High-frequency trading (HFT) has become a hot topic in the investing world, leading many to wonder if it’s a strategy worth exploring. As seasoned investor Daniel Calugar explains, HFT is a form of algorithmic trading that allows for the execution of multiple trades at lightning-fast speeds, far beyond the capacity of a human trader.
For this strategy to be successful, it relies on the implementation of sophisticated computer algorithms and specialized hardware. Although HFT can offer significant advantages in terms of efficiency and liquidity, it has also attracted regulatory attention and sparked debates in the industry.
Below, Dan Calugar will take an in-depth look at what high-frequency trading is, what some of its advantages and disadvantages are, who it might be a fit for, and how it’s regulated in different markets throughout the world.
High-Frequency Trading Explained
As mentioned, high-frequency trading is an algorithmic trading strategy that involves using high-powered computers to execute trades automatically without the need for manual human intervention every time a trade is made.
HFT involves a large volume of transactions being executed in a very tight window to take advantage of market discrepancies. For it to work properly, high-frequency trading systems must be able to work lightning-quick — much faster than a human brain could even process that an advantageous opportunity has presented itself.
Daniel Calugar says that to execute the strategy, the system needs complex algorithms that will analyze thousands of individual stocks at the same time, comparing them with market data to see if there are any trends about to emerge. Once the algorithm identifies the prime investment opportunities, it will use the high-frequency trading system to execute the trades automatically.
In many cases, high-frequency trading aims to take advantage of market inequities for short-term returns. In other words, it’s not often used as a central part of long-term investment strategies.
With a short-term horizon in mind for these investments, every millisecond counts, which is why computers are needed to power the strategy rather than humans. In effect, high-frequency trading has opened an entirely new avenue of trading to the investment market.
Advantages of High-Frequency Trading
There are many advantages of high-frequency trading. We’ll describe some of the main ones in the sections below.
Profit from Small Fluctuations
Investors can take advantage of even the smallest price fluctuations through high-frequency trading. Since the trades are being executed at such a high volume and with such precision, even a few cents here or there in price can result in huge profits.
This would be very difficult for investors to do on their own. However, with the assistance of complex algorithms, traders can identify the best opportunities to invest at the exact best time to do so. And the advanced computer systems can ensure that the trades are executed perfectly – not one second too late.
Profit from Quick Changes
When well-respected investors execute major trades, the market often takes notice and then follows that with similar trades of their own. It’s a race against the clock, though, as the initial trade by the influential investor usually moves the price instantly.
If you aren’t one of the first to pick up on these trades, you could get a bad price.
High-frequency trading, by contrast, allows traders to take advantage of major moves made by well-respected investors. For example, when someone like Warren Buffet executes a trade based on a short-term position, the algorithm can pick up on this and execute a similar trade. This gives you the opportunity to buy (or sell) at a similar price to what Buffet got in this example.
Analyze Massive Amounts of Information
The most powerful aspect of these complex algorithms and high-powered computer systems is the fact that they can analyze massive amounts of information all at the same time. They can be set to scan multiple exchanges and markets simultaneously while applying the same set of trading principles to each.
This allows traders to expand their investment horizons way beyond what they would be able to do on their own with manual systems. Instead of focusing on a narrow set of markets, asset classes, or exchanges, high-frequency trading can identify the prime opportunities in every market, asset class, and exchange.
Dan Calugar points out that many investors who are HFT proponents believe that it brings enhanced liquidity to the investment markets. In addition, since the trades are executed much faster, and at much higher volumes with high-frequency trading, the argument is that competition is increased as a result.
More liquid markets often result in lower risk, which helps to even out the playing field for all traders – regardless of whether they’re using high-frequency trading or more traditional strategies. It also balances out prices on both sides of a transaction – the price at which one wants to sell and the price at which one wants to buy.
Finally, this increased competition helps to ensure that prices are much more accurate than if there aren’t as many players.
Disadvantages of High-Frequency Trading
As you can see, there are plenty of advantages of high-frequency trading. Like anything, though, there are some major disadvantages or, rather, risks. Daniel Calugar will explain some of the main disadvantages below.
Larger Risks of Significant Losses
Most high-frequency traders will only look to make a profit equivalent to a cent or less per share. Since they only intend to hold onto the investment for a very short period – and since they’ll be making very large volumes of trades – this will be enough to produce huge profits.
This is very different from traditional investors, who typically take longer positions on investments and would need more significant price increases – or decreases – to profit.
When high-frequency traders are right, they can turn a few cents here and there into significant profits. But, at the same time, they put a lot of eggs in one basket, so to speak.
Dan Calugar says that relying on very small per-share profits presents a large amount of risk for high-frequency traders that otherwise wouldn’t be seen in other investment strategies.
‘Ghost Liquidity’ is All That’s Created
While many proponents of high-frequency trading say it brings extra liquidity to markets, those on the other side of the argument say that it only creates “ghost liquidity.” That’s because the assets are held onto only for a very short amount of time.
As a result, the money that’s pumped into these assets disappears seemingly as fast as it appeared in the market. This means that ordinary investors never even get to take advantage of the extra liquidity since it’s not really there.
There’s a school of thought that high-frequency trading actually creates high volatility in various markets. Because the volume of the trades is so large, one single order – which could equal thousands of shares or more – can move the price of an asset very suddenly.
So, a price that was around one second is not only gone the next, but it’s significantly higher or lower than it was. In this way, some investors believe that high-frequency trading is actually influencing markets in arbitrary ways rather than really taking advantage of technology to help investors make more informed trades.
For high-frequency trading to work, one must have high-powered computers and reliable high-speed internet. Without either one of those components, HFT simply wouldn’t be possible. Even a temporary blip in internet service could cause a major disruption in the algorithm, which could result in either missed opportunities or ill-timed trades.
In this way, high-frequency trading is really an inequitable practice. Those who don’t have reliable high-speed internet, or don’t have the means to purchase the necessary high-powered technology, won’t be able to take advantage of high-frequency trading strategies.
This “pads the pockets,” in other words, of traders close to major urban areas with reliable internet and who have the funds to invest significantly in the technology that will power the strategy from the back end.
Antithesis of Traditional Trading
According to Daniel Calugar, some critics of high-frequency trading will say it is the antithesis of what traditional trading is all about. Instead of studying markets and individual assets over time and making decisions that will benefit their portfolio over the long run, those who use high-frequency trading are only interested in massive short-term profits.
They rely much more on math and algorithms than they do on intuition, know-how, market analysis, and investment experience. They only look to take advantage of inequities in the market on a very short-term basis. They don’t care what the asset is that they’re buying – or selling – or whether it fits in with their other investment strategies.