High-frequency trading (HFT) is the use of sophisticated technological tools to trade securities like stocks or options, and is typically characterized by several distinguishing features[1]:
In high-frequency trading, programs analyze market data to capture trading opportunities that may open up for only a fraction of a second to several hours.[2] High-frequency trading (HFT) uses computer programs and sometimes specialised hardware [3] to hold short-term positions in equities, options, futures, ETFs, currencies, and other financial instruments that possess electronic trading capability.[4] High-frequency traders compete on a basis of speed with other high-frequency traders, not long-term investors (who typically look for opportunities over a period of weeks, months, or years), and compete with each other for very small, consistent profits.[5][6] As a result, high-frequency trading has been shown to have a potential Sharpe ratio (measure of reward per unit of risk) thousands of times higher than the traditional buy-and-hold strategies.[7] By 2010 high-frequency trading accounted for over 70% of equity trades taking place in the US and was rapidly growing in popularity in Europe and Asia. Aiming to capture just a fraction of a penny per share or currency unit on every trade, high-frequency traders move in and out of such short-term positions several times each day. Fractions of a penny accumulate fast to produce significantly positive results at the end of every day.[5] High-frequency trading firms do not employ significant leverage, do not accumulate positions, and typically liquidate their entire portfolios on a daily basis.[6]
One financial industry source claims algorithmic trading, including high-frequency trading, substantially improves market liquidity.[6] An academic study shows[8] additional benefits, including lowering the costs of trading,[8] increasing the informativeness of quotes,[8] improved linkage between markets,[8] and other positive spillover effects, at least in quiescent or stable markets; the authors of this study also note that "it remains an open question whether algorithmic trading and algorithmic liquidity supply are equally beneficial in more turbulent or declining markets...algorithmic liquidity suppliers may simply turn off their machines when markets spike downward."[8]
Algorithmic and high-frequency trading were both found to have contributed to volatility on the May 6, 2010 Flash Crash, when high-frequency liquidity providers were in fact found to have withdrawn from the market.[9][10][11][12][13][14][15][16] A July, 2011 report by the International Organization of Securities Commissions (IOSCO), an international body of securities regulators, concluded that while "algorithms and HFT technology have been used by market participants to manage their trading and risk, their usage was also clearly a contributing factor in the flash crash event of May 6, 2010."[1][17]
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High-frequency trading has taken place at least since 1999, after the U.S. Securities and Exchange Commission (SEC) authorized electronic exchanges in 1998. At the turn of the 21st century HFT trades had an execution time of several seconds, whereas by 2010 this has decreased to milli- and even microseconds.[18] Until recently high-frequency trading was a little-known topic outside the financial sector, with an article published by the New York Times in July 2009 being one of the first to bring the subject to the public's attention.[19]
In the early 2000s, high-frequency trading still accounted for less than 10% of equity orders, but this proportion was soon to begin rapid growth. According to data from the NYSE, high-frequency trading grew by about 164% between 2005 and 2009.[19] As of the first quarter in 2009, total assets under management for hedge funds with high-frequency trading strategies were $141 billion, down about 21% from their peak before the worst of the crises.[20] The high-frequency strategy was first made successful by Renaissance Technologies.[21] Many high-frequency firms are market makers and provide liquidity to the market which has lowered volatility and helped narrow Bid-offer spreads making trading and investing cheaper for other market participants.[20] In the United States, high-frequency trading firms represent 2% of the approximately 20,000 firms operating today, but account for 73% of all equity orders volume.[22] The Bank of England estimate similar percentages for the 2010 US market share, also suggesting that in Europe HFT accounts for about 40% of equity orders volume and for Asia about 5-10%, with potential for rapid growth.[18] By value, HFT was estimated in 2010 by consultancy Tabb Group to make up 56% of equity trades in the US and 38% in Europe.[23]
High-frequency trading is quantitative trading that is characterized by short portfolio holding periods (see Wilmott (2008)). 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 volumes of information, something ordinary human traders cannot do. Specific algorithms are closely guarded by their owners and are known as "algos".
Most high-frequency trading strategies fall within one of the following trading strategies:[24]
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Market making is 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 [25] 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 trading strategy.[6] Automated Trading Desk, which was bought by Citigroup in July 2007, has been an active market maker, accounting for about 6% of total volume on both NASDAQ and the New York Stock Exchange.[26] Building up market making strategies typically involve precise modelling of the target market microstructure [27] together with stochastic control techniques.[28]
These strategies appear intimately related to the entry of new electronic venues. Academic study of Chi-X entry into the European equity market reveals that its launch coincided with a large HFT that made markets using both the incumbent market, NYSE-Euronext, and the new market, Chi-X. The study shows that the new market provided ideal conditions for HFT market-making, low fees (i.e., rebates for quotes that led to execution) and a fast system, yet the HFT was equally active in the incumbent market to offload nonzero positions. New market entry and HFT arrival are further shown to coincide with a significant improvement in liquidity supply.[29]
Much information happens to be unwittingly embedded in market data, such as quotes and volumes. By observing a flow of quotes, high-frequency trading machines 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.[30]
Certain recurring events generate predictable short-term response in a selected set of securities. High-frequency traders take advantage of such predictability to generate short-term profits.
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 relation 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. The TABB Group estimates that annual aggregate profits of high-frequency arbitrage strategies currently exceed US$21 billion.[31]
A separate, "naive" class of high-frequency trading strategies relies exclusively on ultra-low latency direct market access technology. 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.
Many high-frequency firms are market makers and provide liquidity to the market, which has lowered volatility and helped narrow Bid-offer spreads making trading and investing cheaper for other market participants.[6][20][32] One financial industry source claims algorithmic trading, including high-frequency trading, substantially improves market liquidity.[6] A recent academic study claims [8] additional benefits, including lowering the costs of trading,[8] increasing the informativeness of quotes,[8] improved linkage between markets,[8] and positive spillover effects[8]. The effects of algorithmic and high-frequency trading in volatile markets are the subject of ongoing research since regulators claim these practices contributed to volatility in the May 6, 2010 Flash Crash, as discussed later in this section.[9][10][11][12][13][16]
"The fast-growing practice of high-frequency trading, in which traders place vast flurries of securities trades, is speeding up execution times for all investors, making it cheaper to buy or sell and posing no risk to small investors." - Chicago Board Options Exchange[33]
The speeds of computer connections, measured in milliseconds or microseconds, have become important.[34][35]
More fully automated markets such as NASDAQ, Direct Edge, and BATS, in the US, have gained market share from less automated markets such as the NYSE. Economies of scale in electronic trading have contributed to lowering commissions and trade processing fees, and contributed to international mergers and consolidation of financial exchanges.
Competition is developing among exchanges for the fastest processing times for completing trades. For example in 2009 the London Stock Exchange bought a technology firm called MillenniumIT and announced plans to implement its Millennium Exchange platform[36] which they claim has an average latency of 126 microseconds.[37] Since then, competitive exchanges have continued to reduce latency and today, with turnaround times of three milliseconds available, are useful to traders to pinpoint the consistent and probable performance ranges of financial instruments. These professionals are often dealing in versions of stock index funds like the E-mini S&Ps because they seek consistency and risk-mitigation along with top performance. They must filter market data to work into their software programming so that there is the lowest latency and highest liquidity at the time for placing stop-losses and/or taking profits. With high volatility in these markets, this becomes a complex and potentially nerve-wracking endeavor, where a small mistake can lead to a large loss. Absolute frequency data play into the development of the trader's pre-programmed instructions.[38]
Spending on computers and software in the financial industry increased to $26.4 billion in 2005.[39]
The brief but dramatic stock market crash of May 6, 2010 was originally alleged to be caused by high-frequency trading.[40] However, CME Group, a large futures exchange, stated that, insofar as stock index futures traded on CME Group were concerned, its investigation had found no support for the notion high-frequency trading was related to the crash, and actually stated it had a market stabilizing effect.[41] This conclusion is contradicted in a report on the Flash Crash by the U.S. Securities and Exchange Commission and the Commodity Futures Trading Commission, where regulators stated that the actions of high-frequency trading firms on May 6, 2010 contributed to volatility during the crash.[9][10][11][12][13][14][15][16] Despite the original perception high-frequency traders typically cause no market price impact,[6] and have a stabilizing effect in times of volatility,[6][32][41] and some suggests may actually have been a major factor in minimizing and partially reversing the flash crash,[42] though later reports determined that high-frequency trading had significant price impact and a destabilizing role during the Flash Crash, helping to drive prices down.[9][10][11][12]
After almost five months of investigations, the U.S. Securities and Exchange Commission and the Commodity Futures Trading Commission issued a joint report identifying the cause that set off the sequence of events leading to the Flash crash.[43] The report found that the cause was a single sale of $4.1 billion in futures contracts by a mutual fund, identified as Waddell & Reed Financial, in an aggressive attempt to hedge its investment position.[44][45] The joint report also found that "high-frequency traders quickly magnified the impact of the mutual fund's selling."[9] The joint report "portrayed a market so fragmented and fragile that a single large trade could send stocks into a sudden spiral," that a large mutual fund firm "chose to sell a big number of futures contracts using a computer program that essentially ended up wiping out available buyers in the market," that as a result high-frequency firms "were also aggressively selling the E-mini contracts," contributing to rapid price declines.[9] The joint report also noted "'HFTs began to quickly buy and then resell contracts to each other—generating a 'hot-potato' volume effect as the same positions were passed rapidly back and forth.'" [9] The combined sales by Waddell and high-frequency firms quickly drove "the E-mini price down 3% in just four minutes." [9] As prices in the futures market fell, there was a spillover into the equities markets where "the liquidity in the market evaporated because the automated systems used by most firms to keep pace with the market paused" and scaled back their trading or withdrew from the markets altogether.[9] The joint report then noted that "Automatic computerized traders on the stock market shut down as they detected the sharp rise in buying and selling." [11] As computerized high-frequency traders exited the stock market, the resulting lack of liquidity "...caused shares of some prominent companies like Procter & Gamble and Accenture to trade down as low as a penny or as high as $100,000." [11] While some firms exited the market, high-frequency firms that remained in the market exacerbated price declines because they "'escalated their aggressive selling' during the downdraft."[11]
High-frequency trading has been the subject of intense public focus since regulators claimed these practices as contributing to volatility on May 6, 2010, popularly known as the 2010 Flash Crash,[9][10][11][12][13][14][15][16] a United States stock market crash on May 6, 2010 in which the Dow Jones Industrial Average plunged to its largest intraday point loss, but not percentage loss[46] in history, only to recover much of those losses within minutes.[47] Another area of controversy, related to SEC and CFTC findings in its joint report on the Flash Crash that equity market "market makers and other liquidity providers widened their quote spreads, others reduced offered liquidity, and a significant number withdrew completely from the markets"[43] during the Flash Crash, is whether high-frequency market makers should be subject to regulations that would require them to stay active in volatile markets.[48] As SEC Chairman Mary Schapiro said in a speech on September 22, 2010, "...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." [49]
Despite studies reporting positive findings about high-frequency trading, including that high-frequency trading reduces volatility and does not pose a systemic risk,[6][32][33][41] and both lowers transaction costs for retail investors,[8][32][33] and at the same time does so without impacting long term investors,[5][6][33] high-frequency trading is the subject of increased debate.[50] This debate has been fueled by U.S. Securities and Exchange Commission and Commodity Futures Trading Commission empirical findings that high-frequency trading contributed to volatility on the May 6, 2010 Flash Crash.[9][10][11][12][13][14][15][16] Politicians, regulators, journalists and market participants have all raised concerns on both sides of the Atlantic.[23][50][51] In September 2010, SEC chairperson Mary Schapiro signaled that US authorities were considering the introduction of regulations targeted at HFT, such as a minimum "time in force" rule, to prevent buy orders being canceled very soon after being issued. Criticisms of this proposed law are that currently exchanges allow excess message traffic to queue up at their servers' ports, where it is processed sequentially at a fixed rate and as a result poses no threat to the exchanges.[6] In addition to this equity options markets produce far more message volume than equity markets and has consistently handled the data without issue.[6] Some HFT systems cancel many of their orders almost immediately after placing them as they don't intend the trades to carry through, the false orders are used as part of a pinging tactic to discover the upper price other traders are willing to pay.[50] Some high-frequency trading firms state so many orders get canceled because the orders people get are not the same ones they send. This happens frequently because of an existing regulation regarding re-priced orders.[6]
Another area of concern relates to flash trading. Flash trading is where certain market participants are allowed to see incoming orders to buy or sell securities very slightly earlier than the general market participants, typically 30 milliseconds, in exchange for a fee. According to some sources, the programs can inspect major orders as they come in and use that information to profit.[4] Currently, the majority of exchanges either do not offer flash trading, or have discontinued it, although the exchange Direct Edge currently does offer it to participants. Direct Edge's response to this is the data that flash trading reduces market impact, increases average size of executed orders, reduces trading latency, and provides additional liquidity.[52] Direct Edge also allows all of its subscribers to determine whether they want their orders to participate in flash trading or not so brokers have the option to opt-out of flash orders on behalf of their clients if they choose to.[52] Due to the fact that market participants can choose to utilize it for additional liquidity or not participate in it at all Direct Edge believes the controversy is overstated stating:
"Misconceptions respecting flash technology have, to date, stirred a passionate but ill informed debate."[52]
CounterPunch, a bi-weekly political newsletter contends this creates a two-tiered market in which a certain class of traders can unfairly exploit others, akin to front running.[53] Exchanges claim that the procedure benefits all traders by creating more market liquidity and the opportunity for price improvement.
Direct Edge's response to the "two-tiered market" criticism is as follows:
"First it is difficult to address concerns that may result, particularly when there is no empirical data to support such a result. Furthermore, we do not view technology that instantaneously aggregates passive and aggressive liquidity as creating a two-tier market. Rather, flash technology democratizes access to the non-displayed market and in this regard, removes different "tiers" in market access. Additionally, any subscriber of Direct Edge can be a recipient of flashed orders."[52]
Advanced computerized trading platforms and market gateways are becoming standard tools of most types of traders, including high-frequency traders. Broker-dealers now compete on routing order flow directly, in the fastest and most efficient manner, to the line handler where it undergoes a strict set of Risk Filters before hitting the execution venue(s). Ultra Low Latency Direct Market Access (ULLDMA) is a hot topic amongst Brokers and Technology vendors such as Goldman Sachs, Credit Suisse, and UBS. Typically, ULLDMA systems can currently handle high amounts of volume and boast round-trip order execution speeds (from hitting "transmit order" to receiving an acknowledgment) of 10 milliseconds and under.
Such performance is achieved with the use of hardware acceleration or even full-hardware processing of incoming Market data, in association with high-speed communication protocols, such as 10 Gigabit Ethernet or PCI Express. More specifically, some companies provide full-hardware appliances based on FPGA to obtain sub-microsecond end-to-end Market data processing.[54]
In the US equity markets, some of the highest volume high-frequency traders include Knight Capital Group, Getco LLC, Citadel LLC, Hudson River Trading, Virtu Financial, and Tower Research Capital. .
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