What is high-frequency trading(HFT)?
High-frequency trading is a trading method that uses highly sophisticated computer programs to execute a large number of orders in a very short time. Complex algorithms are developed by investment institutions to give them an edge in competitive markets.
Why High-Frequency Traders have an edge over regular traders?
Your order execution speed will increase your chances of gaining in the stock market. This is one benefit high-frequency traders have over regular investors and traders. The following are reasons why HFTs win more compared to the average investor.
1. Direct access to markets
These advanced computer programs have better access to markets. Instead of going through brokers, these algorithms have access to market exchanges. That is, there is no middle man between HFTers and market exchanges. This is the opposite of how the system works for regular traders.
You do not choose market exchanges that provide your shares. After placing your order, the broker chooses where to buy the number of shares you want and then sell them to you.
Prices of stocks are not the same across many exchanges. After placing your order, your broker will evaluate stock exchanges and buy those shares where they are the cheapest. The broker will then sell those shares to you at a higher price.
2. Understanding of microstructure of the market
Many of us do not understand exactly what happens in the market and therefore, we rely on our brokers for every transaction. This is not the case for HFTs. They understand everything in the market and this helps them make the best choice on every problem.
3.High-speed advantage
Speed is everything in the market. A one or two seconds delay on your order can cost you a lot of money in a volatile market. Your computer does not function at an optimal speed. Even if it is fast, you don’t have the same speed wealthy investors use.
Besides noticing your incoming orders and race to buy them faster than you so that they can sell them to you; they also have a big competition among each other. These competitions between HFTers themselves are pushing them to extreme levels.
HFTs developed a number of solutions to overcome latency issues in order to win the competition.
- Their servers are close to market exchanges.
- Using high tech equipment
- Using programmed computers to do the job
- Building direct communication links between exchanges. For example, the fiber optic communication networks builts by Spread Networks that cost hundreds of millions of dollars. This direct and straight link connects the Chicago Stock Exchange and NYSE. Why would they want to build a straight connection between these two exchanges? The answer: To shave three milliseconds off the time it took to trade between the two exchanges.
Top HFT firms
There are many HFT companies out there. The following are a few of them and you can click on this link if you want to learn more firms or details on each one.
- Tower Research Capital
- Jump Trading
- Virtu Financial
- Two Sigma Securities
- Citadel Securities
Why High-Frequency Trading?
Although High-Frequency Trading activities are condemned to have an upper hand in the market, they may have a good reason for existence. They receive incentives from market exchanges to add liquidity to the market and solve spread problems.
Sources: Businessinsider.com, Investopedia.com, theatlantic.com
