At the beginning of last year, the Members of Congress in the US, Edward J. Markey, stated algorithm trading or high frequency trading clearly corresponds to a high level of risk to the safety and permanence of the capital market in the US and the fact it should be truncated as soon as possible. And he isn’t alone in saying HFT does indeed pose considerable risks to the trading infrastructure.

Many financial analysts claim to back this same assertion with the proof taken from recent market events, such as the Flash Crash along with the loss Knight Capital as a result of a software malfunction. Mentioned below is the summary of the overall risk associated with high frequency trading:

• The sheer speed of the trade puts most trading styles at a considerable disadvantage
• High frequency trading intensifies market volatility
• Most of the ‘other’ types of investors usually run away from it
• HFT volume has a risky high proportion of the total traded volume

But it is also important to understand the fact not everyone agrees with the analysis made in regards to the potential dangers of high frequency trading. It is true the machines have taken over when you talk about modern trading. They have taken the place of human specialists or the smart market makers and a majority of the trading quotes, offers and bids which come flowing in today flow in through high frequency trading computers and systems.

And it is also true the Flash Crash that occurred back in 2010 is a great example of the dangers posed by high frequency trading when Waddell & Reed incorrectly keyed a trading order which resulted in a terrible market dive. HFTs went scurrying out of the scene as the market fell for a short period of time and there were no bid being placed and there were significantly big price dislocations demonstrated by the 10% market freefall.

A Drop in High Frequency Trading

Despite the fact that several trading companies get to enjoy the high speed benefits of HFT, it has been seen that there has been a considerable drop in profitability using HFT. If you look at the reports from 2011 and 2012, you will see that those years saw considerable drops (7.8 billion shares each day to 6.5 billion shares). The drop was of 17%. Another thing to consider is the fact HFT is all about speed and co-location.

HFT providers such as Citadel, Virtu Financial and GETCO have to all constantly bring in new technology and upgrade processing units to match each other’s speed. According to a report, it was revealed GETCO spent a total of $37 million on upgrades.

Lower volumes are bad for HFT solely because of the fact the lower the amount of the orders that enter the market, the fewer the opportunities to make a bid/offer. Another problem that isn’t highlighted much is the fact the amount of traders who want to willingly use HFT is dropping. One of the major concerns with HFT today is the fact that it might blow out of proportion in the capital markets, just like what happened at Knight Capital. Companies employing HFT and the HFT vendors have both failed to display a successful effort to manage and control high frequency trading.

The only things you need to have are state of the art evaluation and tracking control systems to prevent events like the Flash Crash from happening again. Because if HFT isn’t controlled, the losses could easily keep piling up and then you would need to place a more drastic countermeasure: a ban on HFT, which most traders suggest should happen now. But if you talk about the future and improvements, then taking a drastic step like banning it now could overcomplicate the situation.

The science of HFT systems and processors enable the computers to analyze and predict your moves in the market which mean there could be landmines everywhere you look. It is no surprise the framework of modern trading has been forever altered. A human hand that just takes a couple of seconds to conduct a trade now is replaced by a machine which can do the same trade in a millisecond or a microsecond.

The fact is HFT can neither be called bad nor can it be called good and that’s the way it’s going to be in the future as well.

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High-frequency trading (HFT), as the name suggests, refers to the quick transacting and processing of a large number of orders. It is a trading platform traders can use to place and execute orders. In HFT, traders make use of complex algorithms to analyze the financial market they are trading in and then execute the trades accordingly. In other words, HFT is a form of algorithmic trading with the use of the necessary tools that allow traders to make trades quickly.

Obviously, they do take into account the market conditions before going ahead with the trade. Traders who can think on their feet and make quick decisions are the ones who benefit the most from HFT.

History and Growth

Up until a few years back, HFT orders were responsible for more than half the orders placed in the market. However, HFT hasn’t been around for as long as some other trading methods and techniques. It only came to the fore at the turn of the millennium. The turning point was the authorization of electronic exchanges by the SEC, which took place in 1998. Back then, it took at least a few seconds for a trader to execute his/her trade. A decade later, decisions can be made and traders placed in a matter of milliseconds. Trading has never been this quick and it is only going to get faster in the future.

Despite all-round acceptance of the concept, it took a while for HFT to become a household term, at least as far as the financial markets are concerned. It took a 2009 article published in the New York Times to turn things around and make traders and analysts sit up and take notice that HFT is indeed a practice to be reckoned with, not just a passing fad. Things have changed since then, with Italy being the first country to impose a tax on HFT. Initially, traders were required to pay 0.002% tax on any equity transaction they made which didn’t last more than 0.5 seconds.

Rise in Popularity

What’s there to be gained from making trades in milliseconds, you might ask? After all, there are 8 hours when you can make trades on the floor and after that, you can continue planning your trades for the next day online. That being said, HFT really only gained popularity after the traders were rewarded for adding more liquidity to the market. The NYSE has in place a group known as the supplemental liquidly providers (SLPs). There purpose is to increase the competition in the market as well as make existing trades and quotes more liquid. To incentivize this practice, the NYSE pays a rebate to these providers.

Firms which engage in HFT are not known to have in their coffers a large sum of capital, as is the case with the largest trading firms and hedge funds in the market. Moreover, HFT firms are also unlikely to sustain their current positions in the market for too long, usually doing away with them before the end of the trading period. As a result, the Sharpe Ratio for HFT is considerably higher as compared to the usual buy and hold strategies traders use. This is the reason HFT traders compete with others of their ilk rather than against any long-term trader in the market.

How it Works

So, you might be curious to learn how HFT actually works. There are generally three main pointers which can be used to explain the HFT process:

1. HFT firms choose the exchange they want to place the order on. Since they have direct access, they are not required to employ the services of a broker. They make the decisions pertaining to the trade on their own. Cutting out the middleman is what enables them to save time.
2. HFT firms then execute their trades themselves or have a computer with a set of instructions programmed into it to do it for them. Of course, in case there are any variances, a trader has to manually execute the trade. That being said, it still enables them to make traders faster than is manually possible.
3. Having intricate knowledge of how the market works and how trades are executed is important. You need to know how orders are placed and processed as you cannot get any additional help or assistance. Therefore, it is a given that HFT firms have the requisite knowledge to benefit from HFT.

So, this is all you need to know about HFT and how it works. As you can see, it can prove to be a winning strategy, particularly if you can find a way to automate the process.

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MKTPlace is a leading digital and social media platform for traders and investors. MKTPlace offers premiere resources for trading and investing education, digital resources for personal finance, news about IoT, AI, Blockchain, Business, market analysis and education resources and guides.

Wall Street, along with the financial centres in London and Hong Kong, have become algorithm trading hubs where thousands of traders employ sophisticated algorithm programs to gauge the market trends and rely on the analytical superiority of these high powered super computer programs. Algorithm trading is carried out by mathematical robots and big data crawlers that still few people actually know about.

Believe it or not, algorithm trading is now done all over the globe which has led to the emergence of a new technological trend in financial industries of several developed nations. You have to admit that at times people fail to predict market volatilities, the bull and bear trends and a number of factors, which algorithm systems never overlook.

What is Algorithm Trading?

At its core, algorithm trading, which can also be referred to as high frequency or HF trading, is a trading process which is conducted by highly sophisticated computer programs. These programs determine various aspects of a trade, which include critical decisions like timing, trends and prices in the market and the all the factors associated with these factors that can either affect them positively or negatively.  These programs are also designed to function independently, which means they can if they choose to, execute an entire trade order without consulting the trader.

Who Uses Algorithm Trading Strategies?

High frequency or algorithm trading is most commonly conducted by traders belonging to mutual and pension funds and in some cases, institutional traders who aim to break down a big trade into smaller chunks solely to manage the impact and risks caused by it in the market. Algorithm systems are complex and are not meant for every trader. These programs are designed to search for crucial trading factors like the ups and downs in interest rates, minor fluctuation in the economy, important news and notification and a number other intricacies.

They look for areas where they can mark an existing opportunity that is before anyone else can mark them. The algorithm systems which are employed in today’s trading practices have the ability to disperse massive trading orders into manageable pieces so they could be used in a multitude of regions across the world and at a speed which will remain unmatched.

Why Use Algorithm Trading?

The central purpose of HF or algorithm trading is to reduce the risk involved in a trade as much as possible. They present traders with smaller deals which allow them to enter and exit the markets faster than any other trader, also allowing the HF trader to switch between different trading platforms and exchanges.

Moreover, all financial markets are now operated by various sophisticated and overly complex trading technologies which have given a considerable edge to most traders. At the moment in the financial markets, top companies like Goldman Sachs, Morgan Stanley, and Citi, along with Barclays have been using some complex computer programs and big data programming in the Forex markets, which are responsible for a majority of trading in worldwide markets.

75% of All World Trading Is Done Through Algorithms

According to statistics and analytical research done on high frequency trading, it has been identified that algorithm trading now accounts for 75% of all trading done in the world. And not only that, it was also discovered that market trends are established through not just the macroeconomic factors or data but they are also determined by the traders who vigorously compete against each other to see who comes out on top in terms of the fastest information processing and the most analytical business minds. These are backed by big numbers in financial algorithms which have the ability to evaluate massive amounts of data to determine top profits margins.

Algorithm Trading & the Forex Markets

Some of the best algorithm traders in the Forex market are interbank traders who have been incorporating algorithm trading for the past couple of years. However, it is important to realize that algorithm trading has not yet put most independent trades at a disadvantage because most traders are focused on the long-term and upon witnessing the increased liquidity in the financial markets along with stability in share prices, a majority of independent traders are now seeking to integrate their trading styles and strategies with algorithm trading techniques and technologies.

Forms of High Frequency Traders

There are varying forms of algorithm traders. There are many HF traders who are referred to as market swingers and employ trading strategies to trade mostly on signals to create a market through the provision of securities on every side of the buy and sell trade order.

Other algorithm traders use high frequency systems to try and get a fix on where the markets are headed in the short run. Irrespective of the trading strategies these HF traders use and implement, they all aim at one thing only: making massive amounts of money without increasing the risk involved in their trades.

In the past five years alone, there has been a considerable rise in the number of traders using algorithm trading systems and according to a statistical analysis report published by the Aite Group LLC, a Boston based firm, it was identified that a third of all trades that were conducted in Europe and the US in 2006 were carried forward through algorithmic programs. Keeping this number in mind, you can say that 2% of 20,000 US companies use algorithm trading, especially in the equity markets.

Matthew Rothman, an analyst at Barclays Capital, had this to say,

“Five years ago, ‘high-frequency’ traders, and few others considered the funds more than a niche strategy. However, the niche’s role now overshadows that of mainstream brokers mutual funds and hedge funds.”

All in all, it is safe to assume there is going to be a big change in trading trends now that most independent investors and traders have seen what algorithm trading can do for them. And the sole reason for its increase in popularity is its potential for making huge profits while minimizing risk.

Market Place

MKTPlace is a leading digital and social media platform for traders and investors. MKTPlace offers premiere resources for trading and investing education, digital resources for personal finance, news about IoT, AI, Blockchain, Business, market analysis and education resources and guides.