In financial markets, high-frequency trading HFT is a type of algorithmic trading characterized by high speeds, high turnover rates, and high order-to-trade ratios that leverages high-frequency financial data and electronic trading tools. A substantial body of research argues that HFT and electronic trading pose new types of challenges to the financial system. High-frequency trading has taken place at least since the s, mostly in the form of specialists and pit traders buying and selling positions at the physical location of the exchange, with high-speed telegraph service to other exchanges.
On September 2, , Italy became the world's first country to introduce a tax specifically targeted at HFT, charging a levy of 0. The high-frequency strategy was first made popular by Renaissance Technologies  who use both HFT and quantitative aspects in their trading. Many high-frequency firms are market makers and provide liquidity to the market which lowers volatility and helps narrow bid-offer spreads , making trading and investing cheaper for other market participants.
As HFT strategies become more widely used, it can be more difficult to deploy them profitably. Though the percentage of volume attributed to HFT has fallen in the equity markets , it has remained prevalent in the futures markets. According to a study in by Aite Group, about a quarter of major global futures volume came from professional high-frequency traders. High-frequency trading is quantitative trading that is characterized by short portfolio holding periods  All portfolio-allocation decisions are made by computerized quantitative models.
The success of high-frequency trading strategies is largely driven by their ability to simultaneously process large volumes of information, something ordinary human traders cannot do. Specific algorithms are closely guarded by their owners. Many practical algorithms are in fact quite simple arbitrages which could previously have been performed at lower frequency—competition tends to occur through who can execute them the fastest rather than who can create new breakthrough algorithms.
The common types of high-frequency trading include several types of market-making, event arbitrage, statistical arbitrage, and latency arbitrage. Most high-frequency trading strategies are not fraudulent, but instead exploit minute deviations from market equilibrium. A "market maker" is a firm that stands ready to buy and sell a particular stock on a regular and continuous basis at a publicly quoted price.
You'll most often hear about market makers in the context of the Nasdaq or other "over the counter" OTC markets. Market makers that stand ready to buy and sell stocks listed on an exchange, such as the New York Stock Exchange , are called "third market makers.
Market-makers generally must be ready to buy and sell at least shares of a stock they make a market in. As a result, a large order from an investor may have to be filled by a number of market-makers at potentially different prices. There can be a significant overlap between a 'market maker' and 'HFT firm'. HFT firms characterize their business as "Market making -- a set of high-frequency trading strategies that involve placing a limit order to sell or offer or a buy limit order or bid in order to earn the bid-ask spread.
By doing so, market makers provide counterpart to incoming market orders. Although the role of market maker was traditionally fulfilled by specialist firms, this class of strategy is now implemented by a large range of investors, thanks to wide adoption of direct market access.
As pointed out by empirical studies  this renewed competition among liquidity providers causes reduced effective market spreads, and therefore reduced indirect costs for final investors.
Some high-frequency trading firms use market making as their primary strategy. Building up market making strategies typically involves precise modeling of the target market microstructure   together with stochastic control techniques. These strategies appear intimately related to the entry of new electronic venues.
The study shows that the new market provided ideal conditions for HFT market-making, low fees i. New market entry and HFT arrival are further shown to coincide with a significant improvement in liquidity supply. The Michael Lewis book Flash Boys: A Wall Street Revolt discusses high-frequency trading, including the tactics of spoofing , layering and quote stuffing, which are all now illegal.
Much information happens to be unwittingly embedded in market data, such as quotes and volumes. By observing a flow of quotes, computers are capable of extracting information that has not yet crossed the news screens.
Since all quote and volume information is public, such strategies are fully compliant with all the applicable laws. Filter trading is one of the more primitive high-frequency trading strategies that involves monitoring large amounts of stocks for significant or unusual price changes or volume activity. This includes trading on announcements, news, or other event criteria. Software would then generate a buy or sell order depending on the nature of the event being looked for.
Tick trading often aims to recognize the beginnings of large orders being placed in the market. For example, a large order from a pension fund to buy will take place over several hours or even days, and will cause a rise in price due to increased demand. An arbitrageur can try to spot this happening then buy up the security, then profit from selling back to the pension fund. This strategy has become more difficult since the introduction of dedicated trade execution companies in the s which provide optimal trading for pension and other funds, specifically designed to remove the arbitrage opportunity.
Certain recurring events generate predictable short-term responses in a selected set of securities. Another set of high-frequency trading strategies are strategies that exploit predictable temporary deviations from stable statistical relationships among securities.
Statistical arbitrage at high frequencies is actively used in all liquid securities, including equities, bonds, futures, foreign exchange, etc. Such strategies may also involve classical arbitrage strategies, such as covered interest rate parity in the foreign exchange market , which gives a relationship between the prices of a domestic bond, a bond denominated in a foreign currency, the spot price of the currency, and the price of a forward contract on the currency.
High-frequency trading allows similar arbitrages using models of greater complexity involving many more than four securities. Index arbitrage exploits index tracker funds which are bound to buy and sell large volumes of securities in proportion to their changing weights in indices.
If a HFT firm is able to access and process information which predicts these changes before the tracker funds do so, they can buy up securities in advance of the trackers and sell them on to them at a profit. Company news in electronic text format is available from many sources including commercial providers like Bloomberg, public news websites, and Twitter feeds. Automated systems can identify company names, keywords and sometimes semantics to trade news before human traders can process it.
In these strategies, computer scientists rely on speed to gain minuscule advantages in arbitraging price discrepancies in some particular security trading simultaneously on disparate markets. Another aspect of low latency strategy has been the switch from fiber optic to microwave technology for long distance networking.
Especially since , there has been a trend to use microwaves to transmit data across key connections such as the one between New York City and Chicago. High-frequency trading strategies may use properties derived from market data feeds to identify orders that are posted at sub-optimal prices.
Such orders may offer a profit to their counterparties that high-frequency traders can try to obtain. Examples of these features include the age of an order  or the sizes of displayed orders. The effects of algorithmic and high-frequency trading are the subject of ongoing research.
High frequency trading causes regulatory concerns as a contributor to market fragility. Members of the financial industry generally claim high-frequency trading substantially improves market liquidity,  narrows bid-offer spread , lowers volatility and makes trading and investing cheaper for other market participants.
An academic study  found that, for large-cap stocks and in quiescent markets during periods of "generally rising stock prices", high-frequency trading lowers the cost of trading and increases the informativeness of quotes; : They looked at the amount of quote traffic compared to the value of trade transactions over 4 and half years and saw a fold decrease in efficiency.
This makes it difficult for observers to pre-identify market scenarios where HFT will dampen or amplify price fluctuations. The growing quote traffic compared to trade value could indicate that more firms are trying to profit from cross-market arbitrage techniques that do not add significant value through increased liquidity when measured globally.
Economies of scale in electronic trading contributed to lowering commissions and trade processing fees, and contributed to international mergers and consolidation of financial exchanges. The speeds of computer connections, measured in milliseconds or microseconds, have become important. For example, in the London Stock Exchange bought a technology firm called MillenniumIT and announced plans to implement its Millennium Exchange platform  which they claim has an average latency of microseconds.
The brief but dramatic stock market crash of May 6, was initially thought to have been caused by high-frequency trading. In the aftermath of the crash, several organizations argued that high-frequency trading was not to blame, and may even have been a major factor in minimizing and partially reversing the Flash Crash. However, after almost five months of investigations, the U. Securities and Exchange Commission SEC and the Commodity Futures Trading Commission CFTC issued a joint report identifying the cause that set off the sequence of events leading to the Flash Crash  and concluding that the actions of high-frequency trading firms contributed to volatility during the crash.
In the Paris-based regulator of the nation European Union, the European Securities and Markets Authority , proposed time standards to span the EU, that would more accurately synchronize trading clocks "to within a nanosecond, or one-billionth of a second" to refine regulation of gateway-to-gateway latency time— "the speed at which trading venues acknowledge an order after receiving a trade request. The fastest technologies give traders an advantage over other "slower" investors as they can change prices of the securities they trade.
High-frequency trading comprises many different types of algorithms. High-frequency trading has been the subject of intense public focus and debate since the May 6, Flash Crash. In their joint report on the Flash Crash, the SEC and the CFTC stated that "market makers and other liquidity providers widened their quote spreads, others reduced offered liquidity, and a significant number withdrew completely from the markets"  during the flash crash.
Politicians, regulators, scholars, journalists and market participants have all raised concerns on both sides of the Atlantic. She said, "high frequency trading firms have a tremendous capacity to affect the stability and integrity of the equity markets. Currently, however, high frequency trading firms are subject to very little in the way of obligations either to protect that stability by promoting reasonable price continuity in tough times, or to refrain from exacerbating price volatility.
In an April speech, Berman argued: I worry that it may be too narrowly focused and myopic. The Chicago Federal Reserve letter of October , titled "How to keep markets safe in an era of high-speed trading", reports on the results of a survey of several dozen financial industry professionals including traders, brokers, and exchanges.
The CFA Institute , a global association of investment professionals, advocated for reforms regarding high-frequency trading,  including:. Many people misunderstand "Flash Trading" and believe it to be a major concern. They believe flash trading is a form of trading in which certain market participants are allowed to see incoming orders to buy or sell securities very slightly earlier than the general market participants in exchange for a fee.
In actuality, exchanges previously offered a type of order called a "Flash" order on NASDAQ, it was called "Bolt" on the Bats stock exchange that allowed an order to lock the market post at the same price as an order on the other side of the book for a small amount of time 5 milliseconds.
This order type was available to all participants but since HFT's adapted to the changes in market structure more quickly than others, they were able to use it to "jump the queue" and place their orders before other order types were allowed to trade at the given price. Currently, the majority of exchanges do not offer flash trading, or have discontinued it.
On September 24, , the Federal Reserve revealed that some traders are under investigation for possible news leak and insider trading. However, the news was released to the public in Washington D.
Octeg violated Nasdaq rules and failed to maintain proper supervision over its stock trading activities. Nasdaq determined the Getco subsidiary lacked reasonable oversight of its algo-driven high-frequency trading. Knight was found to have violated the SEC's market access rule, in effect since to prevent such mistakes. Regulators stated the HFT firm ignored dozens of error messages before its computers sent millions of unintended orders to the market.
According to the SEC's order, for at least two years Latour underestimated the amount of risk it was taking on with its trading activities. By using faulty calculations, Latour managed to buy and sell stocks without holding enough capital. The SEC noted the case is the largest penalty for a violation of the net capital rule. In response to increased regulation, some   have argued that instead of promoting government intervention, it would be more efficient to focus on a solution that mitigates information asymmetries among traders and their backers.
These exchanges offered three variations of controversial "Hide Not Slide"  orders and failed to accurately describe their priority to other orders.More...