High-Frequency Trading (HFT): How does it work?

By
TradersDNA

HFT

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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