders that provide liquidity to an exchange can profit from the difference between these prices.
Similar to arbitrage trading, bid-ask spreads aren’t common in highly liquid markets. However, since HFT traders handle so many transactions in a short timeframe, they can profit from seemingly minuscule bid-ask spreads.
Also, many exchanges like the NYSE offer HFT traders rebates for adding liquidity to the market. HFT firms like Citadel have become significant market makers, which means they help buyers and sellers connect. If HFT traders abide by their exchange’s rebate requirements, they can earn funds by facilitating large trades.
How does HFT work in crypto?
As the value of cryptocurrencies rose in prior bull runs, more HFT firms began integrating crypto trading into their algorithms. There are even a few HFT companies that specifically target cryptocurrencies like Bitcoin (BTC) and Ethereum (ETH). DRW and Jump Trading are a few high-profile firms that now offer HFT in the crypto market.
In contrast to traditional assets like stocks and precious metals, crypto HFT trading can occur on decentralized exchanges (DEXs). Unlike centralized exchanges (CEXs) like Coinbase and Kraken, DEXs are smart contract protocols built on blockchains like Ethereum. DEXs like Uniswap allow anyone to deposit crypto in liquidity pools to facilitate automated peer-to-peer crypto token swaps.
Since DeFi (decentralized finance) applications like DEXs are in their infancy, they aren’t as regulated as CEXs. DEXs also tend to have lower liquidity than CEXs. These factors provide HFT traders with another avenue to seek arbitrage opportunities.
In addition to access to DeFi, HFT trading in crypto is similar to other asset classes. Algorithms usually look for small price discrepancies across various tokens on multiple exchanges. Once an HFT program spots a profitable opportunity, it’ll open and close countless large transactions within microseconds.
Why do investors use a high-frequency trading strategy?
HFT gained more attention from institutional investors in the early 2000s. Today, many trading firms still use this strategy to generate steady returns. HFT strategies have proven so influential because they:
- Speed up trading time. Timing is essential in short-term trading. Even if a trader spots an arbitrage opportunity, they need to execute their trade within seconds to lock in a profit. The high speed of HFT machines virtually guarantees a trader will be one of the first to seize large gains from minuscule price inefficiencies.
- Analyze multiple markets and exchanges simultaneously. HFTs can process large pools of data from various sources in a fraction of a second. By using one of these machines, investment firms don’t have to spend as much time analyzing or testing different trading strategies. With a strong HFT algorithm, traders have access to limitless trading opportunities.
- Can provide rebates and market-making advantages. Many HFT firms use this technology to provide liquidity to stock and crypto exchanges. Becoming a market maker has various benefits. For instance, market makers can take advantage of the difference between bid-ask prices. Many exchanges incentivize HFT traders to add liquidity with rebates.
- Potentially reduce market risk. HFT traders aren’t betting on long-term investment strategies. Instead, these algorithms look for “sure bets,” such as arbitrage opportunities or wide bid-ask spreads. Also, because HFT orders are usually completed within a few seconds, they won’t put traders at the risk of price fluctuations later in the day.
HFT has triggered a great deal of debate within the financial sector. While some maintain that HFT firms help narrow bid-ask spreads for retail investors, others argue the costs of high-frequency automated trading outweigh the benefits of a potential liquidity boost. Here are some critical observations analysts have made about HFTs:
- HFTs increase the risk for “flash crash” events. The potential dangers of HFT hit mainstream news in 2010 when the Dow Jones Industrial Average fell more than 1,000 points for 30 minutes before bouncing back up. Since implementing more HFT algorithms, many other markets have experienced these “flash crashes.” Most financial analysts believe the overreliance on algorithm trading increases the odds of these erratic intraday stock prices.
- HFT firms have an intel advantage. HFT machines process information much faster than any human. In contrast to the several minutes or hours it takes a person to read a company’s earnings report, an HFT algorithm analyzes essential keywords and makes multiple transactions in seconds. This gives HFT firms more opportunities to seize short-term volatility than average investors.
- HFTs concentrate liquidity into the hands of a few entities. Since HFT firms are some of the world’s largest market makers, they significantly impact price dynamics. Some are concerned this concentration of wealth makes markets easier to manipulate.
- HFTs have been used for unethical trading practices. Speaking of market manipulation, it’s no secret that HFT traders have used their machines to outwit slower algorithms. For instance, HFT traders could spoof markets by making multiple overpriced purchases and immediately canceling them. Slower algorithms react to these high buy orders, only to later discover they weren’t authentic. Meanwhile, an HFT firm could sell call options or shares in their target stock at a profit.
- HFTs are overly reliant on complex algorithms. The algorithms that run HFT programs are becoming increasingly intricate. Even professional coders are having difficulty keeping pace with the complexity of HFT algorithms. As financial markets rely more on HFT for liquidity, it puts them at greater risk for bugs or unforeseen coding errors.
Algorithmic trading techniques like HFT have fundamentally altered day-to-day market activity. While it’s unknown how HFT may affect the volatility of long-term investments, it has made short-term trading far more challenging for retail investors. Although HFT may enhance liquidity, it also gives HFT firms many unique advantages.
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