High Frequency Trading - Meaning, Benefits, and Risks

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Synopsis:

High frequency trading is a type of trading in which powerful computers are utilised to execute large volumes of trades in a very short time frame. In high frequency trading, algorithms play a critical role in initiating transactions once the market hits the predefined parameters. In this article, we shall discuss the concept of high-frequency trading, its pros and cons, and key strategies.

Technology is constantly transforming the way we approach various processes, and stock trading is no exception. With the switch to electronic trading, the process has become swifter, more transparent, and cost-effective. Amongst the latest technological disruption in stock trading is high-frequency trading. In this article, we shall discuss

  • What is high-frequency trading
  • How does high-frequency trading work
  • Major benefits of high frequency trading
  • Key drawbacks of high frequency trading
  • Prominent high frequency trading strategies

What is High-Frequency Trading?

High frequency trading is a variant of stock trading that is characterised by high speed execution of a large number of transactions. This type of trading revolves around extremely powerful computers and low latency networks that leverage processing and transmitting speed to facilitate swift and high volume trading. Hft trading is algorithm driven and requires significant infrastructure - mechanical and human capital wise. As such, this trading methodology is largely deployed only by institutional investors and large fund houses.

How Does High Frequency Trading Work?

At the foundation of high frequency trading are complex algorithms designed to trigger huge volumes of transactions in response to the market reaching certain levels on predefined parameters. In high frequency trading, individual securities are consistently assessed to detect even the most minute of trends and benefit from it through high-speed and bulk transactions.

Although the changes that trigger such trades may be minute and seemingly insignificant, the sheer volume of transactions in high frequency trading amplifies the overall profit. To make high frequency trading possible, substantial investment in technological infrastructure is a prerequisite.

Major Benefits of High-Frequency Trading

There are several reasons why high-frequency trading has been gaining traction. Here are the major benefits of high frequency trading:

  • Leveraging small price movements: With high-frequency trading, traders can benefit from the smallest of changes in the price of a security. Since the entire process of order triggering and placement is automated, it is possible to place a significant number of trade orders in a matter of seconds, something that is not feasible with human effort.
  • Enhancing market liquidity: High frequency trading is considered to have a positive impact on market liquidity. Owing to the constant analysis of price movements and other relevant market data accompanied by the automatic triggering of a large number of orders, the overall liquidity in the market is increased. High frequency trading can, therefore, reduce the spread between bid and ask prices, thereby raising the price efficiency of the market.
  • Tapping arbitrage opportunities: Another significant advantage of high-frequency trading is that it facilitates the identification of arbitrage opportunities. Through a high-frequency trading platform, the difference in the prevailing market prices of a particular security in separate stock exchanges can be automatically detected. Consequently, the required to buy and sell orders can get automatically triggered by the high frequency trading algorithm, and the trader can benefit from the price difference.

Disadvantages and Risks of High-Frequency Trading

High frequency trading has its fair share of disadvantages, risks, and ethical predicaments. Firstly, the time horizon for high frequency trades is minimal and the corresponding trade volume is high, a combination which is construed to increase market volatility. Secondly, the requirement of extremely expensive technology and network resources makes the scope of high frequency trading limited to large fund houses and financial institutions, thereby tilting the scale of the markets unfairly in their favour.

 

Thirdly, there are widespread ethical dilemmas surrounding high frequency trading. The argument that high frequency trading results in ghost liquidity or extremely short-lived liquidity that can only be tapped by high frequency trading platforms and not by other investors makes the methodology a moral grey area. Furthermore, high frequency trading has been found to result in market instability and crashes in several instances. This is exacerbated by the incidents of high frequency traders manipulating the market.

Major High Frequency Trading Strategies

The methodology of high frequency trading revolves around certain trading strategies which facilitate the identification of price movements within and across stock exchanges. Here are some of the prominent strategies of high frequency trading:

  • Market making: This high frequency trading strategy entails the quoting of buy and sell prices for a security in a loop so as to benefit from the buy-sell spread.
  • Momentum trading: The key aim of this high frequency trading strategy is to detect the trends associated with a particular security in the short run, and place buy and sell orders to benefit from those trends.
  • Statistical arbitrage: This high frequency trading strategy is aimed at identifying and leveraging the price discrepancies between securities that ought to be priced at a similar level.

To sum it up

Although high frequency trading enables the execution of large volumes of transactions in an automated manner, it is a subject of constant debate and disagreement between various stakeholders in the market. The ethical predicaments associated with high frequency trading as well as the substantial capital investment required to operationalise it make its scope significantly limited. 

Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.

This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.

For All Disclaimers Click Here: https://bit.ly/3Tcsfuc

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